Analysis for Financial Management

Analysis for Financial Management E l e v en t h Ed i t i o n



Analysis for Financial Management



The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate

Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

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Analysis for Financial Management

Eleventh Edition

ROBERT C. HIGGINS Marguerite Reimers

Emeritus Professor of Finance The University of Washington


JENNIFER L. KOSKI John B. and Delores L. Fery

Faculty Fellow Associate Professor of Finance The University of Washington


TODD MITTON Ned C. Hill Professor of Finance Brigham Young University




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In memory of my son






Preface xi

PART ONE Assessing the Financial Health of the Firm 1

1 Interpreting Financial Statements 3

2 Evaluating Financial Performance 39

PART TWO Planning Future Financial Performance 79

3 Financial Forecasting 81 4 Managing Growth 115

PART THREE Financing Operations 141

5 Financial Instruments and Markets 143

6 The Financing Decision 195

PART FOUR Evaluating Investment Opportunities 237

7 Discounted Cash Flow Techniques 239

8 Risk Analysis in Investment Decisions 289

9 Business Valuation and Corporate Restructuring 343



Brief Contents



Preface xi


Chapter 1 Interpreting Financial Statements 3 The Cash Flow Cycle 3 The Balance Sheet 6

Current Assets and Liabilities 11 Shareholders’ Equity 12

The Income Statement 12 Measuring Earnings 12

Sources and Uses Statements 17 The Two-Finger Approach 18

The Cash Flow Statement 19 Financial Statements and the

Value Problem 24 Market Value vs. Book Value 24 Economic Income vs. Accounting Income 27 Imputed Costs 28

Summary 31 Additional Resources 32 Problems 33

Chapter 2 Evaluating Financial Performance 39 The Levers of Financial Performance 39 Return on Equity 40

The Three Determinants of ROE 40 The Profit Margin 42 Asset Turnover 44 Financial Leverage 49

Is ROE a Reliable Financial Yardstick? 55 The Timing Problem 56 The Risk Problem 56

The Value Problem 58 ROE or Market Price? 59

Ratio Analysis 62 Using Ratios Effectively 62 Ratio Analysis of Stryker Corporation 63

Summary 71 Additional Resources 72 Problems 73


Chapter 3 Financial Forecasting 81 Pro Forma Statements 81

Percent-of-Sales Forecasting 82 Interest Expense 88 Seasonality 89

Pro Forma Statements and Financial Planning 89

Computer-Based Forecasting 90 Coping with Uncertainty 94

Sensitivity Analysis 94 Scenario Analysis 95 Simulation 96

Cash Flow Forecasts 98 Cash Budgets 99 The Techniques Compared 102 Planning in Large Companies 103 Summary 105 Additional Resources 106 Problems 108

Chapter 4 Managing Growth 115 Sustainable Growth 116

The Sustainable Growth Equation 116 vii




viii Contents

Too Much Growth 119 Balanced Growth 119 Under Armour’s Sustainable Growth Rate 121 “What If” Questions 122

What to Do When Actual Growth Exceeds Sustainable Growth 122

Sell New Equity 123 Increase Leverage 125 Reduce the Payout Ratio 125 Profitable Pruning 126 Outsourcing 127 Pricing 127 Is Merger the Answer? 127

Too Little Growth 128 What to Do When Sustainable Growth

Exceeds Actual Growth 129 Ignore the Problem 130 Return the Money to Shareholders 130 Buy Growth 131

Sustainable Growth and Pro Forma Forecasts 132

New Equity Financing 132 Why Don’t U.S. Corporations Issue More

Equity? 135 Summary 136 Additional Resources 137 Problems 138


Chapter 5 Financial Instruments and Markets 143 Financial Instruments 144

Bonds 145 Common Stock 152 Preferred Stock 156

Financial Markets 158 Venture Capital Financing 158 Private Equity 160 Initial Public Offerings 162

Seasoned Issues 163 Issue Costs 168

Efficient Markets 169 What Is an Efficient Market? 170 Implications of Efficiency 172

Appendix Using Financial Instruments to Manage Risks 174

Forward Markets 175 Speculating in Forward Markets 176 Hedging in Forward Markets 177 Hedging in Money and Capital Markets 180 Hedging with Options 180 Limitations of Financial Market Hedging 183 Valuing Options 185

Summary 188 Additional Resources 189 Problems 191

Chapter 6 The Financing Decision 195 Financial Leverage 197 Measuring the Effects of Leverage on a

Business 201 Leverage and Risk 203 Leverage and Earnings 206

How Much to Borrow 208 Irrelevance 208 Tax Benefits 210 Distress Costs 211 Flexibility 215 Market Signaling 217 Management Incentives 220 The Financing Decision and Growth 221

Selecting a Maturity Structure 224 Inflation and Financing Strategy 225

Appendix The Irrelevance Proposition 225

No Taxes 226 Taxes 228

Summary 230 Additional Resources 231 Problems 232



Contents ix


Chapter 7 Discounted Cash Flow Techniques 239 Figures of Merit 240

The Payback Period and the Accounting Rate of Return 241

The Time Value of Money 242 Equivalence 247 The Net Present Value 248 The Benefit-Cost Ratio 250 The Internal Rate of Return 250 Uneven Cash Flows 254 A Few Applications and Extensions 255 Mutually Exclusive Alternatives and Capital

Rationing 259 The IRR in Perspective 260

Determining the Relevant Cash Flows 260

Depreciation 262 Working Capital and Spontaneous

Sources 264 Sunk Costs 265 Allocated Costs 266 Cannibalization 267 Excess Capacity 268 Financing Costs 270

Appendix Mutually Exclusive Alternatives and

Capital Rationing 272 What Happened to the Other

$578,000? 273 Unequal Lives 274 Capital Rationing 277 The Problem of Future Opportunities 278 A Decision Tree 279

Summary 280 Additional Resources 281 Problems 282

Chapter 8 Risk Analysis in Investment Decisions 289 Risk Defined 291

Risk and Diversification 293 Estimating Investment Risk 295

Three Techniques for Estimating Investment Risk 296

Including Risk in Investment Evaluation 297 Risk-Adjusted Discount Rates 297

The Cost of Capital 298 The Cost of Capital Defined 299 Cost of Capital for Stryker Corporation 301 The Cost of Capital in Investment Appraisal 308 Multiple Hurdle Rates 309

Four Pitfalls in the Use of Discounted Cash Flow Techniques 311

The Enterprise Perspective versus the Equity Perspective 312

Inflation 314 Real Options 315 Excessive Risk Adjustment 321

Economic Value Added 322 EVA and Investment Analysis 323 EVA’s Appeal 325

A Cautionary Note 326 Appendix Asset Beta and Adjusted Present

Value 326 Beta and Financial Leverage 327 Using Asset Beta to Estimate Equity

Beta 328 Asset Beta and Adjusted Present Value 329

Summary 332 Additional Resources 333 Problems 335

Chapter 9 Business Valuation and Corporate Restructuring 343 Valuing a Business 345

Assets or Equity? 346



x Contents

Dead or Alive? 346 Minority Interest or Control? 348

Discounted Cash Flow Valuation 349 Free Cash Flow 350 The Terminal Value 351 A Numerical Example 354 Problems with Present Value Approaches to

Valuation 357 Valuation Based on Comparable Trades 357

Lack of Marketability 361 The Market for Control 362

The Premium for Control 362 Financial Reasons for Restructuring 364

The Empirical Evidence 372 The Cadbury Buyout 374 Appendix The Venture Capital Method of

Valuation 376 The Venture Capital Method—One

Financing Round 377

The Venture Capital Method—Multiple Financing Rounds 380

Why Do Venture Capitalists Demand Such High Returns? 382

Summary 384 Additional Resources 385 Problems 386

Glossary 393 Suggested Answers to

Odd-Numbered Problems 405 Index 437





Like its predecessors, the eleventh edition of Analysis for Financial Man- agement is for nonfinancial executives and business students interested in the practice of financial management. It introduces standard techniques and recent advances in a practical, intuitive way. The book assumes no prior background beyond a rudimentary, and perhaps rusty, familiarity with financial statements—although a healthy curiosity about what makes business tick is also useful. Emphasis throughout is on the managerial im- plications of financial analysis.

Analysis for Financial Management should prove valuable to individuals interested in sharpening their managerial skills and to executive program participants. The book has also found a home in university classrooms as the sole text in Executive MBA and applied finance courses, as a compan- ion text in case-oriented courses, and as a supplementary reading in more theoretical finance courses.

Analysis for Financial Management is my attempt to translate into another medium the enjoyment and stimulation I have received over the past four decades working with executives and college students. This experience has convinced me that financial techniques and concepts need not be abstract or obtuse; that recent advances in the field such as agency theory, market sig- naling, market efficiency, capital asset pricing, and real options analysis are important to practitioners; and that finance has much to say about the broader aspects of company management. I also believe that any activity in which so much money changes hands so quickly cannot fail to be interesting.

Part One looks at the management of existing resources, including the use of financial statements and ratio analysis to assess a company’s finan- cial health, its strengths, weaknesses, recent performance, and future prospects. Emphasis throughout is on the ties between a company’s oper- ating activities and its financial performance. A recurring theme is that a business must be viewed as an integrated whole and that effective financial management is possible only within the context of a company’s broader operating characteristics and strategies.

The rest of the book deals with the acquisition and management of new resources. Part Two examines financial forecasting and planning with par- ticular emphasis on managing growth and decline. Part Three considers the financing of company operations, including a review of the principal security types, the markets in which they trade, and the proper choice of security type by the issuing company. The latter requires a close look at fi- nancial leverage and its effects on the firm and its shareholders.



Part Four addresses the use of discounted cash flow techniques, such as the net present value and the internal rate of return, to evaluate invest- ment opportunities. It also deals with the difficult task of incorporating risk into investment appraisal. The book concludes with an examination of business valuation and company restructuring within the context of the ongoing debate over the proper roles of shareholders, boards of directors, and incumbent managers in governing America’s public corporations.

An extensive glossary of financial terms and suggested answers to odd- numbered, end-of-chapter problems follow the last chapter.

Changes in the Eleventh Edition Readers familiar with earlier editions of Analysis for Financial Management will notice a number of changes here. Most important, two talented young teachers and scholars have joined me in preparing the eleventh edition. Jennifer Koski, a colleague at the University of Washington, and Todd Mitton, at Brigham Young University, have done yeomen’s work ushering the book into the digital era. I much appreciate their many contributions. You should expect their responsibilities to grow in any future editions.

A second noteworthy change is the book’s partnership with McGraw- Hill’s Connect. As the following section explains in more detail, Connect is the lynchpin of the publisher’s digital initiative. Combining elements of computerized instruction and electronic publishing, it promises signifi- cant benefits to readers and instructors alike. I am anxious to watch McGraw-Hill turn this promise into reality. There will undoubtedly be bumps along the way, but I am confident we are on the right path.

Other more conventional changes and refinements in the eleventh edi- tion include:

• An introductory discussion of crowdfunding and its possible future. • A new treatment of present value calculations, gracefully introducing

computer spreadsheets as the principal means for solving present value problems, while eliminating reference to present value tables.

• Explicit discussion of present value problems involving uneven cash flows. • Enhanced ‘recommended resources’ at the end of each chapter,

including two-dimensional bar codes (QR codes) and recommended mobile apps for Android and iOS devices.

• Added discussion of payout policy, illustrated by Apple Inc.’s recent experience.

• Updated details on the impact of U.S. regulation on financial manage- ment, including the Dodd-Frank Act and the JOBS Act of 2012.

• Better integration of T-accounts and financial statements. • Use of Stryker Corporation, a leading medical technology company, as

an extended example throughout the book.

xii Preface



McGraw-Hill’s Connect

McGraw-Hill’s Connect® is an online assess- ment solution that connects students with the

tools and resources they’ll need to achieve success. Connect allows faculty to create and deliver exams easily with selectable test bank items. Instruc- tors can also build their own questions into the system for homework or practice. Readers have access to the student resources that accompany this text, as well as McGraw-Hill’s adaptive self-study technology in Learn- Smart and Smartbook.

Connect supports this book in several important ways. The student re- sources include:

• Excel spreadsheets referenced in end-of-chapter problems. • Supplementary chapter problems and suggested answers. • Complimentary software programs described in Additional Resources

at the end of several chapters.

If you are not enrolled in a course using Connect, you can access these stu- dent resources with a free trial by following the instructions accompanying the access code acquired with the book. I encourage you to download these items now for later use. If you are enrolled in a Connect course, ask your instructor for your Connect course URL to access the course resources.

Intended primarily for instructor use, the Connect Instructor Library houses, among other things: • A test bank. • PowerPoint presentations. • An annotated list of suggested cases to accompany the book. • Suggested answers to even-numbered problems.

To access the Instructor Library, log in to your Connect course, select the “Library” tab, and then select “Instructor Resources.”

Connect’s adaptive learning resources, LearnSmart and Smartbook, promise to speed and enrich your mastery of the book by creating a per- sonalized, flexible program of study.

For more information about Connect, LearnSmart, or Smartbook, go to, or contact a McGraw-Hill sales representative. For 24-hour support you can e-mail a Product Specialist or search Frequently Asked Questions at Or for a human, call 800-331-5094.

A word of caution: Analysis for Financial Management emphasizes the ap- plication and interpretation of analytic techniques in decision making. These techniques have proved useful for putting financial problems into perspective and for helping managers anticipate the consequences of their

Preface xiii



actions. But techniques can never substitute for thought. Even with the best technique, it is still necessary to define and prioritize issues, to mod- ify analysis to fit specific circumstances, to strike the proper balance be- tween quantitative analysis and more qualitative considerations, and to evaluate alternatives insightfully and creatively. Mastery of technique is only the necessary first step toward effective management.

I am indebted to Andy Halula of Standard & Poor’s for providing timely updates to Research Insight. The ability to access current Compustat data on CD continues to be a great help in providing timely examples of current practice. I also owe a large thank you to the following people for their in- sightful reviews of the 10th edition and their constructive advice. They did an excellent job; any remaining shortcomings are mine not theirs.

Bruce Campbell Franklin University Charles Evans Florida Atlantic University, Boca Raton Jaemin Kim San Diego State University, San Diego Inayat Ullah Mangla Western Michigan University, Kalamazoo

John Strong College of William & Mary Andy Terry University of Arkansas, Little Rock Marilyn Wiley University of North Texas Jaime Zender University of Colorado, Boulder

I appreciate the exceptional direction provided by Chuck Synovec, Noelle Bathurst, Melissa Caughlin, Dheeraj Chahal, and Mary Jane Lampe of McGraw-Hill on the development, design, and editing of the book. Bill Alberts, David Beim, Dave Dubofsky, Bob Keeley, Jack McDonald, George Parker, Megan Partch, Larry Schall, and Alan Shapiro have my continuing gratitude for their insightful help and support throughout the book’s evolu- tion. Thanks go as well to my daughter, Sara Higgins, for writing and editing the accompanying software. Finally, I want to express my appreciation to students and colleagues at the University of Washington, Stanford University, IMD, The Pacific Coast Banking School, The Koblenz Graduate School of Management, The Gordon Institute of Business Science, The Swiss International Business School ZfU AG, Boeing, and Microsoft, among others, for stimulating my continuing interest in the practice and teaching of financial management.

I envy you learning this material for the first time. It’s a stimulating intellectual adventure.

Robert C. (Rocky) Higgins Marguerite Reimers Emeritus Professor of Finance

Foster School of Business University of Washington

xiv Preface




Assessing the Financial

Health of the Firm





Interpreting Financial Statements

Financial statements are like fine perfume; to be sniffed but not swallowed. Abraham Brilloff

Accounting is the scorecard of business. It translates a company’s diverse activities into a set of objective numbers that provide information about the firm’s performance, problems, and prospects. Finance involves the in- terpretation of these accounting numbers for assessing performance and planning future actions.

The skills of financial analysis are important to a wide range of people, including investors, creditors, and regulators. But nowhere are they more important than within the company. Regardless of functional specialty or company size, managers who possess these skills are able to diagnose their firm’s ills, prescribe useful remedies, and anticipate the financial conse- quences of their actions. Like a ballplayer who cannot keep score, an op- erating manager who does not fully understand accounting and finance works under an unnecessary handicap.

This and the following chapter look at the use of accounting information to assess financial health. We begin with an overview of the accounting prin- ciples governing financial statements and a discussion of one of the most abused and confusing notions in finance: cash flow. Two recurring themes will be that defining and measuring profits is more challenging than one might ex- pect, and that profitability alone does not guarantee success, or even survival. In Chapter 2, we look at measures of financial performance and ratio analysis.

The Cash Flow Cycle

Finance can seem arcane and complex to the uninitiated. However, a comparatively few basic principles should guide your thinking. One is that a company’s finances and operations are integrally connected. A company’s



activities, method of operation, and competitive strategy all fundamentally shape the firm’s financial structure. The reverse is also true: Decisions that appear to be primarily financial in nature can significantly affect company operations. For example, the way a company finances its assets can affect the nature of the investments it is able to undertake in future years.

The cash flow–production cycle shown in Figure 1.1 illustrates the close interplay between company operations and finances. For simplicity, suppose the company shown is a new one that has raised money from owners and creditors, has purchased productive assets, and is now ready to begin operations. To do so, the company uses cash to purchase raw mate- rials and hire workers; with these inputs, it makes the product and stores it temporarily in inventory. Thus, what began as cash is now physical in- ventory. When the company sells an item, the physical inventory changes back into cash. If the sale is for cash, this occurs immediately; otherwise, cash is not realized until some later time when the account receivable is collected. This simple movement of cash to inventory, to accounts receiv- able, and back to cash is the firm’s operating, or working capital, cycle.

4 Part One Assessing the Financial Health of the Firm

FIGURE 1.1 The Cash Flow–Production Cycle


Ch ang

es in

equ ity

Ch ang

es in

lia bil

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Ta xes

Int ere


Di vid

end s


Accounts receivable

Fixed assets

Cash salesP ro

du cti


Collection of credit sales

D epreciation

In ve

stm ent


Cre dit

sa les




Another ongoing activity represented in Figure 1.1 is investment. Over a period of time, the company’s fixed assets are consumed, or worn out, in the creation of products. It is as though every item passing through the business takes with it a small portion of the value of fixed assets. The accountant rec- ognizes this process by continually reducing the accounting value of fixed assets and increasing the value of merchandise flowing into inventory by an amount known as depreciation. To maintain productive capacity and to fi- nance additional growth, the company must invest part of its newly received cash in new fixed assets. The object of this whole exercise, of course, is to ensure that the cash returning from the working capital cycle and the investment cycle exceeds the amount that started the journey.

We could complicate Figure 1.1 further by including accounts payable and expanding on the use of debt and equity to generate cash, but the fig- ure already demonstrates two basic principles. First, financial statements are an important window on reality. A company’s operating policies, production techniques, and inventory and credit-control systems fundamentally de- termine the firm’s financial profile. If, for example, a company requires payment on credit sales to be more prompt, its financial statements will reveal a reduced investment in accounts receivable and possibly a change in its revenues and profits. This linkage between a company’s operations and its finances is our rationale for studying financial statements. We seek to understand company operations and predict the financial consequences of changing them.

The second principle illustrated in Figure 1.1 is that profits do not equal cash flow. Cash—and the timely conversion of cash into inventories, ac- counts receivable, and back into cash—is the lifeblood of any company. If this cash flow is severed or significantly interrupted, insolvency can occur. Yet the fact that a company is profitable is no assurance that its cash flow will be sufficient to maintain solvency. To illustrate, suppose a company loses control of its accounts receivable by allowing customers more and more time to pay, or suppose the company consistently makes more mer- chandise than it sells. Then, even though the company is selling mer- chandise at a profit in the eyes of an accountant, its sales may not be generating sufficient cash soon enough to replenish the cash outflows re- quired for production and investment. When a company has insufficient cash to pay its maturing obligations, it is insolvent. As another example, suppose the company is managing its inventory and receivables carefully, but rapid sales growth is necessitating an ever-larger investment in these assets. Then, even though the company is profitable, it may have too little cash to meet its obligations. The company will literally be “growing broke.” These brief examples illustrate why a manager must be concerned at least as much with cash flows as with profits.

Chapter 1 Interpreting Financial Statements 5



To explore these themes in more detail and to sharpen your skills in using accounting information to assess performance, we need to review the basics of financial statements. If this is your first look at financial ac- counting, buckle up because we will be moving quickly. If the pace is too quick, take a look at one of the accounting texts recommended at the end of the chapter.

The Balance Sheet

The most important source of information for evaluating the financial health of a company is its financial statements, consisting principally of a balance sheet, an income statement, and a cash flow statement. Although these statements can appear complex at times, they all rest on a very sim- ple foundation. To understand this foundation and to see the ties among the three statements, let us look briefly at each.

A balance sheet is a financial snapshot, taken at a point in time, of all the assets the company owns and all the claims against those assets. The basic relationship, and indeed the foundation for all of accounting, is

Assets � Liabilities � Shareholders’ equity

It is as if a herd (flock? column?) of accountants runs through the busi- ness on the appointed day, making a list of everything the company owns, and assigning each item a value. After tabulating the firm’s assets, the ac- countants list all outstanding company liabilities, where a liability is simply an obligation to deliver something of value in the future—or more collo- quially, some form of an “IOU.” Having thus totaled up what the com- pany owns and what it owes, the accountants call the difference between the two shareholders’ equity. Shareholders’ equity is the accountant’s estimate of the value of the shareholders’ investment in the firm just as the value of a homeowner’s equity is the value of the home (the asset), less the mort- gage outstanding against it (the liability). Shareholders’ equity is also known variously as owners’ equity, stockholders’ equity, net worth, or simply equity.

It is important to realize that the basic accounting equation holds for individual transactions as well as for the firm as a whole. When a firm pays $1 million in wages, cash declines $1 million and shareholders’ equity falls by the same amount. Similarly, when a company borrows $100,000, cash rises $100,000, as does a liability named something like loans outstanding. And when a company receives a $10,000 payment from a customer, cash rises while another asset, accounts receivable, falls by the same figure. In each instance the double-entry nature of accounting guarantees that the basic accounting equation holds for each transaction, and when summed across all transactions, it holds for the company as a whole.

6 Part One Assessing the Financial Health of the Firm



To see how the repeated application of this single formula underlies the creation of company financial statements, consider Worldwide Sports (WWS), a newly founded retailer of value-priced sporting goods. In Jan- uary 2014, the founder invested $150,000 of his personal savings and added another $100,000 borrowed from relatives to start the business. After buying furniture and display fixtures for $60,000 and merchandise for $80,000, WWS was ready to open its doors.

The following six transactions summarize WWS’s activities over the course of its first year.

• Sell $900,000 of sports equipment, receiving $875,000 in cash, with $25,000 still to be paid.

• Pay $190,000 in wages, including the owner’s salary.

• Purchase $380,000 of merchandise at wholesale, with $20,000 still owed to suppliers, and $30,000 worth of product still in WWS’s inven- tory at year-end.

• Spend $210,000 on other expenses, such as utilities and rent.

• Depreciate furniture and fixtures by $15,000.

• Pay $10,000 interest on WWS’s loan from relatives and another $40,000 in income taxes to the government.

Table 1.1 shows how an accountant would record these transactions. WWS’s beginning balance, the first line in the table, shows cash of $250,000, a loan of $100,000, and equity of $150,000. But these numbers change quickly as the company buys fixtures and an initial inventory of mer- chandise. And they change further as each of the listed transactions occurs.

Chapter 1 Interpreting Financial Statements 7

TABLE 1.1 Worldwide Sports Financial Transactions 2014 ($ thousands)

Assets � Liabilities � Equity

Accounts Fixed Accounts Loan from Owners’ Cash Receivable Inventory Assets � Payable Relatives Equity

Beginning Balance 1/1/14 $ 250 � $100 $ 150 Initial purchases (140) 80 60 � Sales 875 25 � 900 Wages (190) � (190) Merchandise purchases (360) 30 � 20 (350) Other expenses (210) � (210) Depreciation (15) � (15) Interest payment (10) � (10) Income tax payment (40) � (40)

Ending Balance 12/31/14 $ 175 $25 $110 $ 45 � $20 $100 $ 235



Abstracting from the accounting details, there are two important things to note here. First, the basic accounting equation holds for each transaction. For every line in the table, assets equal liabilities plus owners’ equity. Second, WWS’s year-end balance sheet across the bottom of the table is just its be- ginning balance sheet plus the cumulative effect of the individual transac- tions. For example, ending cash on December 31, 2014 is the beginning cash of $250,000 plus or minus the cash involved in each transaction. Incidentally, WWS’s first year appears to have been a decent one: Owner’s equity is up $85,000 over the year, on top of whatever the owner paid himself in salary.

To further convince you that the bottom row of Table 1.1 really is a balance sheet, the table below presents the same information in a more conventional format.

Worldwide Sports Balance Sheet, December 31, 2014 ($ thousands)

Cash $175 Accounts payable $ 20 Accounts receivable 25 Total current liabilities 20 Inventory 110 Loan from relatives 100

Total current assets 310 Equity 235 Fixed assets 45 Total liabilities and

Total asssets $355 Shareholders’ equity $355

If a balance sheet is a snapshot in time, the income statement and the cash flow statement are videos, highlighting changes in two especially im- portant balance sheet accounts over time. Business owners are naturally interested in how company operations have affected the value of their in- vestment. The income statement addresses this question by partitioning the recorded changes in owners’ equity into revenues and expenses, where revenues increase owners’ equity and expenses reduce it. The difference between revenues and expenses is earnings, or net income.

Looking at the right-most column in Table 1.1, WWS’s 2014 income statement looks like this. Note that the $85,000 net income appearing at the bottom of the statement equals the change in shareholders’ equity over the year.

Worldwide Sports Income Statement, 2014 ($ thousands)

Sales $900 Wages 190 Merchandise purchases 350 Depreciation 15

Gross profit $345 Other expenses 210 Interest expense 10

Income before tax $125 Income taxes 40

Net income $ 85

8 Part One Assessing the Financial Health of the Firm



Chapter 1 Interpreting Financial Statements 9

The focus of the cash flow statement is solvency, having enough cash in the bank to pay bills as they come due. The cash flow statement provides a detailed look at changes in the company’s cash balance over time. As an organizing principle, the statement segregates changes in cash into three broad categories: cash provided, or consumed, by operating activities, by investing activities, and by financing activities. Figure 1.2 is a simple schematic diagram showing the close conceptual ties among the three principal financial statements.

To illustrate the techniques and concepts presented throughout the book, I will refer whenever possible to Stryker Corporation. If you or a relative have ever contemplated a hip or knee replacement, you probably know Stryker. The firm is a leading medical technology company with an especially strong position in orthopedic products. It derives about 60 per- cent of its revenue from the sale of hip and knee replacements and 40 per- cent from medical and surgical equipment—known in the trade as “medsurg.” The company competes in over 100 countries and produces almost 60,000 products and services in 29 facilities throughout the globe.

Headquartered in Kalamazoo, Michigan, with annual sales of over $9 billion, Stryker trades on the New York Stock Exchange and is a mem- ber of the Standard & Poor’s 500 Stock Index. The firm was founded in 1946 by Homer Stryker, a practicing orthopedist, and was originally known as The Orthopedic Frame Company, changing its name to Stryker Corporation in 1964. In 1979, Stryker went public and commenced an extended period of remarkably rapid growth. Beginning in 1976, Stryker’s average compound growth rate in earnings per share exceeded 20 percent per annum for over 30 years, and its corporate mantra became “20 per- cent growth forever.” Recent years have been more challenging, how- ever, as maturing products, the financial crisis, and the medical device excise tax tied to ObamaCare have taken their toll.

FIGURE 1.2 Ties among Financial Statements

Assets at beginning

Cash Shareholders’ Equity

= +Liabilities at beginning Equity at beginning

Assets at end = +Liabilities at end

O pe

ra tin


In ve

st in


Fi na

nc in


Equity at end

Balance sheets

Cash flow statement

Income statement

E xp

en se


R ev

en ue


See Follow Investors > Financial informa- tion for financial statements.

© Stryker.



Tables 1.2 and 1.3 present Stryker’s balance sheets and income state- ments for 2012 and 2013. If the precise meaning of every asset and liability category in Table 1.2 is not immediately apparent, be patient. We will discuss many of them in the following pages. In addition, all of the accounting terms used appear in the glossary at the end of the book.

Stryker Corporation’s balance sheet equation for 2013 is

Assets � Liabilities � Shareholders’ equity $15,743 million � $6,696 million � $9,047 million

10 Part One Assessing the Financial Health of the Firm

See glossary for an exhaustive glossary of accounting terms.

TABLE 1.2 Stryker Corporation, Balance Sheets ($ millions)*

December 31 Change in 2012 2013 Account

Assets Cash $ 1,395 $ 1,339 $ (56) Marketable securities 2,890 2,641 (249) Accounts receivable, less reserve for possible losses 1,430 1,518 88 Inventories 1,265 1,422 157 Other current assets 1,168 1,415 247

Total current assets 8,148 8,335

Gross property, plant, and equipment 2,232 2,497 265 Less accumulated depreciation and amortization 1,284 1,416 132

Net property, plant, and equipment 948 1,081 133

Goodwill and intangible assets, net 3,566 5,833 2,267 Other assets 544 494 (50)

Total assets $13,206 $15,743

Liabilities and Shareholders’ Equity Long-term debt due in one year 16 25 9 Taxes payable 70 131 61 Trade accounts payable 288 314 26 Accrued compensation 467 535 68 Accrued expenses 1,035 1,652 617

Total current liabilities 1,876 2,657

Long-term debt 1,746 2,739 993 Other long-term liabilities 987 1,300 313

Total liabilities 4,609 6,696

Common stock 38 38 Additional paid-in capital 1,098 1,160 Retained earnings 7,461 7,849

Total shareholders’ equity 8,597 9,047 450

Total liabilities and shareholders’ equity $13,206 $15,743

*Totals may not add due to rounding.



Current Assets and Liabilities By convention, U.S. accountants list assets and liabilities on the balance sheet in order of decreasing liquidity, where liquidity refers to the speed with which an item can be converted to cash. Thus among assets cash, marketable securities, and accounts receivable appear at the top, while land, plant, and equipment are toward the bottom. Similarly on the liabil- ities side, short-term loans and accounts payable are toward the top, while shareholders’ equity is at the bottom.

Accountants also arbitrarily define any asset or liability that is expected to turn into cash within one year as current and all others assets and liabil- ities as long term. Inventory is a current asset because there is reason to believe it will be sold and will generate cash within one year. Accounts payable are short-term liabilities because they must be paid within one year. Note that over half of Stryker’s assets are current, a fact we will say more about in the next chapter.

Chapter 1 Interpreting Financial Statements 11

TABLE 1.3 Stryker Corporation, Income Statements ($ millions)

January 1 to December 31

2012 2013

Net sales $8,657 $9,021 Cost of goods sold 2,604 2,762

Gross profit 6,053 6,259

Selling, general, and administrative expenses 3,501 4,077 Research, development, and engineering expenses 471 536 Depreciation and amortization 277 307

Total operating expenses 4,249 4,920

Operating income 1,804 1,339

Interest expense 63 83 Other nonoperating expense 36 44

Total nonoperating expenses 99 127

Income before income taxes 1,705 1,212 Provision for income taxes 407 206

Net income $1,298 $1,006

A Word to the Unwary Nothing puts a damper on a good financial discussion (if such exists) faster than the suggestion that if a company is short of cash, it can always spend some of its shareholders’ equity. Equity is on the liabilities side of the balance sheet, not the asset side. It represents owners’ claims against existing assets. In other words, that money has already been spent.



Shareholders’ Equity A common source of confusion is the large number of accounts appearing in the shareholders’ equity portion of the balance sheet. Stryker has three, beginning with common stock and ending with retained earnings (see Table 1.2). Unless forced to do otherwise, my advice is to forget these dis- tinctions. They keep accountants and attorneys employed, but seldom make much practical difference. As a first cut, just add up everything that is not an IOU and call it shareholders’ equity.

The Income Statement

Looking at Stryker’s operating performance in 2013, the basic income statement relation appearing in Table 1.3 is

Revenues � Expenses � Net income

Cost of Operating Nonoperating Net Net sales � goods sold � expenses � expenses � Taxes � income

$9,021 � $2,762 � $4,920 � $127 � $206 � $1,006

Net income records the extent to which net sales generated during the accounting period exceeded expenses incurred in producing the sales. For variety, net income is also commonly referred to as earnings or profits, frequently with the word net stuck in front of them; net sales are often called revenues or net revenues; and cost of goods sold is labeled cost of sales. I have never found a meaningful distinction between these terms. Why so many words to say the same thing? My personal belief is that accountants are so rule-bound in their calculations of the various amounts that their creativ- ity runs a bit amok when it comes to naming them.

Income statements are commonly divided into operating and nonoper- ating segments. As the names imply, the operating segment reports the results of the company’s major, ongoing activities, while the nonoperating segment summarizes all ancillary activities. In 2013 Stryker reported oper- ating income of $1,339 million and nonoperating expenses of $127 million, consisting largely of interest expense.

Measuring Earnings This is not the place for a detailed discussion of accounting. But because earnings, or lack of same, are a critical indicator of financial health, several technical details of earnings measurement deserve mention.

12 Part One Assessing the Financial Health of the Firm



Chapter 1 Interpreting Financial Statements 13

Accrual Accounting The measurement of accounting earnings involves two steps: (1) identify- ing revenues for the period and (2) matching the corresponding costs to revenues. Looking at the first step, it is important to recognize that revenue is not the same as cash received. According to the accrual principle (a cruel principle?) of accounting, revenue is recognized as soon as “the ef- fort required to generate the sale is substantially complete and there is a reasonable certainty that payment will be received.” The accountant sees the timing of the actual cash receipts as a mere technicality. For credit sales, the accrual principle means that revenue is recognized at the time of sale, not when the customer pays. This can result in a significant time lag between the generation of revenue and the receipt of cash. Looking at Stryker, we see that revenue in 2013 was $9,021 million, but accounts re- ceivable increased $88 million. We conclude that cash received from sales during 2013 was only $8,933 million ($9,021 � $88 million). The other $88 million still awaits collection.

Depreciation Fixed assets and their associated depreciation present the accountant with a particularly challenging problem in matching. Suppose that in 2015, a company constructs for $50 million a new facility that has an expected productive life of 10 years. If the accountant assigns the entire cost of the facility to expenses in 2015, some weird results follow. Income in 2015 will appear depressed due to the $50 million expense, while income in the fol- lowing nine years will look that much better as the new facility contributes to revenue but not to expenses. Thus, charging the full cost of a long-term asset to one year clearly distorts reported income.

The preferred approach is to spread the cost of the facility over its ex- pected useful life in the form of depreciation. Because the only cash outlay associated with the facility occurs in 2015, the annual depreciation listed as a cost on the company’s income statement is not a cash outflow. It is a noncash charge used to match the 2015 expenditure with resulting revenue. Said differently, depreciation is the allocation of past expenditures to future time periods to match revenues and expenses. A glance at Stryker’s income statement reveals that in 2013, the company included a $307 million non- cash charge for depreciation and amortization among their operating ex- penses. In a few pages, we will see that during the same year, the company spent $195 million acquiring new property, plant, and equipment.

To determine the amount of depreciation to take on a particular asset, three estimates are required: the asset’s useful life, its salvage value, and the method of allocation to be employed. These estimates should be based on economic and engineering information, experience, and any other objective



data about the asset’s likely performance. Broadly speaking, there are two methods of allocating an asset’s cost over its useful life. Under the straight- line method, the accountant depreciates the asset by a uniform amount each year. If an asset costs $50 million, has an expected useful life of 10 years, and has an estimated salvage value of $10 million, straight-line depreciation will be $4 million per year ([$50 million � $10 million]�10).

The second method of cost allocation is really a family of methods known as accelerated depreciation. Each technique charges more deprecia- tion in the early years of the asset’s life and correspondingly less in later years. Accelerated depreciation does not enable a company to take more depreciation in total; rather, it alters the timing of the recognition. While the specifics of the various accelerated techniques need not detain us here, you should recognize that the life expectancy, the salvage value, and the al- location method a company uses can fundamentally affect reported earn- ings. In general, if a company is conservative and depreciates its assets rapidly, it will tend to understate current earnings, and vice versa.

Taxes A second noteworthy feature of depreciation accounting involves taxes. Most U.S. companies, except very small ones, keep at least two sets of fi- nancial records: one for managing the company and reporting to share- holders and another for determining the firm’s tax bill. The objective of the first set is, or should be, to accurately portray the company’s financial performance. The objective of the second set is much simpler: to mini- mize taxes. Forget objectivity and minimize taxes. These differing objec- tives mean the accounting principles used to construct the two sets of books differ substantially. Depreciation accounting is a case in point. Re- gardless of the method used to report to shareholders, company tax books will minimize current taxes by employing the most rapid method of de- preciation over the shortest useful life the tax authorities allow.

This dual reporting means that actual cash payments to tax authorities usu- ally differ from the provision for income taxes appearing on a company’s in- come statement, sometimes trailing the provision and other times exceeding it. To illustrate, Stryker’s $206 million provision for income taxes appearing on its 2013 income statement is the tax payable according to the accounting techniques used to construct the company’s published statements. But be- cause Stryker used different accounting techniques when reporting to the tax authorities, taxes actually paid in 2013 were lower than this amount. To confirm this fact, note that Stryker has a tax account on the liabilities side of its balance sheet labeled “taxes payable,” a short-term liability. The liability reflects tax obligations incurred in past periods but not yet paid. The net change in this balance sheet account during 2013 indicates that

14 Part One Assessing the Financial Health of the Firm



Stryker’s tax liability rose $61 million over the year, so that taxes paid must have been $61 million less than the provision for taxes appearing on the income statement. Stryker’s aggressive deferral of tax obligations incurred during the year resulted in a 2013 tax payment less than the tax obligation appearing on its income statement. Here is the detailed accounting with figures in millions:

Provision for income taxes $206 − Increase in taxes payable 61____

Taxes paid $145

At the end of 2013, Stryker’s net tax liability appearing on its balance sheet was $131 million. This sum represents money Stryker must pay tax authorities in future years, but in the meantime can be used to finance the business. Tax deferral techniques create the equivalent of interest-free loans from the government. In Japan and other countries which do not allow the use of separate accounting techniques for tax and reporting purposes, these complications never arise.

Research and Marketing Now that you understand how accountants use depreciation to spread the cost of long-lived assets over their useful lives to better match revenues and costs, you may think you also understand how they treat research and marketing expenses. Because research and development (R&D) and mar- keting outlays promise benefits over a number of future periods, it is only logical that an accountant would show these expenditures as assets when they are incurred and then spread the costs over the assets’ expected use- ful lives in the form of a noncash charge such as depreciation. Impecca- ble logic, but this isn’t what accountants do, at least not in the United States. Because the magnitude and duration of the prospective payoffs from R&D and marketing expenditures are difficult to estimate, ac- countants typically duck the problem by forcing companies to record the entire expenditure as an operating cost in the year incurred. Thus, al- though a company’s research outlays in a given year may have produced technical breakthroughs that will benefit the firm for decades to come, all of the costs must be shown on the income statement in the year incurred. The requirement that companies expense all research and marketing ex- penditures when incurred commonly understates the profitability of high-tech and high-marketing companies and complicates comparison of American companies with those in other nations that treat such expendi- tures more liberally.

Chapter 1 Interpreting Financial Statements 15



16 Part One Assessing the Financial Health of the Firm

Defining Earnings Creditors and investors look to company earnings for help in answering two fundamental questions: How did the company do last period, and how might it do in the future? To answer the first question it is important to use a broad-based measure of income that includes everything affecting the com- pany’s performance over the accounting period. However, to answer the second question we want a narrower income measure that abstracts from all unusual, nonrecurring events to focus strictly on the company’s steady state, or ongoing, performance.

The accounting profession and the Securities and Exchange Commission obligingly provide two such official measures, known as net income and operating income, and require companies to report them on their financial statements.

Net income, or net profit, is the proverbial “bottom line,” defined as total revenue less total expenses. Operating income is profit realized from day-to-day operations excluding taxes, interest income

and expense, and what are known as extraordinary items. An extraordinary item is one that is both unusual in nature and infrequent in occurrence.

For a variety of sometimes-legitimate reasons, corporate executives and business analysts have increasingly argued that these official income measures are inadequate or inappropriate for their purposes and have encouraged a whole cottage industry devoted to creating and promoting new, improved earnings measures. Here are some of the more popular ones:

Pro forma earnings, also known as adjusted earnings, core earnings, or ongoing earnings, are total revenues less total expenses, omitting any and all expenses the company believes might cloud investor perceptions of the true earning power of the business. If this sounds vague, it is. Each company has license to decide what expenses are to be ignored, and to change its mind from year to year. The SEC requires only that the company reconcile its preferred earnings measure with the closest official number in its annual report. In the first three quarters of 2001, during the depths of the dot-com bust, the 100 largest firms traded on the NASDAQ stock exchange reported aggregate pro forma earnings of $20 billion. For the same period, they reported losses according to Generally Accepted Accounting Principles of $82 billion.a In the recent financial crisis, S&P 500 companies reported aggregate 2008 pro forma earnings per share of over $60, while the corresponding figure under GAAP was below $20.b In 2013, our featured company, Stryker Corporation, highlighted “adjusted” net earnings of $1.6 billion, some 60 percent above the comparable GAAP figure, due principally to large product liability claims which the company chose to consider nonrecurring.

EBIT (pronounced E-bit) is earnings before interest and taxes, a useful and widely used measure of a business’s income before it is divided among creditors, owners, and the taxman.

EBITDA (pronounced E-bit-da) is earnings before interest, taxes, depreciation, and amortization. EBITDA has its uses in some industries, such as broadcasting, where depreciation charges may routinely overstate true economic depreciation. However, as Warren Buffett notes, treating EBITDA as equivalent to earnings is tantamount to saying that a business is the commercial equivalent of the pyramids—forever state-of-the-art, never needing to be replaced, improved, or refurbished. In Buffett’s view, EBITDA is a number favored by investment bankers when they cannot justify a deal based on EBIT.

EIATBS (pronounced E-at-b-s) is earnings ignoring all the bad stuff, which is the earnings concept too many executives and analysts appear to prefer.

a “A Survey of International Finance,” The Economist, May 18, 2002, p. 20. b “Chart of the Day: Here’s How You Should Think About ‘Adjusted’ Earnings.” Sam Ro, Business Insider, December 26,




Chapter 1 Interpreting Financial Statements 17

Sources and Uses Statements

Two very basic but valuable things to know about a company are where it gets its cash and how it spends the cash. At first blush, it might appear that the income statement will answer these questions because it records flows of resources over time. But further reflection will con- vince you that the income statement is deficient in two respects: It includes accruals that are not cash flows, and it lists only cash flows associated with the sale of goods or services during the accounting period. A host of other cash receipts and disbursements do not appear on the income statement. Thus, Stryker Corporation increased its investment in accounts receivable by $88 million in 2013 (Table 1.2) with little or no trace of this buildup on its income statement. Stryker also increased long-term debt by almost $1 billion with little effect on its income statement.

To gain a more accurate picture of where a company got its money and how it spent it, we need to look more closely at the balance sheet or, more precisely, two balance sheets. Use the following two-step procedure. First, place two balance sheets for different dates side by side, and note all of the changes in accounts that occurred over the pe- riod. The changes for Stryker in 2013 appear in the rightmost column of Table 1.2. Second, segregate the changes into those that generated cash and those that consumed cash. The result is a sources and uses statement.

Here are the guidelines for distinguishing between a source and a use of cash:

• A company generates cash in two ways: by reducing an asset or by increasing a liability. The sale of used equipment, the liquidation of inventories, and the reduction of accounts receivable are all reductions in asset accounts and are all sources of cash to the company. On the liabilities side of the balance sheet, an increase in a bank loan and the sale of common stock are increases in liabilities, which again generate cash.

• A company also uses cash in two ways: to increase an asset account or to reduce a liability account. Adding to inventories or accounts receivable and building a new plant all increase assets and all use cash. Conversely, the repayment of a bank loan, the reduction of accounts payable, and an operating loss all reduce liabilities and all use cash.

Because it is difficult to spend money you don’t have, total uses of cash over an accounting period must equal total sources.



Table 1.4 presents a 2013 sources and uses statement for Stryker Corporation. It reveals that the company got over one-third of its cash from increased long-term borrowing and, in turn, used almost 80 percent of the cash to increase net goodwill and intangible assets, reflecting size- able acquisitions, as we will soon discuss further.

The Two-Finger Approach I personally do not spend a lot of time constructing sources and uses state- ments. It might be instructive to go through the exercise once or twice just to convince yourself that sources really do equal uses. But once beyond this point, I recommend using a “two-finger approach.” Put the two

18 Part One Assessing the Financial Health of the Firm

TABLE 1.4 Stryker Corporation, Sources and Uses Statement, 2013 ($ millions)*


Reduction in cash 56 Reduction in marketable securities 249 Reduction in other assets 50 Increase in long-term debt due in one year 9 Increase in taxes payable 61 Increase in trade accounts payable 26 Increase in accrued compensation 68 Increase in accrued expenses 617 Increase in long-term debt 993 Increase in other long-term liabilities 313 Increase in total shareholders’ equity 450

Total sources $2,892


Increase in accounts receivable 88 Increase in inventories 157 Increase in other current assets 247 Increase in net property, plant, and equipment 133 Increase in net goodwill and intangible assets 2,267

Total uses $2,892

*Totals may not add due to rounding.

How Can a Reduction in Cash Be a Source of Cash? One potential source of confusion in Table 1.4 is that the reduction in cash and marketable securities in 2013 appears as a source of cash. How can a reduction in cash be a source of cash? Simple. It is the same as when you withdraw money from your checking account. You reduce your bank balance but have more cash on hand to spend. Conversely, a deposit into your bank account increases your balance but reduces spendable cash in your pocket.



Chapter 1 Interpreting Financial Statements 19

balance sheets side by side, and quickly run any two fingers down the columns in search of big changes. This should enable you to quickly observe that the majority of Stryker’s cash came from long-term debt, retained earnings, and increased accrued expenses and most of it went to finance new acquisitions. In 30 seconds or less, you have the essence of a sources and uses analysis and are free to move on to more stimulating activities. The other changes are largely window dressing of more interest to accountants than to managers.

The Cash Flow Statement

Identifying a company’s principal sources and uses of cash is a useful skill in its own right. It is also an excellent starting point for considering the cash flow statement, the third major component of financial statements along with the income statement and the balance sheet.

In essence, a cash flow statement just expands and rearranges the sources and uses statement, placing each source or use into one of three broad cate- gories. The categories and their values for Stryker in 2013 are as follows:

Category Source (or Use) of Cash

($ millions)

1. Cash flows from operating activities $1,886 2. Cash flows from investing activities ($2,217) 3. Cash flows from financing activities $275

Double-entry bookkeeping guarantees that the sum of the cash flows in these three categories equals the change in cash balances over the accounting period.

Table 1.5 presents a complete cash flow statement for Stryker Corpora- tion in 2013. The first category, “cash flows from operating activities,” can be thought of as a rearrangement of Stryker’s financial statements to elimi- nate the effects of accrual accounting on net income. First, we add all non- cash charges, such as depreciation and amortization, back to net income, recognizing that these charges did not entail any cash outflow. Then we add the changes in current assets and liabilities to net income, acknowledging, for instance, that some sales did not increase cash because customers had not yet paid, while some expenses did not reduce cash because the company had not yet paid. Changes in other current assets and liabilities, such as in- ventories, appear here because the accountant, following the matching prin- ciple, ignored these cash flows when calculating net income. Interestingly, the cash generated by Stryker’s operations was over 80 percent more than



the firm’s income. A principal reason for the difference is that the income statement includes a $43.4 million noncash charge for depreciation.

If cash flow statements were just a reshuffling of sources and uses statements, as many textbook examples suggest, they would be redun- dant, for a reader could make his own in a matter of minutes. A chief at- traction of cash flow statements is that companies reorganize their cash flows into new and sometimes revealing categories. To illustrate, Stryker’s cash flow statement in Table 1.5 reveals that during 2013 it paid dividends of $401 million, repurchased $317 million of its common

20 Part One Assessing the Financial Health of the Firm

TABLE 1.5 Stryker Corporation, Cash Flow Statement, 2013 ($ millions)*

Cash Flows from Operating Activities Net income $ 1,006 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization 307 Deferred income taxes 23 Stock-based compensation expense 76 Restructuring charges 50 Changes in assets and liabilities:

Increase in accounts receivables (89) Increase in inventories (77) Increase in accounts payable 1 Increase in accrued expenses and other liabilities 657 Decrease in accrued income taxes (124) Other 56

Net cash provided by operating activities 1,886

Cash Flows from Investing Activities Capital expenditures (195) Acquisitions (2,320) Net decline in investments 298 Net cash used by investing activities (2,217)

Cash Flows from Financing Activities Repurchase of common stock (317) Dividends paid (401) Long-term debt issuance, net of retirements 1,005 Other financing activities 13 Effect of exchange rate changes on cash (25) Net cash provided by financing activities 275

Net increase (decrease) in cash (56) Cash at beginning of year 1,395 Cash and marketable securities at end of year $ 1,339

*Totals may not add due to rounding.



Chapter 1 Interpreting Financial Statements 21

stock, and invested $195 million in new capital expenditures. This is the only place in its financial statements where these basic activities are even mentioned.

A second attraction of a cash flow statement is that it casts a welcome light on firm solvency by highlighting the extent to which operations are generating or consuming cash. Stryker’s cash flow statement in 2013 in- dicates that cash flow from operating activities exceeded net income by a hearty 80 percent, due principally to an increase in something called “accrued expenses and other liabilities.” This is a lot of money for such an innocuous sounding account. Additional digging reveals that the in- crease reflects additions to a reserve account to honor anticipated prod- uct liability claims. In mid-2012, Stryker voluntarily recalled several hip replacement products due to their tendency to cause metal ion poison- ing in some patients. Used in about 20,000 people, remedial treatment requires replacing the failed hip. A year later, with the number of law- suits climbing above 900, Stryker announced it was adding some $600 million to the reserve. From an accounting perspective, this involves adding $600 million to selling, general, and administrative expenses and increasing accrued expenses and liabilities by a like amount. Because this build-up is a noncash charge until patient claims are actually paid, it does not diminish cash flow from operations and must thus be added back to net income.

Why Are The Numbers Different? Stryker’s sources and uses statement in Table 1.4 tells us that inventories rose $157 million in 2013; yet its cash flow statement in Table 1.5 says that inventories increased only $77 million over the same period. Nor is this an isolated example. Many of the apparently identical quantities differ from one statement to the other. Why the difference?

Here are two possible answers. Companies often divide changes in current assets and liabilities into two parts: those attributable to existing activities, and those due to newly acquired businesses, with the first appearing in cash flows from operating activities and the second in cash flows from in- vesting activities. By pushing as much of the increase into investing activities as possible, Stryker enhances its recorded cash generated by operating activities—an appealing outcome. The second answer involves exchange rates. Stryker has assets and liabilities of various types scattered all over the world. To construct a consolidated balance sheet, its accountants translate the company’s foreign-denominated accounts into U.S. dollars at the then prevailing exchange rates. As a result, the balance sheet changes we observe on their consolidated statements are due at least in part to changing currency values. However, because the currency-induced changes are not cash flows until the assets or liabilities are brought home, Stryker omits them from the numbers appearing on its cash flow statement.

Are these answers complicated? Yes. Do the manipulations described add to our understanding of Stryker’s performance? I doubt it.



Another noteworthy entry on Stryker’s cash flow statement is “stock- based compensation expense,” which contributed $76 million to cash flow from operations in 2013. After a long and bitter battle among businesses, Congress, and accounting regulators, employee stock options are finally, and correctly, classified as an expense. However, they are not a cash flow, neither when they are given to the employee nor when she converts them into company stock. So they too must be added back to net income when calculating cash flow from operations. If you are wondering how stock op- tions can be an expense when the firm never seems to have to pay any cash to anyone, the answer is that they are a cost to shareholders, who see their ownership percentage diluted as employees acquire shares without paying full value for them.

Some analysts maintain that net cash provided by operating activi- ties, appearing on the cash flow statement, is a more reliable indicator of firm performance than net income. They argue that because net in- come depends on myriad estimates, allocations, and approximations, devious managers can easily manipulate it. Numbers appearing on a company’s cash flow statement, on the other hand, record the actual movement of cash, and are thus seen to be more objective measures of performance.

There is certainly some merit to this view, but also two problems. First, low or even negative net cash provided by operating activities does not necessarily indicate poor performance. Rapidly growing businesses in particular must customarily invest in current assets, such as accounts receivable and inventories, to support increasing sales. And although such investments reduce net cash provided by operating activities, they do not in any way suggest poor performance. Second, cash flow state- ments turn out to be less objective, and thus less immune to manipula- tion than might be supposed. Here’s a simple example. Suppose two companies are identical except that one sells its product on a simple open account, while the other loans its customers money enabling them to pay cash for the product. In both cases, the customer has the product and owes the seller money. But the increase in accounts receivable recorded by the first company on each sale will lower its cash flows from operating activities relative to the second, which can report the cus- tomer loan as part of investing activities. Because the criteria for appor- tioning cash flows among operating, investing, and financing activities are ambiguous, subjective judgment must be used in the preparation of cash flow statements.

Much of the information contained in a cash flow statement can be gleaned from careful study of a company’s income statement and balance sheet. Nonetheless, the statement has three principal virtues. First, accounting

22 Part One Assessing the Financial Health of the Firm



neophytes and those who do not trust accrual accounting have at least some hope of understanding it. Second, the statement provides more accurate in- formation about certain activities, such as share repurchases and employee stock options than one can infer from income statements and balance sheets alone. Third, it casts a welcome light on cash generation and solvency.

Chapter 1 Interpreting Financial Statements 23

What Is Cash Flow? So many conflicting definitions of cash flow exist today that the term has almost lost its meaning. At one level, cash flow is very simple. It is the movement of money into or out of a cash account over a period of time. The problem arises when we try to be more specific. Here are four common types of cash flow you are apt to encounter.

Net cash flow � Net income � Noncash items

Often known in investment circles as cash earnings, net cash flow is intended to measure the cash a business generates, as distinct from the earnings—a laudable objective. Applying the formula to Stryker’s 2013 figures (Table 1.5), net cash flow was $1,462 million, equal to net income plus depreci- ation, and other noncash charges.

A problem with net cash flow as a measure of cash generation is that it implicitly assumes a busi- ness’s current assets and liabilities are either unrelated to operations or do not change over time. In Stryker’s case, the cash flow statement reveals that changes in a number of current assets and lia- bilities contributed $424 million in cash. A more inclusive measure of cash generation is therefore cash flow from operating activities as it appears on the cash flow statement.

Cash flow from operating activities � Net cash flow ± Changes in current assets and liabilities

A third, even more inclusive measure of cash flow, popular among finance specialists is

Total cash available for distribution to owners and creditors Free cash flow �

after funding all worthwhile investment activities

Free cash flow extends cash flow from operating activities by recognizing that some of the cash a business generates must be plowed back into the business, in the form of capital expenditures, to support growth. Abstracting from a few technical details, free cash flow is essentially cash flow from operating activities less capital expenditures. As we will see in Chapter 9, free cash flow is a fundamental determinant of the value of a business. Indeed, one can argue that the principal means by which a company creates value for its owners is to increase free cash flow.

Yet another widely used cash flow is

A sum of money today having the same value Discounted cash flow �

as a future stream of cash receipts and disbursements

Discounted cash flow refers to a family of techniques for analyzing investment opportunities that take into account the time value of money. A standard approach to valuing investments and busi- nesses uses discounted cash flow techniques to calculate the present value of projected free cash flows. This is the focus of the last three chapters of this book.

My advice when tossing cash flow terms about is to either use the phrase broadly to refer to a general movement of cash or to define your terms carefully.



24 Part One Assessing the Financial Health of the Firm

Financial Statements and the Value Problem

To this point, we have reviewed the basics of financial statements and grappled with the distinction between earnings and cash flow. This is a valuable start, but if we are to use financial statements to make informed business decisions, we must go further. We must understand the extent to which accounting numbers reflect economic reality. When the accountant tells us that Stryker Corporation’s total assets were worth $15,743 million on December 31, 2013, is this literally true, or is the number just an artifi- cial accounting construct? To gain perspective on this issue, and in anticipa- tion of later discussions, I want to conclude by examining a recurring problem in the use of accounting information for financial decision making.

Market Value vs. Book Value Part of what I will call the value problem involves the distinction between the market value and the book value of shareholders’ equity. Stryker’s 2013 balance sheet states that the value of shareholders’ equity is $9,047 million. This is known as the book value of Stryker’s equity. However, Stryker is not worth $9,047 million to its shareholders or to anyone else, for that matter. There are two reasons. One is that financial statements are largely transactions based. If a company purchased an asset for $1 million in 1950, this transaction provides an objective measure of the asset’s value, which the accountant uses to value the asset on the company’s balance sheet. Unfortunately, it is a 1950 value that may or may not have much relevance today. To further confound things, the accountant attempts to reflect the gradual deterioration of an asset over time by periodically sub- tracting depreciation from its balance sheet value. This practice makes sense as far as it goes, but depreciation is the only change in value an American accountant customarily recognizes. The $1 million asset pur- chased in 1950 may be technologically obsolete and therefore virtually worthless today; or, due to inflation, it may be worth much more than its original purchase price. This is especially true of land, which can be worth several times its original cost.

It is tempting to argue that accountants should forget the original costs of long-term assets and provide more meaningful current values. The prob- lem is that objectively determinable current values of many assets do not exist, and it is probably not wise to rely on incumbent mangers to make the necessary adjustments. Faced with a choice between relevant but subjective current values and irrelevant but objective historical costs, accountants opt for irrelevant historical costs. Accountants prefer to be precisely wrong than approximately right. This means it is the user’s responsibility to make any adjustments to historical-cost asset values she deems appropriate.

For more of fair value account- ing and many other account- ing topics, see



Prodded by regulators and investors, the Financial Accounting Stan- dards Board, accounting’s principal rule-making organization, increas- ingly stresses what is known as fair value accounting, according to which certain assets and liabilities must appear on company financial statements at their market values instead of their historical costs. Such “marking to market” applies to selected assets and liabilities that trade actively on fi- nancial markets, including many common stocks and bonds. Proponents of fair value accounting acknowledge it will never be possible to eliminate his- torical- cost accounting entirely, but maintain that market values should be used whenever possible. Skeptics respond that mixing historical costs and market values in the same financial statement only heightens confusion, and that periodically revaluing company accounts to reflect changing mar- ket values introduces unwanted subjectivity, distorts reported earnings, and greatly increases earnings volatility. They point out that under fair value accounting, changes in owners’ equity no longer mirror the results of com- pany operations but also include potentially large and volatile gains and losses from changes in the market values of certain assets and liabilities. The gradual movement toward fair value accounting was initially greeted with howls of protest, especially from financial institutions concerned that the move would increase apparent earnings volatility and, more menac- ingly, might reveal that some enterprises are worth less than historical-cost financial statements suggest. To these firms the appearance of benign sta- bility is apparently more appealing than the hint of an ugly reality.

To understand the second, more fundamental reason Stryker is not worth $9,047 million, recall that equity investors buy shares for the future income they hope to receive, not for the value of the firm’s assets. Indeed, if all goes according to plan, most of the firm’s existing assets will be con- sumed in generating future income. The problem with the accountant’s measure of shareholders’ equity is that it bears little relation to future in- come. There are two reasons for this. First, because the accountant’s num- bers are backward-looking and cost-based, they often provide few clues about the future income a company’s assets might generate. Second, com- panies typically have a great many assets and liabilities that do not appear on their balance sheets but affect future income nonetheless. Examples in- clude patents and trademarks, loyal customers, proven mailing lists, supe- rior technology, and, of course, better management. It is said that in many companies, the most valuable assets go home to their spouses in the evening. Examples of unrecorded liabilities include pending lawsuits, in- ferior management, and obsolete production processes. The accountant’s inability to measure assets and liabilities such as these means that book value is customarily a highly inaccurate measure of the value perceived by shareholders.

Chapter 1 Interpreting Financial Statements 25



It is a simple matter to calculate the market value of shareholders’ equity when a company’s shares are publicly traded: Simply multiply the market price per share by the number of common shares outstanding. On December 31, 2013, Stryker’s common shares closed on the New York Stock Exchange at $75.14. With 378 million shares outstanding, this yields a value of $28,403 million, or 3.1 times the book value ($28,403/$9,047 million). This figure is the market value of Stryker’s equity, often known as its market capitalization or market cap.

Table 1.6 presents the market and book values of equity for 15 repre- sentative companies. It demonstrates clearly that book value is a poor proxy for market value.

Goodwill There is one instance in which intangible assets, such as brand names and patents, find their way onto company balance sheets. It occurs when one company buys another at a price above book value. Suppose an acquiring firm pays $100 million for a target firm and the target’s assets have a book value of only $40 million and an estimated replacement value of only $60 million. To record the transaction, the accountant will allocate $60 million of the acquisition price to the value of the assets acquired and assign the remaining $40 million to a new asset commonly known as

26 Part One Assessing the Financial Health of the Firm

Fair Value Accounting and the Financial Crisis of 2008 The financial crisis of 2008 revealed several quirks and problems with fair value accounting. Among the quirks is fair value’s treatment of company liabilities. Many financial institutions saw the market value of their publicly traded debt plummet during the crisis as investors lost faith in the institutions’ ability to honor their obligations—clearly bad news. Yet fair value accounting forced the organiza- tions to report this drop in value as a gain on the theory that it would now cost them that much less to repurchase and retire the debt. Similarly, when the crisis eased and debt values rose, the same institutions found themselves recording losses as the cost of repurchase went up. As one example, investment bank Morgan Stanley reported a $5.5 billion gain in 2008 on declining debt values, fol- lowed in 2009 by a $5.4 billion loss as the price of their debt recovered.

More worrisome, some observers maintain that fair value accounting may actually have con- tributed to the crisis. They argue that panic selling during the collapse made observed market prices more an indicator of investor fears than of asset values. Moreover, they claim that reliance on these distressed prices to value assets set in motion a vicious cycle whereby falling prices prompted cred- itors to demand payment of the debt, increased collateral, or increased equity relative to debt, all of which forced the debtors into more panic selling. While not abandoning fair value accounting, this criticism has forced accountants and regulators to allow managers some discretion in estimating fair values in distressed markets.c

cFor more on this topic, see Christian Laux and Christian Leuz “The Crisis of Fair Value Accounting: Making Sense of the Recent Debate,” Accounting, Organizations and Society, April 2009. Available at



“goodwill.” The acquiring company paid a handsome premium over the fair value of the target’s recorded assets because it places a high value on its unrecorded, or intangible, assets. But not until the acquisition creates a piece of paper with $100 million written on it is the accountant willing to acknowledge this value.

Looking at Stryker Corporation’s balance sheet in Table 1.2 under the heading “goodwill and intangible assets, net,” we see that the company has $5,833 million of goodwill, its largest single asset and 37 percent of total assets. To put this number in perspective, the median ratio of good- will and intangible assets to total assets among Standard & Poor’s 500 in- dustrial companies—a diversified group of large firms—was 22 percent in 2013. Express Scripts Holding Company, a health care management com- pany, topped the list with a ratio of 81 percent.1

Economic Income vs. Accounting Income A second dimension of the value problem is rooted in the accountant’s dis- tinction between realized and unrealized income. To anyone who has not

Chapter 1 Interpreting Financial Statements 27

TABLE 1.6 The Book Value of Equity Is a Poor Surrogate for the Market Value of Equity, December 31, 2013

Value of Equity Ratio, Market ($ millions) Value to

Company Book Market Book Value

Aetna Inc. 14,026 27,154 1.9 Apache Corp. 33,396 32,829 1.0 Coca-Cola Co. 33,173 170,181 5.1 Delta Air Lines Inc. 11,643 29,502 2.5 Duke Energy Corp. 41,330 50,281 1.2 Facebook Inc. 15,470 153,431 9.9 General Motors Co. 39,498 51,630 1.3 Google Inc. 87,309 374,288 4.3 Harley-Davidson Inc. 3,009 14,651 4.9 Hewlett-Packard Co. 27,269 61,452 2.3 Intel Corp. 58,256 128,218 2.2 Stryker Corp. 9,047 28,403 3.1 Tesla Motors Inc. 667 25,658 38.5 United States Steel Co. 3,348 3 ,995 1.2 Walmart Stores Inc. 76,255 247,098 3.2

1For many years, accounting authorities required companies to write goodwill off as a noncash expense against income over a number of years. Now they acknowledge that most goodwill is not necessarily a wasting asset and only requires a write-down when there is evidence the value of goodwill has declined. There is no offsetting provision requiring the write-up of goodwill when values appear to have risen. If this sounds vague and capricious, I agree.



studied too much accounting, income is what you could spend during the period and be as well off at the end as you were at the start. If Mary Siegler’s assets, net of liabilities, are worth $100,000 at the start of the year and rise to $120,000 by the end, and if she receives and spends $70,000 in wages during the year, most of us would say her income was $90,000 ($70,000 in wages � $20,000 increase in net assets).

But not the accountant. Unless Mary’s investments were in marketable securities with readily observable prices, he would say Mary’s income was only $70,000. The $20,000 increase in the value of assets would not qual- ify as income because the gain was not realized by the sale of the assets. Be- cause the value of the assets could fluctuate in either direction before the assets are sold, the gain is only on paper, and accountants generally do not recognize paper gains or losses. They consider realization the objective evidence necessary to record the gain, despite the fact that Mary is proba- bly just as pleased with the unrealized gain in assets as with another $20,000 in wages.

It is easy to criticize accountants’ conservatism when measuring in- come. Certainly the amount Mary could spend, ignoring inflation, and be as well off as at the start of the year is the commonsense $90,000, not the accountant’s $70,000. Moreover, if Mary sold her assets for $120,000 and immediately repurchased them for the same price, the $20,000 gain would become realized and, in the accountant’s eyes, become part of income. That income could depend on a sham transaction such as this is enough to raise suspicions about the accountant’s definition.

However, we should note three points in the accountant’s defense. First, if Mary holds her assets for several years before selling them, the gain or loss the accountant recognized on the sale date will equal the sum of the annual gains and losses we nonaccountants would recognize. So it’s really not total income that is at issue here but simply the timing of its recognition. Second, accountants’ increasing use of fair value accounting, where at least some as- sets and liabilities are revalued periodically to reflect changes in market value, reduces the difference between accounting and economic income. Third, even when accountants want to use fair value accounting, it is ex- tremely difficult to measure the periodic change in the value of many assets and liabilities unless they are actively traded. Thus, even if an accountant wanted to include “paper” gains and losses in income, she would often have great difficulty doing so. In the corporate setting, this means the accountants frequently must be content to record realized rather than economic income.

Imputed Costs A similar but subtler problem exists on the cost side of the income statement. It involves the cost of equity capital. Stryker’s accountants acknowledge that

28 Part One Assessing the Financial Health of the Firm



in 2013 the company had use of $9,047 million of shareholders’ money, measured at book value. They would further acknowledge that Stryker could not have operated without this money and that this money is not free. Just as creditors earn interest on loans, equity investors expect a return on their in- vestments. Yet if you look again at Stryker’s income statement (Table 1.3), you will find no mention of the cost of this equity; interest expense appears, but a comparable cost for equity does not.

While acknowledging that equity capital has a cost, the accountant does not record it on the income statement because the cost must be imputed, that is, estimated. Because there is no piece of paper stating the amount of money Stryker is obligated to pay owners, the accoun- tant refuses to recognize any cost of equity capital. Once again, the ac- countant would rather be reliably wrong than make a potentially inaccurate estimate. The result has been serious confusion in the minds of less knowledgeable observers and continuing “image” problems for corporations.

Following is the bottom portion of Stryker’s income statement as pre- pared by its accountant and as an economist might prepare it. Observe that while the accountant shows earnings of $1,006 million, the economist records a profit of only $101 million. These numbers differ because the economist includes a $905 million charge as a cost of equity capital, while the accountant pretends equity is free. (We will consider ways to estimate a company’s cost of equity capital in Chapter 8. Here, for illustrative purposes only, I have assumed a 10 percent annual equity cost and applied it to the book value of Stryker’s equity [$905 million � 10% � $9,047 million].)

($ millions) Accountant Economist

Operating income $1,339 $1,339 Interest expense 83 83 Other nonoperating expenses 44 44 Cost of equity 905 Income before taxes 1,212 307 Provision for taxes 206 206

Accounting earnings $1,006 Economic earnings $ 101

The distinction between accounting earnings and economic earnings might be only a curiosity if everyone understood that positive accounting earnings are not necessarily a sign of superior or even commendable per- formance. But when many labor unions, Occupy Wall Streeters, and politicians view accounting profits as evidence that a company can afford higher wages, higher taxes, or more onerous regulation, and when most

Chapter 1 Interpreting Financial Statements 29



managements view such profits as justification for distributing handsome performance bonuses, the distinction can be an important one. Keep in mind, therefore, that the right of equity investors to expect a competitive return on their investments is every bit as legitimate as a creditor’s right to interest and an employee’s right to wages. All voluntarily contribute scarce resources, and all are justified in expecting compensation. Remember too that a company is not shooting par unless its economic profits are zero or

30 Part One Assessing the Financial Health of the Firm

International Financial Reporting Standards A danger inherent in any cross-country comparison of accounting numbers is that accountants in different countries may not keep score by the same rules. Happily, this problem has diminished greatly over the past decade or so, and what optimists might call international accounting standards are emerging. The European Union took the lead in this initiative as part of its much broader effort to hammer out a common, integrated marketplace among member countries. After some 30 years of study, debate, and political wrangling, the accounting initiative became a reality on January 1, 2005, when all 7,000 publicly traded companies in Europe dumped their national accounting rules in favor of the newly designated International Financial Reporting Standards (IFRS). Today, over 100 coun- tries on six continents have adopted IFRS, either directly or by aligning national rules to the interna- tional standards. Conspicuously absent from the earlier adopters have been the United States and Japan who are, nonetheless, working at their own pace to join the club, or at least become affiliate members.

For many years, U.S. accounting authorities viewed American accounting rules as the gold stan- dard to which other countries could only aspire, and their approach to international accounting standards was to invite the rest of the world to adopt theirs. But accounting scandals in the early 2000s and the ensuing collapse of the accounting firm Arthur Andersen have made Americans a bit more humble about their accounting rules and a bit more willing to compromise.

A major barrier to greater transatlantic cooperation on accounting standards has been differing philosophical perspectives on the role such standards should play. The European philosophy is to articulate broad accounting principles and to charge accountants and executives to prepare com- pany accounts consistent with the spirit of those principles. Concerned that principles alone would leave too much room for manipulation, the American approach has been to lay down voluminous, detailed rules defining how each transaction is to be recorded and to demand strict conformance to the letter of those rules. Ironically, this rules-based philosophy seems to have backfired, for rather than limiting manipulation, the American “bright-line” approach appears to have encouraged it by shifting some executives’ focus from preparing fair and accurate statements to figuring out how best to beat the rules. The argument “we didn’t break any rules, so we must be innocent” appears to have been an enticing one.

One response to the breakdown in U.S. accounting standards was passage of the Sarbanes- Oxley Act of 2002, which among other changes requires chief executives and chief financial officers to personally attest to the appropriateness of their company’s financial reports. Another was to take the European, broad-brush approach more seriously. Indeed, there was a time some 10 years ago when it appeared that U.S. regulators and accounting authorities were about to name a date-certain when the United States would adopt IFRS. Today this no longer appears likely. Instead, U.S. and in- ternational accounting authorities appear intent on integrating the two standards on a piecemeal basis over an extended period. Not a single standard perhaps, but at least a workable compromise.



Chapter 1 Interpreting Financial Statements 31

greater. By this criterion, Stryker had a decent but not fantastic year in 2013. On closer inspection, you will find that many companies reporting apparently large earnings are really performing like weekend duffers when the cost of equity is included.

We will look at the difference between accounting and economic prof- its again in more detail in Chapter 8 under the rubric of economic value added, or EVA. In recent years, EVA has become a popular yardstick for assessing company and managerial performance.

In sum, those of us interested in financial analysis eventually develop a love-hate relationship with accountants. The value problem means that financial statements typically yield distorted information about company earnings and market value. This limits their applicability for many impor- tant managerial decisions. Yet financial statements frequently provide the best information available, and if we bear their limitations in mind, they can be a useful starting point for analysis. In the next chapter, we consider the use of accounting data for evaluating financial performance.


1. The cash flow cycle • Describes the flow of cash through a company. • Illustrates that profits and cash flow are not the same. • Reminds a manager she must be at least as concerned with cash flows

as with profits. 2. The balance sheet

• Is a snapshot at a point in time of what a company owns and what it owes.

• Rests on the fundamental accounting equation, assets = liabilities + owners’ equity, which applies to individual transactions as well as entire balance sheets.

• Lists assets and liabilities with maturities of less than a year as current.

• Shows shareholders’ equity on the liability side of the balance sheet as the accounting value of owners’ claims against existing assets.

3. The income statement • Divides changes in owners’ equity occurring over a period of time

into revenues and expenses, where revenues are increases in equity and expenses are reductions.

• Defines net income, or earnings, as the difference between revenues and expenses.



• Identifies revenues generated during the period and matches the corresponding costs incurred in generating the revenue.

• Embodies the accrual principle, which records revenues and ex- penses when there is reasonable certainty payment will be made, not when cash is received or disbursed.

• Records depreciation as the allocation of past expenditures for long-lived assets to future time periods to match revenues and expenses.

4. The cash flow statement • Focuses on solvency, having enough cash to pay bills as they come due. • Is an elaboration of a simple sources and uses statement, according

to which increases in asset accounts and reductions in liability ac- counts are uses of cash, while opposite changes in assets and liabili- ties are sources of cash.

5. The value problem • Emphasizes that accounting statements suffer from several limita-

tions when used to assess economic performance or value busi- nesses: – Many accounting values are transactions-based and hence back-

ward-looking, while market values are forward-looking. – Accounting often creates a false dichotomy between realized and

unrealized income. – Accountants refuse to assign a cost to equity capital, thereby sug-

gesting to lay observers that positive accounting profit means financial health.

• Is diminished by the use of fair value accounting, according to which the value of widely traded assets and liabilities appear at market price rather than historical cost but at the potential cost of distortions, volatility, complexity, and subjectivity.


Breitner, Leslie K., and Robert N. Anthony. Essentials of Accounting. 11th ed. Englewood Cliffs, NJ: Prentice Hall, 2012. 384 pages.

A great way to review or pick up the basics of accounting on your own. Available in paperback, about $75.

Downes, John, and Jordan Elliot Goodman. Dictionary of Finance and Investment Terms. 9th ed. New York: Barron’s Educational Services, Inc., 2012. 912 pages.

More than 5,000 terms clearly defined. Available in paperback, about $10.

32 Part One Assessing the Financial Health of the Firm



Chapter 1 Interpreting Financial Statements 33

Horngren, Charles T., Gary L. Sundem, John A. Elliott, and Donna Philbrick. Introduction to Financial Accounting. 11th ed. Englewood Cliffs, NJ: Prentice Hall, 2013. 648 pages.

The high-octane stuff—best-selling college text. Everything you ever wanted to know about the topic and then some. Yours for only $230.

Tracy, John A. How to Read a Financial Report: Wringing Vital Signs Out of the Numbers. 8th ed. New York: John Wiley & Sons, 2014. 240 pages.

A lively, accessible look at practical aspects of financial statement analysis. Available in paperback, about $15.

Welton, Ralph E., and George T. Friedlob. Keys to Reading an Annual Report. 4th ed. New York: Barron’s Educational Services, Inc., 2008. 208 pages.

A no-nonsense, practical guide to understanding financial reports. About $9.

WEBSITES From this site you can download a free copy of Merrill Lynch’s classic “How to Read a Financial Report” as a PDF file. Duke Professor Campbell Harvey’s glossary of finance with more than 8,000 terms defined and more than 18,000 hyperlinks. Edgar, a Securities and Exchange Commission site, contains virtually all filings of public companies in the United States. It is a treasure trove of financial information, including annual and quarterly reports. The referenced site offers a slick way to access Edgar, including direct downloading of individual filings in PDF and RTF formats. It’s free, and I use it often. An informative, practitioner-oriented website provided by the publishers of CFO magazine. Articles on current issues in accounting and finance.


Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are avail- able in the Instructor Resources within McGraw-Hill’s Connect, connect (See the Preface for more information).

1. a. What does it mean when cash flow from operations on a company’s cash flow statement is negative? Is this bad news? Is it dangerous?



34 Part One Assessing the Financial Health of the Firm

b. What does it mean when cash flow from investing activities on a company’s cash flow statement is negative? Is this bad news? Is it dangerous?

c. What does it mean when cash flow from financing activities on a company’s cash flow statement is negative? Is this bad news? Is it dangerous?

2. Braintree Corporation has $5 billion in assets, $4 billion in equity, and earned a profit of $100 million last year as the economy boomed. Se- nior management proposes paying themselves a large cash bonus in recognition of their performance. As a member of Braintree’s board of directors, how would you respond to this proposal?

3. True or false? a. If a company gets into financial difficulty, it can use some of its

shareholders’ equity to pay its bills for a time. b. It is impossible for a firm to have a negative book value of equity

without the firm going into bankruptcy. c. If a company increases its dividend, its net income will decrease. d. You can construct a sources and uses statement for 2014 if you

have a company’s balance sheets for year-end 2013 and 2014. e. The “goodwill” account on the balance sheet is an attempt by ac-

countants to measure the benefits that result from a company’s public relations efforts in the community.

f. A reduction in an asset account is a use of cash, while a reduction in a liability account is a source of cash.

4. Explain briefly how each of the following transactions would affect a company’s balance sheet. (Remember, assets must equal liabilities plus owners’ equity before and after the transaction.) a. Sale of used equipment with a book value of $300,000 for $500,000

cash. b. Purchase of a new $80 million building, financed 40 percent with

cash and 60 percent with a bank loan. c. Purchase of a new building for $60 million cash. d. A $40,000 payment to trade creditors. e. A firm’s repurchase of 10,000 shares of its own stock at a price of

$24 per share. f. Sale of merchandise for $80,000 in cash. g. Sale of merchandise for $120,000 on credit. h. Dividend payment to shareholders of $50,000.



Chapter 1 Interpreting Financial Statements 35

5. Why do you suppose financial statements are constructed on an ac- crual basis rather than a cash basis when cash accounting is so much easier to understand?

6. Table 3.1 in Chapter 3 presents financial statements over the period 2011–2014 for R&E Supplies, Inc. a. Construct a sources and uses statement for the company over this

period (one statement for all three years). b. What insights, if any, does the sources and uses statement give you

about the financial position of R&E Supplies?

7. You are responsible for labor relations in your company. During heated labor negotiations, the General Secretary of your largest union exclaims, “Look, this company has $15 billion in assets, $7.5 billion in equity, and made a profit last year of $300 million—due largely, I might add, to the effort of union employees. So don’t tell me you can’t afford our wage demands.” How would you reply?

8. You manage a real estate investment company. One year ago the com- pany purchased 10 parcels of land distributed throughout the com- munity for $10 million each. A recent appraisal of the properties indicates that five of the parcels are now worth $8 million each, while the other five are worth $16 million each. Ignoring any income re- ceived from the properties and any taxes paid over the year, calculate the investment company’s accounting earnings and its economic earn- ings in each of the following cases: a. The company sells all of the properties at their appraised values

today. b. The company sells none of the properties. c. The company sells the properties that have fallen in value and

keeps the others. d. The company sells the properties that have risen in value and keeps

the others. e. After returning from a property management seminar, an em-

ployee recommends that the company adopt an end-of-year policy of always selling properties that have risen in value since purchase and always retaining properties that have fallen in value. The em- ployee explains that, with this policy, the company will never show a loss on its real estate investment activities. Do you agree with the employee? Why, or why not?

9. Please ignore taxes for this problem. During 2013, Acadia, Inc. earned net income of $500,000. The firm increased its accounts re- ceivable during the year by $150,000. The book value of its assets



36 Part One Assessing the Financial Health of the Firm

declined by an amount equal to the year’s depreciation charge, or $130,000, and the market value of its assets increased by $25,000. Based only on this information, how much cash did Acadia generate during the year?

10. Jonathan currently is a brew master for Acme Brewery. He really enjoys his job, but is intrigued by the prospect of quitting and starting his own brewery. He currently makes $62,000 at Acme Brewery. Jonathan anticipates that his new brewery will have annual revenues of $230,000, and total annual expenses for operating the brewery, outside of any payments to Jonathan, will be $190,000. Jonathan comes to you with his idea. He believes that he would be equally happy with either option, but that starting his own brewery is the right decision in light of its profitability. Ignoring what might happen beyond the first year, do you agree with him? Why or why not?

11. Selected information for Blake’s Restaurant Supply follows.

($ millions)

2013 2014

Net sales 694 782 Cost of goods sold 450 502 Depreciation 51 61 Net income 130 142 Finished goods inventory 39 29 Accounts receivable 57 87 Accounts payable 39 44 Net fixed assets 404 482 Year-end cash balance 86 135

a. During 2014 how much cash did Blake’s collect from sales? b. During 2014 what was the cost of goods produced by the

company? c. Assuming the company neither sold nor salvaged any assets during

the year, what were the company’s capital expenditures during 2014?

d. Assuming that there were no financing cash flows during 2014 and basing your answer solely on the information provided, what was Blake’s cash flow from operations in 2014?

12. Below are summary cash flow statements for three roughly equal- sized companies.



Chapter 1 Interpreting Financial Statements 37

($ millions)


Net cash flows from operating activities (300) (300) 300 Net cash used in investing activities (900) (30) (90) Net cash from financing activities 1,200 210 (240) Cash balance at beginning of year 150 150 150

a. Calculate each company’s cash balance at the end of the year. b. Explain what might cause company C’s net cash from financing ac-

tivities to be negative. c. Looking at companies A and B, which company would you prefer

to own? Why? d. Is company C’s cash flow statement cause for any concern on the

part of C’s management or shareholders? Why or why not?

13. Telluride Mining’s equity has a market value of $25 million with 800,000 shares outstanding. The book value of its equity is $15 million. a. What is Telluride’s stock price per share? What is its book value per

share? b. If the company repurchases 20% of its shares in the stock market at

their current price, how will this affect the book value of equity if all else remains the same?

c. If there are no taxes or transaction costs, and investors do not change their perceptions of the firm, what should the market value of the firm be after the repurchase?

d. Instead of a share repurchase, the company decides to raise money by selling an additional 10% of its shares on the market. If it can issue these additional shares at the current market price, how will this affect the book value of equity if all else remains the same?

e. If there are no taxes or transaction costs, and investors do not change their perception of the firm, what should the market value of the firm be after this stock issuance? Its price per share?

14. A spreadsheet containing Whistler Corporation’s financial statements is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). a. Prepare a sources and uses statement for Whistler Corp. for fiscal

year 2014. b. Prepare a cash flow statement for Whistler Corp. for fiscal year






Evaluating Financial Performance

You can’t manage what you can’t measure. William Hewlett

The cockpit of a 747 jet looks like a three-dimensional video game. It is a sizable room crammed with meters, switches, lights, and dials requiring the full attention of three highly trained pilots. When compared to the cockpit of a single-engine Cessna, it is tempting to conclude that the two planes are different species rather than distant cousins. But at a more fun- damental level, the similarities outnumber the differences. Despite the 747’s complex technology, the 747 pilot controls the plane in the same way the Cessna pilot does: with a stick, a throttle, and flaps. And to change the altitude of the plane, each pilot makes simultaneous adjustments to the same few levers available for controlling the plane.

Much the same is true of companies. Once you strip away the facade of apparent complexity, the levers with which managers affect their compa- nies’ financial performance are comparatively few and are similar from one company to another. The executive’s job is to control these levers to ensure a safe and efficient flight. And like the pilot, the executive must re- member that the levers are interrelated; one cannot change the business equivalent of the flaps without also adjusting the stick and the throttle.

The Levers of Financial Performance

In this chapter, we analyze financial statements for the purpose of evaluating performance and understanding the levers of management control. We begin by studying the ties between a company’s operating decisions, such as how many units to make this month and how to price them, and its financial performance. These operating decisions are the levers by which manage- ment controls financial performance. Then we broaden the discussion to consider the uses and limitations of ratio analysis as a tool for evaluating per- formance. To keep things practical, we will again use the financial statements



for Stryker Corporation, presented in Tables 1.2, 1.3, and 1.5 of the last chapter, to illustrate the techniques. The chapter concludes with an evalua- tion of Stryker’s financial performance relative to its competition. (See Ad- ditional Resources at the end of the chapter for information about HISTORY, complimentary software for calculating company ratios. Also at the end of the chapter, Table 2.4 presents summary definitions of the princi- pal ratios appearing throughout the chapter.)

Return on Equity

By far the most popular yardstick of financial performance among in- vestors and senior managers is the return on equity (ROE), defined as

Stryker’s ROE for 2013 was

It is not an exaggeration to say that the careers of many senior execu- tives rise and fall with their firms’ ROEs. ROE is accorded such impor- tance because it is a measure of the efficiency with which a company employs owners’ capital. It is a measure of earnings per dollar of invested equity capital or, equivalently, of the percentage return to owners on their investment. In short, it measures bang per buck.

Later in this chapter, we will consider some significant problems with ROE as a measure of financial performance. For now, let us accept it pro- visionally as at least widely used and see what we can learn.

The Three Determinants of ROE To learn more about what management can do to increase ROE, suppose we rewrite ROE in terms of its three principal components:

Denoting the last three ratios as the profit margin, asset turnover, and financial leverage, respectively, the expression can be written as

This says that management has only three levers for controlling ROE: (1) the earnings squeezed out of each dollar of sales, or the profit margin; (2) the sales generated from each dollar of assets employed, or the asset turnover; and (3) the amount of equity used to finance the assets, or the

Return on equity =

Profit margin *

Asset turnover *

Financial leverage

ROE = Net income Sales

* Sales Assets

* Assets

Shareholders’ equity

ROE = $1,006 $9,047

= 11.1%

Return on equity = Net income

Shareholders’ equity

40 Part One Assessing the Financial Health of the Firm

© Stryker.



financial leverage.1 With few exceptions, whatever management does to in- crease these ratios increases ROE.

Note too the close correspondence between the levers of performance and company financial statements. Thus, the profit margin summarizes a company’s income statement performance by showing profit per dollar of sales. The asset turnover ratio summarizes the company’s management of the asset side of its balance sheet by showing the resources required to support sales. And the financial leverage ratio summarizes management of the liabilities side of the balance sheet by showing the amount of share- holders’ equity used to finance the assets. This is reassuring evidence that despite their simplicity, the three levers do capture the major elements of a company’s financial performance.

We find that Stryker’s 2013 ROE was generated as follows:

Table 2.1 presents ROE and its three principal components for 10 highly diverse businesses. It shows quite clearly that there are many paths

11.1% = 11.2% * 0.57 * 1.74

$1,006 $9,047

= $1,006 $9,021

* $9,021

$15,743 *

$15,743 $9,047

Chapter 2 Evaluating Financial Performance 41

1At first glance the ratio of assets to shareholders’ equity may not look like a measure of financial leverage, but consider the following:

And the liabilities-to-equity ratio clearly measures financial leverage.

Assets Equity

= Liabilities + Equity Equity

= Liabilities Equity

+ 1

TABLE 2.1 ROEs and Levers of Performance for 10 Diverse Companies, 2013*

Return on Profit Asset Financial Equity Margin Turnover Leverage (ROE) (P) (A) (T)

(%) � (%) � (times) � (times)

Chevron 14.4 � 9.7 � 0.87 � 1.70 Electricite de France 10.2 � 4.7 � 0.29 � 7.42 Google 14.8 � 21.6 � 0.54 � 1.27 Hewlett-Packard 18.8 � 4.6 � 1.06 � 3.88 Hyundai Motor 15.9 � 10.3 � 0.65 � 2.36 JPMorgan Chase 8.5 � 18.6 � 0.04 � 11.44 Target 12.1 � 2.7 � 1.63 � 2.74 Norfolk Southern 16.9 � 17.0 � 0.35 � 2.88 Southwest Airlines 10.3 � 4.3 � 0.91 � 2.64 Stryker 11.1 � 11.2 � 0.57 � 1.74

*Totals may not add due to rounding.



to heaven: The companies’ ROEs are quite similar, but the combinations of profit margin, asset turnover, and financial leverage producing this end result vary widely. Thus, ROE ranges from a high of 18.8 percent for Hewlett-Packard, a diversified technology company, to a low of 8.5 percent for banker JPMorgan Chase, while the range for the profit margin, to take one example, is from a low of 2.7 percent for discount retailer Target to a high of 21.6 percent for Internet firm Google. ROE differs by about 2 to 1 high to low, but the profit margin varies by a factor of 8 to 1. Compa- rable ranges for asset turnover and financial leverage are 40 to 1 and 9 to 1, respectively.

Why are ROEs similar across firms while profit margins, asset turnovers, and financial leverages differ dramatically? The answer, in a word, is competition. Attainment of an unusually high ROE by one com- pany acts as a magnet to attract rivals anxious to emulate the superior per- formance. As rivals enter the market, the heightened competition drives the successful company’s ROE back toward the average. Conversely, un- usually low ROEs repel potential new competitors and drive existing companies out of business so that over time, survivors’ ROEs rise toward the average.

To understand how managerial decisions and a company’s competi- tive environment combine to affect ROE, we will examine each lever of performance in more detail. In anticipation of the discussion of ratio analysis to follow, we will also consider related commonly used financial ratios.

The Profit Margin The profit margin measures the fraction of each dollar of sales that trickles down through the income statement to profits. This ratio is particularly important to operating managers because it reflects the company’s pricing strategy and its ability to control operating costs. As Table 2.1 indicates, profit margins differ greatly among industries de- pending on the nature of the product sold and the company’s competi- tive strategy.

Note too that profit margin and asset turnover tend to vary inversely. Companies with high profit margins tend to have low asset turns, and vice versa. This is no accident. Companies that add significant value to a prod- uct, such as Google, can demand high profit margins. However, because adding value to a product usually requires lots of assets, these same firms tend to have lower asset turns. At the other extreme, grocery stores and discount retailers, such as Target, bring the product in the store on forklift trucks, sell for cash, and make the customer carry out his own purchases.

42 Part One Assessing the Financial Health of the Firm



Because they add little value to the product, they have very low profit margins and correspondingly high asset turns. It should be apparent, therefore, that a high profit margin is not necessarily better or worse than a low one—it all depends on the combined effect of the profit margin and the asset turnover.

Return on Assets To look at the combined effect of margins and turns, we can calculate the return on assets (ROA):

Stryker’s ROA in 2013 was

This means Stryker earned an average of 6.4 cents on each dollar tied up in the business.

ROA is a basic measure of the efficiency with which a company allo- cates and manages its resources. It differs from ROE, in that it measures profit as a percentage of the money provided by owners and creditors as opposed to only the money provided by owners.

Some companies, such as Google and Norfolk Southern, a railroad, produce their ROAs by combining a high profit margin with a low asset turn; others, such as Target, adopt the reverse strategy. A high profit mar- gin and a high asset turn are ideal, but can be expected to attract consider- able competition. Conversely, a low profit margin combined with a low asset turn will attract only bankruptcy lawyers.

Gross Margin When analyzing profitability, it is often interesting to distinguish between variable costs and fixed costs. Variable costs change as sales vary, while fixed costs remain constant. Companies with a high proportion of fixed costs are more vulnerable to sales declines than other firms, because they cannot reduce fixed costs as sales fall.

Unfortunately, the accountant does not differentiate between fixed and variable costs when constructing an income statement. However, it is usu- ally safe to assume that most expenses in cost of goods sold are variable, while most of the other operating costs are fixed. The gross margin enables

Return on assets = $1,006

$15,743 = 6.4%

ROA = Profitmargin * Asset

turnover = Net income


Chapter 2 Evaluating Financial Performance 43



us to distinguish, insofar as possible, between fixed and variable costs. It is defined as

where gross profit equals net sales less cost of sales. Sixty-nine percent of Stryker’s sales dollar is a contribution to fixed cost and profits: 69 cents of every sales dollar is available to pay for fixed costs and to add to profits.

One common use of the gross margin is to estimate a company’s breakeven sales volume. Stryker’s income statement tells us that total operating expenses in 2013 were $4,920 million. If we assume these ex- penses are fixed and if 69 cents of each Stryker sales dollar is available to pay for fixed costs and add to profits, the company’s zero-profit sales volume must be $4,920/0.69, or $7,130 million.2 Assuming operating expenses and the gross margin are independent of sales, Stryker loses money when sales are below $7,130 million, and makes money when sales are above this figure.

Asset Turnover Some newcomers to finance believe assets are a good thing: the more the better. The reality is just the opposite: Unless a company is about to go out of business, its value is in the income stream it generates, and its assets are simply a necessary means to this end. Indeed, the ideal company would be one that produced income without any assets; then no investment would be required, and returns would be infinite. Short of this fantasy, our ROE equation tells us that, other things constant, financial performance improves as asset turnover rises. This is the second lever of management performance.

The asset turnover ratio measures the sales generated per dollar of assets. Stryker Corporation’s asset turnover of 0.57 means that Stryker generated 57 cents of sales for each dollar invested in assets. This ratio measures asset intensity, with a low asset turnover signifying an asset-intensive business and a high turnover the reverse.

The nature of a company’s products and its competitive strategy strongly influence asset turnover. A steel mill will never have the asset turnover of a grocery store. But this is not the end of the story, because

Gross margin = Gross profit

Sales =

$6,259 $9,021

= 69.4%

44 Part One Assessing the Financial Health of the Firm

2Income � Sales � Variable costs � Fixed costs � Sales � Gross margin � Fixed costs. Setting income to zero and solving for sales, Sales � Fixed costs/Gross margin.



management diligence and creativity in controlling assets are also vital determinants of a company’s asset turnover. When product technology is similar among competitors, control of assets is often the margin be- tween success and failure.

Control of current assets is especially critical. You might think the dis- tinction between current and fixed assets based solely on whether the asset will revert to cash within one year is artificial. But more is involved than this. Current assets, especially accounts receivable and inventory, have several unique properties. One is that if something goes wrong—if sales decline unexpectedly, customers delay payment, or a critical part fails to arrive—a company’s investment in current assets can balloon very rapidly. When even manufacturing companies routinely invest one-half or more of their money in current assets, it is easy to appreciate that even modest alterations in the management of these assets can significantly affect com- pany finances.

A second distinction is that unlike fixed assets, current assets can become a source of cash during business downturns. As sales decline, a company’s investment in accounts receivable and inventory should fall as well, thereby freeing cash for other uses. (Remember, a reduction in an asset account is a source of cash.) The fact that in a well-run company current assets move in an accordion-like fashion with sales is appealing to creditors. They know that during the upswing of a business cycle rising current assets will require loans, while during a downswing falling current assets will provide the cash to repay the loans. In bankers’ jargon, such a loan is said to be self-liquidating in the sense that the use to which the money is put creates the source of repayment.

It is often useful to analyze the turnover of each type of asset on a com- pany’s balance sheet individually. This gives rise to what are known as control ratios. Although the form in which each ratio is expressed may vary, every control ratio is simply an asset turnover for a particular type of asset. In each instance, the firm’s investment in the asset is compared to net sales or a closely related figure.

Why compare assets to sales? The fact that a company’s investment in, say, accounts receivable has risen over time could be due to two forces: (1) Perhaps sales have risen and simply dragged receivables along, or (2) management may have slackened its collection efforts. Relating re- ceivables to sales in a control ratio adjusts for changes in sales, enabling the analyst to concentrate on the more important effects of changing management control. Thus, the control ratio distinguishes between sales- induced changes in investment and other, perhaps more sinister causes. Following are some standard control ratios and their values for Stryker Corporation in 2013.

Chapter 2 Evaluating Financial Performance 45



Inventory Turnover Inventory turnover is expressed as

An inventory turn of 1.9 times means that items in Stryker’s inventory turn over 1.9 times per year on average; said differently, the typical item sits in inventory about 192 days before being sold (365 days�1.9 times � 192 days).

Several alternative definitions of the inventory turnover ratio exist, in- cluding sales divided by ending inventory and cost of goods sold divided by average inventory. Cost of goods sold is a more appropriate numera- tor than sales because sales include a profit markup that is absent from inventory. But beyond this, I see little to choose from among the various definitions.

The Collection Period The collection period highlights a company’s management of accounts re- ceivable. For Stryker

Credit sales appear here rather than net sales because only credit sales generate accounts receivable. As a company outsider, however, I do not know what portion of Stryker’s net sales, if any, are for cash, so I assume they are all on credit. Credit sales per day is defined as credit sales for the accounting period divided by the number of days in the accounting pe- riod, which for annual statements is obviously 365 days.

Two interpretations of Stryker’s collection period are possible. We can say that Stryker has an average of 61.4 days’ worth of credit sales tied up in accounts receivable, or we can say that the average time lag between sale and receipt of cash from the sale is 61.4 days.

Collection period = Accounts receivable Credit sales per day

= $1,518

$9,021�365 = 61.4 days

Inventory turnover = Cost of goods sold Ending inventory

= $2,762 $1,422

= 1.9 times

46 Part One Assessing the Financial Health of the Firm

Beware of Seasonal Companies Interpreting ratios of companies with seasonal sales can be tricky. For example, suppose a com- pany’s sales peak sharply at Christmas, resulting in high year-end accounts receivable. A naïve col- lection period calculated by relating year-end accounts receivable to average daily sales for the whole year will produce an apparently very high collection period because the denominator is insen- sitive to the seasonal peak. To avoid being misled, a better way to calculate the collection period for a seasonal company is to use credit sales per day based only on the prior 60 to 90 days’ sales. This matches the accounts receivable to the credit sales actually generating the receivables.



If we like, we can define a simpler asset turnover ratio for accounts re- ceivable as just credit sales/accounts receivable. However, the collection period format is more informative, because it allows us to compare a com- pany’s collection period with its terms of sale. Thus, if a company sells on 90-day terms, a collection period of 65 days is excellent, but if the terms of sale were 30 days, our interpretation would be quite different.

Days’ Sales in Cash Stryker’s days’ sales in cash is

Stryker has 161.0 days’ worth of sales in cash and securities. Whether this is the right amount of cash for Stryker is difficult to say. On the one hand, cash balances should not be too low. Companies require modest amounts of cash to facilitate transactions and are sometimes required to carry substan- tially larger amounts as compensating balances for bank loans. In addition, cash and marketable securities can be an important source of liquidity for a firm in an emergency. On the other hand, if cash balances are too high, shareholders may become disappointed that the firm’s assets are not put to more productive and profitable uses. So the question of how much cash and securities a company should carry is often closely related to the broader question of how important liquidity is to the company and how best to pro- vide it. The median days’ sales in cash for nonfinancial companies in the Standard & Poor’s 500 Index in 2013 was 40 days, more than double the fig- ure for 2000. In comparison, Stryker’s 161 days is quite high and more in line with information technology companies, which often carry notoriously high cash balances. The median days’ sales in cash in 2013 among the in- formation technology companies in the S&P 500 was 158 days, with Google and Microsoft each clocking in at about 360 days.

Payables Period The payables period is a control ratio for a liability. It is simply the collec- tion period applied to accounts payable. For Stryker

The proper definition of the payables period uses credit purchases, be- cause they are what generate accounts payable. However, an outsider sel- dom knows credit purchases, so it is frequently necessary to settle for the closest approximation: cost of goods sold. This is what I have done above for Stryker; $2,762 million is Stryker’s cost of goods sold, not its credit

Payables period =

Accounts payable Credit purchases per day

= $314 $2,762�365

= 41.5 days

Days’ sales in cash =

Cash and securities Sales per day

= $3,980

$9,021�365 = 161.0 days

Chapter 2 Evaluating Financial Performance 47



purchases. Cost of goods sold can differ from credit purchases for two reasons. First, the company may be adding to or depleting inventory, that is, purchasing at a different rate than it is selling. Second, all manufactur- ers add labor to material in the production process, thereby making cost of goods sold larger than purchases. Because of these differences, it is tricky to compare a manufacturing company’s payables period, based on cost of goods sold, to its purchase terms. For Stryker, it is almost certain that cost of goods sold overstates credit purchases per day and that Stryker’s suppliers are waiting a good bit longer than 41.5 days on aver- age to receive payment.

48 Part One Assessing the Financial Health of the Firm

Google’s Levers of Performance Internet titan Google’s 2013 levers of performance make instructive reading. As shown below, the company combined an attractive profit margin and conservative financial leverage with an abysmally low asset turnover of only 0.54 times to generate a rather ordinary ROE of 14.8 percent. This is mediocre performance for a company selling at over 30 times earnings and perceived by most to be the dominant Internet player.

How can an Internet company generate an asset turnover more like that of a steel mill or a pub- lic utility? A look at Google’s balance sheet explains the mystery. At year-end 2013, roughly $60 bil- lion, or over half of Google’s assets, were in cash and marketable securities. It’s as if the company had merged with a money market mutual fund. And Google is not alone. It is common practice among leading technology companies to build huge war chests, which they argue are necessary to finance continued growth and to facilitate possible acquisitions—like maybe if Panama or South Dakota ever came up for sale. Others, including Ralph Nader, see a more sinister purpose: to keep the money out of the hands of shareholders and to avoid taxes.

To focus on Google’s operating performance apart from its ability to invest excess cash, we can strip cash and marketable securities out of the analysis. To do this, imagine the company returned 90 percent of its cash and securities to shareholders as a giant dividend. Alternatively, imagine Google split into two companies: an operating Internet company and a money market mutual fund charged with investing 90 percent of the firm’s excess cash. This would cut the operating company’s assets and shareholders’ equity by $54 billion, while leaving the company with a still robust 36.6 days’ sales in cash. Assuming a modest 2 percent after-tax return on cash and securi- ties, this would knock $1.08 billion from net income. The resulting revised levers of performance appear in the following summary. Asset turnover is now a more plausible, but still modest, 1.05 times, and ROE is up to a robust 35.6 percent. These numbers more accurately reflect the eco- nomics of Google’s business.

Return on Profit Asset Financial Equity � Margin � Turnover � Leverage

As reported 14.8% � 21.6% � 0.54 � 1.27 Revised 35.6% � 19.8% � 1.05 � 1.71



Fixed-Asset Turnover Companies or industries requiring large investments in long-lived as- sets to produce their goods are said to be capital intensive. Because a preponderance of their costs are fixed, capital-intensive businesses, such as auto manufacturers and airlines, are especially sensitive to the state of the economy, prospering in good times as sales rise relative to costs and suffering in bad as the reverse occurs. Capital intensity, also referred to as operating leverage, is of particular concern to creditors because it magni- fies the basic business risks faced by a firm.

Fixed-asset turnover is a measure of capital intensity, with a low turnover implying high intensity. The ratio in 2013 for Stryker was

where $1,081 million is the book value of Stryker’s net property, plant, and equipment.

Financial Leverage The third lever by which management affects ROE is financial leverage. A company increases its financial leverage when it raises the proportion of debt relative to equity used to finance the business. Unlike the profit mar- gin and the asset turnover ratio, where more is generally preferred to less, financial leverage is not something management necessarily wants to max- imize, even when doing so increases ROE. Instead, the challenge of finan- cial leverage is to strike a prudent balance between the benefits and costs of debt financing. Later we will devote all of Chapter 6 to this important fi- nancial decision. For now, it is sufficient to recognize that more leverage is not necessarily preferred to less and that while companies have consider- able latitude in their choice of how much financial leverage to employ, there are economic and institutional constraints on their decision.

As Table 2.1 suggests, the nature of a company’s business and its assets in- fluence the financial leverage it can employ. In general, businesses with highly predictable and stable operating cash flows, such as Electricite de France, an electric utility, can safely undertake more financial leverage than firms facing a high degree of market uncertainty, such as Google. In addi- tion, businesses such as banks, which usually have diversified portfolios of readily salable, liquid assets, can also safely use more financial leverage than the typical business.

Another pattern evident in Table 2.1 is that ROA and financial leverage tend to be inversely related. Companies with low ROAs generally employ

= 8.3 times

Fixed-asset turnover =

Sales Net property, plant, and equipment

= $9,021 $1,081

Chapter 2 Evaluating Financial Performance 49



more debt financing, and vice versa. This is consistent with the previous paragraph. Safe, stable, liquid investments tend to generate low returns but substantial borrowing capacity. Banks are extreme examples of this pattern. JPMorgan Chase combines what by manufacturing standards would be a horrible 0.7 percent ROA with an astronomical leverage ratio of 11.44 to generate a modest ROE of 8.5 percent. The key to this pairing is the safe, liquid nature of the bank’s assets. (Past loans to Third World dictators, Texas energy companies, and subprime mortgage borrowers are, of course, another story—one the bank would just as soon forget.)

The following ratios measure financial leverage, or debt capacity, and the related concept of liquidity.

Balance Sheet Ratios The most common measures of financial leverage compare the book value of a company’s liabilities to the book value of its assets or equity. This gives rise to the debt-to-assets ratio and the debt-to-equity ratio, defined as

The first ratio says that money to pay for 42.5 percent of Stryker’s assets, in book value terms, comes from creditors of one type or another. The second ratio says the same thing in a slightly different way: Creditors sup- ply Stryker with 74 cents for every dollar supplied by shareholders. As footnote 1 demonstrated earlier, the lever of performance introduced ear- lier, the assets-to-equity ratio, is just the debt-to-equity ratio plus 1.

As many companies have built up large excess balances of cash and mar- ketable securities, analysts have increasingly replaced debt in these equa- tions with “net” debt, defined as total liabilities less cash and marketable securities. The idea is that as safe, interest-bearing assets, excess cash and se- curities are essentially negative debt and should thus be subtracted from li- abilities when measuring aggregate indebtedness. Thought of another way, if a company has excess cash that could, on short notice, be used to pay off outstanding debts, then the company’s true level of indebtedness is lower than the standard leverage ratios would suggest. Because, as noted earlier, Stryker’s cash balances are relatively high, calculating their debt ratios using net debt could be enlightening. Indeed, the net debt figures paint a rather different picture of Stryker’s indebtedness, with a debt-to-assets ratio of only 17.3 percent and a debt-to-equity ratio of only 30.0 percent.

Debt-to-equity ratio = Total liabilities Shareholders’ equity =

$6,696 $9,047

= 74.0%

Debt-to-assets ratio = Total liabilities Total assets

= $6,696

$15,743 = 42.5%

50 Part One Assessing the Financial Health of the Firm



Coverage Ratios A number of variations on these balance sheet measures of financial lever- age exist. Conceptually, however, there is no reason to prefer one over an- other, for they all focus on balance sheet values, and hence all suffer from the same weakness. The financial burden a company faces by using debt financing ultimately depends not on the size of its liabilities relative to as- sets or to equity but on its ability to meet the annual cash payments the debt requires. A simple example will illustrate the distinction. Suppose two companies, A and B, have the same debt-to-assets ratio, but A is very profitable and B is losing money. Chances are that B will have difficulty meeting its annual interest and principal obligations, while A will not. The obvious conclusion is that balance sheet ratios are of primary interest only in liquidation, when the proceeds of asset sales are to be distributed among creditors and owners. In all other instances, we should be more interested in comparing the annual burden the debt imposes to the cash flow available for debt service.

This gives rise to what are known as coverage ratios, the most common of which are times interest earned and times burden covered. Letting EBIT represent earnings before interest and taxes (calculated as earnings before taxes plus interest expense), the ratios are defined as

Both ratios compare income available for debt service in the numerator to some measure of annual financial obligation. For both ratios, the income available is EBIT. This is the earnings the company generates that can be used to make interest payments. EBIT is before taxes because interest payments are before-tax expenditures, and we want to compare like quantities. Stryker’s times interest earned ratio of 15.6 means the company earned its interest obligation 15.6 times over in 2013; EBIT was 15.6 times as large as interest.

= $1,295

$83 + $25

1 – a $206 $1,212

b = 11.4 times

Times burden covered = EBIT

Interest + Principal repayment

1 – Tax rate

Times interest earned = EBIT

Interest expense =

$1,295 $83

= 15.6 times

Chapter 2 Evaluating Financial Performance 51



Though dentists may correctly claim that if you ignore your teeth they’ll eventually go away, the same cannot be said for principal repay- ments. If a company fails to make a principal repayment when due, the outcome is the same as if it had failed to make an interest payment. In both cases, the company is in default and creditors can force it into bankruptcy. The times-burden-covered ratio reflects this reality by expanding the definition of annual financial obligations to include debt principal repayments as well as interest. When including principal repayment as part of a company’s financial burden, we must remember to express the figure on a before-tax basis comparable to interest and EBIT. Unlike in- terest payments, principal repayments are not a tax-deductible expense. This means that if a company is in, say, the 50 percent tax bracket, it must earn $2 before taxes to have $1 after taxes to pay creditors. The other dol- lar goes to the tax collector. For other tax brackets, the before-tax burden of a principal repayment is found by dividing the repayment by 1 minus the company’s tax rate. Adjusting the principal repayment in this manner to its before-tax equivalent is known in the trade as grossing up the principal—about as gross as finance ever gets.

An often-asked question is: Which of these coverage ratios is more meaningful? The answer is that both are important. If a company could always roll over its maturing obligations by taking out new loans as it re- paid old ones, the net burden of the debt would be merely the interest ex- pense, and times interest earned would be the more important ratio. The problem, as we were all vividly reminded during the recent financial panic, is that the replacement of maturing debt with new debt is not an au- tomatic feature of capital markets. In some instances, when capital mar- kets are unsettled or a company’s fortunes decline, creditors may refuse to renew maturing obligations. Then the burden of the debt suddenly be- comes interest plus principal payments, and the times-burden-covered ratio assumes paramount importance.

This is what happened beginning in the summer of 2007 when growing defaults on subprime mortgages prompted some short-term lenders to demand immediate payment from a variety of mortgage investment com- panies. These special purpose companies were issuing short-term debt to finance ownership of complex, long-term mortgage-backed securities. This was a nice business as long as lenders willingly rolled over maturing debts. But the minute they balked, a vicious circle ensued as borrowers sold their securities at cut-rate prices to repay short-term lenders, and short-term lenders, reacting to the falling prices, increasingly refused to roll over maturing obligations.

In sum, it is fair to conclude that the times-burden-covered ratio is too conservative because it assumes the company will pay its existing loans

52 Part One Assessing the Financial Health of the Firm



down to zero, but that the times-interest-earned ratio is too liberal be- cause it assumes the company will always roll over all of its obligations as they mature.

Market Value Leverage Ratios A third family of leverage ratios relates a company’s liabilities to the market value of its equity or the market value of its assets. For Stryker Cor- poration in 2013,

Note that I have assumed the market value of debt equals the book value of debt in both of these ratios. Strictly speaking, this is seldom true, but in most instances, the difference between the two quantities is small. Also, accurately estimating the market value of debt often turns out to be a tedious, time-consuming chore that is best avoided—unless, of course, you are being paid by the hour.

Market value ratios are clearly superior to book value ratios simply be- cause book values are historical, often irrelevant numbers, while market values indicate the true worth of creditors’ and owners’ stakes in the busi- ness. Recalling that market values are based on investors’ expectations about future cash flows, market value leverage ratios can be thought of as coverage ratios extended over many future periods. Instead of comparing income to financial burden in a single year as coverage ratios do, market value ratios compare today’s value of expected future income to today’s value of future financial burdens.

Market value ratios are especially helpful when assessing the finan- cial leverage of rapidly growing, start-up businesses. Even when such companies have terrible or nonexistent coverage ratios, lenders may still extend them liberal credit if they believe future cash flows will be sufficient to service the debt. McCaw Communications offers an ex- treme example of this. At year-end 1990, McCaw had over $5 billion in debt; a debt-to-equity ratio, in book terms, of 330 percent; and annualized interest expenses of more than 60 percent of net revenues.

= $6,696

$6,696 + $28,403 = 19.1%

Market value of debt Market value of assets

= Market value of debt

Market value of debt + equity

= $6,696

$28,403 = 23.6%

Market value of debt

Market value of equity =

Market value of debt Number of shares of stock * Price per share

Chapter 2 Evaluating Financial Performance 53



54 Part One Assessing the Financial Health of the Firm

Moreover, despite explosive growth, McCaw had never made a mean- ingful operating profit in its principal cellular telephone business. Why then did otherwise intelligent creditors loan McCaw $5 billion? Because creditors and equity investors believed it was only a matter of time before the company would begin to generate huge cash flows. This optimism was handsomely rewarded in late 1993 when AT&T paid $12.6 billion to acquire McCaw. Including the $5 billion in debt assumed by AT&T, the acquisition ranked as the second largest in corporate history at the time.

Another example is In 1998 the company recorded its largest-ever loss of $124 million, had never earned a profit, and had only $139 million left in shareholders’ equity. But not to worry: Lenders were still pleased to extend the company $350 million in long- term debt. Apparently, creditors are willing to overlook a number of messy details when a borrower’s sales are growing 300 percent a year and the market value of its equity tops $17 billion—especially when the debt is convertible into equity. After all, in market value terms, Amazon’s debt-to-equity ratio was only 3 percent. Today Amazon’s equity is worth over $160 billion, and its market-value debt-to-equity ratio is below 2 percent.

Economists like market value leverage ratios because they are accurate indicators of company indebtedness at a point in time. But you should be aware that market value ratios are not without problems. One is that they ignore rollover risks. When creditors take the attitude that debt must be re- paid with cash, not promises of future cash, modest market value leverage ratios can be of hollow comfort. Also, despite these ratios’ conceptual ap- peal, few companies use them to set financing policy or to monitor debt lev- els. This may be due in part to the fact that volatile stock prices can make market value ratios appear somewhat arbitrary and beyond management’s control.

Liquidity Ratios One determinant of a company’s debt capacity is the liquidity of its assets. An asset is liquid if it can be readily converted to cash, while a liability is liquid if it must be repaid in the near future. As the subprime mortgage debacle illustrates, it is risky to finance illiquid assets such as fixed plant and equipment with liquid, short-term liabilities, because the liabilities will come due before the assets generate enough cash to pay them. Such “maturity mismatching” forces borrowers to roll over, or refinance, ma- turing liabilities to avoid insolvency.

Two common ratios intended to measure the liquidity of a company’s as- sets relative to its liabilities are the current ratio and the acid test. For Stryker,



The current ratio compares the assets that will turn into cash within the year to the liabilities that must be paid within the year. A company with a low current ratio lacks liquidity, in the sense that it cannot reduce its current assets for cash to meet maturing obligations. It must rely instead on operating income and outside financing.

The acid-test ratio, sometimes called the quick ratio, is a more conser- vative liquidity measure. It is identical to the current ratio except that the numerator is reduced by the value of inventory. Inventory is subtracted because it is frequently illiquid. Under distress conditions, a company or its creditors may realize little cash from the sale of inventory. In liquida- tion sales, sellers typically receive 40 percent or less of the book value of inventory.

You should recognize that these ratios are rather crude measures of liq- uidity, for at least two reasons. First, rolling over some obligations, such as accounts payable, involves virtually no insolvency risk, provided the com- pany is at least marginally profitable. Second, unless a company intends to go out of business, most of the cash generated by liquidating current assets cannot be used to reduce liabilities because it must be plowed back into the business to support continued operations.

Is ROE a Reliable Financial Yardstick?

To this point, we have assumed management wants to increase the com- pany’s ROE, and we have studied three important levers of performance by which they can accomplish this: the profit margin, asset turnover, and financial leverage. We concluded that whether a company is IBM or the corner drugstore, careful management of these levers can positively af- fect ROE. We also saw that determining and maintaining appropriate values of the levers is a challenging managerial task that requires an un- derstanding of the company’s business, the way the company competes, and the interdependencies among the levers themselves. Now it is time to ask how reliable ROE is as a measure of financial performance. If

= $8,335 – $1,422

$2,657 = 2.6 times

Acid test = Current assets – Inventory

Current liabilities

= $8,335 $2,657

= 3.1 times

Current ratio = Current assets

Current liabilities

Chapter 2 Evaluating Financial Performance 55



56 Part One Assessing the Financial Health of the Firm

company A has a higher ROE than company B, is it necessarily a better company? If company C increases its ROE, is this unequivocal evidence of improved performance?

ROE suffers from three critical deficiencies as a measure of financial performance, which I will refer to as the timing problem, the risk problem, and the value problem. Seen in proper perspective, these problems mean ROE is seldom an unambiguous measure of performance. ROE remains a useful and important indicator, but it must be interpreted in light of its limitations, and no one should automatically assume a higher ROE is al- ways better than a lower one.

The Timing Problem It is a cliché to say that successful managers must be forward-looking and have a long-term perspective. Yet ROE is precisely the opposite: backward-looking and focused on a single year. So it is little wonder that ROE can at times be a skewed measure of performance. When, for example, a company incurs heavy startup costs to introduce a hot new product, ROE will initially fall. However, rather than indicating wors- ening financial performance, the fall simply reflects the myopic, one- period nature of the yardstick. Because ROE necessarily includes only one year’s earnings, it fails to capture the full impact of multiperiod decisions.

The Risk Problem Business decisions commonly involve the classic “eat well–sleep well” dilemma. If you want to eat well, you had best be prepared to take risks in search of higher returns. If you want to sleep well, you will likely have to forgo high returns in search of safety. Seldom will you realize both high returns and safety. (And when you do, please give me a call.)

The problem with ROE is that it says nothing about what risks a company has taken to generate it. Here is a simple example. Take-a- Risk, Inc., earns an ROA of 6 percent from wildcat oil exploration in Sudan, which it combines with an assets-to-equity ratio of 5.0 to pro- duce an ROE of 30 percent (6% � 5.0). Never-Dare, Ltd., meanwhile, has an ROA of 10 percent on its investment in government securities, which it finances with equal portions of debt and equity, yielding an ROE of 20 percent (10% � 2.0). Which company is the better per- former? My answer is Never-Dare. Take-a-Risk’s ROE is high, but its high business risk and extreme financial leverage make it a very uncer- tain enterprise. I would prefer the more modest but eminently safer



ROE of Never-Dare.3 Security analysts would make the same point by saying that Take-a-Risk’s ROE might be higher, but that the number is much lower quality than Never-Dare’s ROE, meaning that it is much riskier. In sum, because ROE looks only at return while ignoring risk, it can be an inaccurate yardstick of financial performance.

Return on Invested Capital To circumvent the distorting effects of leverage on ROE and ROA, I recommend calculating return on invested capital (ROIC), also known as return on net assets (RONA):

Stryker’s 2013 ROIC was

The numerator of this ratio is the earnings after tax the company would report if it were all equity financed, and the denominator is the sum of all sources of cash to the company on which a return must be earned. Thus, while accounts payable are a source of cash to the company, they are ex- cluded because they carry no explicit cost. In essence, ROIC is the rate of return earned on the total capital invested in the business without regard for whether it is called debt or equity.

To see the virtue of ROIC, consider the following example. Companies A and B are identical in all respects except that A is highly levered and B is all equity financed. Because the two companies are identical except for capital structure, we would like a return measure that reflects this funda- mental similarity. The following table shows that ROE and ROA fail this test. Reflecting the company’s extensive use of financial leverage, A’s ROE is 18 percent, while B’s zero-leverage position generates a lower but better-quality ROE of 7.2 percent. ROA is biased in the other direction, punishing company A for its extensive use of debt and leaving B unaf- fected. Only ROIC is independent of the different financing schemes the two companies employ, showing a 7.2 percent return for both firms. ROIC thus reflects the company’s fundamental earning power before it is confounded by differences in financing strategies.

$1,29511 – $206�$1,212) $25 + $2,739 + $9,047

= 9.1%

ROIC = EBIT11 – Tax rate2

Interest-bearing debt + Equity

Chapter 2 Evaluating Financial Performance 57

3 Even if I preferred eating well to sleeping well, I would still choose Never-Dare and finance my purchase with a little personal borrowing to lever my return on investment. See the appendix to Chapter 6 for more on the substitution of personal borrowing for company borrowing.





Debt @ 10% interest $ 900 $ 0 Equity 100 1,000

Total assets $1,000 $1,000

EBIT $ 120 $ 120 – Interest expense 90 0

Earnings before tax 30 120 – Tax @ 40% 12 48

Earnings after tax $ 18 $ 72

ROE 18.0% 7.2% ROA 1.8% 7.2% ROIC 7.2% 7.2%

The Value Problem ROE measures the return on shareholders’ investment; however, the in- vestment figure used is the book value of shareholders’ equity, not the market value. This distinction is important. Stryker’s ROE in 2013 was 11.1 percent, and indeed this is the return you could have earned had you been able to buy the company’s equity for its book value of $9,047 million. But that would have been impossible, for, as noted in the previous chapter, the market value of Stryker’s equity was $28,403 million. At this price, your annual return would have been only 3.5 percent, not 11.1 percent ($1,006/$28,403 = 3.5%). The market value of equity is more significant to shareholders because it measures the current, realizable worth of the shares, while book value is only history. So even when ROE measures man- agement’s financial performance, it may not be synonymous with a high return on investment to shareholders. Thus, it is not enough for investors to find companies capable of generating high ROEs; these companies must be unknown to others, because once they are known, the possibility of high returns to investors will melt away in higher stock prices.

The Earnings Yield and the P/E Ratio It might appear that we can circumvent the value problem by simply re- placing the book value of equity with its market value in the ROE. But the resulting earnings yield has problems of its own. For Stryker,

= Earnings per share

Price per share =

$2.66 $75.14

= 3.5%

Earnings yield = Net income

Market value of shareholders’ equity

58 Part One Assessing the Financial Health of the Firm



Chapter 2 Evaluating Financial Performance 59

Is earnings yield a useful measure of financial performance? No! The problem is that a company’s stock price is very sensitive to investor expec- tations about the future. A share of stock entitles its owner to a portion of future earnings as well as present earnings. Naturally, the higher an in- vestor’s expectations of future earnings, the more she will pay for the stock. This means that a bright future, a high stock price, and a low earn- ings yield go together. Clearly, a high earnings yield is not an indicator of superior performance; in fact, it is more the reverse. Said another way, the earnings yield suffers from a severe timing problem of its own that invali- dates it as a performance measure.

Turning the earnings yield on its head produces the price-to-earnings ratio, or P/E ratio. Stryker’s 2013 P/E ratio is

The P/E ratio adds little to our discussion of performance measures, but its wide use among investors deserves comment. The P/E ratio is the price of one dollar of current earnings and is a means of normalizing stock prices for different earnings levels across companies. At year end 2013, in- vestors were paying over $28 per dollar of Stryker’s earnings. A company’s P/E ratio depends principally on two things: its future earnings prospects and the risk associated with those earnings. Stock price, and hence the P/E ratio, rises with improved earnings prospects and falls with increasing risk. A sometimes confusing pattern occurs when a company’s earnings are weak but investors believe the weakness is temporary. Then prices remain buoyant in the face of depressed earnings, and the P/E ratio rises. This has likely happened to Stryker recently as its P/E ratio has doubled since 2011 as earnings per share have fallen 24 percent. In general, the P/E ratio says little about a company’s current financial performance, but it does indicate what investors believe about future prospects.

ROE or Market Price? For years, academicians and practitioners have been at odds over the proper measure of financial performance. Academicians criticize ROE for the rea- sons just cited and argue that the correct measure of financial performance is the firm’s stock price. Moreover, they contend that management’s goal should be to maximize stock price. Their logic is persuasive: Stock price represents the value of the owners’ investment in the firm, and if managers want to further the interests of owners, they should take actions that in- crease value to owners. Indeed, the notion of “value creation” has become a central theme in the writings of many academicians and consultants.

Price per share Earnings per share

= $75.14 $2.66

= 28.2 times



Practitioners acknowledge the logic of this reasoning but question its ap- plicability. One problem is the difficulty of specifying precisely how operat- ing decisions affect stock price. If we are not certain what impact a change in, say, the business strategy of a division will have on the company’s stock price, the goal of increasing price cannot guide decision making. A second problem is that managers typically know more about their company than do outside investors, or at least think they do. Why, then, should managers consider the assessments of less-informed investors when making business decisions? A third practical problem with stock price as a performance measure is that it depends on a whole array of factors outside the company’s control. One can never be certain whether an increase in stock price reflects improving company performance or an improving external economic

60 Part One Assessing the Financial Health of the Firm

Can ROE Substitute for Share Price? Figures 2.1 and 2.2 suggest that the gulf between academicians and practitioners over the proper measure of financial performance may be narrower than supposed. The graphs plot the market value of equity divided by the book value of equity against ROE for two representative groups of com- panies. The ROE figure is a weighted-average ROE over the most recent three years. The solid line in each figure is a regression line indicating the general relation between the two variables. The noticeable positive relationship visible in both graphs suggests that high-ROE companies tend to have high stock prices relative to book value, and vice versa. Hence, working to increase ROE appears to be generally consistent with working to increase stock price.

The proximity of the company dots to the fitted regression line is also interesting. It shows the im- portance of factors other than ROE in determining a company’s market-to-book ratio. As we should ex- pect, these other factors play an important role in determining the market value of a company’s shares.

For interest, I have indicated the positions of several companies on the graphs. Note in Figure 2.1 that Stryker is a bit below the regression line, indicating that based purely on historical ROE, Stryker’s stock is modestly underpriced compared to those of other firms in the medical technology industry. Two other highlighted companies, with market-to-book ratios way above the regression line, are Align Technology and Abiomed. Align is the market leader in invisible orthodontic devices, and Abiomed is the creator of the first total replacement heart and the world’s smallest assistive heart pump (it’s about as thin as this line of text). Investors likely value these companies highly because both are pioneers in medical technology that have seen average sales growth of about 20 percent per year over the last decade. As an example of a company on the other side of the line, Span-America Medical sits well below the regression line despite a relatively healthy ROE of over 17 percent. In contrast to Align and Abiomed, Span-America’s product line is decidedly less splashy (it’s tough to get excited about thera- peutic mattress overlays), and their sales growth has been negative in four of the past six years.

Figure 2.2 shows the same information for 87 companies in Standard & Poor’s 100 Index of the largest U.S. firms. UPS takes the prize here for the highest ROE with a figure of over 45 percent, al- though wins market-to-book honors at almost 16 times. Perhaps this has something to do with the fact that Amazon’s sales have grown at an average rate of 41 percent a year over the past 15 years. At the other end of the spectrum, Exxon Mobil and Apple lie well below the regression line.

To summarize, these graphs offer tantalizing evidence that despite its weaknesses, ROE may serve as at least a crude proxy for share price in measuring financial performance.



Chapter 2 Evaluating Financial Performance 61

FIGURE 2.1 Market to Book Value of Equity vs. Return on Equity for 34 Medical Technology Companies

The regression equation is MV/BV � 1.96 � 10.6 ROE, where MV/BV is the market value of equity relative to the book value of equity in March 2014 and ROE is a weighted-average return on equity for 2013 and the prior two years. Companies with a negative ROE were eliminated. The adjusted R2 is 0.32, and the t-statistic for the slope coefficient is 4.1.

FIGURE 2.2 Market to Book Value of Equity vs. Return on Equity for 87 Large Corporations

Companies are members of Standard & Poor’s 100 Index of largest U.S. corporations. Those with a negative ROE and outliers with ROE above 50 percent were eliminated. The regression equation is MV/BV � 0.69 � 16.2 ROE, where MV/BV is the market value of equity relative to the book value of equity in March 2014 and ROE is a weighted-average return on equity for 2013 and the prior two years. The adjusted R2 is 0.26, and the t-statistic for the slope coefficient is 5.5.

0 0 5 10 15 20 25 30 35








M ar

ke t/b

oo k

va lu

e of

e qu


Weighted-average return on equity (%)


Abiomed Align Technology


C.R. Bard

Merit Medical


Becton Dickinson


0 0 5 10 15 20 25 30 35 40 45 50









Starbucks Mastercard

Home Depot


Exxon Mobil



M ar

ke t/b

oo k

va lu

e of

e qu


Weighted-average return on equity (%)





environment. For these reasons, many practitioners remain skeptical of stock market–based indicators of performance, even while academicians and consultants continue to work on translating value creation into a prac- tical financial objective. One popular effort along these lines is economic value added (EVA), popularized by the consulting firm Stern Stewart Man- agement Services. We will look more closely at EVA in Chapter 8.

Ratio Analysis

In our discussion of the levers of financial performance, we defined a num- ber of financial ratios. It is now time to consider the systematic use of these ratios to analyze financial performance. Ratio analysis is widely used by managers, creditors, regulators, and investors. At root it is an elementary process involving little more than comparing a number of company ratios to one or more performance benchmarks. Used with care and imagination, the technique can reveal much about a company. But there are a few things to bear in mind about ratios. First, a ratio is simply one number divided by another, so it is unreasonable to expect the mechanical calculation of one or even several ratios to automatically yield important insights into any- thing as complex as a modern corporation. It is best to think of ratios as clues in a detective story. One or even several ratios might be misleading, but when combined with other knowledge of a company’s management and economic circumstances, ratio analysis can tell a revealing story.

A second point to bear in mind is that a ratio has no single correct value. Like Goldilocks and the three bears, the observation that the value of a par- ticular ratio is too high, too low, or just right depends on the perspective of the analyst and on the company’s competitive strategy. The current ratio, previously defined as the ratio of current assets to current liabilities, is a case in point. From the perspective of a short-term creditor, a high current ratio is a positive sign suggesting ample liquidity and a high likelihood of repay- ment. Yet an owner of the company might look on the same current ratio as a negative sign suggesting that the company’s assets are being deployed too conservatively. Moreover, from an operating perspective, a high current ratio could be a sign of conservative management or the natural result of a competitive strategy that emphasizes liberal credit terms and sizable inven- tories. In this case, the important question is not whether the current ratio is too high but whether the chosen strategy is best for the company.

Using Ratios Effectively If ratios have no universally correct values, how do you interpret them? How do you decide whether a company is healthy or sick? There are three approaches, each involving a different performance benchmark: Compare

62 Part One Assessing the Financial Health of the Firm



Chapter 2 Evaluating Financial Performance 63

the ratios to rules of thumb, compare them to industry averages, or look for changes in the ratios over time. Comparing a company’s ratios to rules of thumb has the virtue of simplicity but has little else to recommend it. The appropriate ratio values for a company depend too much on the ana- lyst’s perspective and on the company’s specific circumstances for rules of thumb to be very helpful. The most positive thing one can say about them is that over the years, companies conforming to these rules of thumb ap- parently go bankrupt somewhat less frequently than those that do not.

Comparing a company’s ratios to industry ratios provides a useful feel for how the company measures up to its competitors, provided you bear in mind that company-specific differences can result in entirely justifiable deviations from industry norms. Also, there is no guarantee that the industry as a whole knows what it is doing. The knowledge that one rail- road was much like its competitors was cold comfort in the depression of the 1930s, when virtually all railroads got into financial difficulties.

The most useful way to evaluate ratios involves trend analysis: Calcu- late ratios for a company over several years, and note how they change over time. Trend analysis avoids the need for cross-company and cross-industry comparisons, enabling the analyst to draw firmer conclusions about the company’s financial health and its variation over time.

Moreover, the levers of performance suggest one logical approach to trend analysis: Instead of calculating ratios at random, hoping to stumble across one that might be meaningful, take advantage of the structure implicit in the levers. As Figure 2.3 illustrates, the levers of performance organize ratios into three tiers. At the top, ROE looks at the performance of the enterprise as a whole; in the middle, the levers of performance indicate how three important segments of the business contributed to ROE; and on the bottom, many of the other ratios discussed reveal how the management of individual income statement and balance sheet accounts contributed to the observed levers. To take advantage of this structure, begin at the top by noting the trend in ROE over time. Then narrow your focus and ask what changes in the three levers account for the observed ROE pattern. Finally, get out your microscope and study individual accounts for explanations of the observed changes in the levers. To illustrate, if ROE has plunged while the profit margin and financial leverage have remained constant, examine the control of individual asset accounts in search of the culprit or culprits.

Ratio Analysis of Stryker Corporation As a practical demonstration of ratio analysis, let us see what the tech- nique can tell us about Stryker Corporation. Table 2.2 presents previously discussed ratios for Stryker over the years 2009–2013 and industry aver- age figures for 2013. (For summary definitions of the ratios, see Table 2.4



64 Part One Assessing the Financial Health of the Firm

at the end of the chapter.) The comparison industry consists of seven rep- resentative competitors noted at the bottom of the table. (To find similar, readily available data for other companies, see the list of websites at the end of the chapter.)

Beginning with Stryker’s profitability ratios, we see a company that ap- pears to have hit a rough spot in recent years. The firm’s return on equity, which was as high as 17.8 percent in 2010, rests at 11.1 percent in 2013, well below the industry average of 18.5 percent. Part of the disparity is due to Stryker’s use of less debt financing, but a glance at the company’s return on invested capital reveals that this is not the whole story. Recall that ROIC abstracts from company financing to reveal the basic earning power of the firm’s assets. Stryker’s ROIC has fallen steadily from 17.0 percent in 2009 to 9.1 percent in 2013, again below the industry average. To put these figures in broader perspective, the median ROE chalked up by all nonfinancial firms in the S&P 500 Index in 2013 was 15.7 percent, while the corresponding ROIC was 10.9 percent. Looking at worldwide performance, medians for nonfinancial firms in the S&P Global 1200, which generally includes the largest firms from around the world, were 12.6 percent for ROE and 8.8 percent for ROIC.

FIGURE 2.3 The Levers of Performance Suggest One Road Map for Ratio Analysis


Payables period

Debt to assets

Times-interest earned

Times-burden covered

Current ratio

Acid test

Days’ sales in cash

Collection period

Inventory turnover

Fixed asset turnover

Percentage balance sheet

Gross margin

Tax rate

Percentage income statement

Profit Margin Asset Turnover Financial Leverage



Looking at Stryker’s levers of performance can help explain the reasons behind its disappointing ROE. Asset turnover bears only a small part of the blame for the disappointing trend, having declined only slightly in 2013. Nor can we say that financial leverage is the villain, for although Stryker’s assets-to-equity ratio is below industry peers, it is actually rising over the period. In fact, had Stryker’s leverage not increased over the past five years, ROE in 2013 would have been only 9.4 percent (11.2% � 0.6 � 1.4 � 9.4%).

This leaves Stryker’s low and declining profit margin as the primary ex- planation for its disappointing ROE performance. Stryker’s profit margin has fallen steadily from a 2010 peak of 17.4 percent to its most recent read- ing of only 11.2 percent, noticeably below the industry average of 15.6 per- cent. Why the decline? Only a small part of the blame can be attributed to

Chapter 2 Evaluating Financial Performance 65

TABLE 2.2 Ratio Analysis of Stryker Corporation, 2009–2013, and Industry Averages, 2013

Industry 2009 2010 2011 2012 2013 Average*

Profitability ratios:

Return on equity (%) 16.8 17.8 17.5 15.1 11.1 18.5 Return on assets (%) 12.2 11.7 10.8 9.8 6.4 8.8 Return on invested capital (%) 17.0 16.2 15.0 13.0 9.1 11.7 Profit margin (%) 16.5 17.4 16.2 15.0 11.2 15.6 Gross margin (%) 70.0 71.0 69.8 69.9 69.4 71.0 Price-to-earnings ratio (X) 18.1 16.5 14.1 16.0 28.2 19.8

Turnover-control ratios:

Asset turnover (X) 0.7 0.7 0.7 0.7 0.6 0.6 Fixed-asset turnover (X) 7.1 9.2 9.4 9.1 8.3 4.1 Inventory turnover (X) 2.1 2.0 2.0 2.1 1.9 1.8 Collection period (days) 62.3 62.4 62.3 60.3 61.4 75.3 Days’ sales in cash (days) 160.4 218.4 150.2 180.7 161.0 105.9 Payables period (days) 36.2 50.2 50.2 40.4 41.5 102.6

Leverage and liquidity ratios:

Assets to equity (X) 1.4 1.5 1.6 1.5 1.7 2.1 Debt to assets (%) 27.3 34.2 38.1 34.9 42.5 49.6 Debt to equity (%) 37.5 51.9 61.5 53.6 74.0 111.8 Times interest earned (X) 73.5 23.3 18.9 28.1 15.6 21.4 Times burden covered (X) 33.7 16.2 15.4 21.0 11.4 8.4 Debt to assets (market value, %) 11.0 15.1 20.0 18.1 19.1 22.5 Debt to equity (market value, %) 12.4 17.7 24.9 22.1 23.6 29.8 Current ratio (X) 4.1 4.8 3.9 4.3 3.1 2.9 Acid test (X) 3.4 4.1 3.2 3.7 2.6 2.2

*Industry average of seven firms in the medical technology industry: Baxter International, Becton Dickinson, Covidien PLC, Medtronic, Smith & Nephew PLC, St. Jude Medical, and Zimmer Holdings.



Stryker’s gross margin, which is down only modestly. This suggests that the bulk of the decline in profit margin is due to increasing operating expenses, an observation we will be better equipped to explore in a few paragraphs.

Digging a little deeper into these broad trends, we see that Stryker handily beats its industry peers in the management of several important as- sets, although ironically its aggregate asset turnover ratio only equals the industry average. Thus, Stryker’s fixed-asset turnover of 8.3 is more than double the industry average. While this might simply reflect a less capital- intensive business, the more likely explanation is that Stryker is using its property, plant, and equipment more efficiently than its peers. Stryker’s in- ventory turnover suggests that it manages its inventory slightly more effi- ciently than the industry average, and its lower collection period indicates that it is efficient at collecting its bills. Together, these ratios present a bit of a mystery: If Stryker is so efficient at managing these components of total assets, why is its total asset turnover no better than its industry peers? The mystery is largely solved by noting that Stryker’s cash balances are much higher than its peers, as evidenced by a days’ sales in cash ratio of 161 compared to the industry average of 106. If Stryker reduced its excess cash reserves, its total asset turnover would increase, showing more clearly that Stryker is actually quite good at managing its assets.

Looking at Stryker’s leverage ratios, it is apparent that the company has slowly been increasing its reliance on other people’s money. According to the balance sheet ratios—both book and market value versions—the com- pany has higher levels of indebtedness in 2013 than it had in 2009. Still, the debt ratios remain well below the industry averages, so the increasing leverage does not seem to be a cause for concern. Stryker’s coverage ratios have declined with rising debt in recent years, but its times-interest-earned ratio of 15.6 suggests the company can easily cover its interest obligations at current profit levels, even though the figure is below the industry aver- age. Stryker’s times-burden-covered ratio is above the industry average, suggesting that the company remains conservatively financed, even as debt is rising.

Table 2.3 presents what are known as common-size financial statements for Stryker Corporation over the same period, as well as industry averages for 2013. A common-size balance sheet presents each asset and liability as a percentage of total assets. A common-size income statement is analo- gous except that all items are scaled in proportion to net sales rather than total assets. The purpose of scaling financial statements in this fashion is to concentrate on underlying trends by abstracting from changes in the dollar figures caused by growth or decline. In addition, common-size statements are useful for removing simple scale effects when comparing companies of different sizes.

66 Part One Assessing the Financial Health of the Firm



Chapter 2 Evaluating Financial Performance 67

TABLE 2.3 Stryker Corporation, Common-Size Financial Statements, 2009–2013, and Industry Averages, 2013

Industry 2009 2010 2011 2012 2013 Average*

Assets Cash & marketable securities 32.6% 40.2% 27.6% 32.5% 25.3% 15.5% Accounts receivable, less reserve for possible losses 12.7 11.5 11.4 10.8 9.6 11.8 Inventories 10.4 9.7 10.3 9.6 9.0 10.3 Other current assets 8.9 8.7 8.8 8.8 9.0 3.6

Total current assets 64.5 70.0 58.1 61.7 52.9 41.2

Gross plant, property, & equipment 21.7 17.0 16.6 16.9 15.9 36.6 Less accumulated depreciation and amortization 11.2 9.7 9.4 9.7 9.0 19.9

Net property, plant, and equipment 10.5 7.3 7.2 7.2 6.9 16.7

Goodwill and intangible assets, net 17.5 16.3 28.3 27.0 37.1 36.2 Other assets 7.5 6.3 6.4 4.1 3.1 5.8

Total assets 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Liabilities and Shareholders’ Equity Long-term debt due in one year 0.2 0.2 0.1 0.1 0.2 0.9 Short-term borrowings – – – – – 0.5 Trade accounts payable 2.2 2.7 2.8 2.2 2.0 4.0 Taxes payable 1.5 0.4 0.9 0.5 0.8 1.4 Accrued expenses & other current liabilities 12.0 11.4 10.9 11.4 13.9 8.5

Total current liabilities 15.9 14.7 14.7 14.2 16.9 15.4

Long-term debt – 9.2 14.1 13.2 17.4 24.8 Deferred taxes 4.2 3.2 3.6 1.4 2.5 1.8 Other long-term liabilities 7.2 7.1 5.6 6.1 5.7 8.3

Total liabilities 27.3 34.2 38.1 34.9 42.5 49.6 Total shareholders’ equity 72.7 65.8 61.9 65.1 57.5 50.4

Total liabilities and shareholders’ equity 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Income Statements

Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold 30.0 29.0 30.2 30.1 30.6 29.0

Gross profit 70.0 71.0 69.8 69.9 69.4 71.0 Selling, general, and administrative expenses 37.1 37.6 39.4 40.4 45.2 38.0 Research, development, and engineering expenses 5.0 5.4 5.6 5.4 5.9 7.3 Depreciation and amortization 3.0 3.0 3.4 3.2 3.4 6.1

Total operating expenses 45.1 46.0 48.4 49.1 54.5 51.3 Operating income 24.9 25.0 21.4 20.8 14.8 19.6

Interest expense 0.3 1.1 1.1 0.7 0.9 1.6 Other nonoperating expense (income) 0.4 0.3 – 0.4 0.5 (0.3)

Total nonoperating expense 0.8 1.4 1.1 1.1 1.4 1.3 Income before income taxes 24.2 23.6 20.3 19.7 13.4 18.3 Provision for income taxes 7.7 6.2 4.1 4.7 2.3 3.9

Net income 16.5% 17.4% 16.2% 15.0% 11.2% 14.4%

*See footnote to Table 2.2 for companies comprising industry sample.



Looking first at Stryker’s balance sheet, notice that accounts receivable and inventories are slightly below industry averages and decreasing over time. Despite recent decreases in cash and marketable securities, Stryker still carries far higher balances than its peers, likely much more than is re- quired for normal operating purposes. Overall, short-term assets make up 52.9 percent of Stryker’s total assets, well above the industry average of 41.2 percent, and illustrating again the importance of working capital management to most businesses. When a large portion of a company’s in- vestment is in assets as volatile as inventory and accounts receivable, that investment bears close watching.

Further down the balance sheet, observe that in addition to current as- sets, Stryker’s percentage investment in net property, plant, and equipment has also been decreasing over time, and is far below the industry average. Of course, not everything on a percentage balance sheet can decrease si- multaneously, and the offsetting increase for Stryker is goodwill and intan- gible assets, net. Goodwill and intangible assets increase when a company buys another at a price above book value, and Stryker made a dozen major acquisitions between 2009 and 2013. On the liabilities side of the balance sheet, the one trend that sticks out is the increase in long-term debt, con- sistent with the already noted increase in Stryker’s debt ratios.

We are now able to return to the important question of why Stryker’s profit margin has fallen so precipitously in recent years. Glancing down the company’s common-size income statement reveals that its profit mar- gin has fallen because selling, general, and administrative expenses have risen. These operating costs have increased from 37.1 percent of sales in 2009 to over 45 percent in 2013, well above the industry average of 38.0 percent. In contrast, other expense items and cost of goods sold have re- mained relatively stable or have declined as a percent of sales.

Why the sharp jump in selling, general, and administrative expenses? The answer takes us back to our brief discussion in the last chapter of a product liability reserve tied to faulty hip replacements. In 2013, Stryker added $600 million to this reserve, which necessitated an equal-size addi- tion to selling, general, and administrative expenses. Comparable figures for the prior two years were about $175 million. Had Stryker not needed to increase this reserve over the past three years, selling, general, and ad- ministrative expenses as a percent of sales would have been relatively sta- ble and comparable in size to the industry figure. We conclude that Stryker’s recent mediocre financial performance is due principally to large product liability claims. What we make of this conclusion depends on whether we believe such claims are unusual and nonrecurring. If so, the recent decline in profitability should be reversed fairly quickly. On the other hand, if we believe such claims are a common and recurring cost of

68 Part One Assessing the Financial Health of the Firm



Chapter 2 Evaluating Financial Performance 69

doing business in the medical technology field, we should take the decline more seriously.

Some are prone to think that all operating expenses are fixed—that they shouldn’t rise at all, much less as a percentage of sales, as in Stryker’s case. Why aren’t Stryker’s selling, general, and administrative expenses constant over time, they ask? Where are the economies of scale? The an- swer is that scale economies are not so simple. If they were, very large companies, like Walmart and Ford, would quickly dominate smaller com- petitors and eventually monopolize markets. In fact, it appears that while some activities exhibit economies of scale, others are subject to dis- economies of scale, meaning the company becomes less efficient with size. (Imagine how many more meetings are required to coordinate the activi- ties of a 100-person team compared to a 10-person team.) Moreover, many activities exhibit scale economies over only a limited range of activ- ity and then require a large investment to increase capacity. In short, it is natural that Stryker’s selling, general, and administrative expenses will rise as the company grows, but to see them rise so much in proportion to sales is concerning, even if it might be only a temporary problem.

To summarize, our ratio analysis of Stryker Corporation reveals a stable, profitable company that utilizes its assets efficiently and that, despite recent increases in debt, is conservatively financed. The company’s sales growth in the past two years has been only 4.2 percent, a far cry from the days of “20 percent forever.” Moreover, the business’s ROE performance has been poor, due largely to problems with the recall of faulty products. The com- pany’s robust P/E ratio in the face of modest growth and falling earnings suggests that shareholders are optimistic that the product liability problems are only temporary and that the business will soon return to robust health.

Despite declining profitability, Stryker’s modest capital expenditure needs combined with a healthy cash-generating ability, as evidenced by its cash flow statement, have enabled it to generate more cash than necessary to run the business. Over the five years ending in 2013, the company’s cash flow from operations totaled close to $8 billion, while its capital ex- penditures, dividend payments, and stock repurchases came to less than half of this amount. The problem: What to do with the other $4 billion? To date, management’s primary answer has been to buy other companies, including robotic surgery firm MAKO, which they acquired in 2013 for over $1.6 billion. Yet these acquisitions have not been enough to exhaust all of Stryker’s excess cash. As of 2013 Stryker still held nearly $4 billion in cash and marketable securities.

Finding ways to spend excess cash might sound like fun, but Kevin Lobo, Stryker’s new boss, knows better. He realizes that unless he finds productive uses for this cash by reigniting growth, increasing capital



expenditures, acquiring other businesses, or returning the money to shareholders, he risks depressing the company’s stock price, antagoniz- ing his board and shareholders, and possibly inviting attack or takeover by activist investors. We will have more to say about Stryker’s financial challenges in coming chapters.

70 Part One Assessing the Financial Health of the Firm

TABLE 2.4 Definitions of Principal Ratios Appearing in the Chapter

Profitability Ratios

Return on equity � Net income/Shareholders’ equity Return on assets � Net income/Assets

Return on invested capital �

Profit margin � Net income/Sales Gross margin � Gross profit/Sales Price to earnings � Price per share/Earnings per share

Turnover-Control Ratios

Asset turnover � Sales/Assets Fixed-asset turnover � Sales/Net property, plant, and equipment Inventory turnover � Cost of goods sold/Ending inventory Collection period � Accounts receivable/Credit sales per day

(If credit sales unavailable, use sales) Days’ sales in cash � Cash and securities/Sales per day Payables period � Accounts payable/Credit purchases per day

(If purchases unavailable, use cost of goods sold)

Leverage and Liquidity Ratios

Assets to equity � Assets/Shareholders’ equity Debt to assets � Total liabilities/Assets

(Interest-bearing debt is often substituted for total liabilities)

Debt to equity � Total liabilities/Shareholders’ equity Times interest earned � Earnings before interest and taxes/Interest expense

Times burden covered �

Debt to assets (market value) �

Debt to equity (market value) �

Current ratio � Current assets/Current liabilities

Acid test � Current assets – Inventory

Current liabilities

Total liabilities No. equity shares * Price/share

Total liabilities No. equity shares * Price/share + Total liabilities

Earnings before interest and taxes Interest exp. + Prin. pay./11 – Tax rate2

Earnings before interest and taxes * 11 – Tax rate2 Interest-bearing debt + Shareholders’ equity



Chapter 2 Evaluating Financial Performance 71


1. The levers of performance • Are the same for all companies from corner stores to multinational

corporations. • Highlight the means by which managers can influence return on equity. • Consist of three ratios:

– The profit margin. – Asset turnover. – Financial leverage.

• Can vary widely across industries depending on the technology and business strategies employed.

2. Return on equity (ROE) • Is a widely used measure of company financial performance. • Equals the product of the profit margin, asset turnover, and financial

leverage. • Is broadly similar across industries due to competition. • Suffers from three problems as a performance measure:

– A timing problem because business decisions are forward- looking, while ROE is a backward-looking, one-period measure.

– A risk problem because financial decisions involve balancing risk against return, while ROE only measures return.

– A value problem because owners are interested in return on the market value of their investment, while ROE measures return on the accounting book value, a problem that is not solved by mea- suring the return on the market value of equity.

• Despite its problems can serve as a rough proxy for share price in measuring financial performance.

3. The profit margin • Summarizes income statement performance. • Measures the fraction of each sales dollar that makes its way to profits.

4. Asset turnover • Summarizes asset management performance. • Measures the value of sales generated per dollar invested in assets. • Is a control ratio, in that it relates sales, or cost of sales, to a specific

asset or liability; other control ratios are – inventory turnover. – collection period. – days’ sales in cash. – payables period. – fixed-asset turnover.



72 Part One Assessing the Financial Health of the Firm

5. Financial leverage • Summarizes the company’s use of debt relative to equity

financing. • Adds to owners’ risk and is thus not something to be maximized. • Is best measured in the form of coverage ratios that relate

operating earnings to the annual financial burden imposed by the debt.

• Is also measured using balance sheet ratios that relate debt to assets, measured using book or market values.

6. Ratio analysis • Is the systematic use of a number of ratios to analyze financial

performance. • Involves trend analysis and comparison of company ratios to peer

group numbers. • Requires considerable judgment, as there is no single correct value

for any ratio.


Fridson, Martin S., and Fernando Alvarez. Financial Statement Analysis: A Practitioner’s Guide. 4th ed. John Wiley & Sons, 2011. 400 pages.

An executive and an academic combine to write a thorough practical overview of the topic. $48.

Jiambalvo, James. Managerial Accounting. 5th ed. New York: John Wiley & Sons, 2012. 544 pages.

A straightforward and concise introduction to the use of managerial accounting in planning, budgeting, management control, and decision making. (Full disclosure: Jim is my dean, but we are still friends and it is a good book.) $145.

Palepu, Krishna G., and Paul M. Healy. Business Analysis and Valuation: Using Financial Statements. 5th ed. Cengage Learning, 2012. 336 pages.

Part finance, part accounting. An innovative look at the use of accounting information to address selected financial questions, especially business valuation. $199.

For a recent look at the uneven convergence of U.S. and international ac- counting standards, check out this working paper by Elaine Henry, Steve W. J. Lin, and Ya-wen Yong entitled “The European-U.S. GAAP Gap: Amount, Type, Homogeneity, and Value Relevance of IFRS U.S. GAAP Form 20-F Reconciliations,” September 2008.



Chapter 2 Evaluating Financial Performance 73


Designed to accompany this text, HISTORY produces a financial analysis of up to five years of user-supplied, historical financial data about a company. Results appear in four convenient tables of one page each. Balance sheet and income statement entries can be customized to a limited degree to reflect the reporting practices of individual companies. A copy is available for download from McGraw-Hill’s Connect or your course instructor (see Preface for more information).


All of these sites provide vast amounts of information on publicly traded companies, including overviews, stock quotes, financial statements, ratios, charts, and much more.

PROBLEMS Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are available in the Instructor Resources within McGraw-Hill’s Connect, connect. (See the Preface for more information).

1. The Board of Directors of Collins Entertainment, Inc., has been pressuring its CEO to boost ROE. During a recent interview on CNBC, he announces his plan to improve the firm’s financial performance. He will raise prices on all of the company’s products by 10%. He justifies the plan by observing that ROE can be decomposed into the product of profit margin, asset turnover, and financial leverage. By raising prices, he will increase the profit margin and thus ROE. Does this plan make sense to you? Why or why not?

2. a. Which company would you expect to have a higher price-to-earnings ratio, Google or railroad company Union Pacific? Why?

b. Which company would you expect to have the higher debt-to-equity ratio, a financial institution or a high-technology company? Why?

c. Which company would you expect to have a higher profit margin, an appliance manufacturer or a grocer? Why?



74 Part One Assessing the Financial Health of the Firm

d. Which company would you expect to have a higher current ratio, a jewelry store or an online bookstore? Why?

3. True or false? a. A company’s assets-to-equity ratio always equals one plus its liabil-

ities-to-equity ratio. b. A company’s return on equity will always equal or exceed its return

on assets. c. A company’s collection period should always be less than its

payables period. d. A company’s current ratio must always equal or exceed its acid-test

ratio. e. All else equal, a firm would prefer to have a higher asset turnover

ratio. f. Two firms can have the same earnings yield but different price-to-

earnings ratios. g. Ignoring taxes and transactions costs, unrealized paper gains are

less valuable than realized cash earnings.

4. Your firm is considering the acquisition of a very promising technol- ogy company. One executive argues against the move, pointing out that because the technology company is presently losing money, the acquisition will cause your firm’s return on equity to fall. a. Is the executive correct in predicting that ROE will fall? b. How important should changes in ROE be in this decision?

5. Selected financial data for Amberjack Corporation follows.

($ thousands)

Year 1 Year 2

Sales 271,161 457,977 Cost of goods sold 249,181 341,204 Net income (155,034) (403,509) Cash flow from operations (58,405) (20,437)

Cash 341,180 268,872 Marketable securities 341,762 36,900 Accounts receivable 21,011 35,298 Inventories 6,473 72,106

Total current assets 710,427 413,176

Accounts payable 28,908 22,758 Accrued liabilities 44,310 124,851

Total current liabilities 73,218 147,610



Chapter 2 Evaluating Financial Performance 75

a. Calculate the current and quick ratio at the end of each year. How has the company’s short-term liquidity changed over this period?

b. Assuming a 365-day year for all calculations, compute the following: i. The collection period each year based on sales. ii. The inventory turnover and the payables period each year based

on cost of goods sold. iii. The days’ sales in cash each year. iv. The gross margin and profit margin each year.

c. What do these calculations suggest about the company’s perfor- mance?

6. Top management measures your division’s performance by calculat- ing the division’s return on investment (ROI), defined as division operating income divided by division assets. Your division has done quite well recently; its ROI is 30 percent. You believe the division should invest in a new production process, but a colleague disagrees, pointing out that because the new investment’s first-year ROI is only 25 percent, it will hurt performance. How would you respond?

7. Answer the questions below based on the information in the table. The tax rate is 40 percent and all dollars are in millions. For simplicity, assume that the companies have no other liabilities other than the debt shown below.

Atlantic Corp. Pacific Corp.

Earnings before interest and taxes $450 $ 470 Debt (at 8% interest) $290 $1,490 Equity $910 $ 370

a. Calculate each company’s ROE, ROA, and ROIC. b. Why is Pacific’s ROE so much higher than Atlantic’s? Does this

mean Pacific is a better company? Why or why not? c. Why is Atlantic’s ROA higher than Pacific’s? What does this tell

you about the two companies? d. How do the two companies’ ROICs compare? What does this

suggest about the two companies?

8. Table 3.1 in Chapter 3 presents financial statements over the period 2011 through 2014 for R&E Supplies, Inc. a. Use these statements to calculate as many of the ratios in Table 2.2

as you can.



76 Part One Assessing the Financial Health of the Firm

b. What insights do these ratios provide about R&E’s financial performance? What problems, if any, does the company appear to have?

9. You are trying to prepare financial statements for Bartlett Pickle Company, but seem to be missing its balance sheet. You have Bartlett’s income statement, which shows sales last year were $420 million with a gross profit margin of 40 percent. You also know that credit sales equaled three-quarters of Bartlett’s total revenues last year. In addi- tion, Bartlett had a collection period of 55 days, a payables period of 40 days, and an inventory turnover of 8 times based on cost of goods sold. Calculate Bartlett’s year-ending balance for accounts receivable, inventory, and accounts payable.

10. In 2013, Natural Selection, a nationwide computer dating service, had $500 million of assets and $200 million of liabilities. Earnings be- fore interest and taxes were $120 million, interest expense was $28 million, the tax rate was 40 percent, principal repayment require- ments were $24 million, and annual dividends were 30 cents per share on 20 million shares outstanding. a. Calculate the following for Natural Selection:

i. Liabilities-to-equity ratio ii. Times-interest-earned ratio

iii. Times burden covered b. What percentage decline in earnings before interest and taxes

could Natural Selection have sustained before failing to cover: i. Interest payment requirements? ii. Principal and interest requirements?

iii. Principal, interest, and common dividend payments?

11. Given the following information, complete the balance sheet shown below.

Collection period 71 days Days’ sales in cash 34 days Current ratio 2.6 Inventory turnover 5 times Liabilities to assets 75% Payables period 36 days

(All sales are on credit. All calculations assume a 365-day year. Payables period is based on cost of goods sold.)



Chapter 2 Evaluating Financial Performance 77


Current assets: Cash $1,100,000 Accounts receivable Inventory 1,900,000

Total current assets Net fixed assets Total assets 8,000,000

Liabilities and shareholders’ equity

Current liabilities: Accounts payable Short-term debt

Total current liabilities Long-term debt Shareholders’ equity Total liabilities and equity

12. The data below present key ratios for six well-known U.S. corpora- tions: Apple, Boeing, Citigroup, Facebook, McDonald’s, and Walmart. However, the companies are not listed in order, and their names have been removed from the column headings. Using only your understanding of the ratios and the nature of each company listed, match each of the sets of ratios with the appropriate company.


Return on equity (%) 21.89 40.39 13.39 6.59 35.19 29.50 Return on assets (%) 8.07 4.88 11.25 0.72 15.66 18.82 Profit margin (%) 3.42 5.04 21.57 17.77 19.58 21.42 Gross margin (%) 24.81 15.18 78.41 NA 38.77 37.88 Price to earnings (X) 15.71 22.73 81.54 11.16 18.50 15.20 Asset turnover (X) 2.36 0.97 0.52 0.04 0.80 0.88 Collection period (days) 4.70 28.34 34.08 NA 15.92 17.40 Inventory turnover (X) 8.11 1.75 NA NA 163.35 71.14 Debt to equity (%) 76.00 61.54 2.34 221.30 86.25 14.11 Times interest earned (X) 13.50 33.05 10.00 2.21 21.74 NA Current ratio (X) 0.88 1.23 13.56 0.38 1.56 1.63 Acid test (X) 0.21 0.38 13.56 0.38 1.53 1.59

(NA = Not applicable)

13. A spreadsheet containing financial statements for Men’s Wearhouse, Inc., for fiscal years 2006–2010 is available for download from



78 Part One Assessing the Financial Health of the Firm

McGraw-Hill’s Connect or your course instructor (see the Preface for more information). a. Use the spreadsheet to calculate as many of the company’s prof-

itability, turnover-control, and leverage and liquidity ratios as you can for these years (see Table 2.4).

b. What do these ratios suggest about the company’s performance over this period?

14. To answer the questions below, use Boeing Company’s financial state- ments available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). a. For the years 2005–2009, calculate the following for Boeing:

i. Total liabilities-to-equity ratio ii. Times-interest-earned ratio

iii. Times-burden-covered ratio b. What percentage decline in earnings before interest and taxes

could Boeing have sustained in these years before failing to cover: i. Interest and principal repayment requirements? ii. Interest, principal, and common dividend payments?

c. What do these calculations suggest about Boeing’s financial lever- age during this period?




Planning Future

Financial Performance





Financial Forecasting

Planning is the substitution of error for chaos. Anonymous

To this point we have looked at the past, evaluating existing financial statements and assessing past performance. It is now time to look to the future. We begin in this chapter with an examination of the principal tech- niques of financial forecasting and a brief overview of planning and bud- geting as practiced by large, modern corporations. In the following chapter, we look at planning problems unique to the management of company growth. Throughout this chapter our emphasis will be on the techniques of forecasting and planning; so as a counterweight, it will be important that you bear in mind that proper technique is only a part of effective planning. At least as critical is the development of creative market strate- gies and operating policies that underlie the financial plans.

Pro Forma Statements

Finance is central to a company’s planning activities for at least two rea- sons. First, much of the language of forecasting and planning is financial. Plans are stated in terms of financial statements, and many of the mea- sures used to evaluate plans are financial. Second, and more important, the financial executive is responsible for a critical resource: money. Because virtually every corporate action has financial implications, a vital part of any plan is determining whether the plan is attainable given the company’s limited resources.

Companies typically prepare a wide array of plans and budgets. Some, such as production plans and staff budgets, focus on a particular aspect of the firm, while others, such as pro forma statements, are much broader in scope. Here we will begin with the broader techniques and talk briefly about more specialized procedures later when we address planning in large corporations.

Pro forma financial statements are the most widely used vehicles for financial forecasting. A pro forma statement is simply a prediction of what



the company’s financial statements will look like at the end of the forecast period. These predictions may be the culmination of intensive, detailed operating plans and budgets or nothing more than rough, back-of-the- envelope projections. Either way, the pro forma format displays the infor- mation in a logical, internally consistent manner.

A major purpose of pro forma forecasts is to estimate a company’s future need for external funding, a critical first step in financial planning. The process is a simple one. If the forecast says a company’s assets will rise next year to $100, but liabilities and owners’ equity will total only $80, the obvious conclusion is that $20 in external funding will be required. The forecast is silent about what form this new financing should take— whether trade credit, bank borrowing, new equity, or whatever—but one way or another a fresh $20 is necessary. Conversely, if the forecast says as- sets will fall below projected liabilities and owners’ equity, the obvious im- plication is that the company will generate more cash than necessary to run the business. And management faces the pleasant task of deciding how best to deploy the excess. In equation form,

Practitioners often refer to external funding required as the “plug” because it is the amount that must be plugged into the balance sheet to make it balance.

Percent-of-Sales Forecasting As Victor Borge first noted, “Forecasting is always difficult, especially with regard to the future.” One straightforward yet effective way to simplify the challenge is to tie many of the income statement and balance sheet figures to future sales. The rationale for this percent-of-sales approach is the ten- dency, noted in Chapter 2, for all variable costs and most current assets and current liabilities to vary directly with sales. Obviously, this will not be true for all of the entries in a company’s financial statements, and certainly, some independent forecasts of individual items, such as plant and equip- ment, will be required. Nonetheless, the percent-of-sales method does provide simple, logical estimates of many important variables.

The first step in a percent-of-sales forecast should be an examination of historical data to determine which financial statement items have varied in proportion to sales in the past. This will enable the forecaster to decide which items can safely be estimated as a percentage of sales and which must be forecast using other information. The second step is to forecast sales. Because so many other items will be linked mechanically to the sales

External funding required =

Total assets – ¢Liabilities + Owners’equity ≤

82 Part Two Planning Future Financial Performance



forecast, it is critical to estimate sales as accurately as possible. Also, once the pro forma statements are completed, it is a good idea to test the sensi- tivity of the results to reasonable variations in the sales forecast. The final step in the percent-of-sales forecast is to estimate individual financial statement items by extrapolating the historical patterns to the newly estimated sales. For instance, if inventories have historically been about 20 percent of sales and next year’s sales are forecast to be $10 million, we would expect inventories to be $2 million. It’s that simple.

To illustrate the use of the percent-of-sales method, consider the prob- lem faced by Suburban National Bank. R&E Supplies, Inc., a modest- sized wholesaler of plumbing and electrical supplies, has been a customer of the bank for a number of years. The company has maintained average deposits of approximately $30,000 and has had a $50,000 short-term, renewable loan for five years. The company has prospered, and the loan has been renewed annually with only cursory analysis.

In late 2014, the president of R&E Supplies, Inc., visited the bank and requested an increase in the short-term loan for 2015 to $500,000. The president explained that despite the company’s growth, accounts payable had increased steadily and cash balances had declined. A number of sup- pliers had recently threatened to put the company on COD for future purchases unless they received payments more promptly. When asked why he was requesting $500,000, the president replied that this amount seemed “about right” and would enable him to pay off his most insistent creditors and rebuild his cash balances.

Knowing that the bank’s credit committee would never approve a loan request of this magnitude without careful financial projections, the lend- ing officer suggested that he and the president prepare pro forma financial statements for 2015. He explained that these statements would provide a more accurate indication of R&E’s credit needs.

The first step in preparing the pro forma projections was to examine the company’s financial statements for the years 2011 through 2014, shown in Table 3.1, in search of stable patterns. The results of this ratio analysis appear in Table 3.2. The president’s concern about declining liq- uidity and increasing trade payables is well founded; cash and securities have fallen from 22 days’ sales to 7 days’ sales, while accounts payable have risen from a payables period of 39 days to 66 days.1 Another worrisome trend is the increase in cost of goods sold and general, selling, and admin- istrative expenses in proportion to sales. Earnings clearly are not keeping pace with sales.

Chapter 3 Financial Forecasting 83

1 See Table 2.4 in Chapter 2 for definitions of ratios used in this chapter.



TABLE 3.1 Financial Statements for R&E Supplies, Inc., December 31, 2011–2014 ($ thousands)

Income Statements

2011 2012 2013 2014*

Net sales $11,190 $13,764 $16,104 $20,613 Cost of goods sold 9,400 11,699 13,688 17,727_______ ______ ______ ______ Gross profit 1,790 2,065 2,416 2,886 Expenses:

General, selling, and administrative expenses 1,019 1,239 1,610 2,267 Net interest expense 100 103 110 90_______ ______ ______ ______

Earnings before tax 671 723 696 529 Tax 302 325 313 238_______ ______ ______ ______ Earnings after tax $ 369 $ 398 $ 383 $ 291_______ ______ ______ _____________ ______ ______ ______

Balance Sheets


Current assets: Cash and securities $ 671 $ 551 $ 644 $ 412 Accounts receivable 1,343 1,789 2,094 2,886 Inventories 1,119 1,376 1,932 2,267 Prepaid expenses 14 12 15 18_______ ______ ______ ______

Total current assets 3,147 3,728 4,685 5,583 Net fixed assets 128 124 295 287 Total assets $ 3,275 $ 3,852 $ 4,980 $ 5,870_______ ______ ______ _____________ ______ ______ ______

Liabilities and Owners’ Equity

Current liabilities: Bank loan $ 50 $ 50 $ 50 $ 50 Accounts payable 1,007 1,443 2,426 3,212 Current portion long-term debt 60 50 50 100 Accrued wages 5 7 10 18_______ ______ ______ ______

Total current liabilities 1,122 1,550 2,536 3,380 Long-term debt 960 910 860 760 Common stock 150 150 150 150 Retained earnings 1,043 1,242 1,434 1,580_______ ______ ______ ______ Total liabilities and owners’ equity $ 3,275 $ 3,852 $ 4,980 $ 5,870_______ ______ ______ _____________ ______ ______ ______


The last column in Table 3.2 contains the 2015 projections agreed to by R&E’s president and the lending officer. In line with recent experience, sales are predicted to increase 25 percent over 2014. General, selling, and administrative expenses will continue to rise as a result of an unfavorable labor settlement. After comparing R&E’s cash balances to historical levels and to those of competitors, the president believes cash and securities

84 Part Two Planning Future Financial Performance



TABLE 3.2 Selected Historical Financial Ratios for R&E Supplies, Inc., 2011–2014

History Forecast

2011 2012 2013 2014E 2015F

Annual growth rate in sales — 23% 17% 28% 25%

Ratios Tied to Sales

Cost of goods sold (% of sales) 84 85 85 86 86 General, selling, and administrative expenses (% of sales) 9 9 10 11 12

Cash and securities (days sales in cash) 22 15 15 7 18 Accounts receivable (collection period) 44 47 47 51 51 Inventories (inventory turnover) 8 9 7 8 9 Accounts payable (payables period) 39 45 65 66 59

Other Ratios in Percent

Tax/earnings before tax* 45 45 45 45 45 Dividends/earnings after tax 50 50 50 50 50

E � Estimate F � Forecast *Including state and local taxes.

should rise to at least 18 days’ sales. Because cash and securities are gener- ally low return assets, this figure represents the minimum amount the president believes is necessary to operate the business efficiently. This rea- soning is reinforced by the fact that any cash or securities balances above this minimum will just add to the loan amount and thus cost the company more money. Since much of R&E’s cash balances will sit in his bank, the lending officer readily agrees to the projected increase in cash. The pres- ident also thinks accounts payable should decline to no more than a payables period of 59 days. The tax rate and the dividends-to-earnings, or payout ratio, are expected to stay constant.

The resulting pro forma financial statements appear in Table 3.3. Looking first at the income statement, the implication of the preceding assumptions is that earnings after tax will decline to $234,000, down 20 percent from the prior year. The only entry on this statement requir- ing further comment is net interest expense. Net interest expense will clearly depend on the size of the loan the company requires. However, because we do not know this yet, net interest expense has initially been assumed to equal last year’s value, with the understanding that this assumption may have to be modified later.

Estimating the External Funding Required To most operating executives, a company’s income statement is more in- teresting than its balance sheet because the income statement measures

Chapter 3 Financial Forecasting 85



TABLE 3.3 Pro Forma Financial Statements for R&E Supplies, Inc., December 31, 2015 ($ thousands)

Income Statement


Net sales $25,766 25% increase Cost of goods sold 22,159 86% of sales_______ Gross profit 3,607 Expenses:

General, selling, and administrative expenses 3,092 12% of sales Net interest expense 90 Initially constant_______

Earnings before tax 425 Tax 191 45% tax rate_______ Earnings after tax $ 234______________

Balance Sheet


Current assets: Cash and securities $ 1,271 18 days sales Accounts receivable 3,600 51-day collection period Inventories 2,462 9 times turnover Prepaid expenses 20 Rough estimate_______

Total current assets 7,353 Net fixed assets 280 See text discussion_______ Total assets $ 7,633______________

Liabilities and Owners’ Equity

Current liabilities: Bank loan $ 0 Accounts payable 3,582 59-day payables period Current portion of long-term debt 100 See text discussion Accrued wages 22 Rough estimate_______

Total current liabilities 3,704 Long-term debt 660 Common stock 150 Retained earnings 1,697 See text discussion_______ Total liabilities and owners’ equity $ 6,211_______

External funding required $ 1,422______________

profitability. The reverse is true for the financial executive. When the ob- ject of the exercise is to estimate future financing requirements, the in- come statement is interesting only insofar as it affects the balance sheet. To the financial executive, the balance sheet is key.

86 Part Two Planning Future Financial Performance



The first entry on R&E’s pro forma balance sheet (Table 3.3) requiring comment is prepaid expenses. Prepaid expenses, like accrued wages further down the balance sheet, is a small item that increases erratically with sales. Since the amounts are small and the forecast does not require a high degree of precision, rough estimates will suffice.

When asked about new fixed assets, the president indicated that a $43,000 capital budget had already been approved for 2015. Further, depreciation for the year would be $50,000, so net fixed assets would decline $7,000 to $280,000 ($280,000 � $287,000 � $43,000 � $50,000).

Note that the bank loan is initially set to zero. We will calculate the ex- ternal funding required momentarily and will then be in a position to con- sider a possible bank loan. Continuing down the balance sheet, “current portion of long-term debt” is simply the principal repayment due in 2016. It is a contractual commitment specified in the loan agreement. As this required payment becomes a current liability, the accountant shifts it from long-term debt to current-portion long-term debt.

The last entry needing explanation is retained earnings. Since the com- pany does not plan to sell new equity in 2015, common stock remains con- stant. Retained earnings are determined as follows:

$1,697,000 � $1,580,000 � $234,000 � $117,000

In other words, when a business earns a profit larger than its dividend, the excess adds to retained earnings. The retained earnings account is the principal bridge between a company’s income statement and its balance sheet; so as profits rise, retained earnings grow and loan needs decline.2

The last step in constructing R&E’s pro formas is to estimate the amount of external funding required. Using the expression defined earlier,

According to our first-pass forecast, R&E Supplies needs not $500,000 but more than $1.4 million to achieve the president’s objectives.

Mindful of the cautionary tale of the grateful borrower who rises to shake the hand of his banker and exclaims, “I don’t know how I’ll ever

= $1,422,000

= $7,633,000 – $6,211,000

Externalfunding required = Total assets – ¢Liabilities + Owners’equity ≤

Retainedearnings ’15 = Retained

earnings ’14 + Earnings

after tax ’15 – Dividends ’15

Chapter 3 Financial Forecasting 87

2Sometimes companies will complicate this equation by charging certain items, such as gains or losses on foreign currency translation, directly to retained earnings. But this is not a problem here.



repay you,” the lending officer for Suburban National Bank is apt to be of two minds about this result. On the one hand, R&E has a projected 2015 accounts receivable balance equal to $3.6 million, which would probably provide excellent security for a $1.4 million loan. On the other hand, R&E’s cavalier attitude toward financial planning and the president’s ob- vious lack of knowledge about where his company is headed are definite negatives. But before getting too involved in the implications of the fore- cast, we need to recall that our projection does not yet include the higher interest expense on the new, larger loan.

Interest Expense One thing that bothers attentive novices about pro forma forecasting is the circularity involving interest expense and indebtedness. As noted ear- lier, interest expense cannot be estimated accurately until the amount of external funding required has been determined. Yet because the external funding depends in part on the amount of interest expense, it would ap- pear one cannot be accurately estimated without the other.

There are two common ways around this dilemma. The more responsi- ble approach is to use a computer spreadsheet to solve for the interest ex- pense and external funding simultaneously. We will look at this approach in more detail in the section titled Computer-Based Forecasting. The other, more cavalier approach is to ignore the problem with the expectation that the first-pass estimate will be close enough. Given the likely errors in pre- dicting sales and other variables, the additional error caused by a failure to determine interest expense accurately is usually not all that critical.

To illustrate, R&E Supplies’ first-pass pro formas assumed a net inter- est expense of $90,000, whereas the balance sheet indicates total interest- bearing debt of almost $2.2 million. At a 10 percent interest rate, this implies an interest expense of about $220,000, or $130,000 more than our first-pass estimate. But think what happens as we trace the impact of a $130,000 addition to interest expense through the income statement. First, the $130,000 expense is before taxes. At a 45 percent tax rate, the de- cline in earnings after tax will be only $71,500. Second, because R&E Supplies distributes half of its earnings as dividends, a $71,500 decline in earnings after tax will result in only a $35,750 decline in the addition to re- tained earnings. So after all the dust settles, our estimate of the addition to retained earnings and, by implication, the external funding required will be about $35,750 low. But when the need for new external financing is al- ready over $1.4 million, what’s another $35,750 among friends? Granted, increased interest expense has a noticeable percentage effect on earnings, but by the time the increase filters through taxes and dividend payments, the effect on the external funding needed is modest. Moreover, the effect

88 Part Two Planning Future Financial Performance



Chapter 3 Financial Forecasting 89

would be even smaller if the borrowing rate were lower than the assumed 10 percent. The moral to the story is that quick-and-dirty financial fore- casts really can be quite useful. Unless you are naturally inclined toward green eyeshades or have the luxury of charging by the hour, you will find that handmade forecasts are just fine for many purposes.

Seasonality A more serious potential problem with pro forma statements—and, in- deed, with all of the forecasting techniques mentioned in this chapter—is that the results are applicable only on the forecast date. The pro formas in Table 3.3 present an estimate of R&E Supplies’ external financing re- quirements on December 31, 2015. They say nothing about the com- pany’s need for financing on any other date before or after December 31. If a company has seasonal financing requirements, knowledge of year-end loan needs may be of little use in financial planning, since the year end may bear no relation whatever to the date of the company’s peak financing need. To avoid this problem, you should make monthly or quarterly fore- casts rather than annual ones. Or, if you know the date of peak financing need, you can simply make this date the forecast horizon.

Pro Forma Statements and Financial Planning

To this point, R&E’s pro forma statements simply display the financial im- plications of the company’s operating plans. This is the forecasting half of the exercise. It is time now for R&E to do some serious financial planning. Using the techniques described in earlier chapters, management must an- alyze the forecast carefully to decide if it is acceptable or whether it must be changed to avoid identified problems. In particular, R&E management must decide whether the estimated external funding requirement is too large. If the answer is yes, either because R&E does not want to borrow $1.4 million or because the bank is unwilling to grant such a large loan, management must change its plans to conform to the financial realities. This is where operating plans and financial plans merge (or, too often, collide) to create a coherent strategy. Fortunately, the pro forma forecast provides an excellent template for such iterative planning.

To illustrate the process, suppose that Suburban National Bank, con- cerned about R&E management’s obvious lack of financial acumen, will not lend the company more than $1 million. Ignoring the possibility of trying another bank, or selling new equity, R&E’s challenge is to modify its operating plans to shave $400,000 off the projected external funding requirement. There are many ways to meet this challenge, each involving



90 Part Two Planning Future Financial Performance

subtle trade-offs among growth, profitability, and funding needs. And while we are not in a position to evaluate these trade-offs, as R&E management would be, we can illustrate the mechanics. Suppose that after much debate management decides to test the following revised operating plan:

• Tighten up collection of accounts receivable so that the collection pe- riod falls from 51 days to 47.

• Settle for a more modest improvement in trade payables so that the payables period rises from 59 days to 60.

Finally, because a tougher collection policy will drive away some customers and higher trade payables will sacrifice some prompt pay- ment discounts, let us presume that management believes the revised plan will reduce sales growth from 25 percent to 20 percent and in- crease general, selling, and administrative expenses from 12 percent to 12.5 percent.

To test this revised operating plan, we need only make the indicated changes in assumptions and roll out a revised pro forma forecast. Table 3.4 presents the results of this exercise. The good news is that external fund- ing required is now below the $1 million target; the bad news is that this improvement is not free. Earnings after tax in the revised forecast trail the original projection in Table 3.3 by 34 percent [($234 � $155)�$234].

Is R&E Supplies’ revised operating plan optimal? Is it superior to all other possible plans? We cannot say; these are fundamental questions of business strategy that can never be answered with complete assurance. We can say, however, that pro forma forecasts contribute mightily to the plan- ning process by providing a vehicle for evaluating alternative plans, by quantifying the anticipated costs and benefits of each, and by indicating which plans are financially feasible.

Computer-Based Forecasting

Readily available spreadsheets have made it possible for anyone with a modicum of computer skill to spin out elegant (and occasionally useful) pro forma forecasts and sophisticated risk analysis. To demonstrate how easy computer-based forecasting is, Table 3.5 presents an abbreviated one-year forecast for R&E Supplies as it might appear on a computer screen. The first area on the simulated screen is an assumptions box, con- taining all of the information and assumptions required to construct the forecast. Gathering all of the necessary input information in an assumptions box can be a real timesaver later if you want to change as- sumptions. The 2015 data in the assumptions box correspond closely to



TABLE 3.4 Revised Pro Forma Financial Statements for R&E Supplies, Inc., December 31, 2015 ($ thousands, changes in bold)

Income Statement


Net sales $24,736 20% increase Cost of goods sold 21,273 86% of sales_______ Gross profit 3,463 Expenses:

General, selling, and administrative expenses 3,092 12.5% of sales Net interest expense 90 Initially constant_______

Earnings before tax 281 Tax 126 45% tax rate_______ Earnings after tax $ 155______________

Balance Sheet


Current assets: Cash and securities $ 1,220 18 days sales Accounts receivable 3,185 47-day collection period Inventories 2,364 9 times turnover Prepaid expenses 20 Rough estimate_______

Total current assets 6,789 Net fixed assets 280 See text discussion_______ Total assets $ 7,069______________

Liabilities and Owners’ Equity

Current liabilities: Bank loan $ 0 Accounts payable 3,497 60-day payables period Current portion of long-term debt 100 See text discussion Accrued wages 22 Rough estimate_______

Total current liabilities 3,619 Long-term debt 660 Common stock 150 Retained earnings 1,657 See text discussion_______ Total liabilities and owners’ equity $ 6,086_______

External funding required $ 982______________

the data used earlier in our original handmade forecast for R&E Supplies.

The forecast begins immediately below the assumptions box. The first column, labeled “Equations 2015,” is included for explanatory purposes

Chapter 3 Financial Forecasting 91



92 Part Two Planning Future Financial Performance

TABLE 3.5 Forecasting with a Computer Spreadsheet: Pro Forma Financial Forecast for R&E Supplies, Inc., December 31, 2015 ($ thousands)


1 2 Year 2014 Actual 2015 2016 3 Net sales $20,613 4 Growth rate in net sales 25.0% 5 Cost of goods sold/net sales 86.0% 6 Gen., sell., and admin. expenses/net sales 12.0% 7 Long-term debt $ 760 $660 8 Current portion long-term debt $ 100 $100 9 Interest rate 10.0%

10 Tax rate 45.0% 11 Dividend/earnings after tax 50.0% 12 Current assets/net sales 29.0% 13 Net fixed assets $280 14 Current liabilities/net sales 14.5% 15 Owners’ equity $1,730 16 INCOME STATEMENT 17 Equations Forecast Forecast 18 Year 2015 2015 2016 19 Net sales �B3 � B3*C4 $25,766 20 Cost of goods sold �C5*C19 22,159___________ _______ 21 Gross profit �C19 � C20 3,607 22 Gen., sell., and admin. exp. �C6*C19 3,092 23 Interest expense �C9*(C7 � C8 � C40) 231__________________ _______ 24 Earnings before tax �C21 � C22 � C23 285 25 Tax �C10*C24 128___________ _______ 26 Earnings after tax �C24 � C25 156 27 Dividends paid �C11*C26 78___________ _______ 28 Additions to retained earnings �C26 � C27 78 29 30 BALANCE SHEET 31 Current assets �C12*C19 7,472 32 Net fixed assets �C13 280___________ _______ 33 Total assets �C31 � C32 7,752 34 35 Current liabilities �C14*C19 3,736 36 Long-term debt �C7 660 37 Owner’s equity �B15 � C28 1,808___________ _______ 38 Total liabilities and owners’ �C35 � C36 � C37 6,204 39 equity 40 EXTERNAL FUNDING REQUIRED �C33 � C38 $ 1,548



and would not appear on a conventional forecast. Entering the equations shown causes the computer to calculate the quantities appearing in the second column, labeled “Forecast 2015.” The third column, labeled “Forecast 2016,” is presently blank.

Two steps are required to get from the assumptions to the completed forecast. First, it is necessary to enter a series of equations tying the in- puts to the forecasted outputs. These are the equations appearing in the first column. Here is how to read them. The first equation for net sales is � B3 � B3 * C4. This instructs the computer to get the number in cell B3

Chapter 3 Financial Forecasting 93

Why Are Lenders So Conservative? Some would answer, “Too much Republican in-breeding,” but there is another possibility: low returns. Simply put, if expected loan returns are low, lenders cannot accept high risks.

Let us look at the income statement of a representative bank lending operation with, say, 100 $1 million loans, each paying 10 percent interest:

($ thousands)

Interest income (10% � 100 � $1 million) $10,000 Interest expense 7,000_______ Gross income 3,000 Operating expenses 1,000_______ Income before tax 2,000 Tax at 40% rate 800_______ Income after tax $ 1,200______________

The $7 million interest expense represents a 7 percent return the bank must promise depositors and investors to raise the $100 million lent. (In bank jargon, these loans offer a 3 percent lending margin, or spread.) Operating expenses include costs of the downtown office towers, the art collection, wages, and so on.

These numbers imply a minuscule return on assets of 1.2 percent ($1.2 million/[100 � $1 million]). We know from the levers of performance that to generate any kind of reasonable return on equity, banks must pile on the financial leverage. Indeed, to generate a 12 percent ROE, our bank needs a 10-to-1 assets-to-equity ratio or, equivalently, $9 in liabilities for every $1 in equity.

Worse yet, our profit figures are too optimistic because they ignore the reality that not all loans are repaid. Banks typically are able to recover only about 40 percent of the principal value of de- faulted loans, implying a loss of $600,000 on a $1 million default. Ignoring tax losses on defaulted loans, this means that if only two of the bank’s 100 loans go bad annually, the bank’s $1.2 million in ex- pected profits will evaporate. Stated differently, a loan officer must be almost certain that each loan will be repaid just to break even. (Alternatively, the officer must be almost certain of being promoted out of lending before the loans start to go bad.) So why are lenders conservative? Because the ag- gressive ones have long since gone bankrupt.



and add to it that number times the number in cell C4, in other words, $20,613 � $20,613 � 25%. The second equation instructs the computer to multiply forecasted net sales by the forecasted cost of goods sold per- centage. The third says to calculate gross profit by subtracting cost of goods sold from net sales.

There are only three tricky equations. Interest expense, row 23, is the interest rate times end-of-period long-term debt, including the current portion, plus the forecasted external funding required. As discussed ear- lier, the tricky part here is the interdependency between interest expense and external funding required. (I will talk more about this in step 2.) The other two equations are simple by comparison. The equity equation, row 37, is end-of-period equity plus additions to retained earnings; the external funding required equation, row 40, is total assets minus total liabilities and owners’ equity.

The second required step is to incorporate the interdependence be- tween interest expense and external funding required. Without some adjustment on your part, the computer will likely stall and signal “Cir- cular Reference Warning” when you enter the equation for interest ex- pense. To avoid this, you need to modify the way the computer calculates formulas in this file. For Excel 2007 or newer, click the “Microsoft Office Button” in the upper left corner of the spreadsheet; click “Excel Options,” and the “Formulas” category. In the “Calcula- tion Options” section, select the “Enable iterative calculation” box and then click “OK”. Your forecast should now be complete.

Now the fun begins. To modify a forecast assumption, just change the appropriate entry in the assumptions box, and the spreadsheet updates the rest of the forecast. To extend the forecast one more year, just com- plete the entries in the assumptions box, highlight the 2015 forecast, and copy or fill one column to the right. Then make some obvious changes in the equations for net sales and equity, and the computer does the rest. (See Additional Resources at the end of the chapter for information about PROFORMA, complimentary software for constructing pro forma forecasts.)

Coping with Uncertainty

Sensitivity Analysis Several techniques exist to help executives grapple with the uncertainty inherent in all realistic financial projections. The simplest is sensitivity analysis, known colloquially as “what if ” questions: What if R&E’s sales grow by 15 percent instead of 25 percent? What if cost of goods sold is

94 Part Two Planning Future Financial Performance



Chapter 3 Financial Forecasting 95

84 percent of sales instead of 86 percent? It involves systematically changing one of the assumptions on which the pro forma statements are based and observing how the forecast responds. The exercise is useful in at least two ways. First, it provides information about the range of possible outcomes. For example, sensitivity analysis on R&E Supplies’ original forecast might reveal that depending on the future sales vol- ume attained, the company’s need for external financing could vary be- tween $1.4 million and $2 million. This would tell management that it had better have enough flexibility in its financing plans to add an extra $600,000 in external funding as the future unfolds. Second, sensitivity analysis encourages management by exception. It enables managers to determine which assumptions most strongly affect the forecast and which are secondary. This allows them to concentrate their data- gathering and forecasting efforts on the most critical assumptions. Sub- sequently, during implementation of the financial plan, the same information enables management to focus on those factors most critical to the plan’s success.

Scenario Analysis Sensitivity analysis has its uses, but it is important to realize that fore- casts seldom err on one assumption at a time. That is, whatever events throw one assumption in a financial forecast off the mark will likely affect other assumptions as well. For example, suppose we want to estimate R&E Supplies’ external financing needs assuming sales fall 15 percent below expectations. Sensitivity analysis would have us simply cut fore- casted sales growth by 15 percent and recalculate the external financing required. However, this approach implicitly assumes the shortfall in sales will not affect any of the other estimates underlying the forecast. If the proper assumptions are that inventories will initially rise when sales drop below expectations and the profit margin will decline as the company slashes prices to maintain volume, failure to include these complementary effects will cause an underestimate of the need for out- side financing.

Instead of manipulating one assumption at a time, scenario analysis broadens the perspective to look at how a number of assumptions might change in response to a particular economic event. The first step in a scenario analysis is to identify a few carefully chosen events, or scenarios, that might plausibly befall the company. Common scenarios include loss of a major customer, successful introduction of a major new product, or entry of an important new competitor. Then, for each scenario identified, the second step is to carefully rethink the variables in the original forecast



to either reaffirm the original assumption or substitute a new, more accu- rate one. The last step in the analysis is to generate a separate forecast for each scenario. The result is a limited number of detailed projections de- scribing the range of contingencies the business faces.

Simulation Simulation is a computer-assisted extension of sensitivity analysis. To per- form a simulation, begin by assigning a probability distribution to each uncertain element in the forecast. The distribution describes the possible values the variable could conceivably take on and states the probability of each value occurring. Next, ask a computer to pick at random a value for each uncertain variable consistent with the assigned probability distribu- tion and generate a set of pro forma statements based on the selected val- ues. This creates one trial. Performing the last step many times produces a large number of trials. The output from a simulation is a table or, more often, a graph summarizing the results of many trials.

As an example, Figure 3.1 displays the results of a simulation of R&E’s external funding needs using Crystal Ball, a popular simulation program. Our original forecast assumed a 25 percent sales growth in 2015, but this, of course, is only a guess. The figure shows a frequency chart of R&E’s external funds required as the estimated sales growth varies in a range of about 10 to 40 percent. To generate the chart, I selected a bell-shaped, normal distribution for the sales growth estimate from the gallery of dis- tributions provided by Crystal Ball and shown at the bottom of the figure. Then, using the spreadsheet model in Table 3.5, I asked Crystal Ball to display the results of 500 trials as a frequency chart. In less than a minute, I had the result shown. I could have allowed virtually all of the assump- tions in the spreadsheet to vary, and to vary in correlation with one an- other, but this is enough to provide a taste of how easy simulations have become.

The principal advantage of simulation relative to sensitivity analysis and scenario analysis is that it allows all of the uncertain input variables to change at once. The principal disadvantage, in my experience, is that the results are often hard to interpret. One reason is that few executives are used to thinking about future events in terms of probabilities. The frequency chart in Figure 3.1 indicates there is a 2.00 percent chance that R&E’s external funding needs will exceed $1.844 million. Is a 2 percent chance so remote that R&E can safely raise less than $1.844 million, or might the prudent course be to raise even more just in case? How big a chance should the company be willing to take that it will be unable to meet its external funding requirement: 10 percent, 2 percent, or is

96 Part Two Planning Future Financial Performance



.02 percent the right number? The answer isn’t obvious. A second diffi- culty with simulation in practice recalls President Eisenhower’s dictum “It’s not the plans but the planning that matters.” With simulation much of the “planning” goes on inside the computer, and managers too often see only the results. Consequently, they may not gain the depth of in- sight into the company and its future prospects that they would if they used simpler techniques.

Chapter 3 Financial Forecasting 97

FIGURE 3.1 Simulating R&E Supplies’ Need for External Funding: Frequency Chart and Distribution Gallery for Sales Growth



TABLE 3.6 Cash Flow Forecast for R&E Supplies, Inc., 2015 ($ thousands)

Sources of Cash

Net income $ 234 Depreciation 50 Decreases in assets or increases in liabilities:

Increase in accounts payable 370 Increase in accrued wages 4______

Total sources of cash $ 658____________

Uses of Cash

Dividends $ 117 Increases in assets or decreases in liabilities:

Increase in cash and securities 859 Increase in accounts receivable 714 Increase in inventories 195 Increase in prepaid expenses 2 Increase in fixed assets 43 Decrease in long-term debt 100 Decrease in short-term debt 50______

Total uses of cash $2,080____________ Determination of external funding required:

Total sources � External funding required � Total uses $658,000 � External funding required � $2,080,000

External funding required � $1,422,000

98 Part Two Planning Future Financial Performance

The complete Crystal Ball program is available on a 15-day trial basis at For practice using the program to build a simulation model, see problem 15 at the end of this chapter. The list of websites at the end of this chapter includes some freeware alternatives to Crystal Ball.

Cash Flow Forecasts

A cash flow forecast is simply a listing of all anticipated sources of cash to and uses of cash by the company over the forecast period. The difference between forecasted sources and forecasted uses is the external financing required. Table 3.6 shows a 2015 cash flow forecast for R&E Supplies. The assumptions underlying the forecast are the same as those used to construct R&E’s initial pro forma statements in Table 3.3.

Cash flow forecasts are straightforward, easily understood, and com- monly used. Their principal weakness compared to pro forma state- ments is that they are less informative. R&E’s pro forma statements not only indicate the size of the external funding required but also provide



information that is useful for evaluating the company’s ability to raise this amount of money. Thus, a loan officer can use standard analysis tools on a company’s pro forma statements to assess its ability to service a requested loan. Because the cash flow forecast presents only changes in the quantities represented, a similar analysis using cash flow forecasts would be much more difficult.

Cash Budgets

A cash budget is what you and I are apt to prepare when we are worried about our personal finances. We make a list of all expected cash inflows and outflows over coming months, and earnestly hope the former exceeds the latter. When the news is bad, and outflows exceed inflows, we know that reduced savings or a new loan is in our future. Similarly, a corporate cash budget is a simple listing of projected cash receipts and disburse- ments over a forecast period for the purpose of anticipating future cash shortages or surpluses. Many firms use a nested set of financial forecasts, relying on pro forma projections to plan operations and estimate external funding needs, and cash budgets, prepared on a weekly or even daily basis, to manage short-term cash.

The only conceptual challenge to preparing a cash budget for a com- pany lies in the fact that company accounts are based on accrual account- ing, while cash budgets use strictly cash accounting. This makes it necessary to translate company projections regarding sales and purchases into their cash equivalents. For credit sales, this means adjusting for the time lag between a sale and receipt of cash from the sale. Analogously, for credit purchases, it means adjusting for the lag between the purchase of an item and payment of the resulting account payable.

To see the mechanics, Table 3.7 presents Jill Clair Fashions’ monthly cash budget for the third quarter of 2015. Jill Clair is a modest-sized man- ufacturer and distributor of women’s apparel. Sales are quite seasonal, reaching a peak in midsummer, and the company treasurer is concerned about maintaining adequate cash balances during this critical period. For simplicity, the table presents a monthly cash budget. In practice, a trea- surer working with volatile sales and limited cash would likely want weekly and perhaps daily budgets as well.

The top part of the budget, labeled “Determination of Cash Collec- tions and Payments,” makes the necessary conversion between accrual and cash accounting. The company’s stated credit terms are 2 percent/10 net 30 days, meaning customers receive a 2 percent discount when they pay within 10 days, but otherwise the bill is due in full in 30 days. Based on

Chapter 3 Financial Forecasting 99



TABLE 3.7 Cash Budget for Jill Clair Fashions, 3rd Quarter, 2015 ($ thousands)

Actual Projected

May June July Aug. Sept.

I. Determination of Cash Collections and Payments

Projected sales $150 $200 $300 $400 $250

Collection of sales During month of sale 88 118 74

(0.3) (.98) (month’s sales) During 1st month after sale 120 180 240

0.6 (prior month’s sales) During 2nd month after sale 15 20 30

0.1 (sales two months ago) _____ ____ ____ Total collections $223 $318 $344_____ ____ _________ ____ ____ Purchases 0.6 (next month’s projected sales) $180 $240 $150 Payments (prior month’s purchases) $180 $240 $150_____ ____ _________ ____ ____

II. Cash Receipts and Disbursements

Total collections (from above) $223 $318 $344 Sale of used equipment 79_____ ____ ____

Total cash receipts $223 $397 $344 Payments (from above) 180 240 150 Wages and salaries 84 82 70 Interest payments 8 8 8 Rent 10 10 10 Taxes 12 Principal payment on loan 40 Other disbursements 1 27 14_____ ____ ____

Total cash disbursements $283 $367 $304 Net cash receipts (disbursements) $ (60) $ 30 $ 40_____ ____ _________ ____ ____

III. Determination of Cash Surplus or Deficit

Beginning cash 220 160 190 Net cash receipts (disbursements) (60) 30 40_____ ____ ____ Ending cash 160 190 230 Minimum desired cash 200 200 200

Cash surplus (deficit) $ (40) $(10) $ 30_____ ____ _________ ____ ____

past experience, the treasurer anticipates that 30 percent of customers will pay in the month of purchase and claim the discount, 60 percent will pay in the following month, and 10 percent will pay two months after purchase. Looking at July’s numbers, we see that projected sales are $300,000 but collections are only $223,000. Approximately $88,000 of

100 Part Two Planning Future Financial Performance



this total comes from collections of sales made in July. This figure equals 30 percent of 98 percent of July’s sales. (Ninety-eight percent reflects the two percent discount for prompt payment.) Approximately $120,000 of July collections comes from sales booked in June, reflecting the expecta- tion that 60 percent of June buyers will pay the following month. Finally, $15,000 of July collections originates from sales made two months ago and equals 10 percent of May sales.

Jill Clair purchases raw materials equal to 60 percent of next month’s projected sales. So with August projected sales of $400,000, July purchases are $240,000. However, because the company pays its accounts payable 30 days after purchase, cash payments equal June purchases, or only $180,000.

The second section in Table 3.7, labeled “Cash Receipts and Disburse- ments,” records all anticipated cash inflows and outflows for each month. Also appearing is the monthly difference between these quantities, labeled “Net cash receipts (disbursements).” Observe that Jill Clair anticipates re- ceiving cash from two sources: collections from credit sales, as estimated in the top part of the table, and an additional $79,000 from the sale of used equipment. Other possible sources of cash not contemplated here include such things as proceeds from a new bank loan, interest income, and cash from the exercise of employee stock options. In the lower part of this sec- tion, cash disbursements record all anticipated cash payments for each month, including payments for credit purchases as estimated earlier, wages and salaries, interest payments, rent, taxes, a loan principal pay- ment, and other miscellaneous disbursements. In each category, the trea- surer has recorded the anticipated cash cost in the month paid. Note that depreciation does not appear among the disbursements because as a non- cash charge it has no place in a cash budget.

The bottom portion of Jill Clair’s cash budget shows the effect of the company’s anticipated cash inflows and outflows on its need for external funding. The logic is quite simple. One month’s ending cash balance be- comes the next month’s beginning balance, and throughout each month cash rises or falls according to that month’s net cash receipts or disburse- ments. For example, August’s beginning cash balance of $160,000 is July’s ending balance, and during August net cash receipts of $30,000 boost cash to an ending figure to $190,000. Comparing each month’s ending cash balance with the minimum desired level of cash as specified by the trea- surer yields a monthly estimate of the company’s cash surplus or deficit. A deficit measures the amount of money the company must raise on the forecast date to cover anticipated disbursements, and leave ending cash at the desired minimum. A forecasted surplus, on the other hand, means the company can cover anticipated disbursements and still have cash in excess

Chapter 3 Financial Forecasting 101



102 Part Two Planning Future Financial Performance

of the desired minimum. Stated differently, the cash surplus or deficit fig- ures in a cash budget are equal in all respects to the figures for external funding required appearing on a pro forma projection or a cash flow fore- cast. They all measure the company’s future need for external financing or its projected surplus cash.

Jill Clair’s cash budget suggests that the treasurer needs to borrow $40,000 in July, but should be able to reduce the loan to $10,000 the following month, and will be able to repay the loan in full by the end of September. In fact, it appears the company will have $30,000 in excess cash by then, which can be used to pay down other debt, purchase mar- ketable securities, or invest elsewhere in the business.

The Techniques Compared

Although the formats differ, it should be a relief to learn that all of the forecasting techniques considered in this chapter produce the same re- sults. As long as the assumptions are the same and no arithmetic or ac- counting mistakes are made, all of the techniques will produce the same estimate of external funding required. Moreover, if your accounting skills are up to the task, it is possible to reconcile one format with another. Problems 8, 9, and 10 at the end of the chapter allow you to demonstrate this fact for yourself.

A second reassuring fact is that regardless of which forecasting tech- nique is used, the resulting estimate of new financing needs is not biased by inflation. Consequently, there is no need to resort to elaborate inflation adjustments when making financial forecasts in an inflationary environ- ment. This is not to say that the need for new financing is independent of the inflation rate; indeed, as will become apparent in Chapter 4, the financing needs of most companies rise with inflation. Rather, it means that direct application of the previously described forecasting techniques will correctly indicate the need for external financing even in the presence of inflation.

Mechanically, then, the three forecasting techniques are equivalent, and the choice of which one to use can depend on the purpose of the fore- cast. For most planning purposes and for credit analysis, I recommend pro forma statements because they present the information in a form suitable for additional financial analysis. For short-term forecasting and the man- agement of cash, the cash budget is appropriate. A cash flow forecast lies somewhere between the other two. It presents a broader picture of com- pany operations than a cash budget does and is easier to construct and more accessible to accounting novices than pro formas are, but it is also less informative than pro formas.



Chapter 3 Financial Forecasting 103

Planning in Large Companies

In a well-run company, financial forecasts are only the tip of the planning iceberg. Executives throughout the organization devote substantial time and effort to developing strategic and operating plans that eventually be- come the basis for the company’s financial plans. This formalized plan- ning process is especially important in large, multidivision corporations because it is frequently a key means of coordination, communication, and motivation within the organization.

In a large company, effective planning usually involves three formal stages that recur on an annual cycle. In broad perspective, these stages can be viewed as a progressive narrowing of the strategic choices under con- sideration. In the first stage, headquarters executives and division man- agers hammer out a corporate strategy. This involves a broad-ranging analysis of the market threats and opportunities the company faces, an assessment of the company’s own strengths and weaknesses, and a deter- mination of the performance goals to be sought by each of the company’s business units. At this initial stage, the process is creative and largely qual- itative. The role of financial forecasts is limited to outlining in general terms the resource constraints the company faces and testing the financial feasibility of alternative strategies.

In the second stage, division managers and department personnel translate the qualitative, market-oriented goals established in stage 1 into a set of internal division activities deemed necessary to achieve the agreed-on goals. For example, if a stage 1 goal is to increase product X’s market share by at least 2 percent in the next 18 months, the stage 2 plans define what division management must do to achieve this objective. At this point, top management will likely have indicated in general terms the resources to be allocated to each division, although no specific spending plans will have been authorized. So division management will find it necessary to prepare at least rough financial forecasts to ensure that its plans are generally consistent with senior management’s resource commitments.

In the third stage of the planning process, department personnel develop a set of quantitative plans and budgets based on the activities defined in stage 2. This essentially involves putting a price tag on the agreed-on division activities. The price tag appears in two forms: operat- ing budgets and capital budgets. Although each company has its own def- inition of which expenditures are to appear on which budget, capital budgets customarily include expenditures on costly, long-lived assets, whereas op- erating budgets include recurring expenditures such as materials, salaries, and so on.



The integration of these detailed divisional budgets at headquarters produces the corporation’s financial forecast. If management has been realistic about available resources throughout the planning process, the forecast will contain few surprises. If not, headquarters executives may discover that in the aggregate, the spending plans of the divisions ex- ceed available resources and some revisions in division budgets will be necessary.

As company plans evolve from broad strategies to concrete marching orders, the forecasting techniques described in this chapter take on in- creasing importance, first as a means of articulating the financial implica- tions of a chosen strategy, and then as a vehicle for testing alternative strategies. In proper perspective, then, financial forecasting is a family of techniques for translating creative ideas and strategies into concrete action plans, and while proper technique cannot guarantee success, the lack of same certainly heightens the odds of failure.

104 Part Two Planning Future Financial Performance

A Problem with Depreciation XYZ Corporation is forecasting its financing needs for next year. The original forecast shows an ex- ternal financing need of $10 million. On reviewing the forecast, the production manager, having just returned from an accounting seminar, recommends increasing depreciation next year—for report- ing purposes only, not for tax purposes—by $1 million. She explains, rather condescendingly, that this will reduce net fixed assets by $1 million and, because a reduction of an asset is a source of cash, this will reduce the external funding required by a like amount. Explain why the production manager is incorrect.

Answer: Increasing depreciation will reduce net fixed assets. However, it will also reduce provi- sion for taxes and earnings after tax by the same amount. Since both are liability accounts and re- duction of a liability is a use of cash, the whole exercise is a wash with respect to determination of external financing requirements. This is consistent with cash budgeting, which ignores depreciation entirely. Here is a numerical example:

Change in Original Increase in Liability

Depreciation Depreciation Account

Operating income $10,000 $10,000 Depreciation 4,000 5,000_______ _______

Earnings before tax 6,000 5,000 Provision for tax @ 40% 2,400 2,000 �400_______ _______

Earnings after tax 3,600 3,000 Dividends 1,000 1,000_______ _______

Additions to retained earnings $ 2,600 $ 2,000 �$ 600_______ Total change in liabilities �$1,000



Chapter 3 Financial Forecasting 105


1. Pro Forma Statements • Are the principal means by which operating managers can predict

the financial implications of their decisions. • Are predictions of what a company’s financial statements will look

like at the end of the forecast period. • Are commonly used to estimate a company’s future need for external

funding and a great way to test the feasibility of current operating plans.

• Are often based on percent-of-sales forecasts that assume many bal- ance sheet and income statement entries vary in constant proportion to sales.

• Involve four steps: – Review of past financial statements to identify quantities that have

varied in proportion to sales historically. – Careful projection of future sales. – Preparation of independent projections of quantities, such as

fixed plant and equipment, that have not varied in proportion to sales historically.

– Testing the sensitivity of forecast results to variations in projected sales.

• Generate forecasts that are strictly applicable only on the forecast date and thus require care when dealing with seasonal busi- nesses.

• Contain a circularity involving interest expense and total debt out- standing, which can be easily handled with a computer spreadsheet set to enable iterative calculation.

• Are a great platform for effective financial planning where management carefully analyzes their forecast to decide if it is acceptable or whether it must be changed to avoid identified problems.

2. Cash flow forecasts • Project external funding required as the difference between antici-

pated sources and uses of cash over the forecast period. • Yield the same need for external funding as a pro forma projection,

given the same assumptions. • Are less informative than pro forma forecasts because they do not

provide information useful for evaluating how best to meet the indi- cated need for financing.



106 Part Two Planning Future Financial Performance

3. Cash budgets • Project the change in cash balance over the forecast period as the

difference between anticipated cash receipts and disbursements. • Rely on cash rather than accrual accounting. • Yield the same need for external funding as a pro forma projection,

given the same assumptions. • Are commonly used for short-term forecasts ranging from a day to a

month. • Are less informative than pro forma forecasts but easier for account-

ing neophytes to understand.

4. Three ways to cope with uncertainty in financial forecasts are • Sensitivity analysis: change one uncertain input at a time and ob-

serve how the forecast responds. • Scenario analysis: make coordinated changes in several inputs to

mirror the occurrence of a particular scenario, such as loss of a major customer, or a major recession.

• Simulation: assign probability distributions to a number of uncertain inputs and use a computer to generate a distribution of possible outcomes.

5. The planning process in most large companies • Involves three continuing cycles:

– A strategic planning cycle in which senior management is most active.

– An operational cycle in which divisional managers translate qual- itative strategic goals into concrete plans.

– A budgeting cycle that essentially puts a price tag on the opera- tional plans.

• Relies on the techniques of financial forecasting and planning to an increasing degree in each cycle.


Benninga, Simon. Financial Modeling. 4th ed. Cambridge, MA: The MIT Press, 2014. 1,144 pages.

Covers a number of financial models, including pro forma forecasting and simulation techniques, as well as more advanced models such as portfolio analysis, options, duration, and immunization. Microsoft Excel is used throughout. $103.

Mayes, Timothy R., and Todd M. Shank. Financial Analysis with Microsoft Excel. 6th ed. Cengage Learning, 2012. 528 pages.



Chapter 3 Financial Forecasting 107

An introductory-level look at the use of Microsoft Excel for financial analysis. Nowhere near as sophisticated or ambitious as the Benninga book. $70.


Written to accompany this text, PROFORMA converts user-supplied information and assumptions about a company into pro forma financial forecasts for as many as five years into the future. It also performs a ratio analysis and a sustainable growth analysis of the results. Additional “what if” analysis is easy to perform. A copy is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information).

WEBSITES Visit this site to download a full-featured, 15-day trial copy of Crystal Ball, a powerful addition to Excel for simulation analysis. Select “Oracle Crys- tal Ball Free Trial” and follow the instructions.;; If you prefer a free alternative to Crystal Ball using Excel, check out any of these websites. first-spreadsheet-RZ101773335.aspx Check “Get to know Excel 2010: Create your first spreadsheet” for an interactive introduction to Excel. If you would prefer to learn Excel through videos, this link goes to a pop- ular series of tutorials.

Excel Tutorial Apps If you would prefer to learn Excel on your handheld device, tutorials are available for both iOS and Android (search Apple’s app store or Google Play for “Excel Tutorial”). For iOS, consider the free app from GCF. For Android, the free app from Consagrado is highly rated and supports mul- tiple versions of Excel. Links to 116 (and counting) free Excel spreadsheets for analyzing a wide variety of financial issues, plus other Excel tools, all gathered by a finan- cial consultant.



108 Part Two Planning Future Financial Performance


Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are available in the Instructor Resources within McGraw-Hill’s Connect, connect (See the Preface for more information).

1. Suppose you constructed a pro forma balance sheet for a company and the estimate for external financing required was negative. How would you interpret this result?

2. Pro forma financial statements, by definition, are predictions of a company’s financial statements at a future point in time. So why is it important to analyze the historical performance of the company be- fore constructing pro forma financial statements?

3. Suppose that you constructed a pro forma balance sheet and a cash budget for a company for the same time period and the external fi- nancing required from the pro forma forecast exceeded the cash deficit estimated on the cash budget. How would you interpret this result?

4. Sequoia Furniture Company’s sales over the past three months, half of which are for cash, were as follows:

March April May

$400,000 $650,000 $520,000

a. Assume that Sequoia’s collection period is 60 days. What would be its cash receipts in May? What would be its accounts receivable balance at the end of May?

b. Now assume that Sequoia’s collection period is 45 days. What would be its cash receipts in May? What would be its accounts re- ceivable balance at the end of May?

5. Table 3.3 shows the December 31, 2015 pro forma balance sheet and income statements for R&E Supplies, Inc. The pro-forma balance sheet shows that R&E Supplies will need external funding from the bank of $1.4 million. However, they show almost $1.3 million in cash and short-term securities. Why are they talking to the bank for such a large amount when they have most of this sum in their cash account?

6. Table 3.5 presents a computer spreadsheet for estimating R&E Sup- plies’ external financing required for 2015. The text mentions that with modifications to the equations for equity and net sales, the fore- cast can easily be extended through 2016. Write the modified equa- tions for equity and net sales.



Chapter 3 Financial Forecasting 109

7. A spreadsheet containing R&E Supplies’s 2015 pro forma financial forecast as shown in Table 3.5 is available for download from McGraw- Hill’s Connect or your course instructor (see the Preface for more in- formation). Using this spreadsheet, the information presented below, and the modified equations determined in question 6 above, extend the forecast for R&E Supplies contained in Table 3.5 through 2016.

R&E Supplies Assumptions for 2016 ($ thousands)

Growth rate in net sales 30.0% Tax rate 45.0% Cost of goods sold/net sales 86.0% Dividend/earnings after tax 50.0% Gen., sell., & admin. Current assets/net sales 29.0%

expenses/net sales 11.0% Net fixed assets $ 270 Long-term debt $560 Current liabilities/net sales 14.4% Current portion long-term debt $100 Interest rate 10.0%

a. What is R&E’s projected external financing required in 2016? How does this number compare to the 2015 projection?

b. Perform a sensitivity analysis on this projection. How does R&E’s projected external financing required change if the ratio of cost of goods sold to net sales declines from 86.0 percent to 84.0 percent?

c. Perform a scenario analysis on this projection. How does R&E’s projected external financing required change if a severe recession occurs in 2016? Assume net sales decline 5 percent, cost of goods sold rises to 88 percent of net sales due to price cutting, and current assets increase to 35 percent of net sales as management fails to cut purchases promptly in response to declining sales.

The following three problems demonstrate that pro forma forecasts, cash budgets, and cash flow forecasts all yield the same estimated need for exter- nal financing—provided you don’t make any mistakes. For problems 8, 9, and 10, you may ignore the effect of added borrowing on interest expense.

8. The treasurer of Westmark Industrial, Inc., a wholesale distributor of household appliances, wants to estimate his company’s cash bal- ances for the first three months of 2015. Using the information below, construct a monthly cash budget for Westmark for January through March 2015. Westmark’s sales are 20 percent for cash, with the rest on 30-day credit terms. Its purchases are all on 60-day credit terms. Does it appear from your results that the treasurer should be concerned about investing excess cash or looking for a bank loan?



110 Part Two Planning Future Financial Performance

Westmark Industrial, Inc. Selected Information ($ thousands)

2014 (Actual) 2015 (Projected)

October November December January February March

Sales 360 420 1,200 600 240 240 Purchases 510 540 1,200 300 120 120

Wages payable monthly 180 Principal payment on debt due in March 210 Interest due in March 90 Dividend payable in March 300 Taxes payable in February 180 Addition to accumulated depreciation in March 30 Cash balance on January 1, 2015 300 Minimum desired cash balance 150

9. Continuing problem 8, Westmark Industrial’s annual income state- ment and balance sheet for December 31, 2014 appear below. Additional information about the company’s accounting methods and the treasurer’s expectations for the first quarter of 2015 appear in the footnotes.

Income Statement January 1, 2014 to December 31, 2014 ($ thousands)

Net sales $6,000 Cost of goods sold1 3,900_____

Gross profits 2,100 Selling and administrative expenses2 1,620 Interest expense 90 Depreciation3 90_____

Net profit before tax 300 Tax (33%) 99_____

Net profit after tax $ 201

Balance Sheet December 31, 2014 ($ thousands)

Assets Cash $ 300 Accounts receivable 960 Inventory 1,800_____

Total current assets 3,060 Gross fixed assets 900

Accumulated depreciation 150_____ Net fixed assets 750_____

Total assets $3,810



Chapter 3 Financial Forecasting 111

Liabilities Bank loan $ 0 Accounts payable 1,740 Miscellaneous accruals4 60 Current portion long-term debt5 210 Taxes payable 300_____

Total current liabilities 2,310 Long-term debt 990 Shareholders’ equity 510_____ Total liabilities and equity $3,810

1 Cost of goods sold consists entirely of items purchased in first quarter. 2 Selling and administrative expenses consist entirely of wages. 3 Depreciation is at the rate of $30,000 per quarter. 4 Miscellaneous accruals are not expected to change in the first quarter. 5 $210 due in March 2015. No payments for remainder of year.

a. Use this information and the information in problem 8 to construct a pro forma income statement for the first quarter of 2015 and a pro forma balance sheet for March 31, 2015. What is your estimated external financing need for March 31?

b. Does the March 31, 2015, estimated external financing equal your cash surplus (deficit) for this date from your cash budget in prob- lem 8? Should it?

c. Do your pro forma forecasts tell you more than your cash budget does about Westmark’s financial prospects?

d. What do your pro forma income statement and balance sheet tell you about Westmark’s need for external financing on February 28, 2015?

10. Based on your answer to question 9, construct a first-quarter 2015 cash flow forecast for Westmark Industrial.

11. Toys-4-Kids manufactures plastic toys. Sales and production are highly seasonal. Below is a quarterly pro forma forecast indicating external financing needs for 2015. Assumptions are in parentheses.

Toys-4-Kids 2015 Quarterly Pro Forma Forecast

($ thousands)

Qtr 1 Qtr 2 Qtr 3 Qtr 4

Net sales 300 375 3,200 5,000 Cost of sales (70 percent of sales) 210 263 2,240 3,500____ ____ ____ ____ Gross profit 90 113 960 1,500 Operating expenses 560 560 560 560____ ____ ____ ____ Profit before tax (470) (448) 400 940 Income taxes (188) (179) 160 376____ ____ ____ ____ Profit after tax (282) (269) 240 564



112 Part Two Planning Future Financial Performance

Cash (minimum balance � $200,000) 1,235 927 200 200 Accounts receivable (75 percent of quarterly sales) 225 281 2,400 3,750 Inventory (12/31/14 balance � $500,000) 500 500 500 500____ ____ ____ ____ Current assets 1,960 1,708 3,100 4,450 Net plant & equipment 1,000 1,000 1,000 1,000____ ____ ____ ____ Total assets 2,960 2,708 4,100 5,450

Accounts payable (10 percent of quarterly sales) 30 38 320 500 Accrued taxes (payments quarterly in arrears) (188) (179) 160 376____ ____ ____ ____ Current liabilities (158) (142) 480 876 Long-term debt 400 400 400 400 Equity (12/31/14 balance � $3,000,000) 2,718 2,450 2,690 3,254____ ____ ____ ____

Total liabilities and equity 2,960 2,708 3,570 4,530

External financing required 0 0 530 920

a. How do you interpret the negative numbers for income taxes in the first two quarters?

b. Why are cash balances in the first two quarters greater than the min- imum required $200,000? How were these numbers determined?

c. How was “external financing required,” appearing at the bottom of the forecast, determined?

d. Do you think Toys-4-Kids will be able to borrow the external fi- nancing required as indicated by the forecast?

12. Continuing with Toys-4-Kids, introduced in the preceding problem, the company’s production manager has argued for years that it is inef- ficient to produce on a seasonal basis. She believes the company should switch to level production throughout the year, building up finished goods inventory in the first two quarters to meet the peak selling needs in the last two. She believes the company can reduce its cost of goods sold from 70 percent to 65 percent with level produc- tion. (Recall that production mangers typically want to restrict pro- duction to left shoes only so as to reduce costs.) a. Prepare a revised pro forma forecast assuming level production. In

your forecast assume that quarterly accounts payable under level production equal 10 percent of average quarterly sales for the year. To estimate quarterly inventory use the following two formulas:

Inventoryeoq � Inventoryboq � Quarterly production � Quarterly cost of sales

Quarterly production � Annual cost of sales/4 where eoq and boq refer to end of quarter and beginning of quarter, respectively. Please ignore the effect of increased external financing required on interest expense. b. What is the effect of the switch from seasonal to level production

on annual profits?



Chapter 3 Financial Forecasting 113

c. What effect does the switch have on the company’s quarterly end- ing inventory? On the company’s quarterly need for external financing?

d. Do you think the company will be able to borrow the amount of money required by level production? What obsolescence risks does the company incur by building up inventory in anticipation of future sales? Might this be a concern to lenders?

13. This problem asks you to prepare one- and five-year financial fore- casts and conduct some sensitivity analysis and scenario analysis for Aquatic Supplies Company. A spreadsheet containing the company’s 2014 financial statements and management’s projections is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). Use this information to an- swer the questions posed in the spreadsheet.

14. Financial statements and additional information for Noble Equipment Corp. are available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). The com- pany’s fiscal year end is September 30. Noble’s management wants to estimate the company’s cash balances for the last three months of cal- endar year 2014, which are the first three months of fiscal year 2015. The questions accompanying the spreadsheet ask you to prepare a monthly cash budget, pro forma financial statements, and a cash flow forecast for the period.

15. This problem asks you to construct a simple simulation model. If you do not own simulation software, you can download to your computer a free, full-strength version of Crystal Ball for a 15-day trial. Go to (For detailed instructions, see WEBSITES at the end of this chapter.) a. Problem 7 above asked you to extend the forecast for R&E Sup-

plies contained in Table 3.5 through 2016. Using the same spread- sheet, simulate R&E Supplies’ external funding requirements in 2016 under the following assumptions.

i.Represent the growth rate in net sales as a triangular distribution with a mean of 30 percent and a range 25 percent to 35 percent.

ii.Represent the interest rate as a uniform distribution varying from 9 percent to 11 percent.

iii.Represent the tax rate as a lognormal distribution with a mean of 45 percent and a standard deviation of 2 percent.

b. If the treasurer wants to be 95 percent certain of raising enough money in 2016, how much should he raise? (Grab the triangle below the frequency chart on the right and move it to the left until 95.00 appears in the “Certainty” window.)





Managing Growth

Alas, the road to success is always under repair. Anonymous

Growth and its management present special problems in financial plan- ning, in part, because many executives see growth as something to be max- imized. They reason simply that as growth increases, the firm’s market share and profits should rise as well. From a financial perspective, however, growth is not always a blessing. Rapid growth can put considerable strain on a company’s resources, and unless management is aware of this effect and takes active steps to control it, rapid growth can lead to bankruptcy. Companies can literally grow broke. It is a sad truth that rapid growth has driven almost as many companies into bankruptcy as slow growth has. It is doubly sad to realize that those companies that grew too fast met the mar- ket test by providing a product people wanted and failed only because they lacked the financial acumen to manage their growth properly.

At the other end of the spectrum, companies growing too slowly have a different but no less pressing set of financial concerns. As will become ap- parent, if these companies fail to appreciate the financial implications of slow growth, they will come under increasing pressure from restive share- holders, irate board members, and potential raiders. In either case, the financial management of growth is a topic worthy of close inspection.

We begin our look at the financial dimensions of growth by defining a company’s sustainable growth rate. This is the maximum rate at which com- pany sales can increase without depleting financial resources. Then we look at the options open to management when a company’s target growth rate exceeds its sustainable growth rate and, conversely, when growth falls below sustainable levels. An important conclusion will be that growth is not necessarily something to be maximized. In many companies, it may be necessary to limit growth to conserve financial strength. In others, the money used to finance unprofitable growth might better be returned to owners. The need to limit growth is a hard lesson for operating managers used to thinking that more is better; it is a critical one, however, because operating executives bear major responsibility for managing growth.



Sustainable Growth

We can think of successful companies as passing through a predictable life cycle. The cycle begins with a startup phase in which the company loses money while developing products or services and establishing a foothold in the market. This is followed by a rapid growth phase in which the com- pany is profitable but is growing so rapidly that it needs regular infusions of outside financing. The third phase is maturity, characterized by a de- cline in growth and a switch from absorbing outside financing to generat- ing more cash than the firm can profitably reinvest. The last phase is decline, during which the company is perhaps marginally profitable, gen- erates more cash than it can reinvest internally, and suffers declining sales. Mature and declining companies frequently devote considerable time and money to seeking investment opportunities in new products or firms that are still in their growth phase.

We begin our discussion by looking at the growth phase, when financ- ing needs are most pressing. Later we will consider the growth problems of mature and declining firms. Central to our discussion is the notion of sustainable growth. Intuitively, sustainable growth is merely a formaliza- tion of the old adage “It takes money to make money.” Increased sales require more assets of all types, which must be paid for. Retained profits and the accompanying new borrowing generate some cash, but only lim- ited amounts. Unless the company is prepared to sell common stock or borrow excessive amounts, this limit puts a ceiling on the growth it can achieve without straining its resources. This is the firm’s sustainable growth rate.

The Sustainable Growth Equation Let’s begin by writing a simple equation to express the dependence of growth on financial resources. For this purpose, assume

• The company has a target financing, or capital, structure and a target dividend policy it wishes to maintain.

• Management is unable or unwilling to sell new equity.

We will say more about these assumptions soon. For now, it is enough to realize that although they may not be appropriate for all firms, the assumptions describe a great many.

Figure 4.1 shows the rapidly growing company’s plight. It represents the firm’s balance sheet as two rectangles, one for assets and the other for lia- bilities and owners’ equity. The two long, unshaded rectangles represent

116 Part Two Planning Future Financial Performance



the balance sheet at the beginning of the year. The rectangles are, of course, the same height because assets must equal liabilities plus owners’ equity. Now, if the company wants to increase sales during the coming year, it must also increase assets such as inventory, accounts receivable, and productive capacity. The shaded area on the assets side of the figure repre- sents the value of new assets necessary to support the increased sales. Be- cause the company will not be selling equity by assumption, the cash required to pay for this increase in assets must come from retained profits and new debt.

We want to know what limits the rate at which the company in Figure 4.1 can increase sales. Assuming, in effect, that all parts of a busi- ness expand in strict proportion like a balloon, what limits the rate of this expansion? To find out, start in the lower-right corner of the figure with owners’ equity. As equity grows, the firm can borrow more money with- out altering the capital structure; together, the growth of liabilities and the growth of equity determine the rate at which assets expand. This, in turn, limits the growth rate in sales. So after all the dust settles, what lim- its the growth rate in sales is the rate at which owners’ equity expands. A company’s sustainable growth rate therefore is nothing more than its growth rate in equity.

Letting g* represent the sustainable growth rate,

g* = Change in equity


Chapter 4 Managing Growth 117

FIGURE 4.1 New Sales Require New Assets, Which Must Be Financed





New sales require new assets

Liabilities & Equity

New uses of cash require new sources

New debt

Retained profits



where bop denotes beginning-of-period equity. Because the firm will not be selling any new shares by assumption, the only source of new equity will be from retained profits, so we can rewrite this expression as

where R is the firm’s “retention rate.” R is the fraction of earnings retained in the business, or 1 minus the dividend payout ratio. If a company’s tar- get dividend policy is to distribute 10 percent of earnings as dividends, its retention ratio is 90 percent.

The ratio “Earnings/Equity” in this expression should look familiar; it is the firm’s return on equity, or ROE. Thus,

Finally, recalling the levers of performance discussed in Chapter 2, we can rewrite this expression yet again as

where P, A, and are our old friends from Chapter 2, the levers of per- formance, where P is the profit margin, A is the asset turnover ratio, and

is the assets-to-equity ratio. The assets-to-equity ratio wears a hat here as a reminder that it is assets divided by beginning-of-period equity instead of end-of-period equity as defined in Chapter 2.

This is the sustainable growth equation.1 Let’s see what it tells us. Given the assumptions just noted, the equation says that a company’s sus- tainable growth rate in sales, g*, equals the product of four ratios, P, R, A, and . Two of these ratios, P and A, summarize the operating perfor- mance of the business, while the other two describe the firm’s principal fi- nancial policies. Thus, the retention rate, R, captures management’s attitudes toward the distribution of dividends, and the assets-to-equity ratio, , reflects its policies regarding financial leverage.

An important implication of the sustainable growth equation is that g* is the only growth rate in sales that is consistent with stable values of the four ratios. If a company increases sales at any rate other than g*, one or more of the ratios must change. This means that when a company grows at a rate in excess of its sustainable growth rate, it had better improve operations (represented by an increase in the profit margin or the asset turnover ratio) or prepare to alter its financial policies (represented by increasing its retention rate or its financial leverage).





g* = PRATN

g* = R * ROEbop

g* = R * Earnings


118 Part Two Planning Future Financial Performance

1I shall refrain from admonishing you to avoid “prat̂” falls.



Too Much Growth

This is the crux of the sustainable growth problem for rapidly expanding firms: Because increasing operating efficiency is not always possible and al- tering financial policies is not always wise, we see that it is entirely possible for a company to grow too fast for its own good. This is particularly true for smaller companies, which may do inadequate financial planning. Such companies see sales growth as something to be maximized and think too little of the financial consequences. They do not realize that rapid growth has them on a treadmill; the faster they grow, the more cash they need, even when they are profitable. They can meet this need for a time by in- creasing leverage, but eventually they will reach their debt capacity, lenders will refuse additional credit requests, and the companies will find them- selves without the cash to pay their bills. All of this can be prevented if managers understand that growth above the company’s sustainable rate creates financial challenges that must be anticipated and managed.

Please understand; I am not suggesting that a company’s actual growth rate should always equal its sustainable growth rate, or even closely ap- proximate it. Rather, I am saying that management must anticipate any disparity between actual and sustainable growth and have a plan in place for managing that disparity. The challenge is, first, to recognize the dis- parity and, second, to create a viable strategy to manage it.

Balanced Growth Here is another way to think about sustainable growth. Recalling that a com- pany’s return on assets, ROA, can be expressed as the product of its profit mar- gin times its asset turnover, we can rewrite the sustainable growth equation as2

Here R and T̂ reflect the company’s financial policies, while ROA sum- marizes its operating performance. So if a company’s retention ratio is 25 percent and its assets-to-equity ratio is 1.6, its sustainable growth equation becomes simply

This equation says that given stable financial policies, sustainable growth varies linearly with return on assets. Figure 4.2 graphs this relationship with sales growth on the vertical axis, ROA on the horizontal axis, and the sustainable growth equation as the upward-sloping, solid, diagonal line.

g* = 0.4 * ROA

g* = RTN * ROA

Chapter 4 Managing Growth 119

2Strictly speaking, this equation should be expressed in terms of return on invested capital, not return on assets, but the gain in precision is too modest to justify the added mathematical complexity. See Gordon Donaldson, Managing Corporate Wealth (New York: Praeger, 1984), Chapter 4, for a more rigorous exposition.



The line bears the label “Balanced growth” because the company can self- finance only the sales growth–ROA combinations lying on this line. All growth-return combinations lying off this line generate either cash deficits or cash surpluses. Thus, rapidly growing, marginally profitable companies will plot in the upper-left portion of the graph, implying cash deficits, while slowly expanding, highly profitable companies will plot in the lower- right portion, implying cash surpluses. I should emphasize that the phrase “self-finance” does not imply constant debt but rather a constant debt-to- equity ratio. Debt can increase but only in proportion to equity.

When a company experiences unbalanced growth of either the surplus or the deficit variety, it can move toward the balanced growth line in any of three ways: It can change its growth rate, alter its return on assets, or modify its financial policies. To illustrate the last option, suppose the com- pany with the balanced growth line depicted in Figure 4.2 is in the deficit region of the graph and wants to reduce the deficit. One strategy would be to increase its retention ratio to, say, 50 percent and its assets-to-equity ratio to, say, 2.8 to 1, thereby changing its sustainable growth equation to

In Figure 4.2, this is equivalent to rotating the balanced growth line up- ward to the left, as shown by the dotted line. Now any level of profitabil- ity will support a higher growth rate than before.

In this perspective, the sustainable growth rate is the nexus of all growth-return combinations yielding balanced growth, and the sustain- able growth challenge is that of managing the surpluses or deficits caused by unbalanced growth. We will return to strategies for managing growth after looking at a numerical example.

g* = 1.4 * ROA

120 Part Two Planning Future Financial Performance

FIGURE 4.2 A Graphical Representation of Sustainable Growth








G ro

w th

r at

e in

s al

es (

% )

Return on assets (%)

0 38363424 26 28 30 3218 20 2210 12 14 162 4 6 8 40

Cash deficits

Balanced growth g* = 0.4 � ROA

Balanced growth g* = 1.4 � ROA

Cash surpluses



Under Armour’s Sustainable Growth Rate To illustrate the growth management challenges a rapidly growing business faces, let’s look at Under Armour, Inc., an American supplier of sportswear and casual apparel. Table 4.1 presents the company’s actual and sustainable growth rates from 2009 through 2013. For each year, I calculated Under Armour’s sustainable growth rate by plugging the four required ratios into the sustainable growth equation. I calculated the ratios from the company’s financial statements, which are not shown. Observe that Under Armour’s sales grew over 25 percent a year on average over the period, almost half again as much as the firm’s average sustainable growth rate.

How did Under Armour cope with actual growth above sustainable levels? A look at the four required ratios reveals that the company’s prin- cipal response was to increase its profit margin, by a total of some 27 per- cent over the five years. Also important was a 17 percent rise in financial leverage. Management is undoubtedly pleased by the improving profit margin, but also aware that increasing indebtedness is not a long-run answer to the problems of rapid growth.

Figure 4.3 says the same thing graphically. It shows Under Armour’s balanced growth lines in 2009 and 2013 and the growth-return combina- tions the company achieved each year. Despite a beneficial increase in the slope of the company’s balanced growth line produced by the aforemen- tioned increases in margins and leverage, Under Armour remained in the cash deficit portion of the graph every year. The persistent gap between the yearly growth-return combinations and the balanced growth lines

Chapter 4 Managing Growth 121

TABLE 4.1 A Sustainable Growth Analysis of Under Armour, Inc., 2009–2013*

2009 2010 2011 2012 2013

Required ratios: Profit margin, P (%) 5.5 6.4 6.6 7.0 7.0 Retention ratio, R (%) 100.0 100.0 100.0 100.0 100.0 Asset turnover, A (times) 1.57 1.58 1.60 1.59 1.48 Financial leverage, T (times) 1.65 1.69 1.85 1.82 1.93

Under Armour’s sustainable growth rate, g* (%) 14.2 17.0 19.6 20.2 20.0 Under Armour’s actual growth rate in sales, g (%) 18.1 24.2 38.4 24.6 27.1

What If?

Profit Financial Margin Leverage Both

8.0% 2.4 Times Occur

Under Armour’s sustainable growth rate in 2013 (%) 22.8 24.8 28.4

*Totals may not add due to rounding.



throughout the period confirms that Under Armour’s growth manage- ment challenges persist.

“What If” Questions When management faces growth problems, the sustainable growth equa- tion can be useful in searching for solutions. This is done by asking a series of “what if ” questions as shown in the bottom portion of Table 4.1. We see, for example, that in coming years Under Armour can raise its sustainable growth rate to 22.8 percent by increasing its profit margin to 8.0 percent. Alternatively, it can boost its sustainable growth rate to 24.8 percent by raising financial leverage to 2.4 times. Doing both simultaneously will raise sustainable growth to 28.4 percent, roughly comparable to its recent actual growth rates in sales.

What to Do When Actual Growth Exceeds Sustainable Growth

We have now developed the sustainable growth equation and illustrated its use for rapidly growing companies. The next question is: What should management do when actual growth exceeds sustainable growth? The first step is to determine how long the situation will continue. If the company’s

122 Part Two Planning Future Financial Performance

FIGURE 4.3 Under Armour’s Sustainable Growth Challenges, 2009–2013











0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

G ro

w th

r at

e in

s al

es (

% )

Return on assets (%)






Balanced growth 2013

Balanced growth 2009

Cash deficits

Cash surpluses



growth rate is likely to decline in the near future as the firm reaches matu- rity, the problem is only a transitory one that can probably be solved by fur- ther borrowing. In the future, when the actual growth rate falls below the sustainable rate, the company will switch from being an absorber of cash to being a generator of cash and can repay the loans. For longer-term sus- tainable growth problems, some combination of the following strategies will be necessary.

• Sell new equity

• Increase financial leverage

• Reduce the dividend payout

• Prune away marginal activities

• Outsource some or all of production

• Increase prices

• Merge with a “cash cow”

Let’s consider each of these strategies in more detail.

Sell New Equity If a company is willing and able to raise new equity by selling shares, its sustainable growth problems vanish. The increased equity, plus whatever added borrowing it makes possible, become sources of cash with which to finance further growth.

The problem with this strategy is that it is unavailable to many com- panies and unattractive to others. In many countries throughout the world, equity markets are poorly developed or nonexistent. To sell equity in these countries, companies must go through the laborious and expen- sive task of seeking out investors one by one to buy the new shares. This is a difficult undertaking because without active stock market trading of the shares, new investors will be minority owners of illiquid securities. In effect, they will be along for the ride, unable to steer the corporate ship and without a graceful way to bail out. Consequently, those investors in- terested in buying the new shares will be limited largely to family and friends of existing owners.

Even in countries with well-developed stock markets, such as the United States and Britain, many companies find it very difficult to raise new equity. This is particularly true of smaller concerns that, unless they have a glamorous product, find it difficult to attract venture capital money or to secure the services of an investment banker to help them sell the shares to other investors. Without such help, the firms might just as well be in a country without developed markets, for a lack of trading in the stock will again restrict potential buyers largely to family and friends.

Chapter 4 Managing Growth 123



Finally, even many companies that are able to raise new equity prefer not to do so. This is evidenced in Table 4.2, which shows the sources of capital to U.S. nonfinancial corporations over the past decade. Observe that internal sources, depreciation and retained profits, were by far the most important sources of corporate capital, accounting for two-thirds of the total. At the other extreme, new equity has been not a source of capital at all but a use, meaning American corporations on average retired more stock than they issued over this period.

124 Part Two Planning Future Financial Performance

Dell Grows Up Even well-known, successful companies such as tech giant Dell, Inc., have experienced life- threatening growing pains. The company’s young founder, Michael Dell, now admits that in 1993 Dell’s growth spurt had come at the expense of a sound financial position. He says the company’s cash reserves were down to $20 million at one point. “We could have used that up in a day or two. For a company our size, that was ridiculous. I realized we had to change the priorities.”

Had Dell’s priorities remained “growth, growth, growth,” it might not be around today. Michael Dell founded Dell Computer before he was 20 years old. After several years of prodigious growth and with his company at the financial precipice, he lacked the expertise to manage the growth. Fortu- nately, he had the sense to hire more seasoned managers who could calm security analysts and steer Dell in a more conservative direction. Those managers urged Dell to focus on earnings and liq- uidity rather than sales growth. Slowing growth in 1994 cost the company market share, but it also helped convert a loss a year earlier into a $106.6 million profit. The company also instituted formal planning and budgeting processes. Today Dell is one of the world’s largest computer manufacturers and has recorded at least $1 billion in profits for 15 straight years. When Michael Dell and his in- vestment partners took the company private in late 2013, at a purchase price of $25 billion, the com- pany maintained a healthy balance sheet with cash balances approximating 25 percent of assets.

TABLE 4.2 Sources of Capital to U.S. Nonfinancial Corporations, 2004–2013

Source: Federal Reserve System, Financial Accounts of the United States. From data at


Retained profits 18.3% Depreciation 49.4%

Subtotal 67.7%


Increased liabilities 50.6% New equity issues �18.3%

Subtotal 32.3% Total 100.0%



We will return to the puzzling question of why companies do not issue more new equity at the end of the chapter. For now, let us provisionally accept that many companies cannot or will not sell new stock, and con- sider other strategies for managing unsustainably rapid growth.

Increase Leverage If selling new equity is not a solution to a company’s sustainable growth problems, two other financial remedies are possible. One is to cut the dividend payout ratio, and the other is to increase financial leverage. A cut in the payout ratio raises sustainable growth by increasing the pro- portion of earnings retained in the business, while increasing the leverage ratio raises the amount of debt the company can add for each dollar of retained profits.

I like to think of increasing leverage as the “default” option, in two senses of the word. From a computer programming perspective, an in- crease in leverage will be what occurs by default when management does not plan ahead. Over time, the company will find there is too little cash to pay creditors in a timely fashion, and accounts payable will rise by default. Increasing leverage is also the default option in the financial sense that creditors will eventually balk at rising debt levels and force the company into default—step one on the path to bankruptcy.

We will have considerably more to say about financial leverage in the next two chapters. It should be apparent already, however, that there is an upper limit to a company’s use of debt financing. And part of the growth management challenge is to identify an appropriate degree of financial leverage for a company and to ensure this ceiling is not broached.

Reduce the Payout Ratio Just as there is an upper limit to leverage, there is a lower limit of zero to a company’s dividend payments, and most companies are already at this limit. Over half of the almost 10,000 public companies for which data are available on Standard & Poor’s Compustat data service paid no dividends at all in 2013.3 In general, owners’ interest in dividend payments varies in- versely with their perceptions of the company’s investment opportunities. If owners believe the retained profits can be put to productive use earning attractive rates of return, they will happily forgo current dividends in

Chapter 4 Managing Growth 125

3 This does not imply that dividends are in any way insignificant or unimportant in the U.S. economy. For in the same year that less than half of companies were paying dividends, 80 percent of the nation’s largest firms, represented by members of the S&P 500 Index, were distributing over $321 billion to shareholders, a sum equal to almost one-third of earnings. The proper inference is that small, young firms tend not to pay dividends, while large, mature ones do, and that there are many more small, young firms in our economy than large, mature ones.



favor of higher future ones. (There have been few complaints among Google’s shareholders about the lack of dividends.) On the other hand, if company investment opportunities do not promise attractive returns, a dividend cut will anger shareholders, prompting a decline in stock price. An additional concern for closely held companies is the effect of dividend changes on owners’ income and on their tax obligations.

Profitable Pruning Beyond modifications in financial policy, a company can make several operating adjustments to manage rapid growth. One is called “profitable pruning.” During much of the 1960s and early 1970s, some financial ex- perts emphasized the merits of product diversification. The idea was that companies could reduce risk by combining the income streams of busi- nesses in different product markets. The thought was that as long as these income streams were not affected in exactly the same way by economic events, the variability inherent in each stream would “average out” when combined with others. We now recognize two problems with this con- glomerate diversification strategy. First, although it may reduce the risks seen by management, it does nothing for the shareholders. If shareholders want diversification, they can get it on their own by just purchasing shares of different independent companies. Second, because companies have limited resources, and a limited ability to manage disparate activities, they cannot be important competitors in a large number of product markets at the same time. Instead, they are apt to be followers in many markets, un- able to compete effectively with the dominant firms.

Profitable pruning is the opposite of conglomerate merger. This strategy recognizes that when a company spreads its resources across too many prod- ucts, it may be unable to compete effectively in any. Better to sell off mar- ginal operations and plow the money back into remaining businesses.

Profitable pruning reduces sustainable growth problems in two ways: It generates cash directly through the sale of marginal businesses, and it reduces actual sales growth by eliminating some of the sources of the growth. Many businesses have successfully employed this strategy in re- cent years, including Computer Sciences Corporation (CSC), an informa- tion technology services company listed on the New York Stock Exchange. Between 2012 and 2013, CSC sold several of its older opera- tions, not because they were unprofitable, but because CSC wanted to use the cash generated from the sales to support growth in more promising markets, such as cloud computing and big data.

Profitable pruning is also possible for a single-product company. Here the idea is to prune out slow-paying customers or slow-turning inventory. This lessens sustainable growth problems in three ways: It frees up cash,

126 Part Two Planning Future Financial Performance



which can be used to support new growth; it increases asset turnover; and it reduces sales. Sales decline because tightening credit terms and reduc- ing inventory selection drive away some customers.

Outsourcing Outsourcing involves the decision of whether to perform an activity in- house or purchase it from an outside vendor. A company can increase its sustainable growth rate by outsourcing more and doing less in-house. When a company outsources, it releases assets that would otherwise be tied up in performing the activity, and it increases its asset turnover. Both results diminish growth problems. An extreme example of this strategy is a franchisor that sources out virtually all of the company’s capital-intensive activities to franchisees and, as a result, has very little investment.

The key to effective outsourcing is to determine where the company’s unique abilities—or, as consultants would put it, “core competencies”—lie. If certain activities can be performed by others without jeopardizing the firm’s core competencies, these activities are candidates for outsourcing.

Pricing An obvious inverse relationship exists between price and volume. When sales growth is too high relative to a company’s financing capabilities, it may be necessary to raise prices to reduce growth. If higher prices in- crease the profit margin, the price increase will also raise the sustainable growth rate.

In effect, the recommendation here is to make growth itself a decision variable. If rapid growth is a problem, attack the problem directly by cut- ting growth. And while closing early on alternate Wednesdays or turning away every 10th customer might get the job done, the most effective way to cut growth is usually to raise prices.

Is Merger the Answer? When all else fails, it may be necessary to look for a partner with deep pockets. Two types of companies are capable of supplying the needed cash. One is a mature company, known in the trade as a “cash cow,” look- ing for profitable investments for its excess cash flow. The other is a con- servatively financed company that would bring liquidity and borrowing capacity to the marriage. Acquiring another company or being acquired is a drastic solution to growth problems, but it is better to make the move when a company is still financially strong than to wait until excessive growth forces the issue.

Chapter 4 Managing Growth 127



Too Little Growth

Slow-growth companies—those whose sustainable growth rate exceeds actual growth—have growth management problems too, but of a different kind. Rather than struggling continually for fresh cash to stoke the fires of growth, slow-growth companies face the dilemma of what to do with profits in excess of company needs. This might appear to be a trivial or even enviable problem, but to an increasing number of enterprises it is a very real and occasionally frightening one.

To get a closer look at the difficulties insufficient growth creates, let’s look again at Stryker Corporation, the company featured in earlier chap- ters. Table 4.3 presents a five-year sustainable growth analysis of Stryker. (Stryker’s financial statements for 2012 and 2013 appear in Tables 1.2 and 1.3 in Chapter 1; other relevant ratios are in Table 2.2 in Chapter 2.) It shows that Stryker’s sustainable growth rate in sales has exceeded its actual growth rate every year for the last five years and by more than a two-to- one ratio on average. What did management do with the excess cash? They returned much of it to owners by doubling annual dividends and ini- tiating a share repurchase program. In total, these two initiatives dis- gorged almost $1.5 billion each over the period. By 2013, these actions, combined with a falling profit margin and a slowing asset turnover, brought the sustainable growth rate down by almost half. However, it was still almost double the firm’s anemic actual growth rate. Curiously, Stryker has been increasing financial leverage over this period, which only raises its sustainable growth rate and adds to the cash hoard. Perhaps, like many other businesses, management could not resist the historically low bor- rowing rates.

Figure 4.4 says the same thing graphically. Stryker has lowered its bal- anced growth line over the period, despite the increase in financial leverage.

128 Part Two Planning Future Financial Performance

TABLE 4.3 A Sustainable Growth Analysis of Stryker Corporation, 2009–2013*

2009 2010 2011 2012 2013

Required ratios: Profit margin, P (%) 16.5 17.4 16.2 15.0 11.2 Retention ratio, R (%) 82.1 81.3 79.3 75.0 60.1 Asset turnover, A (times) 0.74 0.67 0.67 0.66 0.57 Financial leverage, T (times) 1.68 1.65 1.73 1.72 1.83

Stryker’s sustainable growth rate, g* (%) 16.8 15.7 14.9 12.7 7.1 Stryker’s actual growth rate in sales, g (%) 0.1 8.9 13.5 4.2 4.2

*Totals may not add due to rounding.



Nonetheless, it has consistently operated in the cash surplus portion of the graph. Mediocre sales growth in the last two years has just exacerbated the firm’s excess cash problem.

What to Do When Sustainable Growth Exceeds Actual Growth

The first step in addressing problems of inadequate growth is to decide whether the situation is temporary or longer term. If temporary, management can simply continue accumulating resources in anticipation of future growth.

When the difficulty is longer term, the issue becomes whether the lack of growth is industrywide—the natural result of a maturing market—or unique to the company. If the latter, the reasons for inadequate growth and possible sources of new growth are to be found within the firm. In this event, man- agement must look carefully at its own performance to identify and remove the internal constraints on company growth, a potentially painful process in- volving organizational changes as well as increased developmental expenses. The nerve-wracking aspect of such soul searching is that the strategies initi- ated to enhance growth must bear fruit within a few years or management will be forced to seek other, often more drastic solutions.

When a company is unable to generate sufficient growth from within, it has three options: ignore the problem, return the money to shareholders, or buy growth. Let us briefly consider each alternative.

Chapter 4 Managing Growth 129

FIGURE 4.4 Stryker Corporation’s Sustainable Growth Challenges, 2009–2013












0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

G ro

w th

ra te

in s

al es

( %


Return on assets (%)

Cash deficits

Cash surpluses

2013 2012




Balanced growth 2009

Balanced growth 2013



Ignore the Problem This response takes one of two forms: Management can continue invest- ing in its core businesses despite the lack of attractive returns, or it can simply sit on an ever-larger pile of idle resources. The difficulty with ei- ther response is that, like dogs to a fire hydrant, underutilized resources attract unwelcome attention. Poorly utilized resources depress a com- pany’s stock price and make the firm a feasible and attractive target for a raider. If a raider has done her sums correctly, she can redeploy the target firm’s resources more productively and earn a substantial profit in the process. And among the first resources to be redeployed in such a raid are usually incumbent managers, who find themselves suddenly reading help- wanted ads. Even if a hostile raid does not occur, boards of directors and activist shareholders are increasingly likely to give the boot to underper- forming managements.

Another way to characterize the relationship between investment and growth is to distinguish between good growth and its evil twin, bad growth. Good growth occurs when the company invests in activities offer- ing returns in excess of cost, including the cost of capital employed. Good growth benefits owners and is rewarded by a higher stock price and re- duced threat of takeover. Bad growth involves investing in activities with returns at or below cost. Because ill-advised activities are always readily available, a bad growth strategy is easy to execute. If all else fails, the com- pany can always overpay to purchase the sales and assets of another busi- ness. Such a strategy disposes of excess cash and makes the firm larger, but these cosmetic results only mask the fact that a bad growth strategy wastes valuable resources—and stock markets are increasingly adept at distin- guishing between good and bad growth, and punishing the latter. The moral to the story, then, is that it is not enough for slow-growth companies to grow more rapidly; they must do so in a way that benefits shareholders. All other forms of growth are a snare and a delusion. (We will say more about value-creating investment activities in Chapters 7 and 8.)

Return the Money to Shareholders The most direct solution to the problem of idle resources is to simply re- turn the money to owners by increasing dividends or repurchasing shares. However, while this solution is becoming more common, it is still not the strategy of choice among many executives. The chief reason is that many executives appear to have a bias in favor of growth, even when the growth creates little or no value for shareholders. At the personal level, these ex- ecutives resist paying large dividends because the practice hints of failure. Shareholders entrust managers with the task of profitably investing their capital, and for the company to return the money suggests an inability to

130 Part Two Planning Future Financial Performance



perform a basic managerial function. A cruder way to say the same thing is that dividends reduce the size of management’s empire, an act counter to basic human nature.

Gordon Donaldson and others also document a bias toward growth at the organizational level.4 In a carefully researched review and synthesis of the decision-making behavior of senior executives in a dozen large com- panies, Donaldson noted that executives commonly opt for growth, even uneconomic growth, out of concern for the long-run viability of their or- ganizations. As senior managers see it, size offers some protection against the vagaries of the marketplace. Moreover, growth contributes signifi- cantly to company morale by creating stimulating career opportunities for employees throughout the organization, and when growth slackens, the enterprise risks losing its best people.

Buy Growth The third way to eliminate slow-growth problems is to buy growth. Motivated by pride in their ability as managers, concern for retaining key employees, and fear of raiders, managers often respond to excess cash flow by attempting to diversify into other businesses. Management systemati- cally searches for worthwhile growth opportunities in other, more vibrant industries. And because time is a factor, this usually involves acquiring existing businesses rather than starting new ones from scratch.

The proper design and implementation of a corporate acquisition program is a challenging task that need not detain us here. Two points, however, are worth noting. First, in many important respects, the growth management problems of mature or declining companies are just the mirror image of those faced by rapidly growing firms. Slow-growth businesses are generally seeking productive uses for their excess cash, while rapidly grow- ing ones are in search of additional cash to finance their unsustainably rapid growth. It is natural, therefore, that high- and low-growth companies fre- quently solve their respective growth management problems by merging so that the excess cash generated by one organization can finance the rapid growth of the other. Second, after a flurry of optimism in the 1960s and early 1970s, accumulating evidence increasingly suggests that, from the shareholders’ perspective, buying growth is distinctly inferior to returning the money to owners. More often than not, the superior growth prospects of potential acquisitions are fully reflected in the target’s stock price, so that after paying a substantial premium to acquire another firm, the buyer is left with a mediocre investment or worse. The conflict between managers and owners in this regard is a topic of Chapter 9.

Chapter 4 Managing Growth 131

4 Donaldson, Managing Corporate Wealth.



Sustainable Growth and Pro Forma Forecasts

It is important to keep the material presented here in perspective. I find that comparison of a company’s actual and sustainable growth rates reveals a great deal about the principal financial concerns confronting senior management. When actual growth exceeds sustainable growth, manage- ment’s focus will be on getting the cash to fund expansion; conversely, when actual growth falls below sustainable growth, the financial agenda will swing 180 degrees to one of productively spending the excess cash flow. The sustainable growth equation also describes the way many top executives view their jobs: Avoid external equity financing and work to balance operating strategies, growth targets, and financial policies so that the disparity between actual and sustainable growth is manageable. Finally, for nonfinancial types, the sustainable growth equation is a useful way to highlight the tie between a company’s growth rate and its financial resources.

The sustainable growth equation, however, is essentially just a simplifi- cation of pro forma statements. If you really want to study a company’s growth management problems in detail, therefore, I recommend that you take the time to construct pro forma financial statements. The sustainable growth equation may be great for looking at the forest but is considerably less helpful when studying individual trees.

New Equity Financing

Earlier in the chapter I noted that a fundamental assumption of sustainable growth analysis is that the company cannot or will not issue new equity. Con- sistent with this assumption I also noted in Table 4.2 that over the past decade new equity has been a use of cash to American companies, not a source, mean- ing that businesses have retired more stock than they have issued. It is time now to explore this phenomenon in more detail with particular emphasis on explaining why companies are so reticent to sell new stock.

Figure 4.5 shows the annual value of new equity issues, net of repur- chases by nonfinancial corporations in the United States from 1975 through 2013. Net new equity issues grew erratically to about $28 billion in 1983, then plunged sharply, and have essentially been negative ever since. The figure reached an all-time low of minus $787 billion in 2007 when companies took advantage of healthy internal cash flows and low borrowing rates to repurchase shares aggressively. The repurchase binge ended abruptly the following year when the sharp recession cut internal cash flows, but has increased since.

132 Part Two Planning Future Financial Performance



Reductions in common stock outstanding occur in two ways: when a company repurchases its own stock or when a company acquires the stock of another firm for cash or debt. The best available evidence suggests that the sharp reduction in equity outstanding in recent decades was initially triggered by the hostile takeover battles that swept through the economy in the last half of the 1980s.

In more recent years, the reduction in U.S. equity appears attributable to the growing popularity of share repurchase as a way to distribute cash to shareholders and to manage reported earnings per share. If stock ana- lysts are projecting a 15 percent growth in earnings-per-share but man- agement believes they can only increase earnings 10 percent, one way to meet the analysts’ target is to repurchase 5 percent of the shares outstanding.

These data suggesting that new equity capital is not a source of financ- ing to American business are consistent with evidence showing that in an average year, only about 5 percent of publicly traded companies in the United States sell additional common stock. This means that a typical publicly traded company raises new equity capital in public markets only once every 20 years.5

Recalling the tale of the statistician who drowned crossing the stream because he had heard it was only 5 feet deep on average, we need to

Chapter 4 Managing Growth 133

FIGURE 4.5 Net New Equity Issues, 1975–2013

Sources: Federal Reserve System, Financial Accounts of the United States, Table F.213 nonfinancial corporate business, /current/data.htm.











1975 1980 1985 1990 1995 2000 2005 2010 2015 D

ol la

rs in

b ill

io ns

5 Aydogăn Alti and Johan Sulaeman, “When Do High Stock Returns Trigger Equity Issues?,” Journal of Financial Economics, January 2012, pp. 61–87.



remember that the equity figures presented are the net result of new issues and retirements. Figure 4.6 shows the gross proceeds from new common stock sales in the United States from 1980 to 2013. The average over the period was $69.0 billion, and the high in 2000 was $295.4 billion. To put these numbers in perspective, gross proceeds from new stock sales by non- financial corporations over the past decade equaled 3.0 percent of total sources of capital over the period. The comparable figure as a percent of external sources was 9.0 percent.

Figure 4.6 also shows the money raised from initial public offerings of common stock (IPOs) from 1980 through 2013. Observe that the aggre- gate amount of money raised is comparatively modest, amounting to about one-third of gross new equity proceeds over the period. In 2000, the peak year for IPOs, total money raised equaled only 5 percent of total cor- porate external sources of capital.

I see these graphs as a testament to the dynamism of the American economy in which many firms are retiring equity at the same time others are selling new shares. On balance, the appropriate conclusion is that while the stock market is not an important source of capital to corporate America in the aggregate, it is critical to some companies. Companies making extensive use of the new equity market tend to be what brokers call “story paper,” potentially high-growth enterprises with a particular

134 Part Two Planning Future Financial Performance

FIGURE 4.6 Gross New Stock Issues by Corporations and Initial Public Offerings, 1980–2013

Source: Federal Reserve Bulletin, Table 1.46, “New Security Issues U.S. Corporations,” various issues; Jay Ritter, “Initial Public Offerings: Updated Statistics,” Table 8.

Note: Prior to 1995, issues are total corporate issues less those by real estate and financial corporations; afterward they are issues by nonfinancial corporations. New equity includes preferred stock. IPOs exclude overallotment options but include the international tranche, if any.









1980 1985 1990 1995 2000 2005 2010 2015

D ol

la rs

in b

ill io


Gross public equity issues




product or concept that brokers can hype to receptive investors (the words high-tech and biotech come most readily to mind).

Why Don’t U.S. Corporations Issue More Equity? Here are several reasons. We will consider others in Chapter 6 when we review financing decisions in more detail.

• In recent years, companies in the aggregate simply did not need new equity. Retained profits and new borrowing were sufficient.

• Equity is expensive to issue. Issue costs commonly run in the neighbor- hood of 5 to 10 percent of the amount raised, and the percentage on small issues is even higher. These figures are at least twice as high as the issue costs for a comparable-size debt issue. (On the other hand, the equity can be outstanding forever, so its effective annualized cost is less onerous.)

• Many managers, especially U.S. managers, have a fixation with earn- ings per share (EPS). They translate a complicated world into the simple notion that whatever increases EPS must be good and whatever reduces EPS must be bad. In this view, a new equity issue is bad be- cause, at least initially, the number of shares outstanding rises but earn- ings do not. EPS is said to be diluted. Later, as the company makes productive use of the money raised, earnings should increase but in the meantime, EPS suffers. Moreover, as we will see in Chapter 6, EPS is almost always higher when debt financing is used in favor of equity.

• Then there is the “market doesn’t appreciate us” syndrome. When a com- pany’s stock is selling for $10 a share, management tends to think the price will be a little higher in the future as soon as the current strategy begins to bear fruit. When the price rises to $15, management begins to believe this is just the beginning and the price will be even higher in the near future. Managers’ inherent enthusiasm for their company’s prospects produces a feeling that the firm’s shares are undervalued at whatever price they cur- rently command, and this view creates a bias toward forever postponing new equity issues. A 2001 survey of 371 chief financial officers of U.S. cor- porations by John Graham and Campbell Harvey at Duke University il- lustrates this syndrome. Despite the fact that the Dow Jones Industrial Averages were approaching a new record high at the time of the survey, fewer than one-third of respondents thought the stock market correctly valued their stock; only 3 percent believed their stock was overvalued, and fully 69 percent felt it was undervalued.6

Chapter 4 Managing Growth 135

6 John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics, May–June 2001, pp. 187–243.



136 Part Two Planning Future Financial Performance

• Finally, many managers perceive the stock market to be an unreliable funding source. In addition to uncertainty about the price a company can get for new shares, managers also face the possibility that during some future periods the stock market will not be receptive to new equity issues on any reasonable terms. In finance jargon, the “window” is said to be shut at these times. Naturally, executives are reluctant to develop a growth strategy that depends on such an unreliable source of capital. Rather, the philosophy is to formulate growth plans that can be financed from retained profits and accompanying borrowing and rele- gate new equity finance to a minor backup role. More on this topic in later chapters.


1. A firm’s sustainable growth rate • Reminds managers that more growth is not always a blessing and

that companies can literally “grow broke.” • Is the maximum rate at which a firm can increase sales without rais-

ing new equity or increasing its financial leverage. • Assumes company debt increases in proportion to equity. • Equals the product of four ratios:

– Profit margin. – Retention ratio. – Asset turnover. – Financial leverage, defined as assets divided by beginning of pe-

riod equity. • Also equals the firm’s retention ratio times return on beginning of

period equity. 2. Actual sales growth above a firm’s sustainable growth rate

• Causes one or more of the defining ratios to change. • Must be anticipated and planned for. • Can be managed by

– Increasing financial leverage. – Reducing the dividend payout ratio. – Pruning away marginal activities, products, or customers. – Outsourcing some or all of production. – Increasing prices. – Merging with a “cash cow.” – Selling new equity.



Chapter 4 Managing Growth 137

3. Actual sales growth below a firm’s sustainable growth rate • Produces excess cash that can enhance a firm’s appeal as a takeover

target. • Forces management to find productive uses for the excess cash, such as

– Reducing financial leverage. – Returning the money to shareholders. – Cutting prices. – “Buying growth” by acquiring rapidly growing firms in need of cash.

4. New equity financing • Has on average been a use of cash to American companies for most

of the past 25 years, meaning firms have retired more equity than they have issued.

• Is an important source of cash to a number of smaller, rapidly grow- ing companies with exciting prospects.

• Among other reasons, is seldom used because – Companies in the aggregate have not needed the additional cash. – Issue costs of equity are high relative to those of debt. – New equity tends to reduce earnings per share, something most

managers abhor. – Managers commonly believe their current share price is unrea-

sonably low and they can get a better price by waiting. – Equity is perceived as an unreliable source of financing, not

something a prudent manager should count on.


Higgins, Robert C. “Sustainable Growth under Inflation.” Financial Management, August 1981, pp. 36–40.

A look at the dependence of a company’s sustainable growth rate on the inflation rate. The paper concludes that inflation will reduce sustainable growth only if an “inflation illusion” exists, and that such an illusion likely exists.

WEBSITES A website devoted to everything related to dividends: news, data, education, and more.

Dividend Investor A popular app that puts real-time coverage of dividend-paying stocks at your fingertips. Available for iOS and Android.



138 Part Two Planning Future Financial Performance Lots of good data on interest rates, employment, and so on. A treasure trove of current and historical economic data. Also available as a free app for iOS and Android (search Apple’s app store or Google Play for “FRED Economic Data”). pages.stern.nyu./~adamodar NYU professor Aswath Damodaran’s home page. This site contains an exhaustive but no-nonsense selection of financial data sets and spreadsheets, as well as quite a bit of academic and instructional material. Data sets include bond ratings; spreads and interest coverage ratios by firms; historical returns on stocks, bonds, and bills; and return on equity and levers of performance by industry.


Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are avail- able in the Instructor Resources within McGraw-Hill’s Connect, (See the Preface for more information).

1. To what extent do you agree or disagree with the following statement? “An important top-management job is to make certain that the com- pany’s actual growth rate and sustainable growth rate are as close together as possible.”

2. This chapter distinguishes between good and bad growth. How do they differ, and why does the distinction matter?

3. Are the following statements true or false? Please explain why. a. The only way a company can grow at a rate above its current sus-

tainable growth rate is by issuing new stock. b. The stock market is a ready source of new capital when a company

is incurring heavy losses. c. Share repurchases usually increase earnings per share. d. Companies often buy back their stock because managers believe

the shares are undervalued. e. Only rapidly growing firms have growth management problems. f. Increasing growth increases stock price.

4. Table 3.1 in the last chapter presents R&E Supplies’ financial state- ments for the period 2011 through 2014, and Table 3.5 presents a pro forma financial forecast for 2015. Use the information in these tables to answer the following questions. a. Calculate R&E’s sustainable growth rate in each year from 2012

through 2015. b. Comparing the company’s sustainable growth rate with its

actual and projected growth rates in sales over these years, what



Chapter 4 Managing Growth 139

growth management problems does R&E appear to face in this period?

c. How did the company cope with these problems? Do you see any difficulties with the way it addressed its growth problems over this period? If so, what are they?

d. What advice would you offer management regarding managing fu- ture growth?

5. Looking at Figure 4.5, describe the trend in net equity financing in the United States during the last 30 years. What does this say about the use of equity financing in U.S. corporations?

6. Looking at Figure 4.6, describe the trend in gross public equity is- sues and IPOs in the United States during the last 30 years. How do you explain this trend given what we observe in Figure 4.5? Explain.

7. Medifast, Inc., is a producer and marketer of weight-loss meals and other health and weight-loss products. Following are selected financial data for the company for the period 2006–2010.

2006 2007 2008 2009 2010

Profit margin (%) 6.00 7.00 4.60 5.20 7.20 Retention ratio (%) 99.50 100.00 100.00 100.00 100.00 Asset turnover (X) 1.33 2.02 1.92 2.07 2.64 Financial leverage (X) 1.61 1.69 1.57 1.57 1.64 Growth rate in sales (%) 46.80 84.60 13.10 25.90 57.10

a. Calculate Medifast’s annual sustainable growth rate for the years 2006–2010.

b. Comparing the company’s sustainable growth rate with its actual growth rate in sales, what growth management problems did Med- ifast face over this period?

c. How did the company cope with these problems?

8. Genentech, Inc., is a California-based biotech pioneer acquired by Swiss pharmaceutical giant Roche Holding AG in 2009. Roche paid $46.8 billion in cash for the 44 percent of Genentech it did not already own, implying a market value of over $100 billion for the entire com- pany. For a look at Genentech’s sustainable growth challenges leading up to the acquisition consider the following selected financial data.

2003 2004 2005 2006 2007

Profit margin (%) 17.00 17.00 19.30 22.80 23.60 Retention ratio (%) 100.00 100.00 100.00 100.00 100.00 Asset turnover (X) 0.38 0.49 0.55 0.63 0.62 Financial leverage (X) 1.64 1.44 1.79 1.99 2.00 Growth rate in sales (%) 26.10 40.00 43.50 40.00 26.30



140 Part Two Planning Future Financial Performance

a. Calculate Genentech’s annual sustainable growth rate for the years 2003–2007.

b. Did Genentech face a growth management challenge during this period? Please explain briefly.

c. How did Genentech cope with this challenge? d. Calculate Genentech’s sustainable growth rate in 2007 assuming an

asset turnover of 0.72 times. Calculate the sustainable growth rate in 2007 assuming a financial leverage of 2.20 times. Calculate the sus- tainable growth rate in 2007 assuming both of these changes occur.

9. Jos. A. Bank Clothiers, Inc., is a direct marketer of men’s clothing with over 800 retail stores in 42 states that was recently acquired by Men’s Wearhouse. Following are selected financial data for the company for the period 2006–2010.

2006 2007 2008 2009 2010

Profit margin (%) 7.90 8.30 8.40 9.20 10.00 Retention ratio (%) 100.00 100.00 100.00 100.00 100.00 Asset turnover (X) 1.48 1.37 1.42 1.39 1.30 Financial leverage (X) 2.40 2.11 1.88 1.73 1.68 Growth rate in sales (%) 17.60 10.50 15.20 10.70 11.40

a. Calculate Jos. A. Bank’s annual sustainable growth rate from 2006 through 2010.

b. Did Jos. A. Bank have a growth problem in these years? c. How did Jos. A. Bank cope with its sustainable growth problems?

10. A spreadsheet containing selected financial information for Tournament Sporting Goods is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). Using this information, answer the questions appearing in the spreadsheet regarding Tournament’s growth management challenges.

11. Chapter 3, Problem 13, part f asks you to construct a five-year finan- cial projection for Aquatic Supplies beginning in 2015. Based on your forecast, or the suggested answer available for download from McGraw-Hill’s Connect or your course instructor, calculate Aquatic Supplies’ sustainable and actual growth rates in these years. What do these numbers suggest to you?

12. A spreadsheet containing completed pro forma financial statements for Ottawa Corporation is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more informa- tion). Your task is to use the pro forma financial statements to analyze and propose a solution for Ottawa’s growth challenges. Answer the questions shown in the spreadsheet.




Financing Operations





Financial Instruments and Markets

Don’t tell Mom I’m an investment banker. She still thinks I play piano in a brothel. Anonymous

A major part of a financial executive’s job is to raise money to finance cur- rent operations and future growth. In this capacity, the financial manager acts much as a marketing executive. He or she has a product—claims on the company’s future cash flow—that must be packaged and sold to yield the highest price to the company. The financial manager’s customers are creditors and investors who put money into the business in anticipation of future cash flows. In return, these customers receive a piece of paper such as a stock certificate, a bond, or a loan agreement, that describes the nature of their claim on the firm’s future cash flow. When the paper can be bought and sold in financial markets, it is customarily called a financial security.

In packaging the product, the financial executive must select or design a financial security that meets the needs of the company and is attractive to potential creditors and investors. To do this effectively requires knowl- edge of financial instruments, the markets in which they trade, and the merits of each instrument to the issuing company. In this chapter, we con- sider the first two topics, financial instruments and markets. In the next chapter, we look at a company’s choice of the proper financing instrument.

Although corporate financing decisions are usually the responsibility of top executives and their finance staffs, there are several reasons managers at all levels need to understand the logic on which these decisions rest. First, we all make similar financing decisions in our personal lives when- ever we borrow money to buy a home, a car, or return to school. Second, as investors, we are often consumers of the financial securities that compa- nies issue, and it is always wise to be an informed consumer. Third, and most important for present purposes, sound financing decisions are central



to effective financial management. This is witnessed by the fact that finan- cial leverage is one of the levers of performance by which managers seek to generate competitive returns, and it is a principal determinant of a com- pany’s sustainable growth rate. So failure to appreciate the logic driving an enterprise’s financing decisions robs managers of a complete understand- ing of their company and its challenges.

Before beginning, a few words about what this chapter is not. “Finan- cial markets” is the name given to a dynamic, heterogeneous distribution system through which cash-surplus entities provide money to cash-deficit entities. Businesses are by no means the only, or even the most prominent players in these markets. Other active participants include national, state, and local governments and agencies, pension funds, endowments, individ- uals, commercial banks, insurance companies, and the list goes on and on. This chapter is not a balanced overview of financial markets; rather it is a targeted look at the financing instruments most used by nonfinancial corporations and the means by which they are sold. A further restriction is that we will not consider short-term instruments. When speaking of financial markets it is common to distinguish between money markets, in which securities having a maturity of less than one year trade, and capital markets, in which longer-term instruments are bought and sold. Because nonfinancial businesses rely much more on capital markets for financing, we will say little about money markets, even though they are the larger and more liquid of the two. (For a more comprehensive look at financial markets and instruments, see one of the books recommended at the end of this chapter.)

Financial Instruments

Fortunately, lawyers and regulators have not yet taken all of the fun and cre- ativity out of raising money. When selecting a financial instrument for sale in securities markets, a company is not significantly constrained by law or regulation. The company is largely free to select or design any instrument, provided only that the instrument appeals to investors and meets the needs of the company. Securities markets in the United States are regulated by the Securities and Exchange Commission (SEC) and, to a lesser extent, by state authorities. SEC regulation can create red tape and delay, but the SEC does not pass judgment on the investment merits of a security. It requires only that investors have access to all information relevant to valuing the security and have adequate opportunity to evaluate it before purchase. This freedom has given rise to such unusual securities as Foote Minerals’ $2.20 cumulative, if earned, convertible preferred stock and Sunshine Mining’s silver-indexed bonds. My favorite is a 6 percent bond issued by Hungary in 1983 that, in

144 Part Three Financing Operations



addition to paying interest, included a firm promise of telephone service within three years. The usual wait for a phone at the time was said to run up to 20 years. A close second is a bond proposed by a group of Russian vodka distillers. Known as Lial, or “Liter” bonds, they were to pay annual interest of 20 percent in hard currency or 25 percent in vodka. According to one of the promoters, “Vodka has been currency for 1,000 years. We have just made the relationship formal.”

But, do not let the variety of securities obscure the underlying logic. When designing a financial instrument, the financial executive works with three variables: investors’ claims on future cash flow, their right to partic- ipate in company decisions, and their claims on company assets in liquida- tion. We will now describe the more popular security types in terms of these three variables. In reading the descriptions, bear in mind that the characteristics of a specific financial instrument are determined by the terms of the contract between issuer and buyer, not by law or regulation. So the descriptions that follow should be thought of as indicating general security types rather than exact definitions of specific instruments.

Bonds Economists like to distinguish between physical assets and financial assets. A physical asset, such as a home, a business, or a painting, is one whose value depends on its physical properties. A financial asset is a piece of paper or, more formally, a security representing a legal claim to future cash payouts. The entity agreeing to make the payouts is the issuer, and the recipient is the investor. It is often useful to draw a further distinction among financial assets depending on whether the claim to future payments is fixed as to dollar amount and timing or residual, meaning the investor receives any cash re- maining after all prior fixed claims have been paid. Debt instruments offer fixed claims, while equity, or common stock, offers residual claims. Human ingenuity being what it is, you should not be surprised to learn that some se- curities, such as convertible preferred stock, are neither fish nor fowl, offer- ing neither purely fixed nor purely residual claims.

Derivatives, also known as contingent claims, constitute a third funda- mental security type. A derivative security is distinguished by the fact that its claim to future payments depends upon the value of some other under- lying asset. For example, an option to purchase IBM stock is a derivative because its value depends on the price of IBM shares. The popularity and importance of derivatives have grown enormously since Fisher Black and Myron Scholes first proposed a rigorous way to value options in 1973. The appendix to this chapter considers derivatives briefly as part of a broader discussion of financial risk management, and Chapter 8 revisits the topic in the context of evaluating investment opportunities.

Chapter 5 Financial Instruments and Markets 145



A bond, like any other form of indebtedness, is a fixed-income security. The holder receives a specified annual interest income and a specified amount at maturity—no more and no less (unless the company goes bankrupt). The difference between a bond and other forms of indebted- ness such as trade credit, bank loans, and private placements is that bonds are sold to the public in small increments, usually $1,000 per bond. After issue, the bonds can be traded by investors on organized security exchanges.

I noted in the last chapter that internal financing, in the form of re- tained profits and depreciation, has provided about 68 percent of the money used by American business over the past decade. Looking at exter- nal financing, aggregate data indicate that over the past two decades cor- porate bonds have been the largest source, accounting for about 46 percent of the total. Loans and advances of various kinds from banks and others have contributed another 12 percent. Before dismissing bank loans as of only secondary importance, it is important to bear in mind that although they are not a major source of financing in the aggregate, they are impor- tant to smaller firms. For example, in 2013 the ratio of bank loans to total liabilities among billion dollar–plus manufacturing firms was only 7 percent, while the comparable number for small manufacturers having assets of $25 million or less was 34 percent.1

Three variables characterize a bond: its par value, its coupon rate, and its maturity date. For example, a bond might have a $1,000 par value, a 7 percent coupon rate, and a maturity date of December 31, 2023. The par value is the amount of money the holder will receive on the bond’s maturity date. By custom, the par value of bonds issued in the United States is usually $1,000. The coupon rate is the percentage of par value the issuer promises to pay the investor annually as interest income. Our bond will pay $70 per year in interest (7% � $1,000), usually in two semiannual payments of $35 each. On the maturity date, the company will pay the bondholder $1,000 per bond and will cease further interest payments.

On the issue date, companies usually try to set the coupon rate on the new bond equal to the prevailing interest rate on other bonds of similar maturity and quality. This ensures that the bond’s initial market price will about equal its par value. After issue, the market price of a bond can differ substantially from its par value as market interest rates and credit risk per- ceptions change. As we will see in Chapter 7, when interest rates rise, bond prices fall, and vice versa.

146 Part Three Financing Operations

1 U.S. Federal Reserve, “Financial Accounts of the United States,” U.S. Census Bureau, “Quarterly Financial Report for Manufacturing, Mining, Trade, and Selected Service Industries: 2013 Quarter 4,” Tables 1.1 and 80.1,



Many forms of long-term indebtedness require periodic repayment of principal. This principal repayment is known as a sinking fund. Read- ers who have studied too much accounting will know that technically a sinking fund is a sum of money the company sets aside to meet a future obligation, and this is the way bonds used to work, but no more. Today a bond sinking fund is a direct payment to creditors that reduces princi- pal. Depending on the indenture agreement, there are several ways a firm can meet its sinking-fund obligation. It can repurchase a certain number of bonds in securities markets, or it can retire a certain number of bonds by paying the holders par value. When a company has a choice, it will naturally repurchase bonds if the market price of the bonds is below par value.

I have just described a fixed-interest-rate bond. An alternative more common to loans than bonds is floating-rate debt in which the interest rate is tied to a short-term interest rate such as the 90-day U.S. Treasury bill rate. If a floating-rate instrument promises to pay, say, one percentage point over the 90-day bill rate, the interest to be paid on each payment date will be calculated anew by adding one percentage point to the then prevailing 90-day bill rate. Because the interest paid on a floating-rate in- strument varies in harmony with changing interest rates over time, the instrument’s market value always approximates its principal value.

Chapter 5 Financial Instruments and Markets 147

When Investing Internationally, What You See Isn’t Always What You Get A 10 percent interest rate on a dollar-denominated bond is not comparable to a 6 percent rate on a yen bond or a 14 percent rate on a British sterling bond. To see why, let’s calculate the rate of return on $1,000 invested today in a one-year, British sterling bond yielding 14 percent interest. Suppose today’s exchange rate is £1 � $1.50 and the rate in one year is £1 � $1.35.

$1,000 will buy £666.67 today ($1,000/1.50 � £666.67), and in one year interest and principal on the sterling bond will total £760 (£666.67 [1 � 0.14] � £760). Converting this amount back into dollars yields $1,026 in one year (£760 � 1.35 � $1,026). So the investment’s rate of return, measured in dollars, is only 2.6 percent ([$1,026 � $1,000]�$1,000 � 2.6%).

Why is the dollar return so low? Because investing in a foreign asset is really two investments: purchase of a foreign-currency asset and speculation on future changes in the dollar value of the foreign currency. Here the foreign asset yields a healthy 14 percent, but sterling depreciates 10 percent against the dollar ([$1.50 � $1.35]�$1.50); so the combined return is roughly the difference between the two. The exact relationship is

(1 � Return) � (1 � Interest rate)(1 � Change in exchange rate) (1 � Return) � (1 � 14%)(1 � 10%)

Return � 2.6%

Incidentally, we know that sterling depreciated relative to the dollar over the year because a pound costs less at the end of the year than at the start.



Call Provisions Some corporate bonds contain a clause giving the issuing company the option to retire the bonds prior to maturity. Frequently the call price for early retirement will be at a modest premium above par; or the bond may have a delayed call, meaning the issuer may not call the bond until it has been outstanding for a specified period, usually 5 or 10 years.

Companies want call options on bonds for two obvious reasons. One is that if interest rates fall, the company can pay off its existing bonds and issue new ones at a lower interest cost. The other is that the call option gives a company flexibility. If changing market conditions or changing company strategy requires it, the call option enables management to re- arrange its capital structure.

At first glance, it may appear that a call option works entirely to the company’s advantage. If interest rates fall, the company calls the bonds and refinances at a lower rate. But if rates rise, investors have no similar option. They must either accept the low interest income or sell their bonds at a loss. From the company’s perspective, it looks like “heads I win, tails you lose,” but investors are not so naïve. As a general rule, the more attractive the call provisions to the issuer, the higher the coupon rate on the bond.

Covenants Under normal circumstances, no creditors, including bondholders, have a direct voice in company decisions. Bondholders and other long-term cred- itors exercise control through protective covenants specified in the indenture agreement. Typical covenants include a lower limit on the company’s cur- rent ratio, an upper limit on its debt-to-equity ratio, and perhaps a re- quirement that the company not acquire or sell major assets without prior creditor approval. Creditors have no say in company operations as long as the firm is current in its interest and sinking-fund payments and no covenants have been violated. If the company falls behind in its payments or violates a covenant, it is in default, and creditors gain considerable power. At the extreme, creditors can force the company into bankruptcy and possible liquidation. In liquidation, the courts supervise the sale of company assets and distribution of the proceeds to the various claimants.

Rights in Liquidation The distribution of liquidation proceeds in bankruptcy is determined by what is known as the rights of absolute priority. First in line are, naturally, the government for past-due taxes. Among investors, the first to be repaid are senior creditors, then general creditors, and finally subordinated credi- tors. Preferred stockholders and common shareholders bring up the rear. Because each class of claimant is paid off in full before the next class re- ceives anything, equity shareholders frequently get nothing in liquidation.

148 Part Three Financing Operations



Secured Creditors A secured credit is a form of senior credit in which the loan is collateralized by a specific company asset or group of assets. In liquidation, proceeds from the sale of this asset go only to the secured creditor. If the cash generated from the sale exceeds the debt to the secured creditor, the ex- cess cash goes into the pot for distribution to general creditors. If the cash is insufficient, the lender becomes a general creditor for the remaining liability. Mortgages are a common example of a secured credit in which the asset securing the loan is land or buildings.

Bonds as an Investment For many years, investors thought bonds to be very safe investments. After all, interest income is specified and the chances of bankruptcy are remote. However, this reasoning ignored the pernicious effects of inflation on fixed- income securities. For although the nominal return on fixed-interest-rate bonds is specified, the value of the resulting interest and principal payments to the investor is much less when inflation is high. This implies that investors need to concern themselves with the real, or inflation-adjusted, return on an asset, not the nominal return. And according to this yardstick, even default- free bonds can be quite risky in periods of high and volatile inflation.

Table 5.1 presents the nominal rate of return U.S. investors earned on selected securities over the period 1928 to 2013. Looking at long-term corporate bonds, you can see that had an investor purchased a representa- tive portfolio of corporate bonds at the beginning of 1928 and held them through 2013 (while reinvesting all interest income and principal pay- ments in similar bonds), the annual return would have been 5.7 percent over the entire 86-year period. By comparison, the annual return on an in- vestment in long-term U.S. government bonds would have been 5.2 per- cent over the same period. We can attribute the 0.5 percent difference to a “risk premium.” This is the added return investors in corporate bonds

Chapter 5 Financial Instruments and Markets 149

TABLE 5.1 Rate of Return on Selected Securities, 1928–2013

Source: Professor Aswath Damodaran’s website:; Bureau of Labor Statistics, “CPI Detailed Report,” Table 24. Return on long-term corporate bonds estimated by author.

Security Return*

Common stocks 11.5% Long-term corporate bonds 5.7% Long-term government bonds 5.2% Short-term government bills 3.6% Consumer price index 3.1%

*Arithmetic mean annual returns ignoring taxes and assuming reinvestment of all interest and dividend income.



earn over government bonds as compensation for the risk that the corpo- rations will default on their liabilities or call their bonds prior to maturity.

The bottom entry in Table 5.1 contains the annual percentage change in the consumer price index over the period. Subtracting the annual infla- tion rate from 1928 through 2013 of 3.1 percent from these nominal returns yields real, or inflation-adjusted, returns of 2.6 percent for corpo- rates and 2.1 percent for governments.2 Long-term bonds did little more than keep pace with inflation over this period.

Bond Ratings Several companies analyze the investment qualities of many publicly traded bonds and publish their findings in the form of bond ratings. A bond rating is a letter grade, such as AA, assigned to an issue that reflects the analyst’s appraisal of the bond’s default risk. Analysts determine these ratings using many of the techniques discussed in earlier chapters, includ- ing analysis of the company’s balance sheet debt ratios and its coverage ra- tios relative to competitors. Table 5.2 contains selected debt-rating definitions of Standard & Poor’s, a major rating firm. Table 6.5 in the next chapter shows the differences in key performance ratios by rating category.

Junk Bonds A company’s bond rating is important because it affects the interest rate the company must offer. Moreover, many institutional investors are prohibited from investing in bonds that are rated less than “investment” grade, where investment grade is usually defined as BBB� and above. As a result, there have been periods in the past when companies with lower-rated bonds had great difficulty raising debt in public markets. Below-investment-grade bonds are known variously as speculative, high-yield, or simply junk bonds.

Until the emergence of a vibrant market for speculative-grade bonds in the 1980s, public debt markets were largely the preserve of huge, blue- chip corporations. Excluded from public bond markets, smaller, less prominent companies in need of debt financing were forced to rely on bank and insurance company loans. Although bond markets are still closed to most smaller businesses, the junk bond market has been a boon to many mid-size and emerging companies, which now find public debt an attractive alternative to traditional bank financing. The market has also been an important financing source to corporate raiders and private equity investors for use in highly levered transactions.

150 Part Three Financing Operations

2 These numbers are approximate. The exact equation is ir � (1 � in)�(1 � p) � 1, where ir � real return, in � nominal return, and p � inflation rate. Applying this equation, the real returns on corporate and government bonds are 2.5 percent and 2.0 percent, respectively.



Chapter 5 Financial Instruments and Markets 151

TABLE 5.2 Selected Standard & Poor’s Debt-Rating Definitions

Source: Standard and Poor’s Long-Term Issue Credit Ratings,

A Standard & Poor’s issue credit rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program. . . . It takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. The issue credit rating is not a recommendation to purchase, sell, or hold a financial obligation, inasmuch as it does not comment as to market price or suitability for a particular investor. . . .

Issue credit ratings are based, in varying degrees, on the following considerations:

(1) Likelihood of payment, capacity, and willingness of the obligor to meet its financial commitment on an obligation in accordance with the terms of the obligation.

(2) Nature of and provisions of the obligation. (3) Protection afforded by, and relative position of, the obligation in the event of bankruptcy, reorganization, or

other arrangement under the laws of bankruptcy and other laws affecting creditors’ rights. . . .

AAA An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.

• •

BBB An obligation rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

• •

CCC An obligation rated ‘CCC’ is currently vulnerable to nonpayment, and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.

• •

D An obligation rated ‘D’ is in payment default. The ‘D’ rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor’s believes that such payments will be made during such a grace period. The ‘D’ rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized.

Plus (�) or minus (�): The ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (�) or minus (�) sign to show relative standing within the major rating categories.

Rating agencies have justly been criticized for their role in fostering the recent financial crisis when their ratings of complex mortgage-based securi- ties proved to be wildly optimistic. They appear to have made two egregious errors. First, based on the review of limited historical evidence in a rapidly changing market, the agencies discounted the possibility that housing prices could fall nationwide. Their models convinced them that any decline in housing prices would be only regional, not national. As Mark Adelson, for- mer senior director at Moody’s rating agency, a competitor of Standard & Poor’s, put it later, their method was “like observing 100 years of weather in



What Do Bond Ratings Tell Investors About the Chance of Default? Take a look at the figures below showing bond default rates by rating category and investment hori- zon. The numbers span the years 1981–2013 and are from Standard & Poor’s. Note, for instance, that on average only 0.74 percent of AAA rated bonds defaulted over a 10-year holding period, while the same figure for C rated bonds of all types was 51.35 percent. Default is clearly a distinct possibility among lower rated bonds; no wonder they carry higher interest rates.

The fact that default rates consistently rise as bond ratings fall offers convincing evidence that ratings are indeed useful predictors of default. Notice too the sharp break between invest- ment grade and speculative grade bonds. At, say, a five-year investment horizon the default rate on BBB bonds—the lowest investment rating—is just over 2 percent, while the same figure for BB bonds—the highest speculative rating—is over 8 percent.

Historical Global Average Cumulative Bond Default Rates 1981–2013

Time Horizon (Years)

Bond Rating 1 5 10

AAA 0.00% 0.35% 0.74% AA 0.02% 0.36% 0.84% A 0.07% 0.60% 1.59% BBB 0.21% 2.06% 4.33% BB 0.80% 8.01% 14.39% B 4.11% 19.55% 26.97% CCC/C 26.87% 46.75% 51.35%

Source: Standard and Poor’s Global Fixed Income Research; Standard and Poor’s CreditPro®.

Antarctica to forecast the weather in Hawaii.”3 Second, the agencies all but ignored the possibility that loan origination standards might deteriorate, as- suming instead that the credit quality of the mortgages underpinning the securities to be rated was constant over time. In their minds, it was not ap- propriate to study individual loan files because their job was to rate the qual- ity of the securities, not the underlying mortgages. In the words of Claire Robinson, a 20-year veteran at Moody’s, “We aren’t loan officers. Our ex- pertise is as statisticians on an aggregate basis.”4

Common Stock Common stock is a residual income security. The stockholder has a claim on any income remaining after the payment of all obligations, including interest on debt. If the company prospers, stockholders are the chief

152 Part Three Financing Operations

3 Roger Lowenstein, “Triple-A-Failure,” New York Times Magazine, April 27, 2008. 4 Ibid.



beneficiaries; if it falters, they are the chief losers. The amount of money a stockholder receives annually depends on the dividends the company chooses to pay, and the board of directors, which makes this decision quarterly, is under no obligation to pay any dividend at all.

Shareholder Control At least in theory, stockholders exercise control over company affairs through their ability to elect the board of directors. In the United States, the wide distribution of share ownership and the laws governing election of the board have frequently combined to greatly reduce this authority, although the winds of change are blowing. In some companies, ownership of as little as 10 percent of the stock has been sufficient to control the en- tire board. In many others, there is no dominant shareholder group, and management has been able to control the board even if it owns little or none of the company’s shares.

This does not imply that managers in such companies are free to ignore shareholder interests entirely, for they face at least two potential con- straints on their actions. One is created by their need to compete in prod- uct markets. If management does not make a product or provide a service efficiently and sell it at a competitive price, the company will lose market share to more aggressive rivals and will eventually be driven from the in- dustry. The actions managers take to compete effectively in product mar- kets are most often consistent with shareholder interests.

Securities markets provide a second check on management discretion. If a company wants to raise debt or equity capital in future years, it must maintain its profitability to attract money from investors. Moreover, if managers ignore shareholder interests, stock price will suffer, and the firm may become the target of a hostile takeover. Even when not facing a takeover, a growing number of company boards, often prodded by large institutional shareholders, have become more diligent in monitoring management performance and replacing poor performers. In recent years, more than 20 percent of chief executive departures were forced by their boards.5 We will have more to say about corporate takeovers and the evolving role of the board of directors in Chapter 9.

German and Japanese owners exercise much more direct control over company managements than do their U.S. or English counterparts. In Germany, the legal ability of banks to hold unlimited equity stakes in in- dustrial companies, combined with the historical insignificance of public financial markets, has led to high concentrations of ownership in many companies. Banks are controlling shareholders of many German businesses,

Chapter 5 Financial Instruments and Markets 153

5 “CEO Turnover Rate,” The Economist, May 20, 2010.



with representation on the board of directors and effective control over the business’s access to debt and equity capital. German managers are thus inclined to think twice before ignoring shareholder interests.

Like their American counterparts, Japanese banks are prohibited from owning more than 5 percent of an industrial company’s shares, and Japanese capital markets are more highly developed than German mar- kets. Nonetheless, Japan’s keiretsu form of organization produces results similar to those in Germany. A keiretsu is a group of companies, usually in- cluding a lead bank, that purchase sizable ownership interests in one an- other as a means of cementing important business relations. When the majority of a company’s stock is in the hands of business partners and as- sociates through cross-share holdings, managers ignore shareholder in- terests only at their peril.

Whether the more direct control exercised by German and Japanese shareholders is any better economically than the more indirect American variety is open to question. For while the German and Japanese models may facilitate a direct shareholder voice in company affairs, they also tend to encourage a clubby, “old-boy” approach to corporate governance that can be inimical to necessary change and innovation. Moreover, evidence is accumulating that both the German and Japanese approaches to corporate governance are in decline. In Germany, a growing interest on the part of companies in raising capital on public markets rather than from banks has undermined banks’ authority, while in Japan an increasing emphasis on stock price performance as opposed to business relationships as the prin- cipal criterion for holding shares has recently led to sharp declines in cross-share holdings.

Common Stock as an Investment Common stockholders receive two types of investment return: dividends and possible share price appreciation. If d1 is the dividends per share dur- ing the year and p0 and p1 are the beginning-of-the-year and end-of-the- year stock price, respectively, the annual income a stockholder earns is

Dividing by the beginning-of-the-year stock price, the annual return is

Over the 1928–2013 period, equity investors in large-company common stocks received an average dividend yield of 3.8 percent and average

= d 1 p 0

+ p 1 – p 0

p 0

Annual return =

Dividend yield +

Percentage change in share price

d1 + p1 – p 0

154 Part Three Financing Operations



capital appreciation of 7.5 percent. Over the past decade, these figures have been 2.0 percent and 7.0 percent, respectively.

Common stocks are an ownership claim against primarily real, or pro- ductive, assets. If companies can maintain profit margins during inflation, real, inflation-adjusted profits should be relatively unaffected by inflation. For years this reasoning led to the belief that common stocks are a hedge against inflation, but this did not prove to be the case during the bout of high inflation during the 1970s. Looking at Table 5.1 again, we see that had an investor purchased a representative portfolio of common stocks at the beginning of 1928 and reinvested all dividends received in the same portfolio, his average annual return in 2013, over the entire 86 years, would have been 11.5 percent. However, from 1973 through 1981, a pe- riod when prices rose an average of 9.2 percent a year, the average annual nominal return on common stocks was only 5.2 percent. This implies a negative real return of about 4 percent. The comparable figures for cor- porate bonds over this period were a nominal return of 2.5 percent and a negative real return of about 6.7 percent.

The common stock return of 11.5 percent from 1928 through 2013 compares with a return of 5.2 percent on government bonds over the same period. The difference between the two numbers of 6.3 percent can be thought of as a risk premium, the extra return common stockholders earned as compensation for the added risks they bore. Comparing the re- turn on common stocks to the annual percentage change in consumer prices, we see that the real return to common stock investors over the period was about 8.4 percent (11.5% � 3.1%).

Figure 5.1 presents much of the same information more dramatically. It shows an investor’s wealth at year-end 2013 had she invested $1 in various assets at the beginning of 1928. Common stocks are the clear winners here. By 2013, the original $1 investment in common stock would have grown to a whopping $2,556. In contrast, $1 invested in long-term government bonds would have been worth only $63 in 2013. Reflecting the pernicious effect of inflation, the corresponding real numbers are $191 for common

Chapter 5 Financial Instruments and Markets 155

Do Dividends Increase Annual Return? It may appear from the preceding equation that annual return rises when dividends rise. But the world is not so simple. An increase in current dividends means one of two things: The company will have less money to invest, or it will have to raise more money from external sources to make the same investments. Either way, an increase in current dividends reduces the stockholders’ claim on future cash flow, which reduces share price appreciation. Depending on which effect dominates, annual returns may or may not increase as dividends rise.



stock and $5 for government bonds. Common stocks, however, have proven to be a much more volatile investment than bonds, as Figure 5.2 attests.

Preferred Stock Preferred stock is a hybrid security: like debt in some ways, like equity in others. Like debt, preferred stock is a fixed-income security. It prom- ises the investor an annual fixed dividend equal to the security’s coupon rate times its par value. Like equity, the board of directors need not dis- tribute this dividend unless it chooses. Also like equity, preferred dividend payments are not a deductible expense for corporate tax purposes. For the same coupon rate, this makes the after-tax cost of bonds about two-thirds that of preferred shares. Another similarity with equity is that although preferred stock may have a call option, it frequently has no maturity. The preferred shares are outstanding indefinitely unless the company chooses to call them.

156 Part Three Financing Operations

FIGURE 5.1 If Your Great-Grandmother Had Invested Only a Dollar in 1928; Nominal Returns on U.S. Assets, 1928–2013

(Assumed initial investment of $1 at year-end 1927; includes reinvestment income.)

Source: Professor Aswath Damodaran’s website:; Bureau of Labor Statistics, “CPI Detailed Report”, Table 24.


$10,000 Log scale




$0 1928 1938 1948 1958 1988


1968 1978 1998 2008

Long-term government bonds








Cumulative Preferred Company boards of directors have two strong incentives to pay preferred dividends. One is that preferred shareholders have priority over common shareholders with respect to dividend payments. Common shareholders receive no dividends unless preferred holders are paid in full. Second, virtually all preferred stocks are cumulative. If a firm passes a preferred dividend, the arrearage accumulates and must be paid in full before the company can resume common dividend payments.

Chapter 5 Financial Instruments and Markets 157

FIGURE 5.2 Distribution of Annual Return on Stocks and Bonds, 1928–2013

Source: Professor Aswath Damodaran’s website:

–45 –40 –35 –30 –25 –20 –15 –10 –5 0 5 10 15 20 25 30 35 40 45 50 55








N um

be r

of y

ea rs

Annual Percentage Return

Common stocks












–45 –40 –35 –30 –25 –20 –15 –10 –5 0 5 10 15 20 25 30 35 40 45 50 55

N um

be r

of y

ea rs

Annual Percentage Return

Long-term government bonds



The control preferred shareholders have over management decisions varies. In some instances, preferred shareholders’ approval is routinely required for major decisions; in others, preferred shareholders have no voice in management unless dividend payments are in arrears.

Preferred stock is not a widely used form of financing; at present only 13 percent of S&P 500 companies have any preferred stock on their balance sheet. Some managers see preferred stock as cheap equity. They observe that preferred stock gives management much of the flexibility regarding dividend payments and maturity dates that common equity provides. Yet because pre- ferred shareholders have no right to participate in future growth, they see preferred stock as less expensive than equity. The majority, however, see pre- ferred stock as debt with a tax disadvantage. Because few companies would ever omit a preferred dividend payment unless absolutely forced to, most managers place little value on the flexibility of preferred stock. To them the important fact is that interest payments on bonds are tax deductible, whereas dividend payments on preferred stock are not.

Financial Markets

Having reviewed the basic security types, let us now turn to the markets in which these securities are issued and traded. Of particular interest will be the provocative notion of market efficiency.

Broadly speaking, financial markets are the channels through which in- vestors provide money to companies. Because these channels differ greatly depending on the nature of the company and securities involved, they can best be described by considering the financing needs of three representative firms: a startup, a candidate for an initial public offering, and a multinational. Although these brief vignettes certainly do not ex- haust the topic, I hope they offer a useful overview of financial markets and their more important participants.

Venture Capital Financing Janet Holmes has developed a promising new medical device and now wants to start a company to capitalize on her research. Her problem is finding the financing. After a brief inquiry, she learns that conventional financing sources such as bank loans and public stock or bond offerings are out of the question. Her venture is far too risky to qualify for a bank loan and too small to attract public funding. A banker has expressed in- terest in a small loan collateralized by accounts receivable, machinery, and any personal assets she owns, but this will not be nearly enough. In- stead, it looks as if Ms. Holmes will have to rely primarily on the tradi- tional four-Fs of new venture financing: founders, family, friends, and

158 Part Three Financing Operations



fools. Other possible financing sources are strategic investors and ven- ture capitalists, from whom Ms. Holmes might legitimately aspire to raise as much as $15 million in return for a large fraction, possibly con- trolling interest, of her new company.

Chapter 5 Financial Instruments and Markets 159

The Future of Crowdfunding? Startup companies hungry for capital are increasingly turning to crowdfunding, a process of raising money by pooling a number of small investments from many investors. The concept has been around for many years, but its popularity has exploded in the past decade as new ventures have found it easier to link up with willing investors over the Internet. Because current regulations prohibit the sale of stocks or bonds to small investors, most crowdfunding today works on a donor-based model where individuals donate cash to new ventures in return for products, perks, or other rewards. Crowdfunding websites such as Kickstarter and Indiegogo raised an estimated $5 billion for startup ventures worldwide in 2013.a

That’s a small total compared to the amounts raised in traditional equity and debt markets. However, for companies like Pebble Technologies, which used crowdfunding to raise over $10 million in 2012, the im- pact of crowdfunding can be enormous. Pebble’s initial goal was to raise $100,000 by pre-selling their new smartwatch to donors for $50 below retail. But after selling almost 70,000 watches in less than two months, the company terminated the program with vastly more money in hand than originally intended. Pebble’s experience suggests that two important keys to success in donor-based funding are having modest funding needs and owning what social networkers see as a must-have product.

At this writing, crowdfunding’s new frontier is the expansion of online fund raising to include the sale of stocks and bonds to small investors. Congress is anxious to see such “equity crowdfunding” become a reality, but it is also justifiably concerned that without proper regulation, promoters will seize on the expansion to fleece unwary investors. The 2012 JOBS Act thus not only authorizes equity crowd- funding, but also charges the SEC to first figure out how to protect unwary investors. Now, some two years later, we are still awaiting the SEC’s word. Proposed regulations, issued in October 2013 and run- ning over 500 pages, speak of limiting the amount of money a qualifying company may crowdfund an- nually to $1 million, of restricting the amount an individual may invest annually to $100,000 or less, depending on income, and of requiring “funding portals” to screen participating startups to minimize fraud. How proficient web operators might be at sniffing out financial fraud is not known.

The future of crowdfunding may well be bright once the SEC finishes its job. In the meantime we live in a world where a company like visual-reality startup Oculus VR can crowdfund $2.4 million on a donor basis in 2012 and sell out to Facebook two years later for $2 billion without passing a single penny on to the original donors. Estimates are that donors’ inability to buy equity shares in Oculus cost them a return of 200 times their initial investment.b Yet, if the comments of one disgruntled donor are to be believed, this staggering opportunity loss is not even what really angers them.

“I would have NEVER given a single cent of my money to Oculus if I had known you were going to sell out to Facebook. You sold all of us out. I hope this backfires horribly for Oculus and Facebook. I will personally discourage absolutely anyone I know from buying what was once an indie dream and is now a soulless corporate cash cow. God, I want a refund so badly.”—John Wolfc

a Chance Barnett, “Top 10 Crowdfunding Sites for Fundraising,” Forbes, May 8, 2013. b Ibid,”$2B Facebook Acquisition Raises Question: Is Equity Crowdfunding Better?” Forbes, May 1, 2014. crowdfunding-better/. c © Adario Strange, “Kickstarter Backlash: Early Oculus Supporters Hate Facebook Deal,” Mashable, March 25, 2014.



Strategic investors are operating companies—frequently potential competitors—that make significant equity investments in startups as a way to gain access to promising new products and technology. Some strategic investors, including Microsoft, Intel, and Cisco Systems, have come to view new venture investing as a means of outsourcing research and development. Rather than develop all new products in-house, they sprinkle money across a number of promising startups, expecting to acquire any that prove successful.

Venture capitalists come in two flavors: wealthy individuals, often re- ferred to as “angel investors,” and professional venture capital companies. Venture capital companies are financial investors who make high-risk equity investments in entrepreneurial businesses deemed capable of rapid growth and high investment returns. They purchase a significant fraction of a company and take an active policy role in management. Their goal is to liquidate the investment in five or six years when the company goes public or sells out to another firm. Venture capital firms routinely con- sider dozens of candidates for every investment made and expect to suffer a number of failures for each investment success. In return, they expect winners to return 5 to 10 times their initial investment. According to the National Venture Capital Association, venture capital firms in the United States invested about $30 billion across some 4,000 deals in 2013. The dollar volume is well below the Internet-fueled record of $105 billion in 2000, but it is fairly typical for the past decade, which has seen average volume of $27 billion per year. Most venture capital investments are in technology firms of one kind or another.

Private Equity Venture capital companies are prominent examples of a broader class of companies known as “private equity” firms. Although private equity firms invest in a wide variety of opportunities, including new ventures, lever- aged buyouts, and distressed businesses, they all share an important trait: They employ a unique organizational form known as a private equity part- nership. Instead of the conventional public-company form, private equity investments are structured as limited partnerships with a specified dura- tion, usually of 10 years. Acting as the general partner, the private equity firm raises a pool of money from limited partners, consisting primarily of institutional investors, such as pension funds, college endowments, and in- surance companies. As limited partners, these investors enjoy the same limited liability protections afforded conventional shareholders. The pri- vate equity sponsor then invests the money raised, actively manages the in- vestments for a period of years, liquidates the portfolio, and returns the proceeds to the limited partners. In return, the private equity firm charges

160 Part Three Financing Operations



the limited partners handsome fees consisting of an annual management charge equaling about 2 percent of the original investment, plus what is known as carried interest, often 20 percent or more of any capital apprecia- tion earned on the portfolio. For example, the carried interest on a $1 bil- lion portfolio subsequently liquidated for $3 billion would be $400 million ($400 million � 20% � [$3 billion � $1 billion]). At any one time, private equity firms may be managing a number of limited partnerships of differ- ing size and years to maturity.

Private equity markets have become increasingly popular over the years for a number of reasons. Management of some companies see private eq- uity financing as an attractive alternative to public equity markets because being privately funded allows them to avoid some of the hassle and ex- pense of being a public company, such as meetings with analysts, increased disclosure requirements, and an intense focus on quarterly earnings. In addition, private equity partnerships appear to address several incentive problems inherent in more conventional investment forms.

• The partnership form minimizes any differences between owners and managers. As knowledgeable, active owners, private equity investors make it clear that management works for them and that their goal is not to meet artificial short-run earnings targets, but to create value for owners.

• The fixed life of the partnership imposes an aggressive, buy-fix-sell attitude on managers, prompting them to take decisive actions.

• As Dave Barry might put it, the limited time horizon also assures investors that they will eventually get their money back, rather than having to stand by idly watching management feed it to chipmunks.

How big is the private equity business? Big. Malcolm Gladwell, in his New Yorker story on the rescue of General Motors, notes “In the past twenty-five years, private equity has risen from obscurity to become one of the most powerful forces in the American economy.”6 According to The Economist, “When the Service Employees International Union (SEIU) added up the numbers of workers at the companies in [private equity] firms’ portfolios, it found that five of the ten biggest American employers were private-equity firms. KKR, with 826,710 workers in its domain (from HCA, a health-care giant, to Toys “R” Us, a retailer) is second only to Walmart, the world’s largest retailer, which has 1.9 million employees worldwide.”7

Chapter 5 Financial Instruments and Markets 161

6Malcolm Gladwell, “Overdrive: Who Really Rescued General Motors?” The New Yorker, November 1, 2010. 7“Face value: Bashing the Barbarians,” The Economist, August 2, 2008.



Initial Public Offerings Genomic Devices got its start six years ago when it raised $15 million from three venture capital firms. After two more rounds of venture financing totaling $40 million, Genomic is now a national company with sales of $125 million and an annual growth rate of more than 40 percent. To finance this rapid growth, management estimates the company needs another $25 million equity infusion. At the same time, company founders and venture capital investors are anxious to see some cash from their years of toil. This has led to active consideration of an initial public offering (IPO) of common stock. By creating a public market for the company’s shares, an IPO will provide desired liquidity to existing owners as well as supply necessary funding.

Investment Banking Genomic Devices’ first step toward an IPO will be to conduct what is known in the trade as a “bake-off.” This involves reviewing proposals from several investment bankers detailing the mechanics of how they would sell the new shares and what a great job each could do for the company. Investment bankers can be thought of as the grease that keeps financial markets running smoothly. They are finance specialists who assist companies in raising money. Other activities include stock and bond brokerage, investment counseling, merger and acquisition analy- sis, and corporate consulting. Some banking companies, such as Bank of America, employ thousands of brokers and have offices all over the world. Others, such as Lazard Ltd., specialize in working with compa- nies or trading securities, and consequently are less in the public eye. As to the range of services provided, H. F. Saint said it best in his Wall Street thriller Memoirs of an Invisible Man: “[Investment bankers] per- form all sorts of interesting services and acts—in fact, any service or act that can be performed in a suit, this being the limitation imposed by their professional ethics.”8

When a company is about to raise new capital on public markets, an in- vestment banker’s responsibilities are not unlike his fees: many and varied. (Capital raising techniques differ from one country to another depending on custom and law. In the interest of space, and with apologies to non- American readers, I will confine my comments here to the American scene.) The winner of the bake-off receives the mantle “managing under- writer” and immediately begins advising the company on detailed design of the security to be issued. Then the banker helps the company register the issue with the SEC. This usually takes 30 to 90 days and includes

162 Part Three Financing Operations

8H. F. Saint, Memoirs of an Invisible Man (New York: Dell, 1987), p. 290.



detailed public disclosure of information about the company’s finances, its officer compensation, plans, and so on—information some managements would prefer to keep confidential. Under the new JOBS Act, firms with less than $1 billion in annual revenues may now keep some of this information confidential during the IPO process.

While the registration wends its way toward approval, the managing underwriter orchestrates the “road show,” during which top company executives market the issue to institutional investors in New York and other financial centers. The managing underwriter also puts together a selling and an underwriting syndicate. A syndicate is a team of as many as 100 or more investment banking firms that join forces for a brief time to sell new securities. Each member of the selling syndicate accepts respon- sibility for selling a specified portion of the new securities to investors. Members of the underwriting syndicate in effect act as wholesalers, pur- chasing all of the securities from the company at a guaranteed price and attempting to sell them to the public at a higher price. The “Rules of Fair Practice” of the National Association of Securities Dealers prohibit un- derwriters from selling new securities to the public at a price above the original offer price quoted to the company. If necessary, however, the syn- dicate may sell them at a lower price.

Given the volatility of stock markets and the length of time required to go through registration, it may appear that underwriters bear significant risks when they guarantee the issuer a fixed price for the shares. This is not the way the world works, however. Underwriters do not commit themselves to a firm price on a new security until just hours before the sale, and if all goes as planned, the entire issue will be sold to the public on the first day of offer. It is the company, not the underwriters, that bears the risk that the terms on which the securities can be sold will change during registration.

The life of a syndicate is brief. Syndicates form several months prior to an issue for the purpose of “building the book,” or pre-selling the issue, and disband as soon as the securities are sold. Even on unsuccessful issues, the syndicate breaks up several weeks after the issue date, leaving the un- derwriters to dispose of their unsold shares on their own. I will have more to say about the issue costs and pricing of IPOs in a few paragraphs.

Seasoned Issues Our third representative firm in need of financing is Trilateral Enter- prises, a multinational consumer products company with annual sales of almost $90 billion. Trilateral wants to raise $200 million in new debt and has narrowed the choices down to a “shelf registration,” a “private placement,” or an international issue executed through the company’s Netherlands Antilles subsidiary.

Chapter 5 Financial Instruments and Markets 163



Shelf Registration First authorized in 1982, a shelf registration allows frequent security issuers to avoid the cumbersome traditional registration process by filing a general- purpose registration, good for up to two years, indicating in broad terms the securities the company may decide to issue. Once the registration is approved by the SEC, and provided it is updated periodically, the company can put the registration on the “shelf,” ready for use as desired. A shelf registration cuts the time lag between the decision to issue a security and receipt of the proceeds from several months to as little as 48 hours. Because 48 hours is far too little time for investment bankers to throw a syndicate together, shelf registrations tend to be “bought deals” in which a single investment house buys the entire issue in the hope of reselling it piecemeal at a profit. Also, because it is just as easy for the issuer to get price quotes from two banks as from one, shelf registrations increase the likelihood of competitive bidding among banks. As a result, issue costs for shelf-registered issues are as much as 10 percent to 50 percent lower than for traditionally registered issues, depending on the type of security and other factors.9

Shelf-registered equity issues are also possible. When first authorized in 1990, such issues were quite rare, but recent figures indicate they are growing rapidly in popularity and now account for something like half of all money raised in seasoned equity issues.10 (A seasoned equity issue, or SEO, refers to an equity issue by a company that is already publicly traded. It contrasts with an initial public offering, undertaken by a private firm.) Companies appear attracted to shelf-registered equity because it enables them to time issues in response to temporary stock price move- ments. Moreover, the advent of “universal” shelf registrations, covering both debt and equity issues, allows the issuer to defer the choice of whether to issue debt or equity to a later date, and enables management to avoid signaling investors that it is even considering an equity issue. I will have more to say about market signaling in the next chapter.

Private Placement If it wishes, Trilateral Enterprises can avoid SEC registration entirely by placing its debt privately with one or more large institutional investors. The SEC does not regulate such private placements on the expectation

164 Part Three Financing Operations

9Robert J. Rogowski and Eric H. Sorensen, “Deregulation in Investment Banking, Shelf Registrations, Structure, and Performance,” Financial Management, Spring 1985, pp. 5–15. See also Sanjai Bhagat, M. Wayne Marr, and G. Rodney Thompson, “The Rule 415 Experiment: Equity Markets,” Journal of Finance, December 1985, pp. 1385–1402. 10Bernardo Bortolotti, William L. Megginson, and Scott B. Smart, “The Rise of Accelerated Seasoned Equity Underwritings,” Journal of Applied Corporate Finance, Summer 2008, pp. 35–57. Available at See also Don Autore, Raman Kumar, and Dilip Shome, “The Revival of Shelf-Registered Corporate Equity Offerings,” Journal of Corporate Finance, Vol.14 No.1, 2008.



that large investors, such as insurance companies and pension funds, can fend for themselves without government protection. Because private placements are unregulated, there are no accurate figures on the size of the market. Best guesses are that, excluding bank loans, private placements are about half the size of public markets in terms of total funds provided.11

Private placements are especially attractive to smaller, less well-known firms and to the so-called “information-problematic” companies whose complex organization structures or financing needs make them difficult for individual investors to evaluate. Private placements can also be custom-tailored to specific company needs, arranged quickly, and renego- tiated as needed with comparative ease.

A major disadvantage of private placements has traditionally been that as unregistered securities the SEC prohibits their purchase or sale on pub- lic financial markets. As a result, issuers have historically found it necessary to offer more favorable terms on private placements than on public issues to compensate for their lack of liquidity. This began to change, at least for less information-problematic issuers, in 1990 when the SEC released Rule 144A permitting the trading of private placements among large institu- tional investors. Rule 144A is part of a determined effort by the SEC to en- courage what are essentially two parallel markets for corporate securities: a closely regulated public market for individual investors and a more loosely monitored private market for institutional investors.

International Markets Large corporations can raise money on any of three types of markets: do- mestic, foreign, or international. A domestic financial market is the market in the company’s home country, while foreign markets are the domestic markets of other countries. U.S. financial markets are thus domestic to IBM and General Motors but foreign to Sony Corporation and British Petroleum; Japanese markets are domestic to Sony but foreign to IBM, General Motors, and British Petroleum.

Companies find it attractive to raise money in foreign markets for a variety of reasons. When the domestic market is small or poorly developed, a company may find that only foreign markets are large enough to absorb the contemplated issue. Companies may also want liabilities denominated in the foreign currency instead of their own. For example, when Walt Disney expanded into Japan, it sought yen-denominated liabilities to reduce the foreign exchange risk created by its yen-denominated revenues. Finally,

Chapter 5 Financial Instruments and Markets 165

11Stephen D. Prowse, “The Economics of Private Placements: Middle-Market Corporate Finance, Life Insurance Companies, and a Credit Crunch,” Economic Review, Federal Reserve Bank of Dallas, Third Quarter 1997, pp. 12–24. Available at /er9703b.pdf.



issuers may believe foreign-denominated liabilities will prove cheaper than domestic ones in view of anticipated exchange rate changes.

Access to foreign financial markets has historically been a sometime thing. The Swiss and Japanese governments have frequently restricted access to their markets by limiting the aggregate amount of money for- eigners may raise in a given time period or imposing firm size and credit quality constraints on foreign issuers. Even U.S. markets, the largest and traditionally most open markets in the world, have not always offered un- restricted access to foreigners. Beginning in the late 1960s and continuing for almost a decade, foreign borrowers in the United States were subject to a surcharge known as the interest equalization tax (IET). The tax was purportedly to compensate for low U.S. interest rates, but most observers saw it as an attempt to bolster a weak dollar in foreign exchange markets by constraining foreign borrowing.

The third type of market on which companies can raise money, inter- national financial markets, is best viewed as a free market response to the regulatory constraints endemic in domestic and foreign markets. A trans- action is said to occur in the international financial market whenever the currency employed is outside the control of the issuing monetary author- ity. A dollar-denominated loan to an American company in London, a euro-denominated loan to a Japanese company in Singapore, and a British pound bond issue by a Dutch company underwritten in Frankfurt are all examples of international financial market transactions. In each instance, the transaction occurs in a locale that is beyond the direct regulatory reach of the issuing monetary authority. Thus, the U.S. Federal Reserve has trouble regulating banking activities in London even when the activities involve American companies and are denominated in dollars. Similarly, the European Central Bank has difficulty regulating euro activities in Singapore.

International financial markets got their start in London shortly after World War II and were originally limited to dollar transactions in Europe. From this beginning, the markets have grown enormously to encompass most major currencies and trading centers around the globe. Today, international financial markets give companies access to large pools of capital, at very competitive prices, with minimal regulatory or reporting requirements.

Two important reasons international markets have often been able to offer lower-cost financing than domestic markets are the absence of re- serve requirements on international bank deposits and the ability to issue bonds in what is known as bearer form. In the United States and many other domestic markets, banks must abide by reserve require- ments stipulating that they place a portion of each deposit in a special account at the central bank. Because these reserves tie up resources

166 Part Three Financing Operations



while yielding only modest returns, domestic loans must carry a higher interest rate than international loans to yield the same profit.

The chief appeal of bearer bonds is that they make it easier for investors to avoid paying taxes on interest income. The company issuing a bearer bond never knows the bond’s owners and simply makes interest and princi- pal payments to anyone who presents the proper coupon at the appropriate time. In contrast, the issuer of a registered security maintains records of the owner and the payments made. Because bearer securities facilitate tax avoidance, they are illegal in the United States. This is why Trilateral Enterprises anticipates issuing their bonds to non-U.S. residents through its Netherlands Antilles subsidiary. The use of bearer bonds in international markets means international bonds can carry lower coupon rates than com- parable domestic bonds and still yield the same after-tax returns.

The ability of international financial markets to draw business away from domestic markets acts as a check on efforts to impose regulations in domes- tic markets. As long as companies and investors can avoid onerous domestic regulations by simply migrating to international markets, regulators are forced to take into account the degree to which new regulations will hurt do- mestic markets by driving business overseas. The interest equalization tax is an apt example. When first imposed, the tax had the desired effect of re- stricting foreign companies’ access to dollar financing. Over time, however, borrowers found they could avoid the tax by simply going to the interna- tional markets. The longer-run effect of the IET, therefore, was to shift busi- ness away from the United States without greatly affecting the total volume of dollar financing. Indeed, an avowed goal in repealing the IET was to make U.S. markets more competitive with international markets.

Some wonder if we are starting down a similar path with recent legislation intended to strengthen U.S. public markets. The concern is that the long- term effect of regulatory initiatives, including the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, will be simply to drive business offshore and on to private mar- kets. Although largely circumstantial, evidence consistent with this concern is accumulating. It includes a shift in IPO activity to non-U.S. markets,12 ap- parent increased popularity of going-private transactions among smaller public companies,13 growth of unregulated private markets, called “shadow markets,” on which investors can buy and trade shares of private companies, and a reduction in the number of smaller foreign companies willing to list on U.S. stock exchanges.

Chapter 5 Financial Instruments and Markets 167

12Craig Doidge, George Karolyi, and René Stulz, “The U.S. Left Behind: The Rise of IPO Activity Around the World,” Journal of Financial Economics, December 2013, pp. 546–573. Available at abstract=1795423. 13Ellen Engel, Rachel Hayes, and Xue Wang, “The Sarbanes-Oxley Act and Firms’ Going-Private Decisions,” Journal of Accounting and Economics, September 2007.



Not all regulations are bad, of course. Regulatory oversight of financial markets and the willingness of governments to combat financial panics have greatly stabilized markets and economies for over 70 years. The ongoing question is whether the recent wave of new regulations improves public markets or drives business to less-fettered locales. Stay tuned.

Issue Costs Financial securities impose two kinds of costs on the issuer: annual costs, such as interest expense, and issue costs. We will consider the more im- portant annual costs later. Issue costs are the costs the issuer and its share- holders incur on initial sale. For privately negotiated transactions, the only substantive cost is the fee charged by the investment banker in his or her capacity as agent. On a public issue, there are legal, accounting, and printing fees, plus those paid to the managing underwriter. The managing underwriter states his fee in the form of a spread. To illustrate, suppose ABC Corporation is a publicly traded company that wants to sell 10 mil- lion new shares of common stock using traditional registration proce- dures, and its shares presently trade at $20 on the New York Stock Exchange (NYSE). A few hours prior to public sale, the managing under- writer might inform ABC management, “Given the present tone of the markets, we can sell the new shares at an issue price of $19.00 and a spread of $1.50, for a net to the company of $17.50 per share.” This means the investment banker intends to underprice the issue $1.00 per share ($20 market price less $19 issue price) and is charging a fee of $1.50 per share, or $15 million, for his services. This fee will be split among the managing underwriter and the syndicate members by prior arrangement according to each bank’s importance in the syndicates.

To underprice an issue means to offer the new shares at a price below that of existing shares, or in the case of an IPO, below the market price of the shares shortly after the issue is completed. One obvious motivation invest- ment bankers have for underpricing is to make their own job easier. Selling something worth $20 for $19 is a lot easier than selling for $20. But there appears to be more to the practice than this. In any public sale of securities, well-informed insiders are selling paper of uncertain value to less informed outsiders. One way to quell outsiders’ natural concern with being victimized by insiders is to consistently underprice new issues. This gives uninformed buyers the expectation the shares will more likely rise than fall after issue. Underpricing is not an out-of-pocket cost to the company, but it is a cost to shareholders. The greater the underpricing, the more securities a company must issue to raise a given amount of money. If the securities are bonds, this translates into higher interest expense, and if they are shares, it translates into a reduced percentage ownership for existing owners.

168 Part Three Financing Operations



Empirical studies of issue costs confirm two prominent patterns. First, equity is much more costly than debt. Representative costs of raising cap- ital in public markets, ignoring underpricing, average about 2.2 percent of proceeds for debt, 3.8 percent for convertible bonds, and 7.1 percent for offerings of equity by publicly traded companies. This figure rises to 11.0 percent for IPOs. Second, issue costs for all security types rise rapidly as issue size declines. Issue costs as a percentage of gross proceeds for equity are as low as 3 percent for issues larger than $100 million but rise to more than 20 percent for issues under $500,000. Comparable figures for debt financing are from below 0.9 percent for large issues to more than 10 percent for very small ones.14

Efficient Markets

A recurring issue in raising new capital is timing. Companies are naturally anxious to sell new securities when prices are high. Toward this end, man- agers routinely devote considerable time and money to predicting future price trends in financial markets.

Concern for proper timing of security issues is natural, but there is a perception among many academicians and market professionals that attempting to forecast future prices in financial markets is a loser’s game. Such pessimism follows from the notion of efficient markets, a much- debated and controversial topic in recent years. A detailed discussion of efficient markets would take us too far afield, but because the topic has far- reaching implications, it merits some attention.

Market efficiency is controversial in large part because many propo- nents have overstated the evidence supporting efficiency and have misrep- resented its implications. To avoid this, let us agree on two things right now. First, market efficiency is a question not of black or white but of shades of gray. A market is not efficient or inefficient but more or less effi- cient. Moreover, the degree of efficiency is an empirical question that can be answered only by studying the particular market under consideration. Second, market efficiency is a matter of perspective. The NYSE can be ef- ficient to a dentist in Des Moines who doesn’t know an underwriter from an undertaker; at the same time, it can be highly inefficient to a specialist on the floor of the exchange who has detailed information about buyers and sellers of each stock and up-to-the-second prices.

Chapter 5 Financial Instruments and Markets 169

14Wayne H. Mikkelson and M. Megan Partch, “Valuation Effects of Security Offerings and the Issuing Process,” Journal of Financial Economics, January–February 1986; Inmoo Lee, Scott Lockhead, Jay Ritter, and Quanshui Zhao, “The Cost of Raising Capital,” Journal of Financial Research, Spring 1996; Securities and Exchange Commission, “Report of the Advisory Committee on the Capital Formation and Regulatory Process” (Washington, DC: U.S. Government Printing Office, July 24, 1996).



What Is an Efficient Market? Market efficiency describes how prices in competitive markets respond to new information. The arrival of new information at a competitive market can be likened to the arrival of a lamb chop at a school of flesh-eating piranha, where investors are, plausibly enough, the piranha. The instant the lamb chop hits the water, turmoil erupts as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the waters soon return to normal. Similarly, when new information reaches a competitive market, much turmoil erupts as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence.

An efficient market, then, is one in which prices adjust rapidly to new information and current prices fully reflect available information about the assets traded. “Fully reflect” means investors rapidly pounce on new information, analyze it, revise their expectations, and buy or sell securities accordingly. They continue to buy or sell securities until price changes eliminate the incentive for further trades. In such an environment, current prices reflect the cumu- lative judgment of investors. They fully reflect available information.

The degree of efficiency a particular market displays depends on the speed with which prices adjust to news and the type of news to which they respond. It is common to speak of three levels of informational efficiency:

1. A market is weak-form efficient if current prices fully reflect all infor- mation about past prices.

2. A market is semistrong-form efficient if current prices fully reflect all publicly available information.

3. A market is strong-form efficient if current prices fully reflect all infor- mation public or private.

Extensive tests of many financial markets suggest that with limited exceptions, most financial markets are semistrong-form efficient but not strong-form efficient. In other words, you generally cannot make money trading on public information; insider trading, however, based on private information, can be lucrative. This statement needs to be qualified in two respects. First, there is the issue of perspective. The preceding statement applies to the typical investor, who is subject to brokerage fees and lacks special information-gathering equipment. It does not apply to market makers. Second, it is impossible to test every conceivable type and com- bination of public information for efficiency. All we can say is that the most plausible types of information tested with the most sophisticated

170 Part Three Financing Operations



Chapter 5 Financial Instruments and Markets 171

How Rapidly Do Stock Prices Adjust to New Information? Figure 5.3 gives an indication of the speed with which common stock prices adjust to new infor- mation. It is a result of what is known as an event study. In this instance the researcher, Michael Bradley, is studying the effect of acquisition offers on the stock price of the target firm. It is eas- iest to think of the graph initially as a plot of the daily prices of a single target firm’s stock from a period beginning 40 days before the announcement of the acquisition offer and ending 40 days after. An acquisition offer is invariably good news to the target firm’s shareholders, because the offer is at a price well above the prevailing market price of the firm’s shares; so we expect to see the target company’s stock price rise after the announcement. The question is: How rapidly? The answer evident from the graph is: Very rapidly. We see that the stock price drifts upward prior to the announcement, shoots up dramatically on the announcement day, and then drifts with little direction after the announcement. Clearly, if you read about the announcement in the evening paper and buy the stock the next morning, you will miss out on the major price move. The market will already have responded to the new information. In another study, Louis Ederington and Jae Ha Lee at the University of Oklahoma look at price responses to scheduled news releases in several interest rate and foreign exchange markets on a trade-by-trade basis. They find that price changes begin within 10 seconds of the news release and are basically com- pleted within 40 seconds.a If you want to make money in financial markets trading on news, you’d best not dally.

The upward drift in stock price prior to the announcement is consistent with three possible ex- planations: (1) Insiders are buying the stock in anticipation of the announcement, (2) security ana- lysts are very good at anticipating which firms will be acquisition targets and when the offer will be made, or (3) acquiring firms tend to announce offers after the price of the target firm’s stock has in- creased for several weeks. I have my own views, but will leave it to you to decide which explanation is most plausible.

An old Jewish proverb says, “For example is no proof.” If the price pattern illustrated by the graph were for just one firm, it would be only a curiosity. To avoid this problem, Bradley studied the price patterns of 161 target firms involving successful acquisitions that occurred over 15 years. The prices you see are an index composed of the prices of the 161 firms, and the time scale is in “event time,” not calendar time. Here the event is the acquisition announcement, defined as day 0, and all other dates are relative to this event date. The pattern observed therefore describes general experience, not an isolated event.

In recent years, academicians have performed a great number of event studies involving different markets and events, and the preponderance of these studies indicates that financial markets in the United States respond to new, publicly available information very rapidly.

aLouis H. Ederington and Jae Ha Lee, “The Short-Run Dynamics of the Price Adjustment to New Information,” Journal of Financial and Quantitative Analysis, March 1995, pp. 117–134.

techniques available indicate efficiency. This does not preclude the possibility that a market will be inefficient with respect to some as yet untested information source. Nor does it preclude researchers who find evidence of profitable market inefficiencies and choose to exploit them rather than publish their findings.



172 Part Three Financing Operations

FIGURE 5.3 Time Series of the Mean Price Index of the Shares of 161 Target Firms Involved in Successful Tender Offers

Source: Michael Bradley, “Interfirm Tender Offers and the Market for Corporate Control,” Journal of Business 53, no. 4 (1980).

–40 –30 –20 –10 0 10 20 30 40





tA Announcement


tE Execution


Trading days

Pr ic

e in

de x

Implications of Efficiency If financial markets are semistrong-form efficient, the following state- ments are true:

• Publicly available information is not helpful in forecasting future prices.

• In the absence of private information, the best forecast of future price is current price, perhaps adjusted for a long-run trend.

• Without private information, a company cannot improve the terms on which it sells securities by trying to select the optimal time to sell.

• Without private information or the willingness to accept above- average risk, investors should not expect to consistently earn above the market-average rate of return.

Individuals without private information have two choices: They can admit that markets are efficient and quit trying to forecast security prices, or they can attempt to make the market inefficient from their perspective. This involves acquiring the best available information-gathering system in the hope of learning about events before others do. A variation on this strategy,



Chapter 5 Financial Instruments and Markets 173

usually illegal, is to seek inside information. Or as Chinese fortune cookies have said for years, “A friend in the market is better than money in the purse.” A third gambit used by some investors is to purchase the forecasts of prestigious consulting firms. The chief virtue of this approach appears to be that there will be someone to blame if things go wrong. After all, if the fore- casts were really any good, the consulting firms could make money by trad- ing, thereby eliminating the need to be nice to potential customers.

Did Belief in Market Efficiency Contribute to the Financial Crisis? Market efficiency did not fare well in the recent financial crisis. Among other epitaphs, commenta- tors labeled the concept “incredibly inaccurate,” and “an academic nostrum” that caused “a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments [that] led to our current plight.”a

Is such vitriol warranted? Did the conviction that markets are efficient contribute to the crisis? The answer in my mind is “yes and no.” As noted by Meir Statman of the University of Santa Clara, there are at least two definitions of market efficiency in common use.b The modest definition used here says efficient markets are unbeatable markets in the sense that it is very difficult for investors to consistently outperform market averages on a risk-adjusted basis. Prices in unbeatable markets respond very quickly to new information, and their response is neither consistently too great nor too small. For if ei- ther of these conditions did not hold, markets would no longer be unbeatable. Importantly, the modest definition of efficiency says nothing about whether the response of prices to new information is nec- essarily correct or not. Rather, it says only that the response will reflect prevailing investor sentiment, which might well be misguided. This means that prices might well deviate from their intrinsic values in efficient markets, and price bubbles are eminently possible.

In contrast, the ambitious definition is that efficient markets are not only unbeatable but also ra- tional in the sense that prices always equal intrinsic values. As a result, prices in efficient markets are always “right,” and bubbles cannot occur. Despite ample evidence to the contrary, the ambitious definition has proven intoxicating to some proponents of financial market deregulation, who appear to believe that unregulated markets are also necessarily rational markets.

How much blame does the notion of market efficiency bear for the financial crisis? In truth, early academic proponents of market efficiency did lean toward the rational markets definition, so they must bear some responsibility for initially over-interpreting the significance of their findings. But that was decades ago. Finance scholars today overwhelmingly agree on the modest, unbeat- able markets definition of efficiency. In fact, the increasingly popular academic discipline known as “behavioral finance” is essentially the study of how market sentiment might cause prices to deviate systematically from their intrinsic values.

Much more blame lies with those who continue to believe that efficient markets are equivalent to rational markets. Whether out of intellectual laziness or an overriding philosophical commitment to deregulation, a widespread conviction that unregulated markets are necessarily rational might well have contributed to the lethally dangerous combination of factors that led to the financial panic of 2008.

aJeremy Grantham quoted by Joe Nocera, “Poking Holes in a Theory of the Markets,” The New York Times, June 5, 2009, and Roger Lowenstein, “On Wall Street, the Price Isn’t Right,” The Washington Post, June 7, 2009.

b Meir Statman, “Efficient Markets in Crisis,” Journal of Investment Management, 2nd Quarter 2011, pp. 4–13. Available at



174 Part Three Financing Operations

As the preceding comments attest, market efficiency is a subtle and provocative notion with a number of important implications for investors as well as companies. Our treatment of the topic here has been necessarily brief, but it should be sufficient to suggest that unless executives have in- side information or superior information gathering and analysis systems, they may have little to gain from trying to forecast prices in financial mar- kets. This conclusion applies to many markets in which companies par- ticipate, including those for government and corporate securities, foreign currencies, and commodities.

There is, however, one important caveat to this conclusion. Because managers clearly possess private information about their own compa- nies, they should have some ability to predict future prices of their own securities. This means managers’ efforts to time new security issues based on inside knowledge of their company and its prospects may in fact be appropriate. But notice the distinction. The decision to postpone an equity issue because the president believes the company will signifi- cantly outperform analysts’ expectations in the coming year is fully de- fensible in a world of semistrong-form-efficient markets, but the decision to postpone an issue because the treasurer believes stocks in general will soon rise is not. The former decision is based on inside information; the latter is not.


Using Financial Instruments to Manage Risks The collapse of the Bretton Woods Agreement fixing currency exchange rates in the early 1970s irrevocably changed the job of the financial manager. The ensuing sharp increases in volatility among exchange rates, interest rates, and commodity prices greatly heightened corporate interest in using finan- cial instruments, especially derivative securities, to control the resulting risks. Initial use was piecemeal as companies responded to individual threats as they appeared, but as executives grew more familiar with the instruments and techniques, and as trading volumes rose, attitudes became more proactive.

Indeed, an emerging view on the part of some executives is that a major el- ement of modern business is getting paid to undertake intelligent risks, while deftly avoiding others. According to this view, a steel maker is well positioned to manage the vagaries of changing steel demand, but ill-equipped to cope with volatile interest rates or exchange rates. A logical response then is for the



company to use financial instruments systematically to sidestep these un- wanted risks, enabling it to better focus on the activities at which it excels.

Despite its occasional complexity, operating executives need to under- stand the basics of financial risk management for at least three reasons:

• Statistics put the total value of derivative contracts of all types outstanding in mid-2013 at $693 trillion.1 While the amount of money actually at risk in derivatives contracts is closer to “only” $20 trillion, the markets are huge by any measure, and size alone warrants a basic familiarity. By comparison, the total value of all stocks trading on all exchanges worldwide in mid-2013 was $53 trillion.2

• The fact that a number of otherwise sophisticated companies, includ- ing Procter & Gamble and Volkswagen, have reported multimillion- dollar losses on what were originally intended as risk-reducing activities highlights the damage derivative securities can wreak in the wrong hands. All executives need to appreciate the risks of misusing de- rivatives and how best to avoid them.

• Financial risk management is an indisputably valuable activity, but not a panacea. Executives throughout the firm need a clear understanding of what the techniques can and cannot do if they are to use them effectively.

This appendix looks briefly at two important weapons in the manager’s risk management arsenal: forward contracts and options. We begin by examining the use of these weapons to implement a simple risk manage- ment technique known as hedging. The appendix concludes with a brief overview of the determinants of an option’s value and how to price it. In the interest of brevity, I will confine the hedging discussion to the task of managing foreign exchange risks, although I might just as well have focused on interest rate, commodity price, or credit risks. The story in each instance would be much the same. (For a more in-depth look at financial risk management, I recommend one of two books.3)

Forward Markets

Most markets are spot markets, in which a price is set today for immedi- ate exchange. In a forward market, the price is set today but exchange occurs at some stipulated future date. Buying bread at the grocery store

Chapter 5 Financial Instruments and Markets 175

1Bank for International Settlements, “OTC Derivatives Statistics at end-June 2013,” Table A. Available at 2Data available at 3Michael Crouhy, Dan Galei, and Robert Mark, Essentials of Risk Management, 2nd edition (New York: McGraw-Hill, 2013). Steven Allen, Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, 2nd edition (New York: John Wiley & Sons, 2012).



is a spot market transaction, while reserving a hotel room to be paid for later is a forward market transaction. Most assets trading in forward markets also trade spot. To illustrate these markets, suppose the spot price of one euro today in currency markets is $1.4892, meaning pay- ment of this amount will buy one euro for immediate delivery. In con- trast, assume the 180-day forward rate is $1.4805, meaning payment of this slightly smaller amount in 180 days will buy one euro for delivery at that time. A forward transaction involves an irrevocable contract, most likely with a bank, in which the parties set the price today at which they will trade euros for dollars at a future date.

Speculating in Forward Markets Although our focus in this appendix is on risk avoidance, we will begin at the opposite end of the spectrum by looking at forward market speculation. As you will see, speculation—especially the creative use of one speculation to counteract another—is the essence of the risk management techniques to be described. To demonstrate this important fact, imagine that an irresistible impulse has prompted you to remortgage your home and bet $100,000 on the New York Knicks to beat the Boston Celtics in an upcoming basketball game. Your spouse, however, is not amused to learn of your wager and threatens serious consequences unless you immediately cancel the bet. But, of course, bets are seldom canceled without a broken kneecap or two.

So what do you do? You hedge your bet. Acknowledging your mother was wrong all those years ago—that two wrongs may indeed make one right—you place a second wager, but this time on the Celtics to beat the Knicks. Now, no matter who wins, the proceeds from your winning wager will cover the cost of your losing one, and except for the bookie’s take, it’s just as though you had never made the first bet. You have covered your bet. Companies use financial market “wagers” analogously to manage un- avoidable commercial risks.

For a closer look at forward market speculation, suppose the treasurer of American Merchandising, Inc. (AMI) believes the euro will weaken dramat- ically over the next six months. Forward currency markets offer a simple way for the treasurer to bet on his belief by executing a modest variation on the old “buy-low, sell-high” strategy. Here he will sell high first and buy low later: sell euros forward today at $1.4805, wait 180 days as the euro plum- mets, and then purchase euros in the spot market for delivery on the forward contract. If the treasurer is correct, the forward price at which he sells the euros today will exceed the spot price at which he buys them in six months, and he will profit from the difference. Of course, the reverse is also possible: If the euro strengthens relative to the dollar, the forward selling price could be below the spot buying price, and the treasurer will lose money.

176 Part Three Financing Operations



Chapter 5 Financial Instruments and Markets 177

Putting this into equation form, the treasurer’s gain or loss on, say, a €1 million forward sale is

Gain or loss � (F � S̃ )€1 million

where F is the 180-day forward price and S̃ is the spot price 180 days hence. The spot price has a tilde over it as a reminder that it is unknown today.

A convenient way to represent such transactions is with a position dia- gram showing the transaction’s gain or loss on the vertical axis as a func- tion of the uncertain future spot rate. As Figure 5A.1(a) shows, the treasurer’s gamble is a winner when the future spot price is below today’s forward rate and a loser when it is above that rate. We will refer to this and similar position diagrams throughout the appendix.

Hedging in Forward Markets We are now ready to see how currency speculation can reduce the risk of loss on cross-border transactions. Set aside the treasurer’s bet on the euro for a moment and suppose AMI has just booked a €1 million sale to a Ger- man buyer, with payment to be received in 180 days. The dollar value of this account receivable, of course, depends on the future exchange rate. In symbols,

$ Value of AMI’s receivable �S̃ (€1 million)

where S̃ is again the spot exchange rate. AMI faces foreign exchange risk, or exposure, because the dollar value of its German receivable in six months depends on the uncertain, future spot rate.

Figure 5A.1(b) is a position diagram for AMI’s account receivable. It shows the change in the dollar value of AMI’s receivable as the exchange rate changes. If the spot rate remains at $1.4892, the receivable will show neither a gain nor a loss in value, but as the price of the euro changes, so does the value of the receivable. In particular, an unlucky fall in the euro in coming months could turn an expected profit on the German sale into a loss—not exactly a morale booster for the operating folks who worked so hard to make the sale.

By generating the German account receivable, AMI has inadvertently bet that the euro will strengthen. If it wants to shed this risk, it can easily do so by instructing the treasurer to place an offsetting bet in the forward market. In this instance, the treasurer needs to sell €1 million 180 days forward, just as before. Upon adding the gain or loss on the forward sale



178 Part Three Financing Operations

FIGURE 5A.1 Forward Market Hedge

1.37 1.39 1.41 1.43 1.45 1.47 1.49 1.51 1.53 1.55 1.57 1.59 1.61 –120













(a) Forward sale of €1 million

Forward price

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Today’s spot rate

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Exchange rate ($/€)

(b) € Account receivable

1.37 1.39 1.41 1.43 1.45 1.47 1.49 1.51 1.53 1.55 1.57 1.59 1.61 –120













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(c) Forward market hedge of € receivable

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Forward sale Receivable

Hedged receivable






to the dollar value of the account receivable, we find that AMI has “locked in” a value for the German receivable of $1,480,500:

(F � S̃ )€1 million � (S̃)€1 million

� (F)€1 million

� ($1.4805)€1 million � $1,480,500

The elimination of S̃ from the equation indicates that the treasurer’s judi- cious combination of two opposing bets eliminates AMI’s currency expo- sure. Now, regardless of what happens to the spot rate, AMI will receive $1,480,500 in 180 days. The treasurer has executed a forward market hedge, the effect of which is to replace the unknown future spot rate with the known forward rate in determining the dollar value of the receivable. AMI has locked in the forward rate.

How does the forward market hedge differ from the forward market speculation described earlier? It doesn’t; the transactions are identical. The only difference is one of intent. In the speculation, the treasurer intends to benefit from his belief that the euro will fall. In the hedge, the treasurer presumably has no opinion about the euro’s future price and in- tends only to avoid the risk of losing money on the account receivable. When the same transaction can be either a risky speculation or a risk- reducing hedge depending only on the intent of the person rolling the dice, it should come as no surprise to learn that companies frequently have trouble controlling their risk management activities.

Figure 5A.1(c) shows the forward market hedge graphically. The solid, upward-sloping line is the gain or loss on the unhedged receivable from (b), while the dotted, downward-sloping line is the position diagram for the forward sale from (a). The bold horizontal line represents the com- bined effect of the receivable and the forward sale. When both are un- dertaken, the net outcome is independent of the future spot rate. The forward hedge eliminates risk just as opposing bets on the Celtics–Knicks game did.

Instead of manipulating equations to determine the net effect of hedging, it is usually simpler to do the same thing graphically by adding the position diagram from one bet to that of the other at each exchange rate. For instance, adding the gain on the receivable, denoted by a in Figure 5A.1(c), to the loss on the forward sale, b, yields the net result, c. The fact that the net result at each exchange rate lies on a hor- izontal line confirms that the value of the hedged receivable does not

Gain or loss on forward sale +

$ Value of receivable

Chapter 5 Financial Instruments and Markets 179



depend on the future spot rate. In other words, the hedge eliminates exchange risk.4

Hedging in Money and Capital Markets

The treasurer eliminated exchange risk on AMI’s euro asset by creating a euro liability of precisely the same size and maturity. In the jargon of the trader, he covered the company’s long position by creating an offsetting short position, where a long position refers to a foreign-currency asset and a short position corresponds to a foreign-currency liability. By offsetting one against the other, he squared the position.

A second way to create a short position in euros is to borrow euros today, promising to repay €1 million in 180 days, and sell the euros imme- diately in the spot market for dollars. Then, in 180 days, the €1 million received in payment of the account receivable can be used to repay the loan. After the dust settles, such a money market hedge enables AMI to receive a known sum of dollars today in return for €1 million in 180 days. As you might expect in efficient markets, the costs of hedging in forward markets and in money and capital markets are almost identical.

Hedging with Options

Options are for those who tire of Russian roulette—unless, of course, the options are one leg of a hedge. An option is a security entitling the holder to either buy or sell an underlying asset at a specified price and for a spec- ified time. Options come in two flavors: A put option conveys the right to sell the underlying asset, while a call is the right to buy it. To illustrate, assume for a payment of $48,800 today, you can purchase put options on the euro giving you the right to sell €1 million for $1.49 each at any time over the next 180 days. As a matter of semantics, $1.49 is known as the op- tion’s exercise, or strike, price, and 180 days is its maturity. The $48,800 purchase price, payable today, is referred to as the premium.

Figure 5A.2(a) shows the position diagram for these put options at ma- turity for different exchange rates. The lower, dotted line includes the premium, while the solid line omits it. Concentrating first on the solid

180 Part Three Financing Operations

4The hedged position in Figure 5A.1(c) appears to result in a loss. But this is not correct. Instead, the apparent loss is a mechanical result of the fact that the euro is at a forward discount to the dollar, which, in turn, is due to the fact that euro area interest rates are above U.S. rates. If the euro were not at a forward discount, U.S. investors could earn riskless arbitrage profits by borrowing dollars, buying euros spot, investing the euros at attractive rates, and selling the proceeds forward for dollars. Hence, the euro must sell at a forward discount. A hedge involves an expected loss only when the forward rate is below the treasurer’s expected future spot rate, not the current rate. The figure implicitly assumes the treasurer’s expected future spot rate equals the current spot, which clearly need not be true.



Chapter 5 Financial Instruments and Markets 181

FIGURE 5A.2 Option Market Hedge

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Exchange rate ($/€)

(a) Put option on €1 million

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Exchange rate ($/€)

(b) Call option on €1 million

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Exchange rate ($/€)

(c) Option market hedge of receivable

Strike price


Strike price



Strike price Hedged




–60 –80


–40 –20

0 20 40

100 80 60

1.37 1.39 1.41 1.43 1.491.45 1.47 Exchange rate ($/€)

1.51 1.53 1.55 1.57 1.59 1.61

1.37 1.39 1.41 1.43 1.491.45 1.47 1.51 1.53 1.55 1.57 1.59 1.61

1.37 1.39 1.41 1.43 1.491.45 1.47 1.51 1.53 1.55 1.57 1.59 1.61



–60 –80


–40 –20

0 20 40

100 80 60



–60 –80


–40 –20

0 20 40

100 80 60



line, we see that the puts are worthless at maturity when the spot exchange rate exceeds the option’s strike price. The right to sell euros for $1.49 each obviously isn’t very enticing when they command a higher price in the spot market. In this event, the options will expire worthless, and you will have spent the $48,800 premium for nothing. The outcome is very differ- ent, however, when the spot rate is below the strike price at maturity. If the spot exchange rate falls to $1.45, for instance, the option to sell €1 million at $1.49 is worth $40,000, and this number rises rapidly as the euro sinks further toward zero. In the best of all worlds (provided you’re not European), the euro will be worthless, and your puts will garner $1.49 million—not a bad return on a $48,800 investment.

The position diagram for call options is just the reverse of that for puts. Assume based on today’s closing prices, 180-day call options on €1 million with a strike price of $1.49 are available for a premium of $37,100. As shown in Figure 5A.2(b), these calls will expire worthless unless the spot price rises above the strike price; the right to buy something for more than its spot price has no value. But once above the strike price, the value of the calls rises penny for penny with the spot.

To understand why options appeal to serious speculators, suppose you believe the euro will rise to $1.55 in six months. Using the forward market to speculate on your belief, you can purchase €1 million forward today at $1.4805 each and sell them in six months for $1.55, thereby generating a return of 4.7 percent [(1.55�1.4805)/1.4805 � 0.047]. Alternatively, you can purchase the call options for $37,100, followed in six months by exer- cise of the call and immediate sale of the euros for $1.55 each, thereby pro- ducing a heart-skipping return of 62 percent ([(1.55�1.49) � €1 million � $37,100]�$37,100 � 0.62)—more than ten times higher than the forward market speculation. Of course, the downside risks are equally stimulating: A fall in the euro to $1.43 would generate a loss of only 3.4 percent in the forward market compared to a 100 percent loss in the options market (be- cause the options would expire without being exercised).

How might AMI use options to reduce exchange risk on the company’s German receivable? Because the receivable makes the company long in euros, the treasurer will want to create an offsetting short position; that is, he will want to purchase put options. Calls would only add to AMI’s currency risk.

Analyzing the hedge graphically, Figure 5A.2(c) shows the combined effect of AMI’s German receivable and purchase of the described put op- tions. As before, the upward-sloping, solid line represents the gain or loss in the dollar value of the receivable, and the bent, dotted line shows the payoff on the puts, including the premium. Adding the two together at each exchange rate yields the kinked solid line, portraying AMI’s exchange risk after hedging with options.

182 Part Three Financing Operations



Comparing the forward market hedge in Figure 5A.1 with the option hedge, we see that the option works much like an insurance policy, limiting AMI’s loss when the euro weakens while still enabling the company to ben- efit when it strengthens. The cost of this policy is the option’s premium.

Options are especially attractive hedging vehicles in two circumstances. One is when the hedger has a view about which way currencies will move but is too cowardly to speculate openly. Options enable the hedger to benefit when her views prove correct but limits losses when they are in- correct. Options are also attractive when the exposure is contingent. When a company bids on a foreign contract, its currency exposure obvi- ously depends on whether the bid is accepted. Hedging this contingent exposure in forward markets results in unintended, and possibly costly, reverse exposure whenever the bid is rejected. The worst possible out- come with an option hedge, however, is loss of the premium.

Limitations of Financial Market Hedging

Because new initiates to the world of hedging frequently overestimate the technique’s power, a few cautionary reflections on the severe limitations of financial market hedges are in order.

Two basic conditions must hold before commercial risks can be hedged effectively in financial markets. One is that the asset creating the risk, or one closely correlated with it, must trade in financial markets. In our example, this means euros must be a traded currency. For this reason, an exposure in Indian rupees is much harder to manage than one in euros.

The second necessary condition for effective foreign-currency hedging in financial markets is that the amount and the timing of the foreign cash flow be known with reasonable certainty. This is usually not a problem when the cash flow is a foreign receivable or payable, but when it is an operating cash flow, such as expected sales, cost of sales, or earnings, the story is quite dif- ferent. For example, suppose the treasurer of an American exporter to Germany anticipates earnings next year of €1 million, and she wants to lock in the dollar value of these profits today. What should she do? At first glance, the answer is obvious: Sell €1 million forward for dollars. But further consideration will reveal severe problems with this strategy. First, the ex- porter’s long position in euros equals not next year’s profits but next year’s sales, a much larger number. Second, instead of hedging a known future cash flow as in our account receivable example, the exporter must hedge an unknown, expected amount. Moreover, because changes in the dollar-euro exchange rate will affect the competitiveness of the American exporter’s products in Germany, we know that expected sales are themselves dependent on the future exchange rate. In terms of a position diagram, this means the

Chapter 5 Financial Instruments and Markets 183



foreign cash flow we seek to hedge cannot be represented by a straight line, which greatly complicates any hedging strategy. Third, if the American com- pany expects to continue exporting to Germany into the foreseeable future, its exposure extends far beyond next year’s sales. So even if it successfully hedges next year’s sales, this represents only a small fraction of the company’s total euro exposure. We conclude that hedging the risks of individual trans- actions such as those generating accounts receivable is a straightforward task, but hedging the much larger risks inherent in operating cash flows in finan- cial markets is a complex, nearly impossible undertaking.

Our final caveat about financial market hedging is more philosophical. Empirical studies suggest that foreign exchange, commodity, and debt mar- kets are all “fair games,” meaning the chance of benefiting from unexpected price changes in these markets about equals the chance of losing. If this is

184 Part Three Financing Operations

Currency and Interest Rate Swaps Another derivative security, known as a swap, has altered the way many financial executives think about issuing and managing company debt. A swap is a piece of paper documenting the trade of future cash flows between two parties in which each commits to pay or receive the other’s cash flows. The market value of a swap at any time equals the difference in the value of the underlying cash flows ex- changed. A currency swap involves the trade of liabilities denominated in different currencies, while an interest rate swap entails the trade of fixed-rate payments for floating-rate ones. Swaps do not appear on the participating companies’ financial statements, and lenders typically are unaware a swap has oc- curred. Swaps have become so commonplace that an active market now exists in which standard swaps are bought and sold over the phone much like stocks and bonds. If your company has a 10-year, Swiss franc liability and would prefer one denominated in U.S. dollars, phone a swap dealer for a quote.

Swaps inevitably seem exotic and a bit pathological on first acquaintance, but the underlying concept is really an elementary one. Whenever each of two parties has something the other wants, a trade can benefit both. A swap is such a trade in which the items exchanged are future interest and principal payments. Some swaps, denoted as asset swaps, involve rights to receive future pay- ments, while more common liability swaps involve the obligation to make future payments.

Swaps have proven to be valuable financing tools for at least two reasons. First, swaps help solve a fundamental problem facing many companies when raising capital. Prior to the advent of swaps, a com- pany’s decision about what type of debt to issue often involved a compromise between what the com- pany really wanted and what investors were willing to buy. An issuer might have wanted fixed-rate, French franc debt but settled for floating-rate, Canadian dollar debt because the terms were better. But with swaps, the issuer can have his cake and eat it too. Just issue floating-rate, Canadian dollar debt and immediately swap into fixed-rate, French franc debt. In effect, swaps enable the issuer to separate concerns about what type of debt the company needs from those regarding what type investors want to buy, thereby greatly simplifying the issuance decision and reducing borrowing costs.

A second virtue of swaps is that they are a slick tool for interest rate and currency risk manage- ment. Worried the Swiss franc will soon strengthen, increasing the dollar burden of your company’s Swiss franc debt? No problem: Swap out of francs into dollars. Worried that interest rates are about to fall, saddling your company with a pile of high-cost, fixed-rate debt? Piece of cake: Swap into floating-rate debt and watch borrowing costs float down with the rates.



so, companies facing repeated exchange exposures, or those with a number of exposures in different currencies, might justifiably dispense with hedging altogether on the grounds that over the long run, losses will about equal gains anyway. According to this philosophy, financial market hedging is warranted only when the company seldom faces currency exposures, when the potential loss is too big for the company to absorb gracefully, or when the elimination of exchange exposure yields administrative benefits such as more accurate performance evaluation or improved employee morale.

Valuing Options

Because options are finding increasing applications in corporate finance ranging from incentive compensation to analysis of investment opportu- nities, a brief primer on option valuation is appropriate.

Suppose you hold a five-year option to purchase 100 shares of Cisco Systems stock for $27 a share when the stock is selling for $25, and you want to know what the option is worth today. It is apparent that your op- tion would be worthless if you had to exercise it immediately, for the priv- ilege of buying something for $27 when it is freely available elsewhere for $25 is not highly prized. Your option is said to be “out of the money.” But fortunately, you do not have to exercise the option immediately. You can wait for up to five years before acting. Looking to the future, chances are good that sometime before the option matures, Cisco stock will sell for more than $27. The option will then be “in the money,” in which case you can exercise it and sell the stock for a profit. We conclude that the value of the option today depends fundamentally on two things: the chance that Cisco’s stock will rise above the option’s strike price prior to maturity and the potential amount by which it might exceed the strike price. The chal- lenge in valuing an option is to decide what these two things are worth.

Options have been around for many years, but it was not until 1973 that Fisher Black and Myron Scholes offered the first practical solution to this valuation challenge. Their solution is remarkable both for what it contains and for what it omits. Black and Scholes demonstrated that the value of an option depends on five variables, four of which are readily available in the newspaper. They are

• The current price of the underlying asset (which in our example is Cisco stock).

• The option’s time to maturity.

• The option’s strike price.

• The interest rate.

Chapter 5 Financial Instruments and Markets 185



186 Part Three Financing Operations

As you might expect, the value of a call option rises with the price of the underlying asset and the option’s time to maturity, but falls with the strike price. The Cisco call option is more valuable when Cisco is sell- ing at $50 than at $25 and when the option is good for 10 years as op- posed to 5. Conversely, it is worth less when its strike price is $40 as opposed to $27. The value of a call rises as interest rates rise because a call option can be viewed as a delayed purchase of the underlying asset, and the higher the interest rate, the more valuable this deferral privi- lege becomes.

The one unobservable determinant of an option’s value is the expected volatility of return on the underlying asset. In English, the value of the Cisco option depends on how uncertain investors are about the return on Cisco stock over the life of the option. The standard approach to esti- mating expected volatility is to look at the stock’s past volatility, as mea- sured by the standard deviation of past returns. (Standard deviation is a widely used statistical measure of dispersion, which we will consider in more detail in Chapter 8.) If the standard deviation of return on Cisco stock in the recent past has been 25 percent, this is a plausible estimate of its future volatility.

The intriguing thing about volatility is that option value rises with volatility. In other words, a call option on a speculative stock is actually worth more than an identical option on a blue chip. That’s right. Options are contrary to intuition and to most of finance, where volatility means risk and risk is bad. With options, volatility is good. To see why, recall that an option allows its owner to walk away unscathed when things go poorly. In our example, if Cisco stock never rises above $27, the worst that can happen is you will have some new wallpaper. This means that an option owner is only concerned with upside potential, and the greater the volatility, the greater this potential. If you received a dollar every time a batter hit a home run, wouldn’t you rather back an erratic slugger than a steady singles hitter? The same is true of options. Uncertainty is good for options.

The input variable that is surprisingly missing from the Black-Scholes formula is the predicted future value of the underlying asset. In our exam- ple, there is no need to forecast the value of Cisco stock over the next five years to value the option because the market’s forecast is already embed- ded in the current price.

With the Black-Scholes option-pricing formula in hand, valuing an option is now a straightforward, three-step process. First, find the current values of the four observable variables. Second, estimate the future volatil- ity of the underlying asset’s return, usually by extrapolating its past volatility. And third, throw these numbers into the Black-Scholes option pricing formula, or one of its latter-day extensions, and wait for the



computer to disgorge an answer. As an example, let’s value the Cisco option under the following conditions:

Option strike price $27 Option maturity 5 years Current Cisco stock price $25 5-year government interest rate 2.50% Volatility of Cisco stock price 31.41%

My volatility estimate is from Robert’s Online Option Pricer, a handy web- site that, among other things, provides historical volatilities for many stocks. The number used is Cisco’s annualized historical volatility over the prior month as measured on May 20, 2014. Rather than manipulating the Black- Scholes formula myself—a tedious task—I will use Robert’s Option Pricer, available on the same website. Plugging the requisite five numbers into the option pricer, we learn that the estimated value of the option on 100 Cisco shares is $541. At a volatility of 45 percent, the value jumps to $799.5

Growth of the options industry since introduction of the Black-Scholes pricing model recalls Mark Twain’s quip, “If your only tool is a hammer, pretty soon all the world appears to be a nail.” The ability to price options with reasonable accuracy has led to a remarkable growth in the volume and variety of options traded, including those on interest rates, stocks, stock in- dices, foreign exchange, weather, and a wide variety of physical commodi- ties. In addition to traded options, we have discovered the presence of embedded options lurking in many conventional financial instruments such as home mortgages and commercial bank loans. In the past, these options were either ignored or only crudely reflected in the pricing of the instru- ment. Now it is possible to value each option separately and price it accord- ingly. From the discovery of embedded options in conventional instruments, it has been a small step to the creation of innovative new in- struments that include heretofore unavailable options. Finally, we have re- cently begun to realize that many corporate investment decisions, such as whether or not to introduce a new product, contain embedded options that, at least in theory, can be priced using the techniques described. Examples of what are known as real options include the choice to expand production, to terminate production, or to change the product mix. The ability to price these options promises to greatly improve corporate investment decisions. (We will discuss more on this topic in Chapter 8.) Once you know how to price them, all the world indeed appears to be an option.

Chapter 5 Financial Instruments and Markets 187

5 Robert’s Online Applications are available at I have taken several liberties with the material in this section in the interest of simplicity. First, the pricing formula used in Robert’s Option Pricer is an extension of Black-Scholes. In addition to the five variables discussed, the formula requires the dividend yield, which for Cisco is at present 3 percent. It is also necessary to specify that the Cisco option is an “American” option because it can be exercised at any time prior to maturity.



188 Part Three Financing Operations


1. Financial instruments • Are claims to a company’s cash flows and assets designed to meet the

financing needs of the business and to appeal to investors. • Are not greatly constrained by law or regulation but are subject to

full disclosure requirements. • Are often grouped into four categories:

– Fixed-income securities known as bonds. – Residual-income securities known as common stock. – Hybrid securities having characteristics of both bonds and of stocks. – Derivative securities whose value depends on that of some underly-

ing asset. 2. Realized returns on U.S. common stocks over the years since 1928 have

• Averaged 11.5 percent a year. • Outpaced inflation by an average of 8.4 percent a year. • Been more volatile, and thus riskier, than returns on bonds. • Exceeded the return on government bonds by an average of 6.3 percent

a year. 3. Financial markets

• Are the channels through which companies sell financial instru- ments to investors.

• Include such diverse segments as – Private equity financing: where buyout and venture capital

firms, organized as limited partner- ships, make often high-risk, interme- diate-term investments.

– Initial public offerings: where private companies, with the help of investment bankers, sell own- ership interests to public investors.

– Seasoned issues: where larger public companies use often-specialized techniques such as private placements, shelf registra- tions, and Rule 144A offerings to raise money.

– Cross-border financing: where large companies raise money in other countries’ financial markets, or in international markets, which are best thought of as a free market response to regulatory constraints imposed in domestic markets.



4. Efficient markets • Are markets in which prices respond rapidly to new information

such that current prices fully reflect available information about the assets traded.

• Typically impound new information into prices in a matter of seconds.

• Are often divided into three categories: – Weak-form efficient: when current prices fully reflect all

information about past prices. – Semistrong-form efficient: when current prices fully reflect all

publicly available information. – Strong-form efficient: when current prices fully reflect all

information public or private. • Is a relative term in that the same market can be simultaneously

efficient to retail investors and inefficient to market specialists. 5. In semistrong-form efficient markets, in the absence of private

information • Publicly available information is not helpful in forecasting future

prices. • The best forecast of future price is current price, perhaps adjusted

for a long-run trend. • A company cannot improve the terms on which it sells securities by

attempting to time the issue. • Investors should not expect to consistently earn above-average

returns without accepting above-average risks.


Blinder, Alan S., After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. New York: Penguin Books, 2013. 528 pages.

A clear-eyed, objective account of the recent financial crisis and current state of the economy by a Princeton professor and former vice-chairman of the Federal Reserve. In paperback for about $15.

Dimson, Elroy, Paul Marsh, and Mike Staunton. Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton, NJ: Princeton University Press, 2002. 302 pages.

An elegant book by three British academics providing detailed information about returns earned on financial instruments in 16 countries over the twentieth century. An authoritative source of important information. About $110. Updated annually in Credit Suisse Global Investment Returns Yearbook.

Chapter 5 Financial Instruments and Markets 189



190 Part Three Financing Operations

Fox, Justin. The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. New York: Harper Paperbacks, 2011. 416 pages.

Tells the story of the rise and fall of the rational markets hypothesis. An excellent intellectual history of modern finance. A New York Times Notable Book of 2009. In paperback. $12.

Malkiel, Burton G. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. 10th ed. New York: W. W. Norton & Company, 2012. 496 pages.

The classic best-selling introduction to market efficiency and personal investing by someone who knows both the academic and professional sides of the story. Available in paperback for about $11.

Mishkin, Frederic S., and Stanley G. Eakins. Financial Markets and Institutions. 7th ed. Reading, MA: Addison Wesley, 2011. 704 pages.

An introduction to financial markets including money, bond, stock, mortgage, and foreign exchange markets. Also covers the management of financial institutions and the conduct of monetary policy. About $200.

WEBSITES Home of the Chicago Board Options Exchange. The site includes option quotes, market news, and options education. The CBOE also has a free app for iOS (search Apple’s app store for “CBOE Mobile”). Robert’s Online Applications. Lots of information on stock options and related topics. You give the option pricer the five bits of information necessary to price an option, and it returns the estimated price. Also contains information on the volatility of stock prices. Check out “About options” at the bottom of the option pricer page for a witty introduction to options. Anyone who answers the question “How are options priced?” with “Usually with a lot of difficulty” deserves a look.

NYSE Euronext Option Calculator A free app available for iOS or Android that allows you to calculate theoretical option prices based on values that you input. Watch a popular documentary on the history of the Black-Scholes option pricing formula. It just might convince you that finance can be fascinating. Select “Primer” for an informative introduction to venture capital.



Chapter 5 Financial Instruments and Markets 191


Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are avail- able in the Instructor Resources within McGraw-Hill’s Connect, connect (See the Preface for more information).

1. Table 5.1 indicates that the average annual rate of return on common stocks over many years has exceeded the return on government bonds in the United States. Why do we observe this pattern?

2. Suppose the realized rate of return on government bonds exceeded the return on common stocks one year. How would you interpret this result?

3. What is most important to investors: the number of a company’s shares they own, the price of the company’s stock, or the value of their shareholdings in the company? Why?

4. Two 20-year bonds are identical in all respects except that one allows the issuer to call the bond in return for $1,000 cash at any time after five years while the other contains no call provisions. Will the yield to maturity on the two bonds differ? If so, which will be higher? Why?

5. The return an investor earns on a bond over a period of time is known as the holding period return, defined as interest income plus or minus the change in the bond’s price, all divided by the beginning bond price. a. What is the holding period return on a bond with a par value of

$1,000 and a coupon rate of 6 percent if its price at the beginning of the year was $1,050 and its price at the end was $940? Assume interest is paid annually.

b. Can you give two reasons the price of the bond might have fallen over the year?

6. Information about three securities appears below.

Beginning-of-Year Price End-of-Year Price Interest/Dividend Paid Stock 1 $42.50 $46.75 $ 1.50 Stock 2 $ 1.25 $ 1.36 $ 0.00 Bond 1 $1,020 $1,048 $41.00

a. Assuming interest and dividends are paid annually, calculate the annual holding period return on each security.

b. During the year management of Stock 2 spent $10 million, or $0.50 a share, repurchasing 7.7 million of the company’s shares. How, if at all, does this information affect calculation of the hold- ing period return on Stock 2?



192 Part Three Financing Operations

7. A company wants to raise $500 million in a new stock issue. Its investment banker indicates that the sale of new stock will require 8 percent underpricing and a 7 percent spread. (Hint: the under- pricing is 8 percent of the current stock price, and the spread is 7 percent of the issue price.) a. Assuming the company’s stock price does not change from its cur-

rent price of $75 per share, how many shares must the company sell and at what price to the public?

b. How much money will the investment banking syndicates earn on the sale?

c. Is the 8 percent underpricing a cash flow? Is it a cost? If so, to whom? 8. Magenta Corporation wants to raise $50 million in a seasoned equity

offering, net of all fees. Magenta stock currently sells for $10 per share. The underwriters will require a spread of $0.50 per share, and indicate that the issue must be underpriced by 5 percent. In addition to the underwriter’s fee, the firm will incur $1,000,000 in legal, ac- counting, and other costs. How many shares must Magenta sell?

9. You see an article in the newspaper that details the performance of mu- tual funds over the last five years. You see that, out of 5,600 actively managed mutual funds in the study, 104 outperformed the market in each of the last five years. The author of the article argues that these mutual funds are examples of market inefficiency. “If markets are effi- cient, you would expect to see mutual funds outperforming the market for short periods of time. But when more than 100 mutual funds are able to outperform the market in each of the last five years, you can no longer suppose that markets are truly efficient. Obviously, these 100 fund managers have figured out a way to beat the market every year.” Do you think that this is evidence that markets are not efficient?

10. Suppose in Figure 5.3 that the stock prices of target firms in acquisi- tions responded to acquisition announcements over a three-day pe- riod rather than almost instantly. a. Would you describe such an acquisition market as efficient? Why

or why not? b. Can you think of any trading strategy to take advantage of the de-

layed price response? c. If you and many others pursued this trading strategy, what would

happen to the price response to acquisition announcements? d. Some argue that market inefficiencies contain the seeds of their

own destruction. In what ways does your answer to this problem il- lustrate the logic of this statement, if at all?



Chapter 5 Financial Instruments and Markets 193

e. Immediately after some merger announcements, the stock price of the target firm jumps to a level higher than the bid price. Is this proof of market inefficiency? What might explain this price pattern?

11. a. Suppose that Liquid Force, Inc.’s stock price consistently falls by an amount equal to one-half the dividend it pays on the payment date. Ignoring taxes, can you think of an investment strategy to take advantage of this information?

b. If you and many others pursued this strategy, predict what would happen to Liquid Force’s stock price on the dividend payment date.

c. Suppose that Liquid Force’s stock price consistently falls by an amount equal to twice the dividend payment on the payment date. Ignoring taxes, can you think of an investment strategy to take ad- vantage of this information?

d. If you and many others pursued this strategy, predict what would happen to Liquid Force’s stock price on the dividend payment date.

e. In an efficient market, ignoring taxes and transaction costs, how do you think stock prices will change on dividend payment dates?

f. Given that investors receive returns from common stock in the form of dividends and capital appreciation, do you think that in- creasing dividends will benefit investors in the absence of taxes and transactions costs?

12. If the U.S. stock market is efficient, how do you explain the fact that some people make very high returns? Would it be more difficult to reconcile very high returns with efficient markets if the same people made extraordinary returns year after year?

13. Why do you suppose that smaller firms tend to rely on bank financ- ing while larger companies are more apt to sell bonds in financial markets?

The following two problems test your understanding of the chapter appendix. 14. The common shares of networking giant Cisco Systems, Inc.

(CSCO) recently traded on NASDAQ for $22.64 per share. You have employee stock options to purchase 1,000 CSCO shares for $22 per share. The options expire in three years. The annualized volatility of CSCO stock according to Robert’s Historical Stock Volatilities ( in a recent month was 31.41 percent. The company’s dividend yield is 3.0 percent, and the interest rate is 2.5 percent. (Assume the options are European options that may only be exercised at the maturity date.) a. Is this option a call or a put?



194 Part Three Financing Operations

b. Using Robert’s Option Pricer ( option-pricer1.html) or any other calculator you prefer, estimate the value of your CSCO options.

c. What is the estimated value of the options if their maturity is five months instead of three years? Why does the value of the options decline as the maturity declines?

d. What is the estimated value of the options if their maturity is three years, but CSCO’s volatility is 45 percent? Why does the value of the options increase as volatility increases?

15. Some refer to common stock in a company with debt outstanding as an option on a company’s assets. Do you see any logic to this state- ment? What is the logic, if any?




The Financing Decision

Equity Capital: The least amount of money owners can invest in a business and still obtain credit. Michael Sperry

In the last chapter, we began our inquiry into financing a business by looking at financial instruments and the markets in which they trade. In this chapter, we examine the company’s choice of the proper financing instruments.

Selecting the proper financing instruments is a two-step process. The first step is to decide how much external capital is required. Frequently this is the straightforward outcome of the forecasting and budgeting process described in Chapter 3. Management estimates sales growth, the need for new assets, and the money available internally. Any remaining monetary needs must be met from outside sources. Often, however, this is only the start of the exercise. Next comes a careful consideration of finan- cial markets and the terms on which the company can raise capital. If management does not believe it can raise the required sums on agreeable terms, a modification of operating plans to bring them within budgetary constraints is initiated.

Once the amount of external capital to be raised has been determined, the second step is to select—or, more accurately, design—the instrument to be sold. This is the heart of the financing decision. As indicated in the last chapter, an issuer can choose from a tremendous variety of financial securities. The proper choice will provide the company with needed cash on attractive terms. An improper choice will result in excessive costs, undue risk, or an inability to sell the securities. In this context, it is im- portant to keep in mind that most operating companies make money by creatively acquiring and deploying assets, not by dreaming up clever ways to finance these assets. This means that the focus of the financing decision should generally be on supporting the company’s business strategy, and that care should be taken to avoid financing choices that carry even a modest chance of derailing this strategy. Better to make company financ- ing the passive handmaiden of operating strategy than to jeopardize that



strategy in pursuit of marginally lower financing costs. This is especially true for rapidly growing companies where aggressive financing choices can be especially costly.

For simplicity, we will concentrate on a single financing choice: XYZ Company needs to raise $200 million this year; should it sell bonds or stock? But do not let this narrow focus obscure the complexity of the topic. First, bonds and stocks are just extreme examples of a whole spectrum of possible security types. Fortunately, the conclusions drawn regarding these extremes will apply to a modified degree to other instru- ments along the spectrum. Second, many businesses, especially smaller ones, are often unable or unwilling to sell stock. For these firms, the rele- vant financing question is not whether to sell debt or equity but how much debt to sell. As will become apparent later in the chapter, the inability to raise equity forces companies to approach financing decisions as part of the broader challenge of managing growth. Third and most important, financing decisions are seldom one-time events. Instead, the raising of money at any point in time is just one event in an evolving financial strat- egy. Yes, XYZ Company needs $200 million today, but it will likely need $150 million in two years and an undetermined amount in future years. Consequently, a major element of XYZ’s present financing decision is the effect today’s choice will have on the company’s future ability to raise capital. Ultimately, then, a company’s financing strategy is closely inter- twined with its long-run competitive goals and the way it intends to man- age growth.

A word of warning before we begin: Questions of how best to finance a business recall the professor’s admonition to students in a case discussion class: “You will find that there are no right answers to these cases, but many wrong ones.” In the course of this chapter, you will learn there is no single right answer to the question of how best to finance a business, but you will also discover some important guidelines to help you avoid the many wrong answers.

This chapter addresses a central topic in finance known as OPM: other people’s money. We look first at how OPM fundamentally affects the risk and return faced by the owners of any risky asset. We then examine sev- eral practical tools for measuring these risk-return effects in a corporate setting, and we conclude by reviewing current thinking on the determi- nants of the optimal use of debt by a business. In the course of our review, we will consider the tax implications of various financing instruments, the distress costs a company faces when it relies too heavily on OPM, the in- centive effects of high leverage, the challenges faced by companies unable to sell new equity, and what are known as signaling effects. These refer to the way a company’s stock price reacts to news that the company intends

196 Part Three Financing Operations



to sell a particular financing instrument. The chapter appendix takes up a major conceptual building block in finance known variously as the irrele- vance proposition or the M&M theorem.

Financial Leverage

In physics, a lever is a device to increase force at the cost of greater movement. In business, OPM, or what is commonly called financial leverage, is a device to increase owners’ expected return at the cost of greater risk. Mechanically, financial leverage involves the substitution of fixed-cost debt financing for owners’ equity, and because this substitution increases fixed interest expenses, it follows that financial leverage increases the variability of returns to owners— a common surrogate for risk. Financial leverage is, thus, the proverbial two- edged sword, increasing owners’ expected return, but also their risk.

Table 6.1 illustrates this fundamental point in the form of a very simple risky investment. Ignoring taxes, the investment requires a $1,000 outlay today in return for a 50-50 chance at either $900 or $1,400 in one year. We are interested in how the owners’ expected return and risk vary as we alter the type of financing. Panel A at the top of the table assumes all-equity financing. Observe that the investment promises an equal chance at a return of minus 10 percent or plus 40 percent (a $400 profit on a $1,000 invest- ment implies a 40 percent return). Looking at the bold figures in Panel A,

Chapter 6 The Financing Decision 197

TABLE 6.1 Debt Financing Increases Expected Return and Risk to Owners

The Investment: Pay $1,000 today for a 50-50 chance at $900 or $1,400 in one year.

Panel A: 100% Equity Financing. Owners Invest $1,000.

Probability Investment Return to Weighted Outcome Probability To Owners Owners Return

$ 900 0.50 $ 900 �10% �5% 1,400 0.50 1,400 40 20____

Expected return � 15%

Panel B: 80% Debt Financing; 1-Year Loan at 10% Interest. Owners Invest $200.

Probability Investment Residual to Return to Weighted Outcome Probability Due Lender Owners Owners Return

$ 900 0.50 $880 $ 20 �90% �45% 1,400 0.50 880 520 160 80____

Expected return � 35%



we see that these numbers imply an expected return on the investment of 15 percent with a range of possible outcomes between �10 percent and �40 percent.

Now let’s pile on the debt and see what happens. Assume we finance 80 percent of the cost of the same investment with an $800, one-year loan at an interest rate of 10 percent. This reduces the owners’ investment to $200. Panel B of Table 6.1 shows that while the investment cash flows are unchanged, the residual cash flows to owners change dramatically. Be- cause owners must pay $880 in principal and interest to creditors before receiving anything, they now stand an equal chance of getting back $20 or $520 on their $200 investment. Looking again at the bold numbers in Panel B, this translates into an attractive expected return of 35 percent and a daunting range of possible outcomes between �90 percent and �160 percent.

This example clearly demonstrates that debt financing does two things to owners: It increases their expected return and it increases their risk. The example also illustrates that a single risky investment can be con- verted into a wide variety of risk-return combinations by simply varying the means of financing. Want to minimize risk and return on an invest- ment? Finance with equity. Willing to take a gamble? Make the same in- vestment, but finance it with some debt. Want to really roll the dice? Crank up the leverage. These same observations apply to companies as well as individual investments: Financial leverage increases expected re- turn and risk to shareholders, and companies are able to generate a wide array of shareholder, risk-return combinations by varying the way they fi- nance the business. (Incidentally, if you are worried about what happens to the $800 owners have left over in Panel B, don’t. The same conclusions follow if we assume owners combine their $1,000 of equity with $4,000 of borrowed money to invest $5,000 in the risky asset. All of the dollar fig- ures in Panel B go up, but the returns remain the same.)

A second way to look at financial leverage is to note that it is a close cousin to operating leverage, defined as the substitution of fixed-cost meth- ods of production for variable-cost methods. Replacing hourly workers with a robot increases operating leverage because the robot’s initial cost pushes up fixed costs, while the robot’s willingness to work longer hours without additional pay reduces variable costs. This produces two effects: Sales required to cover fixed costs rise, but once breakeven is reached, profits grow more quickly with additional sales. Analogously, the substitu- tion of debt for equity financing increases fixed costs in the form of higher interest and principal payments, but because creditors do not share in company profits, it also reduces variable costs. Increased financial leverage thus has two effects as well: More operating income is required

198 Part Three Financing Operations



to cover fixed financial costs, but once breakeven is achieved, profits grow more quickly with additional operating income.

To see these effects more clearly, let’s look at the influence of financial leverage on return on equity. Recall from Chapter 2 that despite some problems, ROE is a widely used measure of financial performance defined as profit after tax divided by owners’ equity. As shown in the following footnote, ROE can be written for our purposes as

where ROIC is the company’s return on invested capital (defined in Chapter 2 as EBIT after tax divided by all sources of cash on which a return must be earned), i� is the after-tax interest rate, (1�t)i, D is interest-bearing debt, and E is the book value of equity.1 You can think of ROIC as the return a company earns before the effects of financial leverage are considered. Looking at i�, recall that because interest is a tax- deductible expense, a company’s tax bill declines whenever its interest expense rises; i� captures this effect.

To illustrate this equation, we can write ROE for Stryker Corporation in 2013 as

ROE � 9.1% � (9.1% � 2.5%) $2,764�$9,047 11.1% � 9.1% � 2.0%

where 2.5 percent is Stryker’s after-tax borrowing rate, $2,764 million is its interest-bearing debt, and $9,047 million is its book value of equity. Stryker earned a basic return of 9.1 percent on its assets, which it levered into an 11.1 percent return on equity by substituting $2,764 million of debt for equity in its capital structure.

This revised expression for ROE is revealing. It shows clearly that the impact of financial leverage on ROE depends on the size of ROIC relative to i�. If ROIC exceeds i�, financial leverage, as measured by D�E, increases ROE. The reverse is also true: If ROIC is less than i�, leverage reduces ROE. In English, the equation states that when a company earns more on borrowed money than it pays in interest, return on equity will rise, and vice versa. Leverage thus improves financial performance when things are going well but worsens performance when things are going poorly. It is the classic fair-weather friend.

ROE = ROIC + (ROIC – i¿) D�E

Chapter 6 The Financing Decision 199

1 Write profit after tax as (EBIT � iD)(1�t), where EBIT is earnings before interest and tax, iD is interest expense—written as the interest rate, i, times interest-bearing debt outstanding, D—and t is the firm’s tax rate. This equation reflects the steps an accountant goes through to calculate profit after tax from EBIT. The rest is algebra, as shown in the following equation:

ROE = (EBIT – iD )(1 – t)

E =

EBIT(1 – t) E

– iD(1 – t)

E = ROIC *

D + E E

– i ¿ D E



And lest you think that earning a return above borrowing cost is an easy target, be aware that in 2013 only 45 percent of the publicly traded, non- financial firms accomplished this feat. Even among larger firms with sales above $200 million, the comparable figure was just 65 percent. In business as in other walks of life, expectations are often unfulfilled.

Figure 6.1 is a graphical representation of the earlier ROE equation. The steeply pitched, solid curve represents a typical distribution of possible ROEs for an all-equity company. Note that the expected ROE is 10 percent and the range of possible outcomes is from a loss of about 12 percent to a gain of 35 percent. The flatter, dotted curve shows the possible ROEs for the same distribution of all-equity returns when the company’s debt-to-equity ratio is 2.0 and the after-tax borrowing rate is 4 percent. Debt financing not only levers the expected ROE from 10 percent up to 22 percent but also greatly broadens the range of possible outcomes. Now a loss of as much as 40 percent or a gain of 80 percent can occur.

For at least two reasons, it is appropriate to think of the range of possi- ble ROEs as a measure of risk. First, a larger range of possible outcomes means greater uncertainty about what ROE the company will earn. Sec- ond, a larger range of possible outcomes means a greater chance of bank- ruptcy. Look at the left-side tails of the two distributions; it is apparent that with zero leverage, the worst the company will do is lose about 12 percent on equity, but with a debt-to-equity ratio of 2 to 1, the same level

200 Part Three Financing Operations

FIGURE 6.1 Leverage Increases Risk and Expected Return

–50 –40 –30 –20 –10 0 10 20 30 40 50 60 70 80 90 100


Debt/equity = 0

Return on equity (%)

Debt/equity = 2



of operating income generates a loss of about 40 percent, more than a threefold increase. In this situation, operating income is not sufficient to cover interest expense, and debt magnifies the loss. If the loss is large enough or persistent enough, bankruptcy can occur. We see again that fi- nancial leverage increases both expected return to owners and risk.

Measuring the Effects of Leverage on a Business

For a practical look at measuring the risks and rewards of debt financing in a corporate setting, let us return to the challenge faced by Stryker Corpo- ration in 2014. Recall from Chapter 2 that Stryker is a stable, profitable company that utilizes its assets efficiently and that, despite recent increases in debt, is conservatively financed. Earnings took a hit in 2013, mainly due to the product liability reserve tied to faulty hip replacements. Its chief financial challenge is what to do with the excess cash it is generating.

Here is my fictionalized account of an important financing decision faced by the company. Suppose that in late 2013 Stryker reaches a tenta- tive agreement to purchase an independent maker of medical implants that it has been coveting for several years. The agreed-upon price is $3 billion, and William Jellison, Stryker’s CFO, must decide how to best fi- nance it. The firm’s investment bankers indicate the company can raise money in either of two ways:

• Sell 40 million new shares of common stock at a net price of $75 a share. • Sell $3 billion of bonds with an interest rate of 5 percent and 10 years to

maturity. The bonds would carry an annual sinking fund of $200 million, with the remaining principal of $1 billion due in a single balloon payment at maturity.

Stryker’s long-term debt has increased from a negligible amount five years ago to $2.8 billion in 2013, a move applauded by several younger members of senior management. In their words, “We were leaving money on the table and shortchanging our shareholders by not levering up this business.” One source of their enthusiasm for debt financing appears to be the perception that higher leverage increases return on equity and earn- ings per share, key determinants of the company’s executive bonuses.

Mr. Jellison is concerned, however, that debt financing for an acquisition of this size, more than doubling total debt outstanding, would put too much strain on the company’s financial resources. Complicating matters is the fact that Stryker just recently acquired MAKO Surgical Corporation for over $1.6 billion, a much larger acquisition than other recent takeovers. However, the board of directors deems this new opportunity too important to pass up and has directed Mr. Jellison to prepare a financing recommendation for

Chapter 6 The Financing Decision 201



consideration at their next board meeting. These executives see the current situation as an ideal opportunity to find the right balance between debt and equity financing.

Looking to the future, Mr. Jellison believes that the acquisition would increase Stryker’s earnings before interest and taxes to about $2 billion in 2014. As shown in the following figures, the company’s EBIT has been quite stable, except for the decline in 2013 due to the product liability problems. Mr. Jellison further anticipates that Stryker’s need for outside financing in coming years will be modest, unless another acquisition op- portunity arises. The company expects to pay annual dividends of $1.22 a share in 2014, and Jellison believes the board would be quite reluctant to reduce this amount in future years.

2006 2007 2008 2009 2010 2011 2012 2013 2014F

EBIT ($ millions) 1,113 1,392 1,611 1,646 1,807 1,780 1,768 1,295 2,000F

F � forecast.

Stryker’s investment bankers have advised Mr. Jellison that due to sub- stantial fixed issue costs, it makes sense to raise the entire amount through a single issuance of debt or equity. It is possible Stryker could ultimately choose to use some of its existing cash to help pay for the acquisition, but Mr. Jellison intends initially to analyze the deal assuming the full purchase price is financed externally.

Table 6.2 presents selected information about the two financing options. The table sets up a “what if” analysis, assuming the deal is completed in early 2014. The information in the left-most column in the table is from Stryker’s 2013 year-end financial statements and is presumed valid into early 2014. The table shows that in the absence of any new financing, Stryker will have $2,764 million in debt outstanding, interest expense of $83 million, and $25 million in principal repayments due. All of these numbers escalate sharply with $3 billion in new debt financing. A new

202 Part Three Financing Operations

TABLE 6.2 Selected Information about Stryker Corporation’s Financing Options in 2014 ($ millions)

2014 Projected

Before New Stock Bond Financing Financing Financing

Interest-bearing debt outstanding $2,764 $ 2,764 $5,764 Interest expense 83 83 233 Principal payments 25 25 225 Shareholders’ equity (book value) 9,047 12,047 9,047 Common shares outstanding 378 418 378 Dividends paid at $1.22 per share 461 510 461



stock issue, on the other hand, will leave these quantities unchanged but will increase common shares outstanding from 378 million to 418 million (418 million � 378 million � $3 billion/$75 per share) and total dividend payments from $461 to $510 million ($510 million � 418 million shares � $1.22 per share).

Leverage and Risk Mr. Jellison’s first task in analyzing the financing options should be to decide if Stryker can safely carry the financial burden imposed by the new debt. The best way to do this is to compare the company’s forecasted operating cash flows to the annual financial burden imposed by the debt. There are two ways to do this: construct pro forma financial forecasts of the type discussed in Chapter 3, perhaps augmented by sensitivity analysis and simulations, or more simply, calculate several coverage ratios. To provide a flavor of the analysis without repeating much of Chapter 3, I will confine discussion here to coverage ratios on the understanding that if real money were involved, de- tailed financial forecasting would be the order of the day. Because coverage ratios were treated in Chapter 2, our discussion can be brief.

The before- and after-tax burdens of Stryker’s financial obligations under the two financing options appear in the top portion of Table 6.3. Recall that because we want to compare these financial obligations to the company’s EBIT, a before-tax number, we must gross up the after-tax amounts to their

Chapter 6 The Financing Decision 203

TABLE 6.3 Stryker Corporation’s Projected Financial Obligations and Coverage Ratios in 2014 ($ millions)

Expected EBIT � $2,000 Tax rate � 0.35

Financial Obligations

Stock Bonds

After Tax Before Tax After Tax Before Tax

Interest expense $ 83 $233 Principal payment $ 25 $ 38 $225 $346 Common dividends $510 $785 $461 $709

Coverage Ratios

Stock Bonds

Percentage EBIT Percentage EBIT Coverage Can Fall Coverage Can Fall

Times interest earned 24.1 96% 8.6 88% Times burden covered 16.5 94% 3.5 71% Times common covered 2.2 55% 1.6 36%



before-tax equivalents. This involves dividing the after-tax numbers by (1� t) where t is the company’s tax rate. For this analysis t � 35%.

Three coverage ratios, corresponding to the progressive addition of each financial obligation listed in Table 6.3, appear in the bottom portion of the table for a projected EBIT of $2,000 million. To illustrate the calculation of these ratios, “times common covered” equals $2,000 million EBIT divided by the sum of all three financial burdens stated in before-tax dollars. (For the bond financing option, 1.6 � 2,000�[233 � 346 � 709].) Note that our analysis here is not an incremental one. We are interested in the total burden imposed by new and existing debt, not just that of the new borrowings.

The column headed “Percentage EBIT Can Fall” offers a second way to interpret coverage ratios. It is the percentage amount that EBIT can de- cline from its expected level before coverage drops to 1.0. For example, in- terest expense with bond financing is $233 million; thus, EBIT can fall from $2,000 million to $233 million, or 88 percent, before times interest earned equals 1.0. A coverage of 1.0 is critical, because any lower coverage indicates that operating income will be insufficient to cover the financial burden under consideration, and another source of cash must be available.

As expected, these figures confirm the greater risk inherent in debt financing. In every instance, Stryker’s coverage of its financial obligations will be worse with debt financing than without. In fact, with debt financ- ing, a decline in EBIT of only 36 percent from the projected level will put the company’s dividend in jeopardy. Although missing a dividend payment is admittedly less catastrophic than missing an interest or principal pay- ment, it is still an eventuality most companies would just as soon avoid. At the same time, this risk may be an entirely manageable one for Stryker in light of its previously noted operating stability. Even with charges related to the product recalls in 2013, its EBIT only declined 27 percent.

To put these numbers in further perspective, Mr. Jellison will next want to compare them with various industry figures. As an example, the top part of Table 6.4 shows debt-to-asset and times-interest-earned ratios over the past decade for nonfinancial companies in the Standard & Poor’s 500 stock index, while the bottom part shows the same information by selected industry in 2013. Note that both ratios show declining indebtedness until 2007 when a weakening economy and attractive interest rates lead to a reversal in the trend. Mr. Jellison will be especially interested in the numbers for the “health care” industry, of which Stryker is a member. Stryker’s projected 8.6 times in- terest earned with debt financing is below the industry figure of 12.6, while the corresponding number for stock financing of 24.1 will be well above.

Table 6.5 offers a second comparison. It shows the variation in key per- formance ratios across Standard & Poor’s bond-rating categories in the 2010 through 2012 time period. Note that the median times-interest-earned ratio

204 Part Three Financing Operations



Chapter 6 The Financing Decision 205

TABLE 6.4 Median Nonfinancial Corporate Debt Ratios 2004–2013 and Industry Debt Ratios 2013

Nonfinancial companies in the Standard and Poor’s 500 index and industry components. (Numbers in parentheses are the number of companies in sample.)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Debt to total assets* (%) 20 20 19 21 24 23 23 23 25 25 Times interest earned 9.2 10.9 9.9 8.9 8.9 7.1 9.0 9.9 9.2 9.4

Industry Debt Ratios 2013

Debt to Total Assets (%) Times Interest Earned

Energy (44) 24 6.1 Materials (31) 29 7.4 Industrials (64) 24 11.2 Consumer discretionary (84) 24 8.6 Consumer staples (41) 30 11.1 Health care (54) 24 12.6 Information technology (65) 15 13.9 Telecommunicaton services (5) 40 2.2 Utilities (30) 35 3.1

*All interest-bearing debt; all quantities measured at book value.

TABLE 6.5 Median Values of Key Ratios by Standard & Poor’s Rating Category

Source: David K. Lugg, “CreditStats: 2012 Adjusted Key U.S. and European Industrial and Utility Financial Ratios,” copyright 2012 by Standard and Poor’s.

(Industrial long-term debt, three-year figures, 2010–2012)


Times interest earned (X) 44.4 26.5 12.8 6.3 3.5 1.5 EBITDA interest coverage (X) 48.0 32.8 16.7 8.5 5.3 2.5 Funds from operations/total debt (%) 302.5 86.9 50.3 33.9 24.6 12.7 Pretax return on capital (%) 29.7 21.5 20.5 13.7 11.5 8.3 Debt/debt plus equity (%) 12.1 21.8 36.0 42.9 51.6 74.3

Number of companies 4 13 97 223 251 270 Percent of sample companies (%) 0.5 1.5 11.3 26.0 29.3 31.5

Variable definitions: EBITDA � Earnings before interest, taxes, depreciation, and amortization. Funds from operations � Net income from continuing operations plus depreciation, amortization, deferred

income taxes, and other noncash items. Pretax return on capital � EBIT/average of beginning and ending capital, including short-term debt, current

maturities, long-term debt (including amount for operating lease debt equivalent), non-current deferred taxes, and equity.

Note: These ratings are not meant to be benchmarks for any rating category.



falls steadily across the rating categories, from a high of 44.4 times for AAA companies down to 1.5 times for B firms. By this yardstick, Stryker’s prospective coverage ratio of 8.6 times with bonds would put it in the strong BBB range.

Leverage and Earnings Our brief look at Stryker’s coverage ratios under the two financing op- tions suggests that a $3 billion bond offering is at least feasible. Next, let’s see how the two financing schemes are likely to affect reported income and return on equity. Mr. Jellison can do this by looking at the company’s projected income statement under the two options. Ignoring for the moment the possibility that the company’s financing choice might affect its sales or operating income, Mr. Jellison can begin his analysis with projected EBIT. Table 6.6 shows the bottom portion of a 2014 pro forma income statement for Stryker under boom and bust conditions. Bust cor- responds to a recessionary EBIT of $600 million, while boom represents a healthy EBIT of $2,800 million.

Several noteworthy observations emerge from these figures. One in- volves the tax advantage of debt financing. Observe that Stryker’s tax bill is always $53 million lower under bond financing than under the alterna- tive, leaving more operating income to be divided among owners and creditors. It is as if the government pays companies a subsidy, in the form of reduced taxes, to encourage the use of debt financing. Letting t be the company’s tax rate and I its interest expense, the subsidy equals $tI annu- ally. Many believe this subsidy, frequently referred to as the interest tax

206 Part Three Financing Operations

TABLE 6.6 Stryker Corporation’s Partial Pro Forma Income Statements in 2014 under Bust and Boom Conditions ($ millions except EPS)

Bust Boom

Stock Bonds Stock Bonds

EBIT $ 600 $ 600 $ 2,800 $ 2,800 Interest expense 83 233 83 233______ _____ ______ ______ Earnings before tax 517 367 2,717 2,567 Tax at 35% 181 128 951 898______ _____ ______ ______ Earnings after tax $ 336 $ 239 $ 1,766 $ 1,669

Number of shares 418 378 418 378 Earnings per share $ 0.80 $ 0.63 $ 4.23 $ 4.41______ _____ ______ ____________ _____ ______ ______

Book value of equity 12,047 9,047 12,047 9,047 Return on equity 2.8% 2.6% 14.7% 18.4%



Chapter 6 The Financing Decision 207

shield from debt financing, is a chief attraction of debt financing. It is avail- able to any company using debt financing provided only that it has suffi- cient taxable income to shield.

A second observation is that debt financing reduces earnings after tax, an apparent disadvantage to debt. However, it is important to realize that this is only half the story, for although debt financing does reduce earn- ings after tax, it also reduces shareholders’ investment in the firm. And personally, I would rather earn $90 on a $500 investment than $100 on a $1,000 investment. To capture both effects, it is useful to look at earnings per share and return on equity, two widely tracked indicators of equity performance. First, examining the boom conditions in Table 6.6 we see the expected effect of leverage on shareholder performance: EPS with debt financing is 4 percent higher than with equity, while ROE is a robust 25 percent higher. Under bust conditions, however, the reverse is true: Stock financing in difficult times produces a higher EPS and ROE than debt. This corresponds to our earlier example when the return on in- vested capital (ROIC) was less than the after-tax interest rate.

To display this information more informatively, Mr. Jellison can construct a range of earnings chart relating either ROE or EPS to EBIT. To do so using ROE, he need only plot the EBIT–ROE pairs calculated in Table 6.6 on a graph and connect the appropriate points with straight lines. Figure 6.2 shows the resulting range of earnings chart for Stryker. It presents the

FIGURE 6.2 Range of Earnings Chart for Stryker Corporation









36000 400 800 1200 1600 2000 2400 2800 3200

Earnings before interest and taxes (EBIT) ($ millions)

R et

ur n

on e

qu ity

( R



Crossover point EBIT = $690 million

B oo

m E


Stock financing

Bond financing

23% higher ROE with bonds

B us

t E B


E xp

ec te

d E




return on equity Stryker will report for any level of EBIT under the two fi- nancing options. Consistent with our boom-bust pro formas, note that the debt financing line passes through a ROE of 2.6 percent at $600 million EBIT and 18.4 percent at $2,800 million EBIT, while the corresponding fig- ures for stock financing are 2.8 percent and 14.7 percent, respectively.

Mr. Jellison will be particularly interested in two aspects of the range of earnings chart. One is the increase in ROE Stryker will report at the ex- pected EBIT level if the company selects bonds over stock financing. As the graph shows, this increase will be an attractive 23 percent at the ex- pected EBIT of $2 billion. Mr. Jellison will also observe that in addition to generating an immediate increase in ROE, bond financing puts Stryker on a faster growth trajectory. This is represented by the steeper slope of the bond financing line. For each dollar Stryker adds to EBIT, ROE will rise more with bond financing than with equity. Unfortunately, the re- verse is also true: For each dollar EBIT declines, ROE will fall more with bond financing than with equity financing.

The second aspect of the range of earnings chart that will catch Mr. Jellison’s eye is that debt financing does not always yield a higher ROE. If Stryker’s EBIT falls below a critical crossover value of $690 million, ROE will actually be higher with stock financing than with bonds. Stryker’s expected EBIT is comfortably above the crossover value today and past EBIT has been quite stable, but there are no guarantees going forward. Higher ROE with bond financing is clearly not a certainty.

How Much to Borrow

Coverage ratios, pro forma forecasts, and range of earnings charts yield important information about Stryker’s ability to support various amounts of debt and about the effect of different debt levels on shareholder returns and earnings. With this foundation, it is now time to confront the chap- ter’s central question: How do we determine what level of debt financing is best for a firm? How does William Jellison decide whether Stryker should issue debt or equity? There is general agreement that the purpose of a firm’s financing decision should be to increase firm value. But what does this imply for specific financing decisions? As noted earlier, the cur- rent state of the art will not enable us to answer this question definitively. We can, however, identify the key decision variables and suggest practical guides to Mr. Jellison’s deliberations.

Irrelevance Speaking broadly, there are two possible channels by which financing de- cisions might affect firm value: by increasing the value investors attach to

208 Part Three Financing Operations



a given stream of operating cash flows, or by increasing the amount of the cash flows themselves. Some years ago, two economists eliminated the ap- parently more promising first channel. Franco Modigliani and Merton Miller, known universally today as M&M, demonstrated that when ex- pected operating cash flows are unchanged, the amount of debt a com- pany carries has no effect on its value and, hence, should be of no concern to value-maximizing managers or their shareholders. In their provocative words, when cash flows are constant, “the capital structure decision is ir- relevant.” In terms of risk and return, M&M demonstrated that what’s im- portant is the aggregate amount of each, not how they are divided up among shareholders and creditors.

Note the irony here. Questions of risk and return are centrally impor- tant to individuals. Strongly risk-averse people will prefer safe equity financing, while risk-indifferent folks will prefer debt. And, if financing choices are so important at the individual level, it seems only natural to conclude they must also be important to firms. However, this conclusion does not necessarily follow. Indeed, the genius of M&M’s irrelevance proposition is to demonstrate that under certain conditions, firm financing choices need not affect value—despite the importance of financing deci- sions in our personal lives.

Intuitively, M&M’s irrelevance argument comes down to this: Compa- nies own physical assets, like trucks and buildings, and owe paper liabili- ties, like stocks and bonds. A company’s physical assets are the true creators of value, and as long as the cash flows from these assets stay con- stant, it is hard to imagine how simply renaming paper claims to the cash flows could create value. The company is worth no more with one set of paper claims than another.

Just for good measure, here is a second intuitive argument supporting the M&M irrelevance proposition, based on what is known as “home- made” leverage. It rests on the observation that investors have two ways to lever an investment: They can rely on the company to borrow money, or they can borrow money themselves and buy the stock on margin. It is like a boat with two tillers, and whatever leverage tack the company takes with its corporate financing decision, the investor can override with her home- made decision. But if investors can readily substitute homemade leverage for corporate leverage, why would they care how much debt the company employs? How could firm leverage affect its value? (See the appendix to this chapter for more on the irrelevance proposition and homemade lever- age, including a numerical example.)

No rational executive believes M&M’s irrelevance proposition is liter- ally true, but most acknowledge it to be the starting point for practical con- sideration of how financing decisions affect firm value. By demonstrating

Chapter 6 The Financing Decision 209

See view_with_Merton_Miller for a candid interview with Mer- ton Miller on the M&M theory and his philosophy of personal investing. See also interviews with Gene Fama, Bill Sharpe, and Rex Sinquefield.



that renaming paper claims to a firm’s cash flows alone does not affect value, M&M direct our attention to the second channel by which financing decisions might affect firm value. They thus confirm that firm financing decisions are important to the extent that they affect the amount of the cash flows themselves, and that the best capital structure is the one that maxi- mizes these flows. To decide whether Stryker should issue debt or equity, William Jellison needs to consider how the change in debt will affect com- pany cash flows.

In the following pages, we examine five ways in which a company’s fi- nancing decision can affect its cash flows. With a nod to Michael Porter, Figure 6.3 presents these forces as part of what I will modestly call the Higgins 5-Factor Model. The figure also shows each factor’s direction of influence when considered in isolation. Thus, tax benefits considered alone suggest more debt financing, while distress costs caution more equity. Mr. Jellison’s job is to consider each of these five factors in light of Stryker’s specific circumstances, and come to a reasoned judgment about their collective effect on company cash flows.

Tax Benefits The tax advantages of debt financing are readily apparent. As noted in Table 6.6, Stryker’s tax bill falls $53 million annually when it increases debt by $3 billion—a clear benefit to the firm and its owners. As Warren Buffett so deftly put it, back in the days of a 48 percent corporate tax rate, “If you

210 Part Three Financing Operations

FIGURE 6.3 The Higgins 5-Factor Model for Financing Decisions

*Technically, market signaling affects investor perceptions of company cash flows, not the cash flows themselves. However, this distinction is not important for present purposes.

Financing Decisions

Management incentives

Distress costs

Tax benefits








can eliminate the federal government as a 48 percent partner in your busi- ness, it’s got to be worth more.” As the tax bill goes down, the cash flow available for distribution to owners and creditors rises dollar for dollar.

Distress Costs One popular perspective on selecting an appropriate debt level views the decision as a trade-off between the just-noted tax advantages of debt financing and various costs a company incurs when it uses too much debt. Collectively, these costs are known as the costs of financial distress. According to this view, the tax benefits of debt financing predominate at low debt levels, but as debt increases, the costs of financial distress grow to the point where they outweigh the tax advantages. The appropriate debt level, then, involves a judicious balancing of these offsetting costs and benefits.

The costs of financial distress are more difficult to quantify than the benefits of increased interest tax shields, but they are no less important to financing decisions. These costs come in at least three flavors, which we will review briefly under the headings of bankruptcy costs, indirect costs, and conflicts of interest.

Bankruptcy Costs The expected cost of bankruptcy equals the probability bankruptcy will occur times the costs incurred when it does. As a glance at Stryker’s cov- erage ratios attests, an obvious problem with aggressive debt financing is that rising debt levels increase the probability the business will be unable

Chapter 6 The Financing Decision 211

Changing Attitudes Toward Bankruptcy In recent decades, the public purpose of the bankruptcy process in the United States has shifted somewhat from protecting the rights of creditors toward protecting those of workers, communities, and society at large. Two things have changed in response. One is that creditors have factored the likelihood of greater losses in bankruptcy into their loan pricing by demanding higher rates. The other is that many managers have changed their attitude toward bankruptcy. Bankruptcy was once seen as a black hole in which companies were clumsily dismembered for the benefit of creditors and shareholders lost everything. Today, some executives view it as a quiet refuge where the courts keep creditors at bay while management works on its problems. Manville Corporation was the first company to see the virtues of bankruptcy in August 1982, when, although solvent by any conven- tional definition, it declared bankruptcy in anticipation of massive product liability suits involving as- bestos. Continental Airlines followed in September 1983, using bankruptcy protection to abrogate what it considered ruinous labor contracts. Subsequently, A. H. Robbins and Texaco, among others, have found bankruptcy an inviting haven while wrestling with product liability suits and a massive legal judgment, respectively. In all these instances, the companies expected to emerge from bank- ruptcy healthier and more valuable than when they entered.



to meet its financial obligations. With high debt, what might otherwise be a modest downturn in profits can turn into a contentious bankruptcy as the company finds itself unable to make interest and principal payments in a timely manner.

While this is not the place for a complete review of bankruptcy laws and procedures, two points are worth making. First, bankruptcy does not neces- sarily imply liquidation. Many bankrupt companies are able to continue op- erations while they reorganize their business and are eventually able to leave bankruptcy and return to normal life. Second, bankruptcy in the United States is a highly uncertain process. For once in bankruptcy, a company’s fate rests in the hands of a bankruptcy judge and a multitude of attorneys, each representing an aggrieved party and each determined to pursue the best interests of his or her client until justice is done or the money runs out. Bankruptcy today is thus akin to a high-stakes poker game in which the only certain winners are attorneys. And, depending on their luck, managers and owners can come away with a revitalized business or next to nothing.

Increased debt clearly heightens the probability of bankruptcy, but this is not the whole story. The other important consideration is the cost to the business if bankruptcy does occur. If bankruptcy involves only a few amicable meetings with creditors to reschedule debt, there is little need to limit borrowing to avoid bankruptcy. On the other hand, if bankruptcy spells immediate liquidation at fire-sale prices, aggressive borrowing is obviously foolhardy. A key factor in determining the cost of bankruptcy to an individual company is what can be called the “resale” value of its assets. Two simple examples will illustrate this notion.

First, suppose ACE Corporation’s principal asset is an apartment com- plex and, due to local overbuilding and overly aggressive use of debt financing, ACE has been forced into bankruptcy. Because apartment com- plexes are readily salable, the likely outcome of the proceedings will be the sale of the complex to a new owner and distribution of the proceeds to creditors. The cost of bankruptcy in this instance will be correspondingly modest, consisting of the obvious legal, appraisal, and court costs, plus whatever price concessions are necessary to sell the apartments. In sub- stance, because bankruptcy will have little effect on the operating income generated by the apartment complex, its costs will be relatively low, and ACE can justify aggressive debt financing.

Note that the cost of bankruptcy here does not include the difference be- tween what ACE and its creditors originally thought the apartments were worth and their value just prior to bankruptcy. This loss is due to over- building, not bankruptcy, and is incurred by the firm regardless of how it is financed or whether or not it declares bankruptcy. Even all-equity financ- ing, while it may prevent bankruptcy, will not eliminate this loss.

212 Part Three Financing Operations



At the other extreme, Moletek is a genetic engineering firm whose chief assets are a brilliant research team and attractive growth opportuni- ties. If Moletek stumbles into bankruptcy, the cost is likely to be very high. Selling the company’s assets individually in a liquidation will generate lit- tle cash because most of the assets are intangible. It will also be difficult to realize value by keeping the company intact, either as an independent firm or in the hands of a new owner, for in such an unsettled environment it will be hard to retain key employees and to raise the funds needed to ex- ploit growth opportunities. In essence, because bankruptcy will adversely affect Moletek’s operating income, its costs are likely to be high and Moletek would be wise to use debt sparingly.

In sum, our brief overview of bankruptcy costs suggests that they vary with the nature of a company’s assets. If the resale value of the assets is high either in liquidation or when sold intact to new owners, bankruptcy costs are correspondingly modest. Such firms should be expected to make liberal use of debt financing. Conversely, when resale value is low because the assets are largely intangible and would be difficult to sell intact, bank- ruptcy costs are comparatively high. Companies matching this profile should use more conservative financing.

Another way to say the same thing is to suggest that the value of a com- pany is composed of two types of assets: physical assets in place, and growth options. Growth options are the exciting investment opportuni- ties a firm is positioned to undertake in coming years. While physical as- sets tend to retain value in times of financial distress, growth options clearly do not. Consequently, companies with valuable growth options are ill advised to use aggressive debt financing.

Indirect Costs In addition to direct bankruptcy costs, companies frequently incur a num- ber of more subtle indirect costs as the probability of bankruptcy grows. These costs are especially troublesome because they can be mutually rein- forcing, causing a chain reaction in which one cost feeds on another. In- ternally, these costs include lost profit opportunities as management cuts back investment, R&D, and marketing to conserve cash. Externally, they include lost sales as customers become concerned about future parts and service availability, higher financing costs as investors worry about future payments, and increased operating costs as suppliers become reluctant to make long-run commitments or to provide trade credit. Lost sales and in- creased costs, in turn, pressure management to become even more con- servative, risking further losses. And if this weren’t enough, competitors, tasting blood in the water, are inclined to initiate price wars and to com- pete more aggressively for the company’s customers.

Chapter 6 The Financing Decision 213



Trade creditors in certain industries show an especially strong propen- sity to cut and run. With a portfolio of perhaps thousands of small-ticket receivables to manage, these suppliers are unwilling to work with ailing customers and instead rush for the exits at the first sign of trouble. With a conservative management, restless customers, aggressive competitors, and flighty suppliers, the slope between financial health and bankruptcy can be a slippery one.

Conflicts of Interest Managers, owners, and creditors in healthy companies usually share the same fundamental objective: to see the business prosper. When a com- pany falls into financial distress, however, this harmony can evaporate as the various parties begin to worry more about themselves than the firm. The resulting conflicts of interest are a third potential cost of aggressive debt financing. Here is an example of one such conflict. It is known as the overinvestment problem, but might more aptly be called the “go-for- broke” problem.

XYZ Company is in serious financial difficulty due to over-borrowing, and shareholders’ equity is almost worthless. Realizing that sharehold- ers are about to be wiped out, an opportunistic banker proposes a wildly risky investment scheme. Under normal conditions, the company would never consider the investment, but it presently offers one com- pelling attraction: a small chance at a very large payoff. Shareholders look at the scheme and reason, “This is a truly bad investment, but if we do nothing, our shares will likely end up worthless, while if we make this investment, there is at least a small chance of hitting the jackpot. Then we can settle our debts, and walk away with a little something for ourselves. So what have we got to lose? Let’s go for broke.” This rea- soning accurately describes the U.S. savings and loan industry in the late 1980s when many owners, faced with the near certainty their equity would soon be wiped out, took wild risks with depositors’ money in the hope of a big score.2

So what do these musings about the relative importance of taxes and financial distress costs imply about how to finance a business? Our analysis suggests that managers should consider the following three firm-specific factors when making financing choices:

1. The ability of the company to utilize additional interest tax shields over the life of the debt.

214 Part Three Financing Operations

2 Underinvestment problems can also arise in near-bankrupt companies when managers knowingly forgo attractive, safe investment opportunities because too much of the benefits accrue to creditors instead of shareholders.



2. The increased probability of incurring financial distress costs created by any new leverage.

3. The magnitude of the distress costs should they occur.

Applying this checklist to Stryker, we can say that the first consideration should be no barrier to increased debt in as much as the company appears to have plenty of income to take advantage of the increased interest tax shields. Similarly, the company’s past income stability suggests the in- creased chance of incurring financial distress due to the new, higher debt level is probably not excessive. Finally, the distress costs incurred by Stryker, if it were to have difficulty servicing the new debt, appear moder- ate. The company is not seasonal and does not appear dependent on po- tentially nervous supplier credit. Furthermore, a price war is not likely inasmuch as innovation and product quality seem more important selling points than price. On the other hand, given its medical technology focus, it’s likely that a substantial part of Stryker’s value comes from growth options. Stryker may find it difficult to attract and retain talented research scientists in the face of potential financial distress. Similarly, customers may be unwilling to purchase surgical equipment or orthopedic products if there is any doubt Stryker will be around to honor long-term service contracts or warranties.

Flexibility The tax benefits–distress costs perspective treats financing decisions as if they were one-time events. Should Stryker raise cash today by selling debt or equity? A broader perspective views such individual decisions within the context of a longer-run financing strategy that is shaped in large part by the firm’s growth potential and its access to capital markets over time.

At one extreme, if a firm has the rare luxury of always being able to raise debt or equity capital on acceptable terms, its decision is straight- forward. The company can simply select a target capital structure premised on consideration of long-run tax benefits and distress costs and then base specific debt-equity choices on the proximity of its existing capital structure to the target. If the existing debt level is below target, debt financing is the obvious choice. If the current debt level is above tar- get, time to issue equity.

In the more realistic case where continuous access to capital markets is not guaranteed, the decision becomes more complex. For now manage- ment must worry not only about long-run targets but also about how today’s decision might affect future access to capital markets. This is the notion of financial flexibility: the concern that today’s decision not jeop- ardize future financing options.

Chapter 6 The Financing Decision 215



To illustrate the importance of financial flexibility to certain firms, con- sider the challenges faced by XYZ Enterprises, a rapidly growing business in continuing need of external financing. Even when an immediate debt issue appears attractive, XYZ management must understand that extensive reliance of debt financing will eventually “close off the top,” meaning added debt financing would no longer be available without a proportional increase in equity. (Top as used here refers to the top portion of the liabil- ities side of an American balance sheet. British balance sheets show equity on top of liabilities, but then they drive on the wrong side too.) Having thus reached its debt capacity, XYZ would find itself dependent on the equity market for any additional external financing over the next few years. This is a precarious position because equity can be a fickle source of financing. Depending on market conditions and recent company per- formance, equity may not be available at a reasonable price—or indeed any price. And XYZ would then be forced to forgo attractive investment opportunities for lack of cash. This could prove very expensive, because the inability to make competitively mandated investments can result in a permanent loss of market position. On a more personal note, the CFO’s admission that XYZ must pass up lucrative investment opportunities be- cause he cannot raise the money to finance them will not be greeted warmly by his colleagues. Consequently, a concern for financing future growth suggests that XYZ avoid over-reliance on debt financing, thereby maintaining financial flexibility to meet future contingencies.

The situation is more extreme for most small companies and many larger ones that are unable or unwilling to sell new equity. For these firms the financing decision is not whether to issue debt or equity, but whether to issue debt or restrict growth. Of necessity, these companies need to place their financing decision in the larger context of managing growth. Recall from Chapter 4 that when a company is unable or unwilling to sell new equity, its sustainable growth rate is

where P, R, A, and are profit margin, retention ratio, asset turnover ratio, and financial leverage, respectively. In this equation, P and A are de- termined on the operating side of the business. The financial challenge for these companies is to develop dividend, financing, and growth strategies that enable the firm to expand at an appropriate rate without using too much debt or resorting to common stock financing.

An executive student of mine once told me I would never do anything entrepreneurial because “you know too much about what could go wrong.” In the case of debt financing, I am inclined to agree. Too many entrepreneurs, convinced of the eventual success of their endeavors,


216 Part Three Financing Operations



appear to view debt as an unmitigated blessing. In their eyes, debt’s only attribute is that it enables them to expand the size of their empire beyond their own net worth; thus, their growth management strategy becomes to borrow as much money as creditors will lend. In other words, they maxi- mize in the preceding equation. Delegating the financing decision to creditors certainly simplifies life, but it also unwisely puts a critical man- agement decision in the hands of self-interested outsiders. The smarter approach is to select a prudent capital structure and manage the firm’s growth rate to lie within this constraint.

Market Signaling Concern for future financial flexibility customarily favors equity financing today. A persuasive counterargument against equity financing, however, is the stock market’s likely response. In Chapter 4, we mentioned that on balance, U.S. corporations do not make extensive use of new equity fi- nancing and suggested several possible explanations for this apparent bias. It is time now to discuss another.

Academic researchers have explored the stock market’s reaction to var- ious company announcements regarding future financing, and the results make fascinating reading. Performing event studies similar to the one de- scribed in Chapter 5 on thousands of common stock offerings, researchers have consistently found that a large majority of companies experience a decline in stock price averaging two to three percent, and that the declines cannot reasonably be attributed to chance.3


Chapter 6 The Financing Decision 217

Reverse Engineering the Capital Structure Decision Most companies select or stumble into a particular capital structure and then pray the rating agencies will treat them kindly when rating the debt. A growing number of businesses, however, are reverse en- gineering the process: first selecting the bond rating they want and then working backward to estimate the maximum amount of debt consistent with the chosen rating. Several consulting companies facili- tate this effort by selling proprietary models—based on the observed pattern of past rating agency decisions—for predicting what bond rating a company will receive at differing debt levels.

The appeal of reverse engineering the capital structure decision is twofold. First, it reveals how much more debt a company can take on before suffering a rating downgrade. This is important informa- tion to businesses concerned about overuse of debt and to those interested in increasing the interest tax shields associated with debt financing. Second, it eliminates all speculation about how creditors will re- spond to a particular financing decision, enabling executives to focus instead on the more concrete question of what credit rating is appropriate for their company given its current prospects and strategy.

3 See, for example, Jay Ritter, “Investment Banking and Securities Issuance,” in G. Constantinides, M. Harris, and R. Stulz (Eds.), Handbook of Economics of Finance, 2003. Amsterdam, The Netherlands: North Holland.



On the surface, a loss of two to three percent of market value may not sound like much. But when measured relative to the amount of money to be raised, the loss is quite startling. In their pioneering study of 531 com- mon stock offerings between 1963 and 1981, Paul Asquith and David Mullins showed that announcement losses average more than 30 percent of the size of the new issue.4 To put this number in perspective, a 30 percent loss means that a company planning a $100 million equity issue can expect to suffer a $30 million decline in market value when it announces the sale. For the worst six percent of the issues in the Asquith and Mullins study, the unhappy companies actually lost more in market value from the an- nouncement effect than they hoped to raise from the issue itself.

To complete the picture, similar studies of debt announcements have not observed the adverse price reactions found for equity financing. Fur- ther, it appears that equity announcements work both ways; that is, a com- pany’s announcement of its intention to repurchase some of its shares is greeted by a significant increase in stock price.

Why do these price reactions occur? Several explanations exist. One, suggested most often by executives and market practitioners, attributes the observed price reactions to dilution. According to this reasoning, a new equity issue slices the corporate pie into more pieces and reduces the portion of the pie owned by existing shareholders. It is therefore natural that the shares existing shareholders own will be worth less. Conversely, when a company repurchases its shares, each remaining share represents ownership of a larger portion of the company and hence is worth more.

Other observers, including yours truly, remain unconvinced by this rea- soning, pointing out that while an equity issue may be analogous to slicing a pie into more pieces, the pie also grows by virtue of the equity issue. When a company raises $100 million in new equity, it is clearly worth $100 million more than before the issue. And there is no reason to expect that a smaller slice of a larger pie is necessarily worth less; nor is there any reason to expect remaining shareholders to necessarily gain from a share repurchase. True, each post-repurchase share represents a larger percentage ownership claim, but the repurchase also reduces the size of the company.

A more intriguing explanation involves what is known as market signal- ing. Suppose, plausibly enough, that Stryker’s top managers know much more about their company than do outside investors, and consider again Stryker’s range of earnings chart in Figure 6.2. Begin by reflecting on which option you would recommend if, as Stryker’s chief financial officer, you

218 Part Three Financing Operations

4 Paul Asquith and David Mullins, Jr., “Equity Issues and Offering Dilution,” Journal of Financial Economics, January–February 1986, pp. 61–89.



were highly optimistic about the company’s performance in coming years. After a thorough analysis of the market for Stryker’s products and its com- petitors, you are confident that EBIT can only grow over the next decade. If you have been awake the last few pages, you will know that the most at- tractive option in this circumstance is debt financing. The higher debt level produces a higher ROE today and puts the company on a steeper growth trajectory. Moreover, growing operating income will make it eas- ier to support the higher financial burden of the debt.

Now reverse the exercise and consider which option you would recom- mend if you were concerned about Stryker’s prospects, fearing that future EBIT might well decline. In this scenario, equity financing is the clear winner because of its superior coverage and higher ROE at low operating levels.

But if those who know the most about a company prefer debt when the future looks bright and equity when it looks grim, what does an equity an- nouncement tell investors? Right: It signals the market that management is concerned about the future and has opted for the safe financing choice. Is it any wonder, then, that stock price falls on the announcement and that many companies are reluctant to even mention the “E” word, much less sell it?

The market signal conveyed by a share repurchase announcement is just the reverse. Top management is optimistic about the company’s future prospects and perceives that current stock price is inexplicably low, so low that share repurchase constitutes an irresistible bargain. A repurchase an- nouncement therefore signals good news to investors, and stock price rises.

A more Machiavellian view, which nonetheless comes to the same con- clusion, sees management as exploiting new investors by opportunisti- cally selling shares when they are overpriced and repurchasing them when they are underpriced. But regardless of whether management elects to sell new equity because it is concerned about the company’s future or because it wants to gouge new investors, the signal is the same: New equity announcements are bad news and repurchase announcements are good news.

The need to sell equity at a discount is an example of what economists call the “lemons problem.” Whenever the seller of an asset knows more about it than a buyer, the buyer, fearing she is being offered a lemon, will only purchase the asset at a bargain price. And the greater the information disparity between seller and buyer, the greater the discount will have to be. Your neighbor, who is trying to sell his month-old Mercedes, might be telling the truth when he says he only wants to sell it because he changed his mind about the color. But then again, maybe he is not. Maybe the car has serious problems he is not revealing. Maybe it’s a lemon. To guard against this possibility, a wise but uninformed buyer will only buy the car

Chapter 6 The Financing Decision 219



at a steep discount from the original price. Moreover, wise sellers, know- ing they can only sell almost-new cars at a steep discount, will get used to the color, which, in turn, only increases the odds that the remaining almost-new cars for sale really are lemons.

Stewart Myers of MIT reasons that this lemons problem encourages companies to adopt what he calls a “pecking order” approach to financ- ing.5 At the top of the pecking order as the most preferred means of fi- nancing are internal sources, retained profits, depreciation, and excess cash accumulated from past profit retentions. Companies prefer internal financing sources because they avoid the lemons problem entirely. Exter- nal sources are second in order of preference, with debt financing domi- nating equity because it is less likely to generate a negative signal. Or said differently, debt is preferred to equity because the information disparity between seller and buyer is less with debt, resulting in a smaller lemons problem. The financing decision, then, essentially amounts to working progressively down this pecking order in search of the first feasible source. Myers also notes that the observed debt-to-equity ratios of such pecking- order companies are less a product of a rational balancing of advantages and disadvantages of debt relative to equity and more the aggregate result over time of the company’s profitability relative to its investment needs. Thus, high-profit-margin, modestly growing companies can get away with little or no debt, while lower-margin, more rapidly expanding busi- nesses may be forced to live with higher leverage ratios.

Management Incentives Incentive effects are not relevant in most financing decisions, but when relevant, their influence can be dominating.

Managers in many companies enjoy a degree of autonomy from owners. And human nature being what it is, they are inclined to use this autonomy to pursue their own interests rather than those of owners. This separation of ownership and control enables managers to indulge their personal pref- erences for such things as retaining profits in the business rather than re- turning them to owners, pursuing growth at the expense of profitability, and settling for satisfactory performance rather than excellence.

A virtue of aggressive debt financing in some instances is that it can re- duce the gap between owners’ interests and those of managers. The me- chanics are simple. When a company’s interest and principal repayment burden is high, even the most recalcitrant manager understands that he must generate healthy cash flows or risk losing the business and his job. With creditors breathing down their necks, managers quickly find there is

220 Part Three Financing Operations

5 Stewart C. Myers, “The Capital Structure Puzzle,” Journal of Finance, July 1984, pp. 575–592.



no room for ill-advised investments or less than maximum effort. As dis- cussed in more detail in Chapter 9, leveraged buyout firms have found that aggressive debt financing, especially when combined with significant management ownership, can create powerful incentives to improve per- formance. Ownership in such highly levered companies serves as a carrot to encourage superior performance, while the high debt level is a stick to punish inferior performance.

The Financing Decision and Growth We have examined five ways in which a company’s financing choices can affect its cash flows and hence its value. The art of the financing decision is to weigh the relative importance of these five forces for the specific firm. To illustrate the process, let’s consider what these forces suggest about how debt levels should vary with firm growth.

Rapid Growth and the Virtues of Conservatism Review of the likely effect of the five forces on rapidly growing busi- nesses strongly suggests that high growth and high debt are a dangerous

Chapter 6 The Financing Decision 221

International Differences in Leverage Recent research reveals substantial geographical differences in corporate financing practices.a

Looking at public companies in 39 countries around the globe, the study reports that median debt ra- tios (measured as interest-bearing debt/firm market value) range from over 50 percent for firms in South Korea to below 10 percent for those in Australia. Although there are exceptions, the general trend is that companies headquartered in developed countries, such as Canada and the United King- dom, carry lower debt ratios, while those in developing countries, such as Indonesia and Pakistan, have higher debt ratios.

The study also shows that the maturity of debt used by companies varies a great deal across countries. Firms in stable, developed economies strongly favor long-term debt, while those in devel- oping economies rely much more on short-term financing. At the extremes, the median ratio of long- term debt to total debt for firms in New Zealand is almost 90 percent, while the same figure for businesses in China is less than 10 percent.

Why such large differences in leverage in different countries? Of course, there are many rea- sons, but the research shows that much of the variation comes down to the reaction of investors and firms to the country’s legal and judicial systems. Or said differently, the relative importance of the Higgins 5-Factor variables discussed here varies with the host country’s legal and regulatory prac- tices. So, when a country’s tax code favors debt financing, firms in that country will use more debt. No surprise there. Similarly, if a country is lax in its enforcement of debt contracts, lenders there will insist on short-term loans to retain more control over their investment. In sum, even if two firms in different countries operate in the exact same business, don’t assume that they will necessarily have similar financial structures. a Joseph P. H. Fan, Sheridan Titman, and Garry Twite, “An International Comparison of Capital Structure and Debt Maturity Choices,” Journal of Financial and Quantitative Analysis, April 2012, pp. 23–56.



combination. First, the most powerful engine of value creation in a rap- idly growing business is new investment, not interest tax shields or in- centive effects that might accompany debt financing. Better, therefore, to make financing a passive servant to growth by striving to maintain un- restricted access to financial markets. This implies modest debt financ- ing. Second, to the extent that high-growth firms generate volatile income streams, chances of financial distress rise rapidly as interest coverage falls. Third, because much of a high-growth firm’s value is rep- resented by intangible growth opportunities, expected distress costs of such firms are large.

These considerations suggest the following financing polices for rapidly growing businesses:

• Maintain a conservative leverage ratio with ample unused borrowing capacity to ensure continuous access to financial markets.

• Adopt a modest dividend payout policy that enables the company to finance most of its growth internally.

• Use cash, marketable securities, and unused borrowing capacity as tem- porary liquidity buffers to provide financing in years when investment needs exceed internal sources.

• If external financing is necessary, use debt only to the point where the leverage ratio begins to affect financial flexibility.

• Sell equity rather than limit growth, thereby constraining growth only as a last resort after all other alternatives have been exhausted.

Low Growth and the Appeal of Aggressive Financing Compared to their rapidly growing brethren, slow-growth companies have a much easier time with financing decisions. Because their chief financial problem is disposing of excess operating cash flow, concerns about financial flexibility and adverse market signaling are largely foreign to them. However, beyond merely eliminating a problem, this situation creates an opportunity that a number of companies have successfully ex- ploited. The logic goes like this. Face the reality that the business has few attractive investment opportunities, and seek to create value for owners through aggressive use of debt financing. Use the company’s healthy operating cash flow as the magnet for borrowing as much money as is feasible, and use the proceeds to repurchase shares.

Such a strategy promises at least three possible payoffs to owners. First, increased interest tax shields reduce income taxes, leaving more money for investors. Second, the share repurchase announcement should generate a positive market signal. Third, the high financial

222 Part Three Financing Operations



leverage may significantly improve management incentives. Thus, the burden high financial leverage imposes on management to make large, recurring interest and principal payments or face bankruptcy may be just the elixir needed to encourage them to squeeze more cash flow out of the business.

In summary, an old saw among bank borrowers is that the only com- panies banks are willing to lend money to are those that don’t need it. We see now that much the same dynamic may be at work on the borrowers’ side. Slow-growth businesses that don’t need external financing may find it attractive to finance aggressively, while rapidly growing businesses in need of external cash find it appealing to maintain conservative capital structures.

Empirical work supports the wisdom of this perspective. In their study of the ties between company value and the use of debt financing, John McConnell and Henri Servaes have found that for high-growth busi- nesses increasing leverage reduces firm value, while precisely the reverse is true for slow-growth businesses.6

Chapter 6 The Financing Decision 223

Don’t Talk to Deere & Company About Market Signaling The experiences of Deere & Company, the world’s largest farm equipment manufacturer, in the late 1970s and early 1980s provide a vivid object lesson for much of this chapter. Among the lessons il- lustrated are the value of financial flexibility, the use of finance as a competitive weapon, and the power of market signaling.

Beginning in 1976, rising oil prices, high and increasing inflation rates, and record-high interest rates sent the farm equipment industry into a severe tailspin. Much more conservative financially than its principal rivals, Massey Ferguson and International Harvester, Deere chose this moment to use its superior balance sheet strength as a competitive weapon. While competitors retrenched under the burden of high interest rates and heavy debt loads, Deere borrowed liberally to finance a major capital investment program and support financially distressed dealers. The strategy saw Deere’s three-company market share rise from 38 percent in 1976 to 49 percent by 1980; such was the value of Deere’s superior financial flexibility.

But by late 1980s, with its borrowing capacity dwindling and the farm equipment market still de- pressed, Deere faced the difficult choice between curtailing its predatory expansion program and issuing new equity into the teeth of an industry depression. On January 5, 1981, the company an- nounced a $172 million equity issue and watched the market value of its existing shares immediately fall by $241 million. So powerful was the announcement effect that Deere’s existing shareholders lost more value than Deere stood to raise from the issue.

Despite the negative market response, Deere managers were so strongly convinced of the long- run virtues of their strategy that they gritted their teeth, issued the equity, and used the proceeds to reduce indebtedness. Deere thus regained the borrowing capacity and the financial flexibility it needed to continue expanding, while its rivals remained mired in financial distress.

6John J. McConnell and Henri Servaes, “Equity Ownership and the Two Faces of Debt,” Journal of Financial Economics, September 1995, pp. 131–157.



What does all this imply for Stryker Corporation’s decision? Based on the information available, my advice on balance is to issue debt. Unless management anticipates an imminent return to rapid growth or more large acquisitions, flexibility would not appear to be a major concern, and equity’s $900 million signaling cost would certainly be painful ($900 mil- lion � 30% � $3 billion). Meanwhile, debt’s $53 million first year inter- est tax shield would be nice, and the increased interest and principal requirements on the new debt might encourage management to work harder and smarter. As to risks, Stryker’s historically stable cash flows sug- gest that expected distress costs will remain modest, even at the lower in- terest coverage ratios created by the debt financing. Finally, debt financing will help solve Stryker’s continuing problem of what to do with the excess cash being generated. In the future, they can use some of it to service the new debt. All in all, a nice package.

Selecting a Maturity Structure

When a company decides to raise debt, the next question is: What ma- turity should the debt have? Should the company take out a one-year loan, sell seven-year notes, or market 30-year bonds? Looking at the firm’s entire capital structure, the minimum-risk maturity structure oc- curs when the maturity of liabilities equals that of assets, for in this con- figuration, cash generated from operations over coming years should be

224 Part Three Financing Operations

Colt Industries’ Experience with Aggressive Financing Colt Industries’ late 1986 recapitalization illustrates the potential of aggressive financing in mature businesses. Facing increasing cash flows from its aerospace and automotive operations and a dearth of attractive investment opportunities, Colt decided to recapitalize its business by offering shareholders $85 in cash plus one share of stock in the newly recapitalized company in exchange for each old share held.

To finance the $85 cash payment, Colt borrowed $1.4 billion, raising total long-term debt to $1.6 billion and reducing the book value of shareholders’ equity to minus $157 million. In other words, after the recapitalization, Colt’s liabilities exceeded the book value of its assets by $157 million, yielding a negative book value of equity. We are talking serious leverage here. But book values are of secondary importance to lenders when the borrower has the cash flow to service its obligations, and this is where Colt’s healthy operating cash flows were critical. Management’s willingness to commit virtually all of its future cash flow to debt service enabled the company to secure the needed financing.

How did the shareholders make out? Quite well, thank you. Just prior to the announcement of the exchange offer, Colt’s shares were trading at $67, and immediately after the exchange was com- pleted, shares in the newly recapitalized company were trading for $10. So the offer came down to this: $85 cash plus one new share of stock worth $10 in exchange for each old share worth $67. This works out to a windfall gain to owners of $28 a share, or 42 percent ($28 � $85 � $10 � $67).



Chapter 6 The Financing Decision 225

sufficient to repay existing liabilities as they mature. In other words, the liabilities will be self-liquidating. If the maturity of liabilities is less than that of assets, the company incurs a refinancing risk because some maturing liabilities will have to be paid off from the proceeds of newly raised capital. Also, the rollover of maturing debt is not an automatic feature of capital markets. When the maturity of liabilities is greater than that of assets, cash provided by operations should be more than suf- ficient to repay existing liabilities as they mature. This provides an extra margin of safety, but it also means the firm may have excess cash in some periods.

If maturity matching is minimum risk, why do anything else? Why allow the maturity of liabilities to be less than that of assets? Companies mismatch either because long-term debt is unavailable on acceptable terms or because management anticipates that mismatching will reduce total borrowing costs. For example, if the treasurer believes interest rates will decline in the future, an obvious strategy is to use short-term debt now and hope to roll it over into longer-term debt at lower rates in the future. Of course, efficient- markets advocates criticize this strategy on the grounds that the treasurer has no basis for believing she can forecast future interest rates.

Inflation and Financing Strategy An old adage in finance is that it’s good to be a debtor during inflation be- cause the debtor repays the loan with depreciated dollars. It is important to understand, however, that this saying is correct only when the inflation is unexpected. When creditors expect inflation, the interest rate they charge rises to compensate for the expected decline in the purchasing power of the loan principal. This means it is not necessarily advantageous to borrow during inflation. In fact, if inflation unexpectedly declines dur- ing the life of a loan, it can work to the disadvantage of the borrower. The proper statement of the old adage, therefore, is that it’s good to be a bor- rower during unexpected inflation.


The Irrelevance Proposition This appendix demonstrates the irrelevance of capital structure proposi- tion mentioned in the chapter and illustrates in greater detail why the tax deductibility of interest favors debt financing. The irrelevance proposi- tion says that holding expected cash flows constant, the way a company



finances its operations has no effect on firm or shareholder value. As far as owners are concerned, a company might just as well use 90 percent debt financing as 10 percent.

The irrelevance proposition is significant not because it describes reality, but because it directs attention to what’s important about financing decisions: understanding how financing choices affect firm cash flows. The proposition is also an interesting intellectual puzzle in its own right.

No Taxes Legend has it that a waitress once asked Yogi Berra how many pieces he’d like his pizza cut into, and he replied, “You’d better make it six; I don’t think I’m hungry enough to eat eight.” Absent taxes, a company’s financing decision can be likened to slicing Yogi’s pizza: No matter how you slice up claims to the firm’s cash flow, it is still the same firm with the same earning power and hence the same market value. The benefits of increased return to shareholders from higher leverage are precisely offset by the increased risks so that market value is unaffected by leverage.

Here is an example demonstrating this assertion. Your stockbroker has come up with two possible investments, Timid Inc. and Bold Company. The two firms happen to be identical in every respect except that Timid uses no debt financing while Bold relies on 80 percent debt at an annual interest cost of 10 percent. Each has $1,000 of assets and generates ex- pected annual earnings before interest and tax of $400 in perpetuity. For simplicity, we will suppose that both companies distribute all their earn- ings every year as dividends.

The first two columns of Table 6A.1 show the bottom portion of pro forma income statements for the two companies in the absence of taxes. Note that Timid, Inc., shows higher earnings because it has no interest expense. Comparing Timid’s $400 annual earnings to your prospective investment of $1,000 suggests a 40 percent annual return. Not bad! However, your broker recommends Bold Company, pointing out that because of the company’s aggressive use of debt financing, you can pur- chase its entire equity for only $200. Comparing Bold Company’s annual income of $320 to a $200 investment produces an expected annual return of 160 percent ($320�$200 � 160%). Wow!

But you have studied enough finance to know that the expected re- turn to equity almost always rises with debt financing, so this result is not especially surprising. Moreover, a moment’s reflection should con- vince you that it is incorrect to compare returns on two investments with

226 Part Three Financing Operations



different risk. If the return on investment A is greater than the return on investment B and they have the same risk, A is the better choice. But if A has a higher return and higher risk, as in the present case, all bets are off. Poker players and fighter pilots might prefer investment A despite its higher risk, while we more timid souls might reach the opposite conclusion.

More to the point, it is important to note that you are not dependent on Bold Company for financial leverage. You can borrow on your own ac- count to help pay for your purchase of Timid’s shares and in so doing pre- cisely replicate Bold’s numbers. The bottom portion of the left two columns in Table 6A.1, labeled Personal Income, show the results of your borrowing $800 at 10 percent interest to finance purchase of Timid’s shares. Subtracting $80 interest and comparing your total income to your

Chapter 6 The Financing Decision 227

TABLE 6A.1 In the Absence of Taxes, Debt Financing Affects Neither Income nor Firm Value; In the Presence of Taxes, Prudent Debt Financing Increases Income and Firm Value

No Taxes Corporate Taxes at 40%

Timid Inc. Bold Co. Timid Inc. Bold Co.

Corporate Income

EBIT $ 400 $400 $ 400 $400 Interest expense 0 80 0 80_____ ____ _____ ____ Earnings before tax 400 320 400 320 Corporate tax 0 0 160 128_____ ____ _____ ____ Earnings after tax $ 400 $320 $ 240 $192_____ ____ _____ _________ ____ _____ ____ Investment $1,000 $200 $1,000 $200 Rate of return 40% 160% 24% 96%

Personal Income

Dividends received 400 320 240 192 Interest expense 80 0 80 0_____ ____ _____ ____ Total income $ 320 $320 $ 160 $192_____ ____ _____ _________ ____ _____ ____ Equity invested $ 200 $200 $ 200 $200 Rate of return 160% 160% 80% 96%

Personal Taxes at 33%

Income before tax 160 192 Personal taxes 53 63_____ ____ Income after tax $ 107 $129_____ _________ ____ Equity invested $ 200 $200 Rate of return 54% 64%



$200 equity investment, we find that your levered return on Timid stock is now also 160 percent. You can generate precisely the same return on ei- ther investment provided you are willing to substitute personal debt for corporate debt.

So what have we proven? We have shown that when investors can substitute homemade leverage for corporate leverage in the absence of taxes, the way a business is financed does not affect the total return to owners. And if total return is not affected, neither is the value of the business. Firm value is independent of financing. If investors can repli- cate the leverage effects of corporate borrowing on their own account, there is no reason for them to pay more for a levered firm than an unlevered one. (If the logic here seems a bit counterintuitive, you will be heartened to learn that Franco Modigliani and Merton Miller won Nobel Prizes largely for explaining it.)

Taxes Let us now repeat our saga in a more interesting world that includes taxes. The figures in the upper-right corner of Table 6A.1 show Timid and Bold’s earnings after taxes in the presence of a 40 percent corporate tax rate. As before, absent any borrowing on your part, Bold continues to offer the more attractive return of 96 percent versus 24 percent for Timid. But contrary to the no-taxes case, the substitution of personal borrowing for corporate borrowing does not eliminate the differential. Even after borrowing $800 to help finance purchase of Timid, your re- turn is only 80 percent versus 96 percent on Bold’s stock. The levered business now offers a higher return and thus is more valuable than its unlevered cousin.

Why does debt financing increase the value of a business in the pres- ence of taxes? Look at the tax bills of the two companies. Timid’s taxes are $160, while Bold’s are only $128, a saving of $32. Three parties share in the fruits of a company’s success: creditors, owners, and the tax col- lector. Our example shows that debt financing, with its tax-deductible interest expense, reduces the tax collector’s take in favor of the owners’. In other words, the financing decision increases expected cash flow to owners.

The bottom portion of Table 6A.1 is for suspicious readers who think these results might hinge on the omission of personal taxes. There you will note that imposition of a 33 percent personal tax on income reduces the annual after-tax advantage of debt financing from $32 to $22, but does not eliminate it. Note too that this conclusion holds at any personal tax rate, as long as it is the same for both firms. Because many investors, such

228 Part Three Financing Operations



Chapter 6 The Financing Decision 229

as mutual funds and pension funds, do not pay taxes, the convention is to dodge the problem of defining an appropriate personal tax rate by con- centrating on earnings after corporate taxes but before personal taxes. We will gratefully follow that convention here.

I should note that our finding of a tax law bias in favor of debt financ- ing is largely an American result. In most other industrialized countries, corporate and personal taxes are at least partially integrated, meaning div- idend recipients receive at least partial credit on their personal tax bills for corporate taxes paid on distributed profits. As in our no-tax example, there are no tax benefits to debt financing when corporate and personal taxes are fully integrated.

In the presence of American-style corporate taxes, then, the reshuffling of paper claims to include more debt does create value—at least from the shareholders’ perspective, if not from that of the U.S. Treasury— because it increases the cash flow available to private investors. The amount of the increase in annual income to shareholders created by debt financing equals the corporate tax rate times the interest expense, or what we referred to earlier as the interest tax shield. In our example, annual company earnings after tax plus interest expense increases $32 a year ($192 � $80 � $240 � $32), which also equals the tax rate of 40 percent times the interest expense of $80.

Saying the same thing in symbols, if VL is the value of the company when levered and VU is its value unlevered, our example says that

where t is the corporate tax rate, I is annual interest expense in dollars, and Value (tI) represents the value today of all future interest tax shields. In the next chapter, we will refer to this last term as the present value of future tax shields. In words, then, our equation says the value of a levered com- pany equals the value of the same company unlevered plus the present value of the interest tax shields.

Taken at face value, this appendix suggests a disquieting conclusion: The value of a business is maximized when it is financed entirely with debt. But you know after reading the chapter that this is just the beginning of our story. For just as the tax deductibility of interest causes firm value to rise with leverage, the costs of financial distress cause it to fall. Add con- cerns about financial flexibility, market signaling, and incentive effects; season with a pinch of sustainable growth; and you have the recipe for the modern view on corporate financing decisions. Not a feast, perhaps, but certainly a hearty first course.

VL = VU + Value (tI )



230 Part Three Financing Operations


1. Financial leverage • Is a fundamental financial variable affecting return on equity and

sustainable growth. • Involves the substitution of fixed cost debt financing for variable cost

equity. • Like operating leverage increases breakeven sales but increases the

rate of earnings per share growth once breakeven is achieved. • Increases expected return and risk to owners. • Increases expected ROE and EPS as well as their variability. • Creates a wide array of risk-return combinations out of a single risky

investment depending on the amount of financial leverage used. 2. To measure the effect of leverage on company risk,

• Stress test pro forma forecasts. • Estimate coverage ratios at differing debt levels. • Interpret coverage ratios in light of the variability of operating

income, the coverage ratios of peers, and across different bond ratings.

3. To measure the effect of leverage on company returns, • Assess projected income statements under different economic

conditions. • Prepare a range of earnings chart noting the increase in ROE and

EPS at the projected EBIT level and the proximity of expected EBIT to the “cross-over” value.

4. The irrelevance proposition • Argues that under idealized conditions and assuming leverage does

not affect operating income, financing decisions do not affect firm or shareholder value.

• Implies that financing decisions are important to the degree that they affect operating income.

5. The Higgins 5-Factor Model • Identifies five ways in which company financing can affect operating

income: – Tax benefits: due to the tax deductibility of interest – Distress costs: imposed by various parties when con-

cerns arise about a company’s ability to honor its financial obligations

– Financial flexibility: the possibility that high debt levels will limit future financing options



Chapter 6 The Financing Decision 231

– Market signaling: the information managers convey when they opt for one form of financing over another

– Management incentives: the increased pressure to generate cash flows to meet high debt service obligations

• Emphasizes that the financing decision involves a careful assessment of each factor in light of the company’s specific circumstances.

• Suggests that rapidly growing businesses are wise to maintain con- servative capital structures, while slow-growth firms may want to consider the opposite strategy.


Andrade, Gregor, and Steven N. Kaplan, “How Costly Is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions That Became Distressed.” Journal of Finance, October 1998, pp. 1443–1493.

The authors look at 31 highly levered transactions that became distressed due to too much debt and estimate that financial distress costs are in the range of 10 to 20 percent of firm value.

Asquith, Paul, and David W. Mullins, Jr., “Signaling with Dividends, Stock Repurchases, and Equity Issues.” Financial Management, Autumn 1986, pp. 27– 44.

A well-written summary of empirical work on measuring the capital market’s reaction to major equity-related announcements. An excellent introduction to and overview of market signaling.

Hovakimian, Armen, Tim Opler, and Sheridan Titman, “The Debt-Equity Choice,” Journal of Financial and Quantitative Analysis, March 2001, pp. 1–24.

Presents evidence that capital structure choices are consistent with the pecking-order theory in the short run but that the tax benefits–distress costs trade-off theory is more important in the long run.

Parsons, Christopher A., and Sheridan Titman, “Empirical Capital Structure: A Review,” Foundations and Trends in Finance, 2008. 92 pages. Available at

An accessible, academically oriented survey of empirical work on capital structure decisions divided into three parts: the characteristics of firms associated with different capital structure structures, factors causing firms to move away from their capital structure targets, and the consequences of leverage choices for firm behavior.



232 Part Three Financing Operations

Stern, Joel M., and Donald H. Chew, Jr., (Eds.), The Revolution in Corporate Finance, 4th ed. Malden, MA: Blackwell Publishing, 2003. 631 pages.

A collection of practitioner-oriented articles, many by leading academics, originally appearing in the Journal of Applied Corporate Finance. See especially “The Modigliani-Miller Proposition after 30 Years,” by Merton Miller; “Raising Capital: Theory and Evidence,” by Clifford W. Smith, Jr.; and “Still Searching for Optimal Capital Structure,” by Stewart C. Myers. $60.

WEBSITES The American Bankruptcy Institute’s website with news and statistics about many aspects of corporate and personal bankruptcy. For brief, easy-to-follow tutorials on capital structure, bankruptcy, and related topics, select Learn � Economics and finance � Finance and capital markets � Stocks and bonds. Also available as a free app for iOS (search Apple’s app store for “Khan Academy”). This site allows you to explore different career options in finance, including information on required skills, working environments, and salaries.


Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are avail- able in the Instructor Resources within McGraw-Hill’s Connect, (See the Preface for more information).

1. Looking at Table 6.4, why do public utilities have such a low times- interest-earned ratio? Why is the ratio for information technology companies so high?

2. What is operating leverage? How, if at all, is it similar to financial leverage? If a firm has high operating leverage would you expect it to have high or low financial leverage? Explain your reasoning.

3. Explain why increasing financial leverage increases the risk borne by shareholders.

4. Explain how a company can incur costs of financial distress without ever going bankrupt. What is the nature of these costs?

5. One recommendation in the chapter is that companies with promis- ing investment opportunities should strive to maintain a conservative



Chapter 6 The Financing Decision 233

capital structure. Yet many promising small businesses are heavily indebted. a. Why should most companies with promising investment opportu-

nities strive to maintain conservative capital structures? b. Why do you suppose many promising small businesses fail to

follow this recommendation?

6. Why might it make sense for a mature, slow-growth company to have a high debt ratio?

7. As the chief financial officer of Cascade Designs, you have the follow- ing information: Next year’s expected net income after tax but before

new financing $70 million Sinking-fund payments due next year on the

existing debt $20 million Interest due next year on the existing debt $15 million Common stock price, per share $40.00 Common shares outstanding 25 million Company tax rate 30% a. Calculate Cascade’s times-interest-earned ratio for next year

assuming the firm raises $70 million of new debt at an interest rate of 6 percent.

b. Calculate Cascade’s times-burden-covered ratio for next year assuming annual sinking-fund payments on the new debt will equal $7 million.

c. Calculate next year’s earnings per share assuming Cascade raises the $70 million of new debt.

d. Calculate next year’s times-interest-earned ratio, times-burden- covered ratio, and earnings per share if Cascade sells 2 million new shares at $35 a share instead of raising new debt.

8. A broker wants to sell a customer an investment costing $100 with an expected payoff in one year of $106. The customer indicates that a 6 percent return is not very attractive. The broker responds by sug- gesting the customer borrow $90 for one year at 4 percent interest to help pay for the investment. a. What is the customer’s expected return if she borrows the money? b. Does borrowing the money make the investment more attractive? c. What does the Irrelevance Proposition say about whether borrow-

ing the money makes the investment more attractive?



234 Part Three Financing Operations

9. Explain how each of the following changes will affect a company’s range of earnings chart such as that shown in Figure 6.2. How would each of the changes affect the attractiveness of increased debt financ- ing relative to increased equity financing? a. An increase in the interest rate on the new debt to be raised. b. An increase in the company’s stock price. c. Increased uncertainty about the issuing company’s future earnings. d. Increased cash dividends paid on common stock. e. An increase in the amount of debt the company already has

outstanding. 10. FARO Technologies, whose products include portable 3D measure-

ment equipment, recently had 17 million shares outstanding trading at $42 a share. Suppose the company announces its intention to raise $200 million by selling new shares. a. What do market signaling studies suggest will happen to FARO’s

stock price on the announcement date? Why? b. How large a gain or loss in aggregate dollar terms do market sig-

naling studies suggest existing FARO shareholders will experience on the announcement date?

c. What percentage of the value of FARO’s existing equity prior to the announcement is this expected gain or loss?

d. At what price should FARO expect its existing shares to sell imme- diately after the announcement?

11. This is a more difficult but informative problem. James Brodrick & Sons, Inc., is growing rapidly and, if at all possible, would like to fi- nance its growth without selling new equity. Selected information from the company’s five-year financial forecast follows.

Year 1 2 3 4 5

Earnings after tax ($ millions) 100 130 170 230 300 Capital Investment ($ millions) 175 300 300 350 440 Target book value debt-to-equity ratio (%) 120 120 120 120 120 Dividend payout ratio (%) ? ? ? ? ? Marketable securities ($ millions) 200 200 200 200 200 (Year 0 marketable securities = $200 million.)

a. According to this forecast, what dividends will the company be able to distribute annually without raising new equity and while main- taining a balance of $200 million in marketable securities? What will the annual dividend payout ratio be? (Hint: remember sources of cash must equal uses at all times.)



b. Assume the company wants a stable payout ratio over time and plans to use its marketable securities portfolio as a buffer to absorb year-to-year variations in earnings and investments. Set the annual payout ratio equal to the five-year sum of total dividends paid de- termined in question (a) divided by total earnings. Then solve for the size of the company’s marketable securities portfolio each year.

c. Suppose earnings fall below forecast every year. What options does the company have for continuing to fund its investments?

d. What does the pecking-order theory say about how management will rank these options?

e. Why might management be inclined to follow this pecking order? 12. An all-equity business has 100 million shares outstanding selling for

$20 a share. Management believes that interest rates are unreasonably low and decides to execute a leveraged recapitalization (a recap). It will raise $1 billion in debt and repurchase 50 million shares. a. What is the market value of the firm prior to the recap? What is the

market value of equity? b. Assuming the Irrelevance Proposition holds, what is the market

value of the firm after the recap? What is the market value of equity?

c. Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.

d. Assume now that the recap increases total firm cash flows, which adds $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity?

e. Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario?

13. In recent years, Haverhill Corporation has averaged a net income of $10 million per year on net sales of $100 million per year. It cur- rently has no long-term debt, but is considering a debt issue of $5 million. The interest rate on the debt would be 6 percent. Haverhill currently faces an effective tax rate of 35 percent. What would be Haverhill’s annual interest tax shield if it goes through with the debt issuance?

14. This problem asks you to analyze the capital structure of HCA, Inc., the largest private operator of health care facilities in the world. In 2006, a syndicate of private equity firms acquired the firm for $31.6 billion and took it private. In November 2010, as interest rates hit record lows, the company announced a dividend recapitalization in which it would distribute an extraordinary $2 billion dividend financed

Chapter 6 The Financing Decision 235



236 Part Three Financing Operations

in large part by a $1.53 billion bond offering. A spreadsheet with HCA’s financial statements for 2005–2009 and specific questions is available for download through McGraw-Hill’s Connect or your course instructor (see the Preface for more information).

15. This problem asks you to evaluate a major increase in financial lever- age on the part of Avon Products, Inc. The company’s financial statements for 2001–2003 and specific questions are available for download through McGraw-Hill’s Connect or your course instructor (see the Preface for more information). You may also find it useful to consult the company’s past annual reports (10-Ks) available at

16. Problem 13, part f in Chapter 3 asks you to construct a five-year financial projection for Aquatic Supplies beginning in 2015. Based on your forecast or the suggested answer available through McGraw- Hill’s Connect, answer the questions below. a. Calculate the company’s annual times-interest-earned ratio over

the forecast period. b. Calculate the percentage EBIT can fall before interest coverage

dips below 1.0 for each year in the forecast. c. Consulting Table 6.5 in the text, what bond rating would Aquatic

Supplies have in 2014 if the rating was based solely on the firm’s in- terest coverage ratio?

d. Based on this rating, would a significant increase in financial lever- age be a prudent strategy for Aquatic Supplies?




Evaluating Investment






Discounted Cash Flow Techniques

A nearby penny is worth a distant dollar. Anonymous

The chief determinant of what a company will become is the investments it makes today. The generation and evaluation of creative investment pro- posals is far too important a task to be left to finance specialists; instead, it is the ongoing responsibility of all managers throughout the organization. In well-managed companies, the process starts at a strategic level with senior management specifying the businesses in which the company will compete and determining the means of competition. Operating managers then translate these strategic goals into concrete action plans involving specific investment proposals. A key aspect of this process is the financial evaluation of investment proposals, or what is frequently called capital budgeting. The achievement of an objective requires the outlay of money today in expectation of increased future benefits. It is necessary to decide, first, whether the anticipated future benefits are large enough, given the risks, to justify the current expenditure, and second, whether the proposed investment is the most cost-effective way to achieve the objective. This and the following chapter address these questions.

Viewed broadly, the discounted cash flow techniques considered here and in the following chapters are relevant whenever a company contem- plates an action entailing costs or benefits that extend beyond the current year. This covers a lot of ground, including such disparate topics as valu- ing stocks and bonds, analyzing equipment acquisitions or sales, choosing among competing production technologies, deciding whether to launch a new product, valuing divisions or whole companies for purchase or sale, assessing marketing campaigns and Research and Development (R&D) programs, and even designing a corporate strategy. Indeed, it is not an ex- aggeration to say that discounted cash flow analysis is the backbone of modern finance and even modern business.



Figures of Merit

The financial evaluation of any investment opportunity involves the fol- lowing three discrete steps:

1. Estimate the relevant cash flows.

2. Calculate a figure of merit for the investment.

3. Compare the figure of merit to an acceptance criterion.

A figure of merit is a number summarizing an investment’s economic worth. A common figure of merit is the rate of return. Like the other fig- ures of merit to be discussed, the rate of return translates the complicated cash inflows and outflows associated with an investment into a single num- ber summarizing its economic worth. An acceptance criterion, on the other hand, is a standard of comparison that helps the analyst determine whether an investment’s figure of merit is attractive enough to warrant acceptance. It’s like a fisher who can keep only fish longer than 10 inches. To the fisher, the length of the fish is the relevant figure of merit, and 10 inches is the acceptance criterion.

Although determining figures of merit and acceptance criteria ap- pears to be difficult on first exposure, the first step, estimating the rel- evant cash flows, is the most challenging in practice. Unlike the basically mechanical problems encountered in calculating figures of merit and acceptance criteria, estimating relevant cash flows is more of an art form, often requiring a thorough understanding of a company’s markets, competitive position, and long-run intentions. Difficulties range from commonplace concerns with depreciation, financing costs, and working capital investments to more arcane questions of shared resources, excess capacity, and contingent opportunities. And pervading the whole topic is the fact that many important costs and benefits cannot be measured in monetary terms and so must be evaluated qualitatively.

In this chapter, we will initially set aside questions of relevant cash flows and acceptance criteria to concentrate on figures of merit. Later we will return to the estimation of relevant cash flows. Acceptance criteria will be addressed in the following chapter under the general heading “Risk Analysis in Investment Decisions.”

To begin our discussion of figures of merit, let’s consider a simple nu- merical example. Pacific Rim Resources, Inc., is contemplating construc- tion of a container-loading pier in Seattle. The company’s best estimate of the cash flows associated with constructing and operating the pier for a 10-year period appears in Table 7.1.

240 Part Four Evaluating Investment Opportunities



Figure 7.1 presents the same information in the form of a cash flow dia- gram, which is simply a graphical display of the pier’s costs and benefits distributed along a time line. Despite its simplicity, I find that many com- mon mistakes can be avoided by preparing such a diagram for even the most elementary investment opportunities. We see that the pier will cost $40 million to construct and is expected to generate cash inflows of $7.5 million annually for 10 years. In addition, the company expects to salvage the pier for $9.5 million at the end of its useful life, bringing the 10th-year cash flow to $17 million.

The Payback Period and the Accounting Rate of Return Pacific’s management wants to know whether the anticipated benefits from the pier justify the $40 million cost. As we will see shortly, a proper answer to this question must reflect the time value of money. But before addressing this topic, let’s consider two commonly used, back-of-the-envelope-type figures of merit that, despite their popularity, suffer from some glaring weaknesses. One, known as the payback period, is defined as the time the company must wait before recouping its original investment. The pier’s payback period is 51⁄3 years, meaning the company will have to wait this long to recoup its original investment (51⁄3 � 40�7.5).

The second widely used, but nonetheless deficient, figure of merit is the accounting rate of return, defined as

Accounting rate of return �

The pier’s accounting rate of return is 21.1 percent ([(7.5 � 9 � 17)�10]�40).

Annual average cash inflow Total cash outflow

Chapter 7 Discounted Cash Flow Techniques 241

TABLE 7.1 Cash Flows for Container-Loading Pier ($ millions)

Year 0 1 2 3 4 5 6 7 8 9 10

Cash flow ($40) 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 17

FIGURE 7.1 Cash Flow Diagram for Container-Loading Pier

1 2 3 4 5 6 7 98 10






The problem with the accounting rate of return is its insensitivity to the timing of cash flows. For example, a postponement of all of the cash inflows from Pacific’s container-loading pier to year 10 obviously reduces the value of the investment but does not affect the accounting rate of re- turn. In addition to ignoring the timing of cash flows within the payback date, the payback period is insensitive to all cash flows occurring beyond this date. Thus, an increase in the salvage value of the pier from $9.5 mil- lion to $90.5 million clearly makes the investment more attractive. Yet it has no effect on the payback period, nor does any other change in cash flows in years 7 through 10.

In fairness to the payback period, I should add that although it is clearly an inadequate figure of investment merit, it has proven to be useful as a rough measure of investment risk. In most settings, the longer it takes to recoup an original investment, the greater the risk. This is especially true in high-technology environments where man- agement can forecast only a few years into the future. Under these cir- cumstances, an investment that does not promise to pay back within the forecasting horizon is equivalent to a night in Las Vegas without the floorshow.

The Time Value of Money An accurate figure of merit must reflect the fact that a dollar today is worth more than a dollar in the future. This is the notion of the time value of money, and it exists for at least three reasons. One is that infla- tion reduces the purchasing power of future dollars relative to current ones; another is that in most instances, the uncertainty surrounding the receipt of a dollar increases as the date of receipt recedes into the fu- ture. Thus, the promise of $1 in 30 days is usually worth more than the promise of $1 in 30 months, simply because it is customarily more certain.

A third reason money has a time value involves the important notion of opportunity costs. By definition, the opportunity cost of any investment is the return one could earn on the next best alternative. A dollar today is worth more than a dollar in one year because the dollar today can be productively invested and will grow into more than a dollar in one year. Waiting to receive the dollar until next year carries an opportunity cost equal to the return on the forgone investment. Because there are always productive opportunities for investment dollars, all investments involve opportunity costs.

Compounding and Discounting Because money has a time value, we cannot simply combine cash flows occurring at different dates as we do in calculating the payback period

242 Part Four Evaluating Investment Opportunities



and the accounting rate of return. To adjust investment cash flows for their differing time value, we need to use the ideas of compounding and discounting. Anyone who has ever had a bank account knows intuitively what compounding is. Suppose you have a bank account paying 10 per- cent annual interest, and you deposit $1 at the start of the year. What will it be worth at the end of the year? Obviously, $1.10. Now suppose you leave the dollar in the account for two years. What will it be worth then? This is a little harder, but most of us realize that because you earn interest on your interest, the answer is $1.21. Compounding is the process of determining the future value of a present sum. The follow- ing simple cash flow diagrams summarize the exercise. And note the pattern: As the number of years increases, so too does the power by which we raise the interest rate term (1 � .10). By extension, the future value of $1.00 in, say, 19 years at 10 percent interest is thus, F19 � $1(1 � .10)19 � $6.12.

Discounting is simply compounding turned on its head: It is the process of finding the present value of a future sum. Yet despite the obvious simi- larities, many people find discounting somehow mysterious. And as luck would have it, the convention has become to use discounting rather than compounding to analyze investment opportunities.

Here is how discounting works. Suppose you can invest money to earn a 10 percent annual return and you are promised $1 in one year. What is the value of this promise today? Clearly, it is worth less than $1, but the exact figure is probably not something that pops immediately to mind. In fact, the answer is $0.909. This is the present value of $1 to be received in one year, because if you had $0.909 today, you could invest it at 10 percent interest, and it would grow into $1 in one year [$1.00 � 0.909(1 � 0.10)].

0 1 20 1

F1 = $1 + (10%)($1) = $1 (1 + .10) = $1.10

F2 = $1.10 + (10%) ($1.10) = $1 (1 + .10)2

= $1.21

Single-period compounding Two-period compounding

Interest rate = 10%

F1 F2

$1 $1

Chapter 7 Discounted Cash Flow Techniques 243



244 Part Four Evaluating Investment Opportunities

Now, if we complicate matters further and ask what is the value of one dollar to be received in two years, intuition fails most of us com- pletely. We know the answer must be less than $0.909, but beyond that, things are a fog. In fact, the answer is $0.826. This sum, invested for two years at 10 percent interest, will grow, or compound, into $1 in two years. The following cash flow diagrams illustrate these discounting problems. Note the formal similarity to compounding. The only differ- ence is that in compounding we know the present amount and seek the future sum, whereas in discounting we know the future sum and seek the present amount.

Present Value Calculations How did I know the answers to these discounting problems? I could have done the arithmetic in at least three ways: Solve the formulas ap- pearing below the cash flow diagrams by hand, or with a simple calcu- lator; punch the numbers into a financial calculator; or use a computer spreadsheet, such as Excel. Financial calculators and spreadsheets can be thought of as basically a family of present value formulas where you provide the information and the device does the arithmetic. All three methods, of course, yield the same answer, but as discounting problems become more complex, the appeal of a computer spreadsheet grows accordingly.

Financial calculators use five basic variables to perform present value calculations, four to describe the cash flows and one for the interest rate. Each variable corresponds to a separate key on the calculator. The four cash flow variables are: n, the number of periods; PV, a present cash flow; PMT, a uniform cash flow occurring each period—also known as an

0 1 20 1

P = P =

Single-period discounting Two-period discounting

Interest rate = 10%

$1 $1 + (10%) ($1)

$1 $1.10 + (10%) ($1.10)

1 1 + .10

1 (1.10)2

$0.909 $0.826

= =

= =


$1 $1



annuity; and FV, a future cash flow. The diagram below shows how the variables relate to one another.

The fifth variable, i, the interest rate, plays a pivotal role and de- serves brief additional comment before continuing. In present value calculations the interest rate is frequently called the discount rate. It can be interpreted either of two ways. When a company already has cash in hand, the discount rate is the rate of return available on alternative, similar-risk investments. In other words, it is the company’s opportunity cost of capital. When a firm must raise the cash by selling securities, the discount rate is the rate of return expected by buyers of the securities. In other words, it is the investors’ opportunity cost of capital. As we will see in Chapter 8, the discount rate is frequently used to adjust an in- vestment’s cash flows for risk and hence is also known as a risk-adjusted discount rate.

To solve a discounting problem using a financial calculator, begin by deciding which variable you want to calculate, enter the other four vari- ables you know (in any order), and ask the calculator to find the unknown quantity. So, for example, to solve the single-period discounting problem above, input the number of periods (1), the interest rate (10), and the future value (1). Enter zero for the periodic payment (PMT) because there are none. Then ask the calculator to calculate the PV, and it will return the answer of �0.909. The answer has a minus sign to indicate that $0.909 must be paid today to receive $1 in one period.

The following schematic illustrates the solution to this problem using a financial calculator.

Input: 1 10 ? 0 1

Output: �0.909

Solving the two-period discounting problem above is a simple matter of replacing the 1 stored in the n key with a 2, and recalculating the PV.


0 3 4 . . .

. . .

1 n2



Chapter 7 Discounted Cash Flow Techniques 245



As a more challenging example, let us calculate the future value of a $100 investment in 22 years when the interest rate is 7 percent. Entering these values into a financial calculator and solving for FV this time, the answer is $443.04. The investment’s value rises over fourfold in 22 years at only 7 percent interest. Perhaps patience really is a virtue.

Input: 22 7 100 0 ?

Output: �443.04

To replicate these calculations using a computer spreadsheet, we first need to change a couple of symbols describing the cash flows. Specifically, replace n with NPER to describe the number of periods, and i with RATE to capture the interest rate. With these modest changes, the egg- shaped icon below shows how to solve the one-period discounting prob- lem with a spreadsheet. Start again by selecting the variable you want to calculate; here, the Present Value, PV.

As you begin to enter the equation appearing on the icon’s top line into the spreadsheet, it produces the prompt appearing on the bottom line. Now, just complete the equation by entering the prompted variables in the specified order, and the spreadsheet reveals the indicated answer, ($0.909). Yes, it’s that simple. To solve the two-period discounting prob- lem, just set [nper] to 2, and the answer changes to ($0.826).

As a detail, notice that the interest rate is now a decimal rather than a percentage as with the financial calculator. Also, note that the variables in square brackets in the prompt are optional. If left blank, the spreadsheet will treat them as zero. The optional variable “[type]” allows the user to specify whether payments are due at the beginning or the end of the period, and can usually be left blank.1

For ease of exposition, I will use this egg-shaped icon often to describe subsequent discounted cash flow calculations, without meaning to suggest that a spreadsheet is the only way to perform them.

=PV(.1,1,0,1) = ($0.909) PV(rate, nper, pmt, [fv], [type])


246 Part Four Evaluating Investment Opportunities

1 Excel contains over 50 financial functions for all sorts of arcane calculations. To learn more about the handful of functions described in the text, as well as the many others, go to Excel and select Formulas � Financial.



Equivalence As further practice, and to begin discussion of an important topic known as equivalence, suppose the Cincinnati Reds baseball team offers a talented young catcher a contract promising $2 million a year for four years. The athlete’s agent wants to know the value of the contract today when the ballplayer has similar-risk investment opportunities promising 15 percent a year.

The cash flow diagram for the contract is

The icon for determining the value of the contract today is

Although the baseball player expects to receive a total of $8 million over the next four years, the present value of these payments is barely over $5.7 million. Such is the power of compound interest.

The important fact about the $5.71 million present value here is that it is equivalent in value to the future flows promised by the contract. It is equivalent because if the athlete had the present value today, he could transform it into the future cash flows simply by investing it at the discount rate. To confirm this important fact, the following table shows the cash flows involved in transforming $5.71 million today into the baseball player’s contract offer of $2 million a year for four years. We begin by investing the present value at 15 percent interest. At the end of the first year, the investment grows to over $6.5 million, but the first $2 million salary payment reduces the principal to just over $4.5 mil- lion. In the second year, the investment grows to over $5.2 million, but the second salary installment brings the principal down to just over $3.2 million. And so it goes until at the end of four years, the $2 million salary payment just exhausts the account. Hence, from the baseball player’s perspective, $5.71 million today is equivalent in value to

=PV(.15,4,2) = ($5.71) PV(rate, nper, pmt, [fv], [type])

$2 million

0 3 41 2


Chapter 7 Discounted Cash Flow Techniques 247



$2 million a year for four years because he can readily convert the former into the latter by investing it at 15 percent.

The Net Present Value Now that you have mastered compounding, discounting, and equiva- lence, let’s use these concepts to analyze the container pier investment. More specifically, let us replace the future cash flows appearing in Figure 7.1 with a single cash flow of equivalent worth occurring today. Because all cash flows will then be in current dollars, we will have eliminated the time dimension from the decision and can proceed to a direct comparison of present value cash inflows against present value outflows.

Here is the arithmetic. Assuming other similar-risk investment oppor- tunities are available yielding 10 percent annual interest, the present value of the cash inflows from the pier investment is $49.75 million.

Note that the cash flow in year 10 is composed of the last year of a $7.5 million annuity plus a $9.5 million salvage value, for a total of $17 million.

The cash flow diagrams that follow provide a schematic representa- tion of this calculation. The present value calculation transforms the messy original cash flows on the left into two cash flows of equivalent worth on the right, each occurring at time zero. And our decision becomes elementary. Should Pacific invest $40 million today for a stream of future cash flows with a value today of $49.75 million? Yes, obviously. Paying $40 million for something worth $49.75 million makes eminent sense.

=PV(.10,10,7.5,9.5) = ($49.75) PV(rate, nper, pmt, [fv], [type])

Beginning- End-of- of-Period Interest at Period

Year Principal 15% Principal Withdrawal

1 $5,710,000 $856,500 $6,566,500 $2,000,000 2 4,566,500 684,975 5,251,475 2,000,000 3 3,251,475 487,721 3,739,196 2,000,000 4 1,739,196 260,879 2,000,075 2,000,000

Note: The $75 remaining in the account after the last withdrawal is due to round-off error.

248 Part Four Evaluating Investment Opportunities



What we have just done is calculate the pier’s net present value, or NPV, an important figure of investment merit:


The NPV for the container pier is $9.75 million.

NPV and Value Creation The declaration that an investment’s NPV is $9.75 million may not gen- erate a lot of enthusiasm around the water cooler, so it is important to provide a more compelling definition of the concept. An investment’s NPV is nothing less than a measure of how much richer you will become by undertaking the investment. Thus, Pacific’s wealth rises $9.75 million when it builds the pier because it pays $40 million for an asset worth $49.75 million.

This is an important insight. For years, a common mantra among ac- ademics, management gurus, and an increasing number of senior exec- utives has been that managers’ purpose in life should be to create value for owners. A crowning achievement of finance has been to transform value creation from a catchy management slogan into a practical decision-making tool that not only indicates which activities create value but also estimates the amount of value created. Want to create value for owners? Here’s how: Embrace positive-NPV activities—the higher the NPV, the better—and eschew negative-NPV activities. Treat zero-NPV activities as marginal because they neither create nor destroy wealth.

In symbols, when

NPV � 0, accept the investment.

NPV � 0, reject the investment.

NPV � 0, the investment is marginal.

Present value of cash inflows

– Present value of cash outflows

Original cash flow diagram Equivalent-worth cash flow diagram








Chapter 7 Discounted Cash Flow Techniques 249



The Benefit-Cost Ratio The net present value is a perfectly respectable figure of investment merit, and if all you want is one way to analyze investment opportunities, feel free to skip ahead to the section “Determining Relevant Cash Flows.” On the other hand, if you want to be able to communicate with people who use different but equally acceptable figures of merit, and if you want to reduce the work involved in analyzing certain types of investments, you will need to slog through a few more pages.

A second time-adjusted figure of investment merit popular in govern- ment circles is the benefit-cost ratio (BCR), also known as the profitability index, defined as


The container pier’s BCR is 1.24 ($49.75�$40). Obviously, an investment is attractive when its BCR exceeds 1.0 and is unattractive when its BCR is less than 1.0.

The Internal Rate of Return Without doubt, the most popular figure of merit among executives is a close cousin to the NPV known as the investment’s internal rate of return, or IRR. To illustrate the IRR and show its relation to the NPV, let’s follow the fan- ciful exploits of the Seattle area manager of Pacific Rim Resources as he tries to win approval for the container pier investment. After determining that the pier’s NPV is positive at a 10 percent discount rate, the manager forwards his analysis to the company treasurer with a request for approval. The treasurer responds that she is favorably impressed with the manager’s methodology but believes that in today’s interest rate environment, a discount rate of 12 percent is more appropriate. So the Seattle manager calculates a second NPV at a 12 percent discount rate and finds it to be $5.44 million—still positive but considerably lower than the original $9.75 million ($5.44 million � $45.44 million, as shown next, �$40 million).

Confronted with this evidence, the treasurer reluctantly agrees that the project is acceptable and forwards the proposal to the chief financial officer. (That the NPV falls as the discount rate rises here should come as

=PV(.12,10,7.5,9.5) = ($45.44) PV(rate, nper, pmt, [fv], [type])

Present value of cash inflows Present value of cash outflows

250 Part Four Evaluating Investment Opportunities



no surprise, for all of the pier’s cash inflows occur in the future, and a higher discount rate reduces the present value of future flows.)

The chief financial officer, who is even more conservative than the treasurer, also praises the methodology but argues that with all the risks involved and the difficulty in raising money, an 18 percent discount rate is called for. After doing his calculations a third time, the dejected Seattle manager now finds that at an 18 percent discount rate, the NPV is �$4.48 million (�$4.48 million � $35.52 million, as shown next, �$40 million).

Because the NPV is now negative, the chief financial officer, betraying his former career as a bank loan officer, gleefully rejects the proposal. The manager’s efforts prove unsuccessful, but in the process he has helped us understand the IRR.

Table 7.2 summarizes the manager’s calculations. From these figures, it is apparent that something critical happens to the investment merit of the container pier as the discount rate increases from 12 to 18 percent. Some- where within this range, the NPV changes from positive to negative and the investment changes from acceptable to unacceptable. The critical dis- count rate at which this change occurs is the investment’s IRR.

Formally, an investment’s IRR is defined as

IRR � Discount rate at which the investment’s NPV equals zero

The IRR is yet another figure of merit. The corresponding acceptance criterion against which to compare the IRR is the opportunity cost of cap- ital for the investment. If the investment’s IRR exceeds the opportunity cost of capital, the investment is attractive, and vice versa. If the IRR equals the cost of capital, the investment is marginal.

=PV(.18,10,7.5,9.5) = ($35.52) PV(rate, nper, pmt, [fv], [type])

Chapter 7 Discounted Cash Flow Techniques 251

TABLE 7.2 NPV of Container Pier at Different Discount Rates

Discount Rate NPV

10% $9.75 million 12 5.44

IRR � 15% 18 �4.48



In symbols, if K is the percentage cost of capital, then if

IRR � K, accept the investment.

IRR � K, reject the investment.

IRR � K, the investment is marginal.

You will be relieved to learn that in most, but regrettably, not all, in- stances, the IRR and the NPV yield the same investment recommenda- tions. That is, in most instances, if an investment is attractive based on its IRR, it will also have a positive NPV, and vice versa. Figure 7.2 illustrates the relation between the container pier’s NPV and its IRR by plotting the information in Table 7.2. Note that the pier’s NPV � 0 at a discount rate of about 15 percent, so this by definition is the project’s IRR. At capital costs below 15 percent, the NPV is positive and the IRR also exceeds the cost of capital, so the investment is acceptable on both counts. When the cost of capital exceeds 15 percent, the reverse is true, and the investment is unacceptable according to both criteria.

Figure 7.2 suggests several informative ways to interpret an investment’s IRR. One is that the IRR is a breakeven return in the sense that at capital costs below the IRR the investment is attractive, but at capital costs greater than the IRR it is unattractive. A second, more important interpretation is that the IRR is the rate at which money remaining in an investment grows, or compounds. As such, an IRR is comparable in all respects to the interest rate on a bank loan or a savings deposit. This means you can compare the

252 Part Four Evaluating Investment Opportunities

FIGURE 7.2 NPV of Container Pier at Different Discount Rates

Discount rate (percent)


( $

m ill

io ns

) $ 50







–20 0 4 8 12 16 20 24




IRR of an investment directly to the annual percentage cost of the capital to be invested. We cannot say the same thing about other, simpler mea- sures of return, such as the accounting rate of return, because they do not properly incorporate the time value of money.

The following icon confirms that the container pier’s IRR is indeed 15 percent. Feel free to ignore the optional [guess] variable here. IRR calculations commonly involve a bit of trial-and-error searching on the part of the computer for the right number, and the guess variable can simplify the computer’s task by defining a plausible starting point. But in all but rare instances, using it is not worth the effort.

=RATE(10,7.5,-40,9.5) = 15% RATE(nper, pmt, pv, [fv], [type], [guess])

Chapter 7 Discounted Cash Flow Techniques 253

The Container Pier Investment Is Economically Equivalent to a Bank Account Paying 15 Percent Annual Interest To confirm that an investment’s IRR is equivalent to the interest rate on a bank account, suppose that instead of building the pier, Pacific Rim Resources puts the $40 million cost of the pier in a clearly hypothetical bank account earning 15 percent annual interest. The table below demonstrates that Pacific can then use this bank account to replicate precisely the cash flows from the pier and that, just like the investment, the account will run dry in 10 years. In other words, ignoring any differences in risk, the fact that the pier’s IRR is 15 percent means the investment is economically equivalent to a bank savings account yielding this rate.

($ millions)

Beginning- Interest End-of- Withdrawals � of-Period Earned Period Investment

Year Principal at 15% Principal Cash Flows

1 $40.0 $6.0 $46.0 $ 7.5 2 38.5 5.8 44.3 7.5 3 36.8 5.5 42.3 7.5 4 34.8 5.2 40.0 7.5 5 32.5 4.9 37.4 7.5 6 29.9 4.5 34.4 7.5 7 26.9 4.0 30.9 7.5 8 23.4 3.5 26.9 7.5 9 19.4 2.9 22.3 7.5

10 14.8 2.2 17.0 17.0



Uneven Cash Flows Perceptive readers may have noticed a problem with what we have cov- ered to this point: All of the cash flows in all of the examples can be described using the four variables defined earlier. What happens when the cash flows are not so well behaved? What happens when they are more erratic? To illustrate the problem, let’s modify our container pier example a bit and assume that Pacific Container now estimates it will take time to ramp up to full capacity and that first-year cash flows will be only $3.5 million, not $7.5 million as originally projected. The revised cash flow diagram is

And we are now stuck because it is no longer possible to describe the in- vestment’s cash flows purely in terms of the original four variables, nper, pv, pmt, and fv.

Fortunately, spreadsheets offer a simple, elegant solution to this problem involving two new functions known as =IRR and =NPV. Table 7.3 shows an Excel spreadsheet illustrating their use. The numbers on the left are the revised container pier cash flows. The icons for the two new functions appear to the right. Looking first at the IRR icon, note that the prompt replaces the usual PV, PMT, and FV variables with a new variable called values. The values point the speadsheet to a range of cells containing the investment’s cash flows. Here the cash flows are in cells B3 through B13, and the values appear in the formula as B3:B13. All you need to do to calculate the IRR of an arbitrary list of numbers, then, is to enter the relevant range containing the numbers into the =IRR function.

The =NPV function is similar. It calls for an interest rate and a range of cash flows containing at least one nonzero value and returns the cash flows’ net present value. Here I have entered the cash flows in the range B4 through B13. “But wait,” you exclaim, “why did you omit the cash

1 2 3 4 5 6 7 98 10





254 Part Four Evaluating Investment Opportunities



flow in B3 from this range?” The answer is that, by definition, the =NPV function calculates the net present value of the specified range as of one period before the first cash flow. Had I entered “=NPV (C15,B3:B13)” the computer would have calculated the NPV of the investment as of time minus 1. To avoid this error, I calculated the NPV of the cash flows from years 1 through 10, which by definition the com- puter will calculate as of time 0, and then I added the time 0 cash flow separately. Remember this annoying convention, and the =NPV function can be very handy.

A Few Applications and Extensions Discounted cash flow concepts are the foundation for much of finance. To demonstrate their versatility, to sharpen your mastery of the concepts, and to introduce some topics we will refer to later in the book, I want to con- sider several useful applications and extensions.

Bond Valuation Investors regularly use discounted cash flow techniques to value bonds. To illustrate, suppose ABC Corporation bonds have an 8 percent coupon rate paid annually, a par value of $1,000, and nine years to maturity. An investor wants to determine the most she can pay for the bonds if she wants to earn at least 7 percent on her investment. The relevant cash flow diagram is:

Chapter 7 Discounted Cash Flow Techniques 255

TABLE 7.3 Working with Uneven Cash Flows



256 Part Four Evaluating Investment Opportunities

3 4 . . .

. . .

1 92




In essence, the investor wants to find P such that it is equivalent in value to the future cash receipts discounted at 7 percent. Calculating the pres- ent value, we find it equals $1,065.15, meaning her return over nine years will be precisely 7 percent when she pays this amount for the bond.

Moreover, we know her return will fall below 7 percent when she pays above this price, and rise above 7 percent when she pays less.

More commonly, an investor knows the price of a bond and wants to know what return it implies. If ABC Corporation bonds are selling for $1,030, the investor wants to know the return she will earn if she buys the bonds and holds them to maturity. In the jargon of the trade, she wants to know the bond’s yield to maturity. Performing the necessary calculation, we learn the bond’s yield to maturity, or IRR, is 7.53 percent.

The IRR of a Perpetuity Some financial instruments, including certain British and French government bonds, have no maturity date and simply promise to pay the stated interest every year forever. Annuities that last forever are called

=RATE(9,80,-1030,1000) = 7.53% RATE(nper, pmt, pv, [fv],[type],[guess])

=PV(.07,9,80,1000) = ($1,065.15) PV(rate, nper, pmt, [fv], [type])



perpetuities. Many preferred stocks are perpetuities. Later in Chapter 9 when valuing companies, we will occasionally find it convenient to think of company cash flows as perpetuities.

How can we calculate the present value of a perpetuity? It turns out to be embarrassingly easy. Begin by noting that the present value of an annu- ity paying $1 a year for 100 years discounted at, say, 12 percent is only $8.33!

Think of it: Although the holder will receive a total of $100, the present value is less than $9. Why? Because if the investor put $8.33 in a bank account today yielding 12 percent a year, he could withdraw approxi- mately $1 in interest every year forever without touching the principal (12% � $8.33 � $0.9996). Consequently, $8.33 today has approximately the same value as $1 a year forever.

This suggests the following simple formula for the present value of a perpetuity. Letting A equal the annual receipt, r the discount rate, and P the present value,


To illustrate, suppose a share of preferred stock sells for $480 and prom- ises an annual dividend of $52 forever. Then its IRR is 10.8 percent (52�480). Because the equations are so simple, perpetuities are often used to value long-lived assets and in many textbook examples.

Equivalent Annual Cost In most discounted cash flow calculations, we seek a present value or an internal rate of return, but this is not always the case. Suppose, for exam- ple, that Pacific Rim Resources is considering leasing its $40 million con- tainer pier to a large Korean shipping company for a period of 12 years. Pacific Rim believes the pier will have a $4 million continuing value at the end of the lease period. To consummate the deal, the company needs to know the annual fee it must charge to recover its investment, including the opportunity cost of the funds used. In essence, Pacific Rim needs a

r = A P

P = A r

=PV(.12,100,1) = ($8.33) PV(rate, nper, pmt, [fv], [type])

Chapter 7 Discounted Cash Flow Techniques 257



number that converts the initial expenditure and the salvage value into an equal value annual payment. At a 10 percent interest rate and ignoring taxes, the required annual lease payment is $5.68 million.

This quantity, known as the investment’s equivalent annual cost, is the effective, time-adjusted annual cost of the pier. The calculation tells us that if Pacific Rim sets the lease payment equal to the pier’s equivalent annual cost, it will earn an IRR of precisely 10 percent on the investment. We will discuss more about equivalent annual costs in the chapter appendix.

=PMT(.10,12,-40,4) = ($5.68) PMT(rate, nper, pv, [fv], [type])

258 Part Four Evaluating Investment Opportunities

A Note on Differing Compounding Periods For simplicity, I have assumed that the compounding period for all discounted cash flow calculations is one year. Of course, this is not always the case. In the United States and Britain, bond interest is calculated and paid semi-annually; many credit card issuers use monthly compounding; and some savings instruments advertise daily compounding.

The existence of different compounding intervals forces us to distinguish between two interest rates: a quoted interest rate, often called the annual percentage rate or APR, and a true rate, known as the effective annual rate, or EAR.

To appreciate the distinction, you know that $1 put to work at 10 percent interest, compounded an- nually, will be worth $1.10 in one year. But what will it be worth when the compounding period is semi- annual? To find out we need to divide the stated interest rate by 2 and double the number of compounding periods. Thus, at the end of six months, the investment will be worth $1.05, and at the end of the year it will be worth $1.1025 ($1.05 � .05 � $1.05). With semi-annual compounding, the in- terest earned in the first compounding period earns interest in the second, leading to a slightly higher ending value. So although the stated interest rate is 10 percent, semi-annual compounding boosts the effective return to 10.25 percent. The account’s APR is 10 percent, but its EAR is 10.25 percent.

Letting m equal the number of compounding periods in a year, we can generalize this example to the following expression.

Thus, the effective annual interest rate on a 6 percent savings account with daily compounding is (1 � .06�365)365 � 1 � 6.18%, while the effective annual rate on a credit card loan charging 18 percent, compounded monthly, is (1 � .18�12)12 � 1 � 19.56%.

There are two morals to this story. First, when an instrument’s compounding period is less than one year, its true interest rate is its EAR, not its APR. And second, when comparing instruments with different compounding periods, you must look at their EARs, not their APRs. This might all be of only minor interest were it not for the fact that common practice, strongly supplemented by Federal Truth in Lending laws, emphasizes APRs to the virtual exclusion of EARs.

EAR = a1 + APR m bm – 1



Mutually Exclusive Alternatives and Capital Rationing We now consider briefly two common occurrences that often complicate investment selection. The first is known as mutually exclusive alternatives. Frequently, there is more than one way to accomplish an objective, and the investment problem is to select the best alternative. In this case, the investments are said to be mutually exclusive. Examples of mutually ex- clusive alternatives abound, including the choice of whether to build a concrete or a wooden structure, whether to drive to work or take the bus, and whether to build a 40-story or a 30-story building. Even though each option gets the job done and may be attractive individually, it does not make economic sense to do more than one. If you decide to take the bus to work, driving to work as well could prove a difficult feat. When con- fronted with mutually exclusive alternatives, then, it is not enough to decide if each option is attractive individually; you must determine which is best. Mutually exclusive investments are in contrast to independent investments, where the capital budgeting problem is simply to accept or reject a single investment.

When investments are independent, all three figures of merit introduced earlier—the NPV, BCR, and IRR—will generate the same investment deci- sion, but this is no longer true when the investments are mutually exclusive. In all of the preceding examples, we implicitly assumed independence.

A second complicating factor in many investment appraisals is known as capital rationing. So far, we have implicitly assumed that sufficient money is available to enable the company to undertake all attractive op- portunities. In contrast, under capital rationing, the decision maker has a fixed investment budget that may not be exceeded. Such a limit on invest- ment capital may be imposed externally by investors’ unwillingness to supply more money, or it may be imposed internally by senior manage- ment as a way to control the amount of investment dollars each operating unit spends. In either case, the investment decision under capital rationing requires the analyst to rank the opportunities according to their invest- ment merit and accept only the best.

Both mutually exclusive alternatives and capital rationing require a ranking of investments, but here the similarity ends. With mutually exclusive investments, money is available, but for technological reasons only certain investments can be accepted; under capital rationing, a lack of money is the complicating factor. Moreover, even the criteria used to rank the investments differ in the two cases, so the best investment among mutually exclusive alternatives may not be the best under condi- tions of capital rationing. The appendix to this chapter discusses these technicalities and indicates which figures of merit are appropriate under which conditions.

Chapter 7 Discounted Cash Flow Techniques 259



The IRR in Perspective Before turning to the determination of relevant cash flows in investment analysis, I want to offer a few concluding thoughts about the IRR. The IRR has two clear advantages over the NPV and the BCR. First, it has considerably more intuitive appeal. The statement that an investment’s IRR is 45 percent is more likely to get the juices flowing than the excla- mation that its NPV is $12 million or its BCR is 1.41. Second, the IRR sometimes makes it possible to sidestep the challenging task of determin- ing the appropriate discount rate for an investment. Thus, when a normal- risk opportunity’s IRR is 80 percent, we can be confident that it is a winner at any reasonable discount rate. And when the IRR is 2 percent, we can be equally certain it is a loser regardless of the rate. The only instances in which we have to worry about coming up with an accurate discount rate are when the IRR is in a marginal range of, say, 5 to 25 percent. This dif- fers from the NPV and the BCR, where we have to know the discount rate before we can even begin the analysis.

Unfortunately, the IRR also suffers from several technical problems that compromise its use, and while this is not the place to describe these problems in detail, you should know they exist. (See one of the books rec- ommended at the end of this chapter for further information.) One diffi- culty is that on rare occasions an investment can display multiple IRRs; that is, its NPV can equal zero at two or more different discount rates. Other investments can have no IRR; their NPVs are either positive at all discount rates or negative at all rates. A second, more serious problem to be discussed in the appendix is that the IRR is an invalid yardstick for analyzing mutually exclusive alternatives and under capital rationing.

On balance then the IRR is, like many politicians, appealing but flawed. And although a diligent technician can circumvent each of the problems mentioned, I have to ask if it is worth the effort when the NPV offers a simple, straightforward alternative. In my view, the appropriate watch- word for the IRR is to appreciate its intuitive appeal but read the warning label before applying.

Determining the Relevant Cash Flows

It’s time now to set aside the computer and confront the really difficult part of evaluating investment opportunities. Calculating a figure of merit requires an understanding of the time value of money and equivalence, and it neces- sitates a modicum of algebra. But these difficulties pale to insignificance compared to those arising in estimating an investment’s relevant cash flows. Calculating figures of merit requires only technical competence; determin- ing relevant cash flows demands business judgment and perspective.

260 Part Four Evaluating Investment Opportunities



Two principles govern the determination of relevant cash flows. Both are obvious when stated in the abstract but can be devilishly difficult to apply in practice:

1. The cash flow principle: Because money has a time value, record invest- ment cash flows when the money actually moves, not when the accoun- tant using accrual concepts says they occur. And if the money doesn’t move, don’t count it.

2. The with-without principle: Imagine two worlds, one in which the invest- ment is made and one in which it is rejected. All cash flows that are different in these two worlds are relevant to the decision, and all those that are the same are irrelevant.

The following extended example illustrates the practical application of these principles to a number of commonly recurring cash flow estimation problems.

Nina Sanders, newly appointed general manager of the Handheld Devices Division of Plasteel Communications, has a problem. Prior to her appointment, division executives had put together a proposal to introduce an exciting new line of smartphones with flexible screens. The numbers spun out by division analysts looked excellent, but when the proposal was presented to the company’s Capital Expenditure Review Committee, it was attacked from all sides. One committee member called the presentation “plain amateurish”; another accused Ms. Sanders’s division of “trying to steal” his assets. Surprised by the strong emotions expressed and anxious to avoid further confrontation, the committee chair quickly tabled the pro- posal pending further review and likely revision by Ms. Sanders. Her task now was to either substantiate or correct the work of her subordinates.

Table 7.4 shows the projected costs and benefits of the new product as presented to the committee, with the most contentious issues high- lighted. The top part of the table shows the initial investment and antic- ipated salvage value in five years. The smartphone business was changing so rapidly that executives believed improved new devices would make the contemplated product obsolete within about five years. The center portion of the table is essentially a projected income state- ment for the new product, while the bottom portion, beginning with “Free Cash Flow,” contains the financial analysis. According to these figures, the new line costs $46 million and promises a 37 percent inter- nal rate of return.

Free cash flow (FCF) is the “bottom line” of investment projections. It is the estimated total cash consumed or generated each year by the investment, and as such is the cash flow stream we discount to calculate the investment’s NPV or IRR. A generic definition is

FCF � Earnings after tax � Noncash charges � Investment

Chapter 7 Discounted Cash Flow Techniques 261



262 Part Four Evaluating Investment Opportunities

TABLE 7.4 Division Financial Analysis of New Line of Smartphones ($ millions)


0 1 2 3 4 5

Plant and equipment $(30) $ 15 Increased working capital (14) Preliminary engineering (2) Excess capacity 0

Total investment $(46) Total salvage value $ 15

Sales $60 $82 $140 $157 $120 Cost of sales 26 35 60 68 52

Gross profit 34 47 80 89 68 Interest expense 5 4 4 3 3 Allocated expenses 0 0 0 0 0 Selling and administrative expenses 10 13 22 25 19

Total operating expenses 14 17 26 28 22 Operating income 20 29 54 61 46

Depreciation 3 3 3 3 3

Income before tax 17 26 51 58 43 Tax at 40 percent 7 11 20 23 17

Income after tax $10 $16 $ 30 $ 35 $ 26 Free cash flow $(46) $10 $16 $ 30 $ 35 $ 41 Net present value @ 15% $ 35 Benefit-cost ratio 1.76 Internal rate of return 37%

Totals may not add due to rounding.

where we think of a project’s salvage value as a negative investment. We will say more about FCF in later chapters.

Depreciation The first point of contention at the meeting was the division’s treatment of depreciation. As shown in Table 7.4, division analysts had followed con- ventional accounting practice by subtracting depreciation from gross profit to calculate profit after tax. Upon seeing this, one committee mem- ber asserted that depreciation was a noncash charge and therefore irrele- vant to the decision, while other participants agreed that depreciation was relevant but maintained the division’s approach was incorrect. Ms. Sanders needed to determine the correct approach.

Accountants’ treatment of depreciation is reminiscent of the Swiss method of counting cows: Count the legs and divide by four. It gets the job done, but not always in the most direct manner. Division analysts are



correct in noting that the physical deterioration of assets is an economic fact of life that must be included in investment evaluation. However, they did this when they forecasted that the salvage value of new plant and equipment would be less than its original cost. Thus, new plant and equip- ment constructed today for $30 million and salvaged five years later for $15 million is clearly forecasted to depreciate over its life. Having in- cluded depreciation by using a salvage value below initial cost, it would clearly be double-counting to also subtract an annual amount from oper- ating income as accountants would have us do.

And here our story would end were it not for the tax collector. Although annual depreciation is a noncash charge and hence irrelevant for investment analysis, annual depreciation does affect a company’s tax bill, and taxes are relevant. So we need to use the following two-step procedure: (1) Use stan- dard accrual accounting techniques, including the treatment of depreciation as a cost, to calculate taxes due; then (2) add depreciation back to income after tax to calculate the investment’s after-tax cash flow (ATCF). ATCF is the correct measure of an investment’s operating cash flow. Note that ATCF equals the first two terms in the free cash flow expression just defined, where depreciation is the most common noncash charge.

Table 7.4 reveals that division analysts did step 1 but not step 2. They neglected to add depreciation back to income after tax to calculate ATCF. Given their estimates, the appropriate number for year 1 is

After-tax cash flow � Earnings after tax � Depreciation $13 � $10 � $3

I should hasten to add that in the course of the next few pages, we will make further corrections to the table, resulting in additional changes in ATCF. But focusing now solely on depreciation, $13 million is the correct number.

The following table shows the full two-step process for calculating year 1 ATCF:

Chapter 7 Discounted Cash Flow Techniques 263

Note the subtraction of depreciation to calculate taxable income and the subsequent addition of depreciation to calculate ATCF.

Operating income $20 Less: Depreciation 3

Profit before tax 17 Less: Tax at 40% 7

Income after tax 10 Plus: Depreciation 3

After-tax cash flow $13



The table also suggests a second way to calculate ATCF:

After-tax cash flow � Operating income � Taxes $13 � $20 � $7

This formulation shows clearly that depreciation is irrelevant for calculat- ing ATCF except as it affects taxes.

Working Capital and Spontaneous Sources In addition to increases in fixed assets, many investments, especially those for new products, require increases in working-capital items such as in- ventory and receivables. According to the with-without principle, changes in working capital that are the result of an investment decision are rele- vant to the decision. Indeed, in some instances, they are the largest cash flows involved.

Division analysts thus are correct to include a line item in their spread- sheet for changes in working capital. However, working capital investments

264 Part Four Evaluating Investment Opportunities

Depreciation as a Tax Shield Here is yet another way to view the relation between depreciation and ATCF.

The recommended way to calculate an investment’s ATCF is to add depreciation to profit after tax. In symbols,

ATCF � (R � C � D)(I � T) � D

where R is revenue, C is cash costs of operations, D is depreciation, and T is the firm’s tax rate. Com- bining the depreciation terms, this expression can be written as

ATCF � (R �C )(I � T ) � TD

where the last term is known as the tax shield from depreciation. This expression is interesting in several respects. First, it shows unambiguously that were it not

for taxes, annual depreciation would be irrelevant for estimating an investment’s ATCF. Thus, if T is zero in the expression, depreciation disappears entirely.

Second, the expression demonstrates that ATCF rises with depreciation. The more depreciation a profitable company can claim, the higher its ATCF. On the other hand, if a company is not paying taxes, added depreciation has no value.

Third, the expression is useful for evaluating a class of investments known as replacement de- cisions, in which a new piece of equipment is being considered as a replacement for an old one. In these instances, cash operating costs and depreciation may vary among equipment options, but not revenues. Because revenues do not change among equipment options, the with-without principle tells us they are not relevant to the decision. Setting R equal to zero in the above equation,

ATCF � (�C)(I � T ) � TD

In words, the relevant cash flows for replacement decisions are operating costs after tax plus de- preciation tax shields.



have several unique features not captured in the division’s numbers. First, working-capital investments usually rise and fall with the new product’s sales volume. Second, they are reversible in the sense that at the end of the investment’s life, the liquidation of working-capital items usually generates cash inflows approximately as large as the original outflows. Or, said differ- ently, working-capital investments typically have large salvage values. The third unique feature is that many investments requiring working-capital in- creases also generate spontaneous sources of cash that arise in the natural course of business and have no explicit cost. Examples include increases in virtually all non-interest-bearing short-term liabilities such as accounts payable, accrued wages, and accrued taxes. The proper treatment of these spontaneous sources is to subtract them from the increases in current assets when calculating the project’s working-capital investment.

To illustrate, the following table shows a revised estimate of the working- capital investment required to support the division’s new product assum- ing (1) new current assets, net of spontaneous sources, equal 20 percent of sales and (2) full recovery of working capital at the end of the product’s life. Note that the annual investment equals the year-to-year change in working capital so that it rises and falls with sales.

Year 0 1 2 3 4 5

New-phone sales $ 0 $ 60 $ 82 $ 140 $157 $120 Working capital @ 20% of sales 0 12 16 28 31 24 Change in working capital 0 12 4 12 3 �7 Recovery of working capital 24

Total working capital investment $ 0 $ (12) $ (4) $ (12) $ (3) $ 31

Sunk Costs A sunk cost is one that has already been incurred and that, according to the with-without principle, is not relevant to present decisions. By this crite- rion, the division’s inclusion of $2 million in already incurred preliminary engineering expenses is clearly incorrect and should be eliminated. The division’s response that “we need to record these costs somewhere or the engineers will spend preproduction money like water” has merit. But the proper place to recognize them is in a separate expense budget, not in the new-product proposal. When making investment decisions, it is important to remember that we are seekers of truth, not auditors controlling costs or managers measuring performance. We are thus not captives of the partic- ular reporting or performance appraisal systems used by the company.

This seems easy enough, but here are two examples where ignoring sunk costs is psychologically harder to do. Suppose you purchased some common

Chapter 7 Discounted Cash Flow Techniques 265



stock a year ago at $100 a share and it is presently trading at $70. Even though you believe $70 is an excellent price for the stock given its current prospects, would you be prepared to admit your mistake and sell it now, or would you be tempted to hold it in the hope of recouping your original in- vestment? The with-without principle says the $100 price is sunk and hence irrelevant, except for possible tax effects, so sell the stock. Natural human reluctance to admit a mistake and the daunting prospect of having to justify the mistake to a skeptical boss or spouse frequently muddy our thinking.

As another example, suppose the R&D department of a company has de- voted 10 years and $10 million to perfecting a new, long-lasting light bulb. Its original estimate was a development time of two years at a cost of $1 million, and every year since R&D has progressively extended the development time and increased the cost. Now it is estimating only one more year and an added expenditure of only $1 million. Since the present value of the bene- fits from such a light bulb is only $4 million, there is strong feeling in the company that the project should be killed and whoever had been approving the budget increases throughout the years should be fired.

In retrospect, it is clear the company should never have begun work on the light bulb. Even if successful, the cost will be well in excess of the ben- efits. Yet at any point along the development process, including the cur- rent decision, it may have been perfectly rational to continue work. Past expenditures are sunk, so the only question at issue is whether the antici- pated benefits exceed the remaining costs required to complete develop- ment. Past expenditures are relevant only to the extent that they influence one’s assessment of whether the remaining costs are properly estimated. So if you believe the current estimates, the light bulb project should con- tinue for yet another year.

Allocated Costs The proper treatment of depreciation, working capital, and sunk costs in in- vestment evaluation is comparatively straightforward. Now things get a bit murkier. According to Plasteel Communications’s Capital Budgeting Manual,

New investments that increase sales must bear their fair share of corporate overhead expenses. Therefore, all new-product proposals must include an annual overhead charge equal to 14 percent of sales, without exception.

Yet, as Table 7.4 reveals, division analysts ignored this directive in their analysis of the new smartphone. They did so on the grounds that the man- ual is simply wrong, that allocating overhead expenses to new products violates the with-without principle and stifles creativity. In their words, “If exciting projects like this one have to bear the deadweight costs of corpo- rate overhead, we’ll never be competitive in this business.”

266 Part Four Evaluating Investment Opportunities



The point at issue here is whether expenses not directly associated with a new investment, such as the president’s salary, legal department expenses, and accounting department expenses, are relevant to the decision. A straightforward reading of the with-without principle says that if the presi- dent’s salary will not change as a result of the new investment, it is not rele- vant, nor are legal and accounting department expenses, if they will not change. This is clear enough. If they won’t change, they aren’t relevant.

But who is to say these expenses will not change with the new invest- ment? Indeed, it appears to be an inexorable fact of life that over time, as companies grow, presidents’ salaries become larger while legal and accounting departments expand. The issue therefore is not whether expenses are allocated but whether they vary with the size of the business. Although we may be unable to see a direct cause-effect tie between such expenses and increasing sales, a longer-run relation likely exists between the two. Consequently, it does make sense to require all sales-increasing investments to bear a portion of those allocated costs that grow with sales. Remember, allocated costs are not necessarily fixed costs.

A related problem arises with cost-reducing investments. To illustrate, as a part of their performance appraisal system, many companies allocate overhead costs to departments or divisions in proportion to the amount of direct labor expense the unit incurs. Suppose a department manager in such an environment has the opportunity to invest in a labor-saving asset. From the department’s narrow perspective, such an asset offers two bene- fits: (1) a reduction in direct labor expense and (2) a reduction in the over- head costs allocated to the department. Yet from the total-company perspective and from the correct economic perspective, only the reduc- tion in direct labor is a benefit because the total-company overhead costs are unaffected by the decision. They are simply reallocated from one cost center to another, and thus, are not relevant to the investment decision.

Cannibalization During the meeting, a product manager in another division argued that the new smartphone proposal was “incomplete and overly optimistic.” He stressed two points. First, the decision should be made from a corporate per- spective, not from a narrow divisional one. Second, from this perspective the projected cash flows must reflect the reality that the new device will canni- balize sales of existing offerings. That is, the new device will attract a num- ber of customers who would otherwise purchase one of the company’s existing products. By his estimate, the new device would attract about 10 per- cent of his division’s customer base, resulting in lost cash flows of approxi- mately $7 million a year. He argued that, at a minimum, this figure must appear as an annual cost in the new device’s projected cash flows.

Chapter 7 Discounted Cash Flow Techniques 267



The product manager is correct that the decision should be made from a corporate perspective. Moreover, the with-without principle appears to support his contention that the new product should bear any cannibalization costs. But does it really? Plasteel Communications is certainly not the only innovator among smartphone manufacturers. Suppose, for example, that Samsung or LG Electronics will likely intro- duce a similar flexible-screen smartphone whether Plasteel does or not. In this circumstance, the sales in question will be lost whatever Plasteel decides to do, and are thus not relevant to the decision. Ultimately, then, whether losses due to cannibalization are relevant hinges on the degree of competition, and the proper mantra in competitive markets is “better we eat our lunch than our competitors do.” I believe Nina Sanders is correct to ignore cannibalization costs in Table 7.4. To do otherwise would be to erect a dangerous barrier to innovation.

The treatment of cannibalization in resource allocation decisions can have important strategic implications. Frequently, dominant firms in an industry are reluctant to adopt new, disruptive technologies due to con- cern about cannibalizing existing lucrative activities. This reluctance to innovate can open the door for smaller new entrants, who have no such worries, to compete effectively against entrenched giants. A case in point is the cell phone industry itself, in which pipsqueak McCaw Cel- lular Communications competed effectively against giant AT&T for many years, in large part because AT&T was concerned that cell phone revenues would just cannibalize land line revenues to no net gain. It was not until 1994, when the cell phone industry truly threatened to eat AT&T’s lunch, that the behemoth finally acted by purchasing McCaw for over $10 billion.

Excess Capacity The most acrimonious debate over the proposed new product involved the Handheld Division’s plan to use another division’s excess production capacity. Three years earlier, the Switching Division had added a new production line that was presently operating at only 50 percent capacity. Handheld analysts reasoned that they could put this idle capacity to good use by manufacturing several subcomponents of their new smart- phone there. As they saw it, using idle capacity avoided a major capital expenditure and saved the corporation money. They therefore had assigned zero cost to use of the excess capacity. The general manager of the Switching Division saw things rather differently. He argued vehemently that those assets were his, he had paid for them, and he damned sure wasn’t going to give them away. He demanded that the

268 Part Four Evaluating Investment Opportunities



Handheld Division either purchase his idle capacity for a fair price or build their own production line. He estimated that the excess capacity was worth at least $20 million. Handheld analysts responded that this was nonsense. The excess capacity had already been paid for and was thus a sunk cost for the current decision.

For technological reasons, it is frequently necessary to acquire more capacity than needed to accomplish a task, and the question arises of how to handle the excess. In this instance, as is often the case, the an- swer depends on the company’s future plans. If the Switching Division has no alternative use for the excess capacity now or in the future, no cash flows are triggered when the Handheld Division uses it. The idle capacity thus is a free good with zero cost. On the other hand, if the Switching Division has alternative uses for the capacity now, or if it is likely to need the capacity in the future, there are costs associated with its use by the Handheld Division, and they should appear in the new- product proposal.

As a concrete example, suppose the Switching Division estimates that it will need the excess capacity in two years to accommodate its own growth. In this event, it is appropriate to assign zero cost to the ca- pacity for the first two years but to require the Handheld Division’s new product to bear the cost of new capacity at the end of year 2. Even though the Handheld Division may not ultimately occupy the new ca- pacity, its acquisition is contingent on today’s decision and therefore relevant to that decision. After the dust settles, the Handheld Division benefits from the temporarily idle capacity by deferring expenditures on new capacity for two years.

Sharing resources among divisions in this way raises a host of practi- cal accounting questions such as whether the first division should com- pensate the second for resources used, how the transaction will affect divisional performance measures, and how the cost of new capacity in two years will be recorded. However, because these questions do not in- volve the movement of cash to or from the firm, they are not germane to the investment decision. The watchword thus should be to make the correct investment choice today and worry about accounting issues such as these later.

The reverse excess capacity problem also arises: A company is contem- plating acquisition of an asset that is too large for its present needs and must decide how to treat the excess capacity created. For example, sup- pose a company is considering the acquisition of a hydrofoil boat to pro- vide passenger service across a lake, but effective use of the hydrofoil will require construction of two very expensive special-purpose piers. Each pier will be capable of handling 10 hydrofoils, and for technical reasons it

Chapter 7 Discounted Cash Flow Techniques 269



is impractical to construct smaller piers. If the full cost of the two piers must be borne by the one boat presently under consideration, the boat’s NPV will be large and negative, suggesting rejection of the proposal; yet if only one-tenth of the pier costs are assigned to the boat, its NPV will be positive. How should the pier costs be treated?

The proper treatment of the pier costs again depends on the company’s future plans. If the company does not anticipate acquiring any additional hydrofoils in the future, the full cost of the piers is relevant to the present decision. On the other hand, if this boat is but the first of a contemplated fleet of hydrofoils, it is appropriate to consider only a fraction of the pier’s costs today. More generally, the problem the company faces is that of defining the investment. The relevant question is not whether the com- pany should acquire a boat but whether it should enter the hydrofoil transportation business. The broader question forces the company to look at the investment over a longer time span and consider explicitly the num- ber of boats to be acquired.

Financing Costs Financing costs refer to any dividend, interest, or principal payments as- sociated with the particular means by which a company intends to fi- nance an investment. As shown in Table 7.4, Handheld Division analysts anticipate financing a significant fraction of the new product’s cost with debt and have included a line item in their projections for the interest cost on the debt. Nina Sanders realized that according to the with-without principle, financing costs of some sort are relevant to the decision; money is seldom free. But she was not sure her analysts had treated them properly.

Ms. Sanders’s intuition is correct. Her analysts have indeed erred by including interest expense among the cash flows. Financing costs are cer- tainly relevant to investment decisions, but care must be taken not to double-count them. As Chapter 8 will clarify, the most common discount rate used in calculating any of the recommended figures of merit equals the annual percentage cost of capital to the company. It would obviously be double-counting to subtract financing costs from an investment’s annual cash inflows and expect the investment to also generate a return greater than the cost of the capital employed. The standard procedure, therefore, is to reflect the cost of money in the discount rate and ignore all financ- ing costs when estimating an investment’s cash flows. We will revisit this problem in the next chapter.

Table 7.5 presents Ms. Sanders’s revised figures for her division’s new-product proposal reflecting all of the suggested corrections. The new line of smartphones still looks attractive, with an IRR of 30 percent, and Ms. Sanders now has reason to be more confident of her division’s

270 Part Four Evaluating Investment Opportunities



Chapter 7 Discounted Cash Flow Techniques 271

TABLE 7.5 Revised Financial Analysis of New Line of Smartphones ($ millions)

Assumptions: Increased working capital 20% of sales, full recovery at end of year 5 Preliminary engineering Already spent—sunk cost Excess capacity $20 million cost of new capacity in year 2,

$2 million annual depreciation, continuing value in year 5 of $14 million Interest expense Subsumed in discount rate Allocated expenses Variable allocated costs equal to 14% of sales


0 1 2 3 4 5

Plant and equipment $(30) 15 Increased working capital 0 (12) (4) (12) (3) 31 Preliminary engineering 0 Excess capacity (20) 14

Total costs $(30) $(12) $(24) $ (12) $ (3) Total salvage value $ 60

Sales $ 60 $ 82 $140 $157 $120 Cost of sales 26 35 60 68 52

Gross profit 34 47 80 89 68 Interest expense 0 0 0 0 0 Allocated expenses 8 11 20 22 17 Selling and administrative expenses 10 13 22 25 19

Total operating expenses 18 25 42 47 36 Operating income 16 22 38 42 32

Depreciation 3 3 5 5 5

Income before tax 13 19 33 37 27 Tax at 40% 5 8 13 15 11

Income after tax $ 8 $ 11 $ 20 $ 22 $ 16 Add back depreciation 3 3 5 5 5

After-tax cash flow $ 11 $ 14 $ 25 $ 27 $ 21

Free cash flow $(30) $ (1) $(10) $ 13 $ 24 $ 82

Net present value @ 15% $ 25 Benefit-cost ratio* 1.64 Internal rate of return 30%

Totals may not add due to rounding. *BCR � PVinflows/PVoutflows � $63.0/$38.4 � 1.64.

recommendations and to expect a more cordial welcome from her col- leagues on the Capital Budget Review Committee.

From these examples, I hope you have gained an appreciation for the challenges executives face in identifying relevant costs and benefits in new investment opportunities and why this is a job for operating managers, not finance specialists.




Mutually Exclusive Alternatives and Capital Rationing I noted briefly in the chapter that the presence of mutually exclusive alternatives or capital rationing complicates investment analysis. This appendix explains how investments should be analyzed in these cases.

Two investments are mutually exclusive if accepting one precludes fur- ther consideration of the other. The choices between building a steel or a concrete bridge, laying a 12-inch pipeline instead of an 8-inch one, or driving to Boston instead of flying are all mutually exclusive alternatives. In each case, there is more than one way to accomplish a task, and the objective is to choose the best way. Mutually exclusive investments stand in contrast to independent investments, where each opportunity can be analyzed on its own without regard to other investments.

When investments are independent and the decision is simply to ac- cept or reject, the NPV, the BCR, and the IRR are equally satisfactory figures of merit. You will reach the same investment decision regardless of the figure of merit used. When investments are mutually exclusive, the world is not so simple. Let’s consider an example. Suppose Petro Oil and Gas Company is considering two alternative designs for new service stations and wants to evaluate them using a 10 percent discount rate. As the cash flow diagrams in Figure 7A.1 show, the inexpensive option in- volves a present investment of $522,000 in return for an anticipated $100,000 per year for 10 years; the expensive option costs $1.1 million but, because of its greater customer appeal, is expected to return $195,000 per year for 10 years.

Table 7A.1 presents the three figures of merit for each investment. All the figures of merit signal that both options are attractive, the NPVs are

272 Part Four Evaluating Investment Opportunities



$1.1 million


1 2 3 4 5 6 7 8 109 1 2 3 4 5 6 7 8 109 Inexpensive option Expensive option

0 0

FIGURE 7A.1 Cash Flow Diagrams for Alternative Service Station Designs



positive, the BCRs are greater than 1.0, and the IRRs exceed Petro’s op- portunity cost of capital. If it were possible, Petro should make both in- vestments, but because they are mutually exclusive, this does not make technical sense. So rather than just accepting or rejecting the investments, Petro must rank them and select the better one. When it comes to rank- ing the alternatives, however, the three figures of merit no longer give the same signal, for although the inexpensive option has a higher BCR and a higher IRR, it has a lower NPV than the expensive one.

To decide which figure of merit is appropriate for mutually exclusive al- ternatives, we need only remember that the NPV is a direct measure of the anticipated increase in wealth created by the investment. Since the expen- sive option will increase wealth by $98,200, as opposed to only $92,500 for the inexpensive option, the expensive option is clearly superior.

The problem with the BCR and the IRR for mutually exclusive alter- natives is that they are insensitive to the scale of the investment. As an ex- treme example, would you rather have an 80 percent return on a $1 investment or a 50 percent return on a $1 million investment? Clearly, when investments are mutually exclusive, scale is relevant, and this leads to the use of the NPV as the appropriate figure of merit.

What Happened to the Other $578,000?

Some readers may think the preceding reasoning is incomplete because I have said nothing about what Petro can do with the $578,000 it would save by choosing the inexpensive option. It would seem that if this saving could be invested at a sufficiently attractive return, the inexpensive option might prove to be superior after all. We will address this concern in the section titled “Capital Rationing.” For now, it is sufficient to say that the problem arises only when there is a fixed limit on the amount of money Petro has available to invest. When the company can raise enough money to make all investments promising positive NPVs, the best use of any money saved by selecting the inexpensive option must be to invest in zero- NPV opportunities. And because zero-NPV investments do not increase wealth, any money saved by selecting the low-cost option does not alter our decision.

Chapter 7 Discounted Cash Flow Techniques 273

TABLE 7A.1 Figures of Merit for Service Station Designs

NPV at 10% BCR at 10% IRR

Inexpensive option $92,500 1.18 14% Expensive option 98,200 1.09 12



Unequal Lives

The Petro Oil and Gas example conveniently assumed that both service station options had the same 10-year life. This, of course, is not always the case. When the alternatives have different lives, a simple compari- son of NPVs is usually inappropriate. Consider the problem faced by a company trying to decide whether to build a wooden bridge or a steel one:

• The wooden bridge has an initial cost of $125,000, requires annual maintenance expenditures of $15,000, and will last 10 years.

• The steel bridge costs $200,000, requires $5,000 annual maintenance, and will last 40 years.

Which is the better buy? At a discount rate of, say, 15 percent, the present value cost of the wooden bridge over its expected life of 10 years is $200,282 ($125,000 initial cost � $75,282 present value of maintenance expenditures as shown next).

This compares with a figure for the steel bridge over its 40-year life of $233,209 ($200,000 initial cost � $33,209 present value of maintenance expenditures as shown next).

So if the object is to minimize the cost of the bridge, a simple comparison of present values would suggest that the wooden structure is a clear win- ner. However, this obviously overlooks the differing life expectancy of the two bridges, implicitly assuming that if the company builds the wooden bridge, it will not need a bridge after 10 years.

The message is clear: When comparing mutually exclusive alternatives having different service lives, it is necessary to reflect this difference in the analysis. One approach is to examine each alternative over the same com- mon investment horizon. For example, suppose our company believes it

=PV(.15,40,5) = ($33.209) PV(rate, nper, pmt, [fv], [type])

=PV(.15,40,5) = ($33.209) PV(rate, nper, pmt, [fv], [type])

274 Part Four Evaluating Investment Opportunities



will need a bridge for 20 years; due to inflation, the wooden bridge will cost $200,000 to reconstruct at the end of 10 years; and the salvage value of the steel bridge in 20 years will be $90,000. The cash flow diagrams for the two options are thus as follows:

Now the present value cost of the wooden bridge is $268,327 ($125,000 initial cost � $93,890 present value of maintenance expenditures as shown below � $49,437 present value cost of a new bridge in 10 years as shown below).

And the cost of the steel bridge is $225,798 ($200,000 initial cost � $25,798 present value of maintenance expenditures net of salvage value).

=PV(.15,20,5,-90) = ($25.798) PV(rate, nper, pmt, [fv], [type])

=PV(.15,10,0,200) = ($49.437) PV(rate, nper, pmt, [fv], [type])

=PV(.15,20,15) = ($93.890) PV(rate, nper, pmt, [fv], [type])


0 1 2 3 4

$ 90

$ 5 20

Steel bridge ($ thousands)


0 1 2 3 4 $ 15


Wooden bridge ($ thousands)



Chapter 7 Discounted Cash Flow Techniques 275



Compared over a common 20-year investment horizon, the steel bridge has the lower present value cost and is thus superior.

A second way to choose among mutually exclusive alternatives with differing lives is to calculate the equivalent annual cost of each. Here’s the arithmetic for the two bridges.

Wooden bridge

Steel bridge

Spreading the $200,282 present value cost of the wooden bridge over its 10-year life expectancy, we find that the bridge’s equivalent annual cost is $39,900, while the analogous figure over a 40-year life for the steel bridge is only $35,100. Looking at the decision over a 40-year horizon, and assuming no change in the cost of a new wooden bridge every 10 years, our decision is now obvious. Because we can have the steel bridge at an equivalent annual cost below that of the wooden bridge, the steel bridge is the better choice.

But notice the assumption necessary to reach this conclusion. If due to technological improvements, we believe the replacement cost of the wooden bridge will fall over time, its higher equivalent annual cost in the first decade might well be offset by lower annual costs in subsequent decades, tipping the balance in favor of the wooden bridge. Similarly, if we believe inflation will cause the replacement cost of the wooden bridge to rise over time, its equivalent annual cost in the first decade is again insufficient information on which to base an informed decision. We conclude that equivalent annual costs are a slick way to analyze mu- tually exclusive alternatives with differing lives when prices are con- stant. However, the technique is more difficult to apply in the face of changing prices.

=PMT(.15,40,233.209) = ($35.1) PMT(rate, nper, pv, [fv], [type])

=PMT(.15,10,200.282) = ($39.9) PMT(rate, nper, pv, [fv], [type])

276 Part Four Evaluating Investment Opportunities



Capital Rationing

Implicit in our discussion to this point has been the assumption that money is readily available to companies at a cost equal to the discount rate. The other extreme is capital rationing. Under capital rationing, the company has a fixed investment budget that it may not exceed. As was true with mutually exclusive alternatives, capital rationing requires us to rank investments rather than simply accept or reject them. Despite this simi- larity, however, you should understand that the two conditions are fundamentally different. With mutually exclusive alternatives, the money is available but, for technical reasons, the company cannot make all investments. Under capital rationing, it may be technically possible to make all investments, but there is not enough money. This difference is more than semantic, for, as the following example illustrates, the nature of the ranking process differs fundamentally in the two cases.

Suppose Sullivan Electronics Company has a limited investment budget of $200,000 and management has identified the four independent investment opportunities appearing in Table 7A.2. According to the three figures of merit, all investments should be undertaken, but this is impossi- ble because the total cost of the four investments exceeds Sullivan’s budget. Looking at the investment rankings, the NPV criterion ranks A as the best investment, followed by B, C, and D in that order, while the BCR and IRR rank C best, followed by D, B, and A. So we know that A is either the best investment or the worst.

To make sense of these rankings, we need to remember that the un- derlying objective in evaluating investment opportunities is to increase wealth. Under capital rationing, this means the company should under- take that bundle of investments generating the highest total NPV. How is this to be done? One way is to look at every possible bundle of in- vestments having a total cost less than the budget constraint and select the bundle with the highest total NPV. A shortcut is to rank the investments

Chapter 7 Discounted Cash Flow Techniques 277

TABLE 7A.2 Four Independent Investment Opportunities under Capital Rationing (capital budget � $200,000)

Investment Initial Cost NPV at 12% BCR at 12% IRR

A $200,000 $10,000 1.05 14.4% B 120,000 8,000 1.07 15.1 C 50,000 6,000 1.12 17.6 D 80,000 6,000 1.08 15.5



by their BCRs and work down the list, accepting investments until either the money runs out or the BCR drops below 1.0. This suggests that Sullivan should accept projects C, D, and 7�12 of B, for a total NPV of $16,670 [(6,000 � 6,000 � 7�12 � 8,000)]. Only 7�12 of B should be undertaken because the company has only $70,000 remain- ing after accepting C and D.

Why is it incorrect to rank investments by their NPVs under capital rationing? Because under capital rationing, we are interested in the payoff per dollar invested—the bang per buck—not just the payoff itself. The Sullivan example illustrates the point. Investment A has the largest NPV, equal to $10,000, but it has the smallest NPV per dollar invested. Since investment dollars are limited under capital rationing, we must look at the benefit per dollar invested when ranking investments. This is what the BCR does.

Two other details warrant mention. In the preceding example, the IRR provides the same ranking as the BCR, and although this is usually the case, it is not always so. It turns out that when the two rankings dif- fer, the BCR ranking is the correct one. Why the rankings differ and why the BCR is superior are not worth explaining here. It is sufficient to remember that if you rank by IRR rather than BCR, you might oc- casionally be in error. A second detail is that when fractional invest- ments are not possible—when it does not make sense for Sullivan Electronics to invest in 7�12 of project B—rankings according to any figure of merit are unreliable, and one must resort to the tedious method of looking at each possible bundle of investments in search of the highest total NPV.

The Problem of Future Opportunities

Implicit in the preceding discussion is the assumption that as long as an investment has a positive NPV, it is better to make the investment than to let the money sit idle. However, under capital rationing, this may not be true. To illustrate, suppose the financial executive of Sullivan Electronics believes that within six months, company scientists will develop a new product costing $200,000 and having an NPV of $60,000. In this event, the company’s best strategy is to forgo all the investments presently under consideration and save its money for the new product.

This example illustrates that investment evaluation under capital rationing involves more than a simple appraisal of current opportunities; it also involves a comparison between current opportunities and future prospects. The difficulty with this comparison at a practical level is that it

278 Part Four Evaluating Investment Opportunities



Chapter 7 Discounted Cash Flow Techniques 279

FIGURE 7A.2 Capital Budgeting Decision Tree

is unreasonable to expect a manager to have anything more than a vague impression of what investments are likely to arise in the future. Conse- quently, it is impossible to decide with any assurance whether it is better to invest in current projects or wait for brighter future opportunities. This means practical investment evaluation under capital rationing necessarily involves a high degree of subjective judgment.

A Decision Tree

Mutually exclusive investment alternatives and capital rationing compli- cate an already confusing topic. To provide a summary and an overview, Figure 7A.2 presents a capital budgeting decision tree. It indicates the figure or figures of merit that are appropriate under the various condi- tions discussed in the chapter. For example, following the lowest branch in the tree, we see that when evaluating investments under capital ra- tioning that are independent and can be acquired fractionally, ranking by the BCR is the appropriate technique. To review your understanding of the material, see if you can explain why the recommended figures of merit are appropriate under the various conditions indicated, whereas the others are not.

Ind epe

nde nt

Capital rationing


Fractional projects

Mutually exclusive

Equal lives

No fractional projects

Unequal lives

Unequal lives

Equ al l


Mutu ally e

xclus ive

Accept bundle of investments with highest NPV

Accept bundle of investments with highest NPV over common horizon

Accept bundle of investments with highest NPV

Rank by BCR

Rank by NPV

Rank by NPV over common investment horizon

Use NPV, IRR, or BCR



280 Part Four Evaluating Investment Opportunities


1. Evaluation of an investment opportunity involves three steps: • Estimate relevant cash flows. • Calculate a figure of merit. • Compare the figure of merit to an acceptance criterion.

2. Money has a time value because • Cash deferred imposes an opportunity cost. • Inflation reduces purchasing power over time. • Risk customarily increases with the futurity of a cash flow.

3. Equivalence • Says that a present sum and future cash flows have the same value

when the present sum can be invested at the discount rate to replicate the future cash flows.

• Enables the use of compounding and discounting to eliminate the time dimension from investment analysis.

4. The Net Present Value (NPV) • Equals the difference between the present value of an investment’s

cash inflows and the present value of its outflows. • Is a valid figure of investment merit. • When positive, indicates the investment should be undertaken. • Is an estimate of the expected increase or decrease in wealth accruing

to the investor. • Provides a practical decision rule for managers seeking to create

shareholder value.

5. The Internal Rate of Return (IRR) • Is the discount rate at which an investment’s NPV equals zero. • Is the rate at which money retained in the investment is growing. • Is a breakeven rate, meaning that in most instances an investment

should be undertaken whenever its IRR exceeds the discount rate, and vice versa.

• Is a close cousin of the NPV and in most circumstances a valid fig- ure of merit.

6. Estimation of relevant cash flows • Is the most difficult task in evaluating investment opportunities. • Is guided by two broad principles:

– The cash flow principle: If money moves, count it, otherwise do not.



Chapter 7 Discounted Cash Flow Techniques 281

– The with-without principle: All cash flows that differ with or without the investment are relevant, all others are not.

• Presents recurring challenges involving: – Annual depreciation: Only relevant to estimate taxes. – Working capital and Net amount relevant including

spontaneous sources: salvage value. – Sunk costs: Not relevant. – Allocated costs: Relevant when variable. – Cannibalization: Seldom relevant in competitive

markets. – Excess capacity: Relevant if alternative use now or in

future. – Financing costs: Relevant but usually captured in

discount rate, not cashflows.


Bierman, Harold, and Seymour Smidt. The Capital Budgeting Decision, 9th ed. Philadelphia, PA: Taylor & Francis, Inc., 2006. 402 pages.

The names Bierman and Smidt, both faculty members at Cornell Uni- versity, have been synonymous with capital budgeting for many years. This edition is a clear and concise introduction to a complex topic. Available in paperback for $64. (See also Advanced Capital Budgeting Refinements in The Economic Analysis of Investment Projects, by the same authors. 2007. 392 pages. Available in paperback for $57.)


Written to accompany this text, the Excel program DCF performs a discounted cash flow analysis of user-supplied cash flows. Output consists of six figures of merit, including NPV and IRR, a present value profile graph, and a cash flow diagram. A copy is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information).

WEBSITES Financial Calculator Apps A number of financial calculators are available for iOS, including official versions of the popular Texas Instruments BAII Plus and Hewlett Packard 12C. In Apple’s app store, search for “financial calculator.” For Android, official TI and HP calculators are not available, but other independently created financial calculators are available at Google Play. A series of well-prepared interactive tutorials, including quizzes, on a range of business topics including NPV, IRR, and risk. More than 20 years of Warren Buffett’s legendary letters to shareholders, and an opportunity to purchase a Berkshire Hathaway golf shirt. Check out Buffett’s “Owner’s Manual,” a succinct explanation of Berkshire’s broad economic principles of operations. When I grow up, I want to write like Warren Buffett.

PROBLEMS Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are available in the Instructor Resources within McGraw-Hill’s Connect, connect. (See the Preface for more information).

There are several ways to perform the computations necessary to answer these questions. My choice is to use Microsoft Excel because of its power, flexibility, and ubiquity. A one-page tutorial on the use of Microsoft Excel to perform financial calculations is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information).

1. Answer the following questions assuming the interest rate is 8 percent. Time Value of Money Problems a. What is the present value of $1,000 to be received in four years? b. What is the present value of $1,000 to be received in eight

years? Why does the present value fall as the number of years increases?

c. What will be the value in seven years of $12,000 invested today? d. How much would you pay for the right to receive $5,000 at the

end of year 1, $4,000 at the end of year 2, and $8,000 at the end of year 5?

e. How long will it take for a $2,000 investment to double in value? f. What will be the value in 20 years of $1,000 invested at the end of

each year for the next 20 years? g. A couple wishes to save $250,000 over the next 18 years for their

child’s college education. What uniform annual amount must they deposit at the end of each year to accomplish their objective?

h. How long must a stream of $600 payments last to justify a purchase price of $7,500.00? Suppose the stream lasted only five years. How large would the salvage value (liquidating payment) need to be to justify the investment of $7,500.00?

282 Part Four Evaluating Investment Opportunities



Chapter 7 Discounted Cash Flow Techniques 283

i. The projected cash flows for an investment appear below. What is the investment’s NPV?

Year 0 1 2 3 4 5

Cash flow �$200 50 75 110 110 80

Rate of Return Problems j. An investment of $1,300 today returns $61,000 in 50 years. What

is the internal rate of return on this investment? k. An investment costs $900,000 today and promises a single payment

of $11.5 million in 22 years. What is the promised rate of return, IRR, on this investment?

l. What return do you earn if you pay $22,470 for a stream of $5,000 payments lasting ten years? What does it mean if you pay less than $22,470 for the stream? More than $22,470?

m. An investment promises to double your money in five years. What is the promised IRR on the investment?

n. The projected cash flows for an investment appear below. What is the investment’s IRR?

Year 0 1 2 3 4 5

Cash flow �$460 �28 75 160 280 190

o. In 2013, Picasso’s painting Le Rêve was sold to hedge-fund manager Steven A. Cohen for $155 million. In 1941, 72 years earlier, the same painting sold for $7,000. Calculate the rate of return on this investment. What does this suggest about the merits of fine art as an investment?

Bank Loan, Bond, and Stock Problems p. How much would you pay for a 10-year bond with a par value of

$1,000 and a 7 percent coupon rate? Assume interest is paid annually. q. How much would you pay for a share of preferred stock paying a

$5-per-share annual dividend forever? r. A company is planning to set aside money to repay $150 million in

bonds that will be coming due in eight years. How much money would the company need to set aside at the end of each year for the next eight years to repay the bonds when they come due? How would your answer change if the money were deposited at the be- ginning of each year?

s. An individual wants to borrow $120,000 from a bank and repay it in six equal annual end-of-year payments, including interest. What should the payments be for the bank to earn 8 percent on the loan? Ignore taxes and default risk.



284 Part Four Evaluating Investment Opportunities

2. Microsoft Corp. reported earnings per share of $0.66 in 2003 and $2.58 in 2013. At what annual rate did earnings per share grow over this period?

3. A developer offers lots for sale at $60,000, $10,000 to be paid at sale and $10,000 to be paid at the end of each of the next five years with “no interest to be charged.” In discussing a possible purchase, you find that you can get the same lot for $48,959 cash. You also find that on a time purchase there will be a service charge of $2,000 at the date of purchase to cover legal and handling expenses and the like. Ap- proximately what rate of interest before income taxes will actually be paid if the lot is purchased on this time payment plan?

4. You are looking to purchase a Tesla Model S luxury sedan. The price of the car is $77,520. However, you negotiate a six-year loan, with no money down and no monthly payments during the first year. After the first year, you will pay $1,250 per month for the following five years, with a balloon payment at the end to cover the remaining principal on the loan. The APR on the loan with monthly compounding is 5 percent. What will be the amount of the balloon payment six years from now?

5. A wealthy graduate of a local university wants to establish a scholar- ship to cover the full cost of one student each year in perpetuity at her university. To adequately prepare for the administration of the schol- arship, the university will begin awarding it starting in three years. The estimated full cost of one student this year is $45,000 and is ex- pected to stay constant in real terms in the future. If the scholarship is invested to earn an annual real return of 5 percent, how much must the donor contribute today to fully fund the scholarship?

6. You are selling a product on commission, at the rate of $1,000 per sale. To date you have spent $800 promoting a particular prospective sale. You are confident you can complete this sale with an added expendi- ture of some undetermined amount. What is the maximum amount, over and above what you have already spent, that you should be willing to spend to assure the sale?

7. One year ago, Caffe Vita Coffee Roasting Co. purchased three small- batch coffee roasters for $3.3 million. Now in 2013, the company finds that new roasters that offer significant advantages are available. The new roasters can be purchased for $4.5 million, and have no sal- vage value. Both the new and the old roasters are expected to last until 2023. Management anticipates that the new roasters will produce a gross margin of $1.2 million a year, so that, using straight-line depre- ciation, the annual taxable income will be $750,000.



Chapter 7 Discounted Cash Flow Techniques 285

The current roasters are expected to produce a gross profit of $600,000 a year and, assuming a total economic life of 11 years and straight-line depreciation, a profit before tax of $300,000. The cur- rent market value of the old roasters is $1.5 million. The company’s tax rate is 45 percent, and its minimum acceptable rate of return is 10 percent. Ignoring possible taxes on sale of used equipment and assuming zero salvage values at the end of the roasters’ economic lives, should Caffe Vita replace its year-old roasters?

8. Neptune Biometrics, despite its promising technology, is having diffi- culty generating profits. Having raised $85 million in an initial public offering of its stock early in the year, the company is poised to intro- duce a new product, an inexpensive fingerprint door lock. If Neptune engages in a promotional campaign costing $55 million this year, its annual after-tax cash flow over the next five years will be only $1 mil- lion. If it does not undertake the campaign, it expects its after-tax cash flow to be �$15 million annually for the same period. Assuming the company has decided to stay in its chosen business, is this campaign worthwhile when the discount rate is 8 percent? Why or why not?

9. Consider the following investment opportunity: Initial cost at time 0 $15 million Annual revenues beginning at time 1 $20 million Annual operating costs exclusive of depreciation $13 million Expected life of investment 5 years Salvage value after taxes $ 0 Annual depreciation for tax purposes $ 3 million Tax rate 40% What is the rate of return on this investment? Assuming the investor wants to earn at least 10 percent after corporate taxes, is this invest- ment attractive?

10. This problem tests your understanding of the chapter appendix. A company is considering the following investment opportunities.

Investment A B C

Initial cost ($ millions) 5.5 3.0 2.0 Expected life 10 yrs 10 yrs 10 yrs NPV @ 15% $340,000 $300,000 $200,000 IRR 20% 30% 40%

a. If the company can raise large amounts of money at an annual cost of 15 percent, and if the investments are independent of one an- other, which should it undertake?



b. If the company can raise large amounts of money at an annual cost of 15 percent, and if the investments are mutually exclusive, which should it undertake?

c. Considering only these three investments, if the company has a fixed capital budget of $5.5 million, and if the investments are in- dependent of one another, which should it undertake?

11. What’s wrong with this picture? In the following discussion see how many errors you can spot and explain briefly why each is an error. You do not need to correct the error. “Natalie, I think we’ve got a winner here. Take a look at these numbers!

($ thousand

Year 0 1 2 3 … 10

Initial cost �1,000 Units sold 100 100 100 … 100 Price/unit 15 15 15 … 15 Total revenue 1,500 1,500 1,500 … 1,500 Cost of goods sold 800 800 800 … 800 Gross profit 700 700 700 … 700 Operating expenses Depreciation 100 100 100 … 100 Interest expense 100 100 100 … 100

Income before tax 500 500 500 … 500 Tax @ 40% 200 200 200 … 200 Income after tax 300 300 300 … 300

“Now, Natalie, here’s how I figure it: The boss says our corporate goal should be to increase earnings by at least 15 percent every year, and this project certainly increases earnings. It adds $300,000 to net income after tax every year. My trusty calculator tells me that the rate of return on this project is 30 percent ($300/$1,000), well above our minimum target return of 10 percent. And if you want to use net pres- ent value, its NPV discounted at 10 percent is $843.50. So, what do you think, Natalie?” “Well, David, it looks pretty good, but I do have a few questions.” “Shoot, Natalie.” “OK. What about increases in accounts receivable and stuff like that?” “Not relevant! We’ll get that money back when the project termi- nates, so it’s equivalent to an interest-free loan, which is more of a benefit than a cost.”

286 Part Four Evaluating Investment Opportunities



“But, David, what about extra selling and administrative costs? Haven’t you left those out?” “That’s the beauty of this, Natalie. Given the recent recession, I fig- ure we can handle the added business with existing personnel. In fact, one of the virtues of the proposal is that we should be able to retain some people we would otherwise have to terminate.” “Well, you’ve convinced me, David. Now, I think it will be only fair if the boss puts you in charge of this exciting new project.”

12. Read the information regarding a possible new investment available from McGraw-Hill’s Connect or your course instructor. a. Complete the spreadsheet to estimate the project’s annual after tax

cash flows. b. What is the investment’s net present value at a discount rate of

10 percent? c. What is the investment’s internal rate of return? d. How does the internal rate of return change if the discount rate

equals 20 percent? e. How does the internal rate of return change if the growth rate in

EBIT is 8 percent instead of 3 percent? 13. The spreadsheet for this problem provides a brief overview of se-

lected financial functions in Excel and poses several questions regard- ing mortgage loans requiring monthly payments. The spreadsheet is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information).

14. This problem asks you to evaluate two mutually exclusive investment alternatives with differing life expectancies under various conditions including capital rationing. Relevant information about the invest- ments and specific questions are available for download from Mc- Graw-Hill’s Connect or your course instructor (see the Preface for more information).

15. You work for Mattel and you are negotiating with Warner Brothers for the rights to manufacture and sell Harry Potter lunchboxes (you already sell related action figures). Your marketing department estimates that you can sell $500 million worth of lunchboxes per year for three years, starting next year. At the end of year three, you will liquidate the assets of the business. Additional information is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). Given this information, identify the relevant cash flows, and calculate the investment’s net present value, benefit-cost ratio, and internal rate of return.

Chapter 7 Discounted Cash Flow Techniques 287





Risk Analysis in Investment Decisions

A man’s gotta make at least one bet a day, else he could be walking around lucky and never know it. Jimmy Jones, horse trainer

Most thoughtful individuals and some investment bankers know that all interesting financial decisions involve risk as well as return. By their na- ture, business investments require the expenditure of a known sum of money today in anticipation of uncertain future benefits. Consequently, if the discounted cash flow techniques discussed in the last chapter are to be useful in evaluating realistic investments, they must incorporate consider- ations of risk as well as return. Two such considerations are relevant. At an applied level, risk increases the difficulty of estimating relevant cash flows. More importantly at a conceptual level, risk itself enters as a fundamental determinant of investment value. If two investments promise the same ex- pected return but have differing risks, most of us will prefer the low-risk alternative. In the jargon of economics, we are risk averse, and as a result, risk reduces investment value.

Risk aversion among individuals and corporations creates the common pattern of investment risk and return shown in Figure 8.1. The figure shows that for low-risk investments, such as government bonds, expected return is modest, but as risk increases, so too must the anticipated return. I say “must” because the risk-return pattern shown is more than wishful thinking. Unless higher-risk investments promise higher returns, you and I, as risk-averse investors, will not hold them.

This risk-return trade-off is fundamental to much of finance. Over the past five decades, researchers have demonstrated that under idealized con- ditions, and with risk defined in a specific way, the risk-return trade-off is a straight line one as depicted in the figure. The line is known as the mar- ket line and represents the combinations of risk and expected return one can anticipate in a properly functioning economy.



The details of the market line need not detain us here. What is impor- tant is the realization that knowledge of an investment’s expected return is not enough to determine its worth. Instead, investment evaluation is a two-dimensional task involving a balancing of risk against return. The appropriate question when evaluating investment opportunities is not “What’s the rate of return?” but “Is the return sufficient to justify the risk?” The investments represented by A and B in Figure 8.1 illustrate this point. Investment A has a higher expected return than B; nonetheless, B is the better investment. Despite its modest return, B lies above the market line, meaning it promises a higher expected return for its risk than avail- able alternatives, whereas investment A lies below the market line, mean- ing alternative investments promising a higher expected return for the same risk are available.1

This chapter examines the incorporation of risk into investment evaluation. Central to our discussion of discounted cash flow techniques in the last chapter was a quantity variously referred to as the interest rate, the discount rate, and the opportunity cost of capital. While stressing that this quantity somehow reflected investment risk and the time value of money, I was purposely vague about its origins. It is time now to correct this omission by explaining how to incorporate investment risk into the discount rate. After defining investment risk in more detail, we will esti- mate the cost of capital to Stryker Corporation, the company profiled in earlier chapters, and will examine the strengths and weaknesses of the cost

290 Part Four Evaluating Investment Opportunities

FIGURE 8.1 The Risk-Return Trade-Off

1 Saying the same thing more analytically, we know from our earlier study of financial leverage that owners of asset B need not settle for safe, low returns. Rather, they can use debt financing to lever B’s expected return and risk to higher values. In fact, the market line tells us that with just the right amount of debt financing, owners of asset B can attain A’s higher expected return, and more, with no greater risk. B is therefore the better investment.

Expected return

Interest rate on government bonds

Investment risk

Market line





of capital as a risk-adjusted discount rate. The chapter concludes with a look at several important pitfalls to avoid when evaluating investment opportunities and at economic value added, a related topic in the world of performance appraisal. The appendix considers two logical extensions to the chapter material known as asset-betas and adjusted present value analysis, or APV.

You should know at the outset that the topics in this chapter are not sim- ple, for the addition of a whole second dimension to investment analysis in the form of risk introduces a number of complexities and ambiguities. The chapter, therefore, will offer a general road map for how to proceed and an appreciation of available techniques rather than a detailed set of answers. But look on the bright side: If investment decisions were simple, there would be less demand for well-educated managers and aspiring financial writers.

Risk Defined

Speaking broadly, there are two aspects to investment risk: The dispersion of an investment’s possible returns, and the correlation of these returns with those available on other assets. Looking first at dispersion, Figure 8.2 shows the possible rates of return that might be earned on two investments in the form of bell-shaped curves. According to the figure, the expected re- turn on investment A is about 12 percent, while the corresponding figure for investment B is about 20 percent.

Dispersion risk captures the intuitively appealing notion that risk is tied to the range of possible outcomes, or alternatively to the uncertainty sur- rounding the outcome. Because investment A shows considerable bunch- ing of possible returns about the expected return, its risk is low.

Chapter 8 Risk Analysis in Investment Decisions 291

Are You Risk Averse? Here is a simple test to find out. Which of the following investment opportunities do you prefer?

1. You pay $10,000 today and flip a coin in one year to determine whether you will receive $50,000 or pay another $20,000.

2. You pay $10,000 today and receive $15,000 in one year.

If investment 2 sounds better than 1, join the crowd; you are risk averse. Even though both invest- ments cost $10,000 and promise an expected one-year payoff of $15,000, or a 50 percent return, stud- ies indicate that most people, when sober and not in a casino, prefer the certainty of option 2 to the uncertainty of option 1. The presence of risk reduces the value of 1 relative to 2.

For a simple, self-test of your risk tolerance from Rutgers University, see njaes.rutgers .edu/money/riskquiz.



Investment B, on the other hand, evidences considerably less clustering, and is thus higher risk. Borrowing from statistics, one way to measure this clustering tendency is to calculate the standard deviation of return. The details of calculating an investment’s expected return and standard deviation of return need not concern us here.2 It is enough to know that

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FIGURE 8.2 Illustration of Investment Risk: Investment A Has a Lower Expected Return and a Lower Risk than B

2 An investment’s expected return is the probability-weighted average of possible returns. If three returns are possible—8, 12, and 18 percent—and if the chance of each occurring is 40, 30, and 30 percent, respectively, the investment’s expected return is

Expected return � 0.40 � 8% � 0.30 � 12% � 0.30 � 18% � 12.2%

The standard deviation of return is the probability-weighted average of the deviations of possible returns from the expected return. To illustrate, the differences between the possible returns and the expected return in our example are (8% � 12.2%), (12% � 12.2%), and (18% � 12.2%). Because some of these differences are positive and others are negative, they would tend to cancel one another out if we added them directly. So we square them to ensure the same sign, calculate the probability- weighted average of the squared deviations, and then find the square root.

Standard deviation

� [0.4(8% � 12.2%)2 � 0.3(12% � 12.2%)2 � 0.3(18% � 12.2%)2]1/2 � 4.1%

The probability-weighted average difference between the investment’s possible returns and its expected return is 4.1 percentage points.

–50 –40 –30 –20 –10 0 10 20 30 40 50 60 70 80 90 Return (%)

Investment A

Investment B

Probability (%)



risk relates to the dispersion, or uncertainty, in possible outcomes and that techniques exist to measure this dispersion.

Risk and Diversification Dispersion risk, as just described, is often known as an investment’s total risk, or more fancifully its Robinson Crusoe risk. It is the risk an owner would face if he were alone on a desert island unable to buy any other assets. The story changes dramatically, however, once the owner is off the desert island and again able to hold a diversified portfolio. For then the risk from holding a given asset is customarily less than the asset’s total risk—frequently a lot less. In other words, there is more—or perhaps I should say less—to risk than simply dispersion in possible outcomes.

To see why, Table 8.1 presents information about two very simple risky investments: purchase of an ice cream stand and an umbrella shop.3 For simplicity, let’s suppose tomorrow’s weather will be either rain or sun with equal probability. Purchase of the ice cream stand is clearly a risky under- taking, since the investor stands to make a 60 percent return on his investment if it is sunny tomorrow but lose 20 percent if it rains. The umbrella shop is also risky, since the investor will lose 30 percent if tomorrow is sunny but will make 50 percent if it rains.

Yet despite the fact that these two investments are risky when viewed in isolation, they are not risky when seen as members of a portfolio con- taining both investments. In a portfolio consisting of half ownership of

Chapter 8 Risk Analysis in Investment Decisions 293

TABLE 8.1 Diversification Reduces Risk

Return on Weighted Investment Weather Probability Investment Outcome

Ice cream stand Sun 0.50 60% 30% Rain 0.50 �20 �10

Expected outcome � 20

Umbrella shop Sun 0.50 �30 �15 Rain 0.50 50 25

Expected outcome � 10


1�2 Ice cream stand Sun 0.50 15 7.5 and umbrella shop Rain 0.50 15 7.5

Expected outcome � 15%

3 I used to think this was a fanciful example until I noticed how quickly street vendors in Washington, D.C., switched between selling soft drinks and umbrellas depending on the weather.



the ice cream stand and of the umbrella shop, the losses and gains from the two investments precisely counterbalance one another in each state, so that regardless of tomorrow’s weather, the outcome is a certain 15 per- cent (e.g., if it is sunny tomorrow, the ice cream stand makes 60 percent on half of the portfolio and the umbrella shop loses 30 percent on the other half for a net of 15 percent [15% � 0.5 � 60% � 0.5 � �30%]). The expected outcome from the portfolio is the average of the expected outcomes from each investment, but the risk of the portfolio is zero. Owning both assets eliminates the dispersion in possible returns. Despite what you may have heard, there really is a free lunch in finance. It is called diversification.

This is an extreme example, but it does illustrate an important fact about risk: When it is possible to own a diversified portfolio, the relevant risk is not the investment’s risk in isolation—its Robinson Crusoe risk— but its risk as part of the portfolio. And, as the example demonstrates, the difference between these two perspectives can be substantial.

An asset’s risk in isolation is greater than its risk as part of a portfolio whenever the asset’s returns and the portfolio’s returns are less than per- fectly correlated. In this commonplace situation, some of the asset’s return variability is offset by variability in the portfolio’s returns, and the effective risk borne by the investor declines. Look again at Table 8.1. The return on the ice cream stand is highly variable, but because it hits a trough precisely when the umbrella shop return hits a peak, return variability for the two investments combined disappears. The portfolio will earn 15 percent rain or shine. In other words, when assets are combined in a portfolio an “averaging out” process occurs that reduces risk.

Because most business investments depend to some extent on the same underlying economic forces, it is unusual to find investment opportunities with perfectly inversely correlated returns as in the ice cream stand– umbrella shop example. However, the described diversification effect still exists. Whenever investment returns, or cash flows, are less than perfectly positively correlated—whenever individual investments are unique in some respects—an investment’s risk as part of a portfolio is less than the dispersion of its possible returns.

Saying the same thing more formally, it is possible to partition an investment’s total risk into two parts as follows:

Total risk � Systematic risk � Unsystematic risk

Systematic risk reflects exposure to economywide, or marketwide events, such as interest rate changes and business cycles, and cannot be reduced by diversification. Unsystematic risk, on the other hand, reflects investment- specific events, such as fires and lawsuits, which can be eliminated through

294 Part Four Evaluating Investment Opportunities



diversification. Because savvy shareholders own diversified investment portfolios, only systematic risk is relevant for evaluating investment op- portunities. The rest can be diversified away.

Figure 8.3 demonstrates the power of diversification in common stock portfolios. It shows the relationship between the variability of portfolio returns, as measured by the standard deviation of return, and the number of randomly chosen stocks in the portfolio. Note that variability is high when the number of stocks is low but declines rapidly as the number in- creases. As the number of stocks in the portfolio grows, the “averaging out” effect takes place, and unsystematic risk declines. Studies suggest that unsystematic risk all but vanishes when portfolio size exceeds about 50 randomly chosen stocks, and that diversification eliminates approxi- mately one-half of total risk.4

Estimating Investment Risk

Having defined risk and risk aversion in at least a general way, let us next consider how we might estimate the amount of risk present in a particular investment opportunity. In some business situations, an investment’s risk can be calculated objectively from scientific or historical evidence. This is

Chapter 8 Risk Analysis in Investment Decisions 295

0 10 20 30 40 6050 Number of stocks in portfolio

Portfolio risk, standard deviation (%)







Unsystematic risk

Systematic risk

FIGURE 8.3 The Power of Diversification in Common Stock Portfolios

4 John Campbell, Martin Lettau, Burton Malkiel, and Yexiao Xu, “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk,” Journal of Finance 56 (February 2001), pp. 1–43.



true, for instance, of oil and gas development wells. Once an exploration company has found a field and mapped out its general configuration, the probability that a development well drilled within the boundaries of the field will be commercially successful can be determined with rea- sonable accuracy.

Sometimes history can be a guide. A company that has opened 1,000 fast-food restaurants around the world should have a good idea about the expected return and risk of opening the 1,001st. Similarly, if you are think- ing about buying IBM stock, the historical record of the past variability of annual returns to IBM shareholders is an important starting point when estimating the risk of IBM shares. I will say more about measuring the systematic risk of traded assets, such as IBM shares, in a few pages.

These are the easy situations. More often, business ventures are one- of-a-kind investments for which the estimation of risk must be largely subjective. When a company is contemplating a new-product investment, for example, there is frequently little technical or historical experience on which to base an estimate of investment risk. In this situation, risk appraisal depends on the perceptions of the managers participating in the decision, their knowledge of the economics of the industry, and their understanding of the investment’s ramifications.

Three Techniques for Estimating Investment Risk Three previously mentioned techniques—sensitivity analysis, scenario analysis, and simulation—are useful for making subjective estimates of investment risk. Although none of the techniques provides an objective measure of investment risk, they all help the executive to think systemati- cally about the sources of risk and their effect on project return. Reviewing briefly, an investment’s IRR or NPV depends on a number of uncertain economic factors, such as selling price, quantity sold, useful life, and so on.

296 Part Four Evaluating Investment Opportunities

Systematic Risk and Conglomerate Diversification Some executives seize on the idea that diversification reduces risk as a justification for conglomerate diversification. Even when a merger promises no increase in profitability, it is said to be beneficial be- cause the resulting diversification reduces the risk of company cash flows. Because shareholders are risk averse, this reduction in risk is said to increase the value of the firm.

Such reasoning is at best incomplete. If shareholders wanted the risk reduction benefits of such a conglomerate merger, they could achieve them much more simply by just owning shares of the two independent companies in their own portfolios. Shareholders do not depend on company manage- ment for such benefits. Executives intent on acquiring other firms must look elsewhere to find a rationale for their actions.



Sensitivity analysis involves an estimation of how the investment’s figure of merit varies with changes in one of these uncertain factors. One com- monly used approach is to calculate three returns corresponding to an optimistic, a pessimistic, and a most likely forecast of the uncertain vari- ables. This provides some indication of the range of possible outcomes. Scenario analysis is a modest extension that changes several of the un- certain variables in a mutually consistent way to describe a particular event.

We looked at simulation in some detail in Chapter 3 as a tool for finan- cial planning. Recall that simulation is an extension of sensitivity and sce- nario analysis in which the analyst assigns a probability distribution to each uncertain factor, specifies any interdependence among the factors, and asks a computer repeatedly to select values for the factors according to their probability of occurring. For each set of values chosen, the computer calculates a particular outcome. The result is a graph, similar to Figure 3.1, plotting project return against frequency of occurrence. The chief bene- fits of sensitivity analysis, scenario analysis, and simulation are that they force the analyst to think systematically about the individual economic de- terminants of investment risk, indicate the sensitivity of the investment’s return to each of these determinants, and provide information about the range of possible returns.

Including Risk in Investment Evaluation

Once you have an idea of the degree of risk inherent in an investment, the second step is to incorporate this information into your evaluation of the opportunity.

Risk-Adjusted Discount Rates The most common way to do this is to add an increment to the discount rate; that is, discount the expected value of the risky cash flows at a dis- count rate that includes a premium for risk. Alternatively, you can com- pare an investment’s IRR, based on expected cash flows, to a required rate of return that again includes a risk premium. The size of the premium nat- urally increases with the perceived risk of the investment.

To illustrate the use of such risk-adjusted discount rates, consider a $10 million investment promising risky cash flows with an expected value of $2 million annually for 10 years. What is the investment’s NPV when the risk-free interest rate is 5 percent and management has decided to use a 7 percent risk premium to compensate for the uncertainty of the cash flows?

A little figure work reveals that at a 12 percent, risk-adjusted discount rate the investment’s NPV is $1.3 million ($11.3 million present value of future

Chapter 8 Risk Analysis in Investment Decisions 297



cash flows, less $10 million initial cost). The positive NPV indicates that the investment is attractive even after adjusting for risk. An equivalent approach is to calculate the investment’s IRR of 15.1 percent and note that it exceeds the 12 percent risk-adjusted rate, again signaling the investment’s merit.

Note how the risk-adjusted discount rate reduces the investment’s appeal. If the investment were riskless, its NPV at a 5 percent discount rate would be $5.4 million, but because a higher risk-adjusted rate is deemed appropriate, NPV falls by over $4 million. In essence, manage- ment requires an inducement of at least this amount before it is willing to make the investment.

A virtue of risk-adjusted discount rates is that most executives have at least a rough idea of how an investment’s required rate of return should vary with risk. Stated differently, they have a basic idea of the position of the market line in Figure 8.1. For instance, they know from the historical data in Table 5.1 of Chapter 5 that over many years, common stocks have yielded an average annual return about 6.3 percentage points higher than the return on government bonds. If the present return on government bonds is 4 percent, it is plausible to expect an investment that is about as risky as common stocks to yield a return of about 10.3 percent. Similarly, executives know that an investment promising a return of 40 percent is at- tractive unless its risk is extraordinarily high. Granted, such reasoning is imprecise; nonetheless, it does lend some objectivity to risk assessment.

The Cost of Capital

Now that we have introduced risk-adjusted discount rates and illustrated their use, the remaining challenge is to identify the appropriate rate for a specific investment. Do we just add 7 percentage points to the risk-free rate, or is there a more objective process?

There is a more objective process, and it rests on the notion of the cost of capital. When creditors and owners invest in a business, they incur op- portunity costs equal to the returns they could have earned on alternative, similar-risk investments. Together these opportunity costs define the minimum rate of return the company must earn on existing assets to meet the expectations of its capital providers. This is the firm’s cost of capital. If we can estimate this minimum required rate of return, we have an objectively determined risk-adjusted discount rate suitable for evaluating typical, or average risk, investments undertaken by a firm. Rather than re- lying on managers’ “gut feelings” about investment risk, the cost of capital methodology enables us to look to financial markets for valuable information about the appropriate risk-adjusted discount rate.

298 Part Four Evaluating Investment Opportunities



Moreover, once we know how to estimate one company’s cost of capi- tal, we can use the technique to estimate the risk-adjusted discount rate applicable to a wide variety of project risks. The trick is to reason by anal- ogy as follows. If Project A appears to be about as risky as investments un- dertaken by Company 1, use Company 1’s cost of capital as the required return for Project A, or better yet, use an average of the cost of capital to Company 1 and all its industry peers. Thus, if a traditional pharmaceuti- cal company is contemplating an investment in the biotech industry, a suitable required rate of return for the decision is the average cost of cap- ital to existing biotech firms. In the following paragraphs, we define the cost of capital more precisely, estimate Stryker’s cost of capital, and discuss its use as a risk-adjustment vehicle.

The Cost of Capital Defined Suppose we want to estimate the cost of capital to XYZ Corporation and we have the following information:

XYZ Liabilities and Owners’ Equity Opportunity Cost of Capital

Debt $100 10% Equity 200 20

We will discuss the origins of the opportunity costs of capital in a few pages. For now just assume we know that given alternative investment op- portunities, creditors expect to earn at least 10 percent on their loans and shareholders expect to earn at least 20 percent on their ownership of XYZ shares. With this information, we need answer only two simple questions to calculate XYZ’s cost of capital:

1. How much money must XYZ earn annually on existing assets to meet the expectations of creditors and owners?

The creditors expect a 10 percent return on their $100 loan, or $10. However, because interest payments are tax deductible, the effective after- tax cost to a profitable company in, say, the 50 percent tax bracket is only $5. The owners expect 20 percent on their $200 investment, or $40. So in total, XYZ must earn $45 [$45 � (1 � 0.5)(10%)$100 � (20%)$200].

2. What rate of return must the company earn on existing assets to meet the expectations of creditors and owners?

A total of $300 is invested in XYZ on which the company must earn $45, so the required rate of return is 15 percent ($45/$300). This is XYZ’s cost of capital.

Chapter 8 Risk Analysis in Investment Decisions 299



Let’s repeat the preceding reasoning using symbols. The money XYZ must earn annually on existing capital is

(1 � t)KDD � KEE

where t is the tax rate, KD is the expected return on debt or the cost of debt, D is the amount of interest-bearing debt in XYZ’s capital structure, KE is the expected return on equity or the cost of equity, and E is the amount of equity in XYZ’s capital structure. Similarly, the annual return XYZ must earn on existing capital is


where KW is the cost of capital. From the preceding example,

In words, a company’s cost of capital is the cost of the individual sources of capital, weighted by their importance in the firm’s capital structure. The subscript W appears in the expression to denote that the cost of cap- ital is a weighted-average cost. This is also why the cost of capital is often denoted by the acronym WACC for weighted-average cost of capital. To demonstrate that KW is a weighted-average cost, note that one-third of XYZ’s capital is debt and two-thirds is equity, so its WACC is one-third the cost of debt plus two-thirds the cost of equity:

The Cost of Capital and Stock Price An important tie exists between a company’s cost of capital and its stock price. To see the linkage, ask yourself what happens when XYZ Corpora- tion earns a return on existing assets greater than its cost of capital. Because the return to creditors is fixed by contract, the excess return accrues entirely to shareholders. Because the company can earn more than shareholders’ opportunity cost of capital, XYZ’s stock price will rise as new investors are attracted by the excess return. Conversely, if XYZ earns a return below its cost of capital on existing assets, shareholders will not receive their expected return, and its stock price will fall. The price will continue falling until the prospective return to new buyers again equals equity investors’ opportunity cost of capital. Another definition of the cost of capital, therefore, is the return a firm must earn on existing assets to keep its stock price constant. Finally, from a shareholder value perspective,

15% = (1>3 * 5%) + (2>3 * 20%)

15% = (1 – 50%)10% * $100 + 20% * $200

$100 + $200

KW = (1 – t)KDD + KEE

D + E

300 Part Four Evaluating Investment Opportunities



we can say that management creates value when it earns returns above the firm’s cost of capital and destroys value when it earns returns below this target.

Cost of Capital for Stryker Corporation To use the cost of capital as a risk-adjusted discount rate, we must be able to measure it. This involves assigning values to all of the quantities on the right side of equation 8.1. To illustrate the process, let’s estimate Stryker’s cost of capital at year-end 2013.

The Weights We begin by measuring the weights, D and E. There are two common ways to do this, only one of which is correct: Use the book values of debt and equity appearing on the company’s balance sheet, or use the market values. By market value, I mean the price of the company’s bonds and com- mon shares in securities markets multiplied by the number of each security type outstanding. As Table 8.2 shows, the book values of Stryker’s debt and equity at the end of 2013 were $2,764 million and $9,047 million, respectively. The figure for debt includes only interest-bearing debt be- cause other liabilities are either the result of tax accruals that are subsumed in the estimation of after-tax cash flow (ATCF) or spontaneous sources of cash that are part of working capital in the investment’s cash flows. The table also indicates that the market value of Stryker’s debt and equity on the same date were $2,764 million and $28,403 million, respectively.

Consistent with common practice, I have assumed here that the market value of Stryker’s debt equals its book value. This assumption is almost certainly incorrect, but just as certainly the difference between the book and market values of debt is quite small compared to that for equity. The market value of Stryker’s equity is its price per share at year-end of $75.14 times 378 million common shares outstanding. The market value of eq- uity exceeds the book value by a ratio of over 3 to 1 because investors are upbeat about the company’s future prospects.

Chapter 8 Risk Analysis in Investment Decisions 301

TABLE 8.2 Book and Market Values of Debt and Equity for Stryker Corporation (December 31, 2013)

Book Value Market Value

Amount Percentage Amount Percentage Source ($ millions) of Total ($ millions) of Total

Debt $ 2,764 23.4% $ 2,764 8.9% Equity 9,047 76.6% 28,403 91.1%

Total $ 11,811 100.0% $31,167 100.0%



To decide whether book weights or market weights are appropriate for measuring the cost of capital, consider the following. Suppose that 10 years ago you invested $20,000 in a portfolio of common stocks that, through no doing of your own, is now worth $50,000. After talking to stockbrokers and investment consultants, you believe a reasonable return on the portfolio, given present market conditions, is 10 percent a year. Would you be satisfied with a 10 percent return on the original $20,000 cost of the portfolio, or would you expect to earn 10 percent on the cur- rent $50,000 market value? Obviously, the current market value is rele- vant for decision making; the original cost is sunk and therefore irrelevant. Similarly, Stryker’s owners and creditors have investments worth $28,403 million and $2,764 million, respectively, on which they expect to earn competitive returns. Thus, the market values of debt and equity are appropriate for measuring the cost of capital.

The Cost of Debt This is an easy one. Bonds with risk and maturity similar to Stryker’s were yielding a return of approximately 4.5 percent in December 2013, and the company’s marginal tax rate is about 35 percent. Consequently, the after-tax cost of debt to Stryker was 2.9 percent [(1 � 35%) � 4.5%]. Some finan- cial neophytes are tempted to use the coupon rate on the debt rather than the prevailing market rate in this calculation. But the coupon rate is, of course, a sunk cost. Moreover, because we want to use the cost of capital to evaluate new investments, we want the cost of new debt.

The Cost of Equity Estimating the cost of equity is as hard as estimating debt was easy. With debt, or preferred stock, the company promises the holder a specified stream of future payments. Knowing these promised payments and the current price of the security, it is a simple matter to calculate the expected return. This is what we did in the last chapter when we calculated the yield to maturity on a bond. With common stock, the situation is more complex. Because the company makes no promises about future payments to share- holders, there is no simple way to calculate the return expected.

Assume a Perpetuity One way out of this dilemma recalls the story of the physicist, the chemist, and the economist trapped at the bottom of a 40-foot pit. After failing with a number of schemes based on their knowledge of physics and chemistry to extract themselves from the pit, the two finally turn to the economist in des- peration and ask if there isn’t anything in his professional training that might help them devise a means of escape. “Why, yes,” he replies. “The problem

302 Part Four Evaluating Investment Opportunities



is really quite elementary. Simply assume a ladder.” Here our “ladder” is an assumption about the future payments shareholders expect. From this heroic beginning, the problem really does become quite elementary. To illustrate, suppose equity investors expect to receive an annual dividend of $d per share forever. Because we know the current price, P, and have as- sumed a future payment stream, all that remains is to find the discount rate that makes the present value of the payment stream equal the current price. From the last chapter, we know that the present value of such a per- petuity at a discount rate of KE is

and, solving for the discount rate,

In words, if you are willing to assume investors expect a company’s stock to behave like a perpetuity, the cost of equity capital is simply the dividend yield.

Perpetual Growth A somewhat more plausible assumption is that shareholders expect a per share dividend next year of $d and expect this dividend to grow at the rate of g percent per annum forever. Fortunately, it turns out that this cash flow stream also has an unusually simple solution. Without boring you with the arithmetic details, the present value of the assumed payment stream at a discount rate of KE is

and, solving for the discount rate,

This equation says that if the perpetual growth assumption is correct, the cost of equity capital equals the company’s dividend yield (d/P), plus the growth rate in dividends. This is known as the perpetual growth equation for KE.

The problem with the perpetual growth estimate of KE is that it is only as good as the assumption on which it is based. For mature companies such as railroads, electric utilities, and steel mills, it may be reasonable to assume that observed growth rates will continue indefinitely. And in these

KE = d P

+ g

P = d

KE – g

KE = d P

P = d


Chapter 8 Risk Analysis in Investment Decisions 303



cases, the perpetual growth equation yields a plausible estimate of the cost of equity capital. In all other instances, when it is implausible to think the company can maintain its current rate of growth indefinitely, the equation over-estimates the cost of equity.

Let History Be Your Guide A second and generally more fruitful approach to estimating the cost of equity capital looks at the determinants of expected returns on risky in- vestments. In general, the expected return on any risky asset is composed of three factors:

Expected return �

Risk-free �

Inflation �

Risk on risky asset interest rate premium premium

The equation says that the owner of a risky asset should expect to earn a re- turn from three sources. The first is compensation for the opportunity cost incurred in holding the asset. This is the risk-free interest rate. The second is compensation for the declining purchasing power of the currency over time. This is the inflation premium. The third is compensation for bearing the asset’s systematic risk. This is the risk premium. Fortunately, we do not need to treat the first two terms as separate factors because together they equal the expected return on a default-free bond such as a government bond. Since we can readily determine the government bond interest rate, the only challenge is to estimate the risk premium.

When the risky asset is a common stock, it is useful to let history be our guide and recall from Table 5.1 that on average over the last century, the an- nual return on U.S. common stocks has exceeded that on government bonds by 6.3 percentage points. As a reward for bearing the added systematic risk, common stockholders earned a 6.3 percentage point higher annual return than government bondholders. Treating this as a risk premium and adding it to a 2013 long-term government bond rate of 4.0 percent yields an estimate of 10.3 percent as the cost of equity capital for a typical company.

What is the logic of treating the 6.3 percentage point historical excess return as a risk premium? Essentially, it is that over a long enough time, the return investors receive and what they expect to receive should approximate each other. For example, suppose investors expect a 20-percentage-point excess return on common stocks but the actual return keeps turning out to be 3 percentage points. Then two things should happen: Investors should lower their expectations, and selling by disappointed investors should increase subsequent realized returns. Even- tually expectations and reality should come into rough parity.

We now have an estimate of the cost of capital to an “average-risk” company, but of course few companies are precisely average-risk. How,

304 Part Four Evaluating Investment Opportunities



then, can we customize our average cost expression to reflect the risk of a specific firm? The answer is to insert a “customization factor,” known as the company’s equity beta, into the expression so that it becomes

or in symbols,

KE � ig � be � Rp (8.2)

where ig is a government bond rate, be is the equity beta of the target com- pany, and Rp is the excess return on common stocks. You can think of be as a scale factor reflecting the systematic risk of a specific company’s shares rel- ative to that of an average share. When the stock’s systematic risk equals that of an average share, be equals 1.0, and the historical risk premium applies directly. But for above-average risk shares, be exceeds 1.0, and the risk premium grows accordingly. Conversely, for below-average risk shares, be is below 1.0, and only a fraction of the historical risk premium applies.

Estimating Beta But, you might well ask, how do we estimate a company’s beta? Actually, it’s pretty simple. Figure 8.4 provides everything required to

Cost of equity capital =

Interest rate on government bond + be a

Historical excess return on common stocks b

Chapter 8 Risk Analysis in Investment Decisions 305

FIGURE 8.4 Stryker Corporation’s Beta is the Slope of the Best-Fit Line Below Monthly Returns of Stryker Corporation v. S&P 500, 60 Months through December 2013










–12% –10% –8% –6% –4% –2% 0% 2% 4% 6% 8% 10% 12%


S&P 500




estimate Stryker’s beta. It shows the monthly realized returns on Stryker’s common stock relative to returns on the Standard & Poor’s 500 Stock Index over the past 60 months. For example, in September 2011, the S&P index fell 7 percent, while Stryker’s stock fell 3 percent. This return pair constitutes one point on the graph. The S&P 500 index is a broadly diversified portfolio containing many common shares; so its systematic risk is a reasonable surrogate for the systematic risk of an average share, and of the market as a whole. Also appearing in the figure is a best-fit, straight line indicating the average relationship among the paired returns. (If you are familiar with regression analysis, this is a simple regression line.)

The slope of this line is the beta estimate we seek. It measures the sen- sitivity of Stryker’s equity returns to movements in the S&P index. The indicated slope of 0.89 means that on average, the return on Stryker’s equity rises or falls 0.89 percent for every one percent change in the index, indicating that Stryker’s equity is lower risk than average. Clearly, if this line were less steeply sloped, Stryker’s stock would be less sensitive to

306 Part Four Evaluating Investment Opportunities

A Virtue of Statistics Many of the concepts in this chapter can be described quite simply with the aid of a little statistics. As already noted, an investment’s total risk refers to its dispersion in possible returns, commonly represented by the standard deviation of returns, while its systematic risk depends on the extent to which the investment’s returns correlate with those on a broadly diversified portfolio. We can thus represent the systematic risk of investment j as

Systematic risk � rjmsj

where rjm is the correlation coefficient between investment j and well-diversified portfolio m, and sj is the standard deviation of returns on investment j. The correlation coefficient is, of course, a dimensionless number ranging between �1 and �1, with �1 characterizing perfectly positively correlated returns and �1 perfectly inversely correlated returns. For most business investments, rjm is in the range of 0.5 to 0.8, meaning that 20 to 50 percent of the investment’s total risk can be diversified away.

A common stock’s equity beta equals its systematic risk relative to that of a well-diversified port- folio, or in symbols, stock j ’s equity beta is

But because any variable must be perfectly positively correlated with itself, this expression reduces to

In addition to representing stock j ’s equity beta, this expression also equals the slope coefficient of the regression of rj on rm, where rj and rm are realized returns on stock j and the diversified port- folio, respectively.

b j = rjmsj


b j = rjmsj




market movements, or alternatively to economywide events, and thus less risky. A more steeply sloped line would imply just the reverse. The fact that all of the return pairs plotted in the figure do not lie precisely on the straight line reflects the importance of unsystematic risk in determining Stryker’s monthly returns. Remember that because unsystematic risk can be eliminated through diversification, it should play no role in determin- ing required returns or prices.

Fortunately, you do not need to worry about calculating betas your- self. Beta risk is so important a factor in security analysis that many fi- nancial websites regularly publish the betas of virtually all publicly traded common stocks. Table 8.3 presents recent betas for a represen- tative sample of firms. Observe that beta ranges from a low of 0.18 for Consolidated Edison, an electric utility, to a high of 3.32 for American International Group, the infamous insurer rescued by the government in the recent crisis. Note, too, that the numbers are intuitively plausi- ble, with high-risk businesses such as some technology companies hav- ing high betas, while low-risk companies such as utilities have lower betas.

Inserting Stryker’s estimated equity beta of 0.89 into equation 8.2 yields the following cost of equity capital:

KE � 4.0% � 0.89 � 6.3% � 9.6%

Chapter 8 Risk Analysis in Investment Decisions 307

TABLE 8.3 Representative Company Betas

Source: Center for Research in Security Prices (CRSP)

Company Beta Company Beta

Advanced Micro Devices 2.22 Dean Foods 0.63 Adobe 1.43 Duke Energy 0.28 0.54 eBay 1.26 American International Group 3.32 Exxon Mobil 0.68 Apple 0.84 Ford Motor Co. 2.23 AT&T Inc. 0.54 Goldman Sachs 1.32 Avon Products 1.48 H&R Block 0.66 Baxter International 0.56 Intel 0.94 Berkshire Hathaway 0.54 JDS Uniphase 2.45 Boeing 1.19 Microsoft 0.96 Caterpillar 1.98 Safeway 0.85 Coca-Cola 0.49 Southern Company 0.24 Consolidated Edison 0.18 Southwest Airlines 1.28 Costco Wholesale 0.64 Wellpoint 0.75 Cummins 1.72 Wells Fargo Bank 1.83



Stryker’s Weighted-Average Cost of Capital All that remains now is the figure work. Table 8.4 presents my estimate of Stryker’s cost of capital in tabular form. Stryker’s weighted-average cost of capital is 9.0 percent. This means that at year-end 2013, Stryker needed to earn at least this percentage return on the market value of existing assets to meet the expectations of creditors and shareholders and, by inference, to maintain its stock price. In equation form,

Before leaving our discussion of beta, I should note that while the mo- tivation offered for equation 8.2 has been largely intuitive, the equation actually rests on a solid conceptual foundation known as the Capital Asset Pricing Model, or the CAPM. According to the CAPM, equation 8.2 is nothing less than the equation of the market line shown earlier in Figure 8.1. As such, it describes the equilibrium relationship between the expected return on any risky asset and its systematic risk. Said differently, equation 8.2 defines the minimum acceptable rate of return an investor should demand on any risky asset.

The Cost of Capital in Investment Appraisal The fact that the cost of capital is the return a company must earn on existing assets to meet creditor and shareholder expectations is an interest- ing detail, but we are after bigger game here: We want to use the cost of capital as an acceptance criterion for new investments.

Are there any problems in applying a concept derived for existing assets to new investments? Not if one critical assumption holds: The new investment must have the same risk existing assets do. If it does, the new investment is essentially a “carbon copy” of existing assets, and the cost of capital is the appropriate risk-adjusted discount rate. If it does not, we must proceed more carefully.

= 9.0%

KW = (1 – 0.35)(4.5%)($2,764 million) + (9.6%)($28,403 million)

$2,764 million + $28,403 million

308 Part Four Evaluating Investment Opportunities

TABLE 8.4 Calculation of Stryker Corporation’s Weighted-Average Cost of Capital*

Source Amount ($ millions) Percentage of Total Cost after Tax Weighted Cost

Debt $ 2,764 8.9% 2.9% 0.3% Equity $28,403 91.1% 9.6% 8.7%

Weighted-Average Cost of Capital � 9.0%

*Totals may not add due to rounding.



The market line in Figure 8.5 clearly illustrates the importance of the equal-risk assumption. It emphasizes that the rate of return risk-averse individuals anticipate rises with risk. This means, for example, that man- agement should demand a higher expected return when introducing a new product than when replacing aged equipment, because the new product is presumably riskier and therefore warrants a higher return. The figure also shows that a company’s cost of capital is but one of many possible risk- adjusted discount rates, the one corresponding to the risk of the firm’s existing assets. We conclude that the cost of capital is an appropriate acceptance criterion only when the risk of the new investment equals that of existing assets. For all other investments, the cost of capital is inappro- priate. But do not despair, for even when inappropriate itself, the cost of capital concept is central to identifying a correct risk-adjusted rate.

Multiple Hurdle Rates Companies adjust their hurdle rates for differing investment risks in at least three possible ways. The first two are straightforward extensions of the cost of capital. For large projects, the approach is to identify an industry in which the contemplated investment would be considered average risk, estimate

Chapter 8 Risk Analysis in Investment Decisions 309

Firm’s cost of capital

Increasing risk- adjusted discount rate

Risk-adjusted discount rate or expected return

Risk of firm’s existing assets

Increasing investment risk

Investment risk

Market line

FIGURE 8.5 An Investment’s Risk-Adjusted Discount Rate Increases with Risk



the weighted-average cost of capital for several companies in the industry, and use an average of these estimates as the project’s required rate of return. For example, when a pharmaceutical company contemplates a biotechnol- ogy investment, a reasonable hurdle rate for the decision is an average of the capital costs to existing biotechnology companies.

A challenge when applying this approach is deciding which companies to include in the sample. The cost of capital to a diversified firm is the weighted-average of the capital costs prevailing in each of its businesses. This means that even when a diversified company is a major competitor in the target business, its cost of capital may not accurately reflect the risk of that business. As a result, the best sample candidates are “pure-plays,” un- diversified firms that compete only in the target business. However, pure- plays are not always available, and in their absence considerable judgment and a certain amount of art must be applied when selecting sample com- panies and deciding how best to weight their numbers.

A second risk adjustment technique used by multidivision companies is to calculate a separate cost of capital for each division. As just noted, the cost of capital to a multidivision company will be an average of the costs of cap- ital appropriate to each business line. When such companies use a single, corporatewide cost of capital across all divisions, they risk committing two types of errors. In low-risk divisions they are inclined to reject some worth- while, low-risk investments for lack of expected return, while in their high- risk divisions, they are inclined to do just the opposite: accept uneconomic, high-risk investments because of their prospective returns. Over time, such

310 Part Four Evaluating Investment Opportunities

The Cost of Capital to a Private Company Two hurdles exist to estimating a private company’s cost of capital. The first is conceptual. Some owners of private companies argue that because their company’s securities do not trade on public markets, any cost of capital based on these markets is not relevant to them. This reasoning is incor- rect. Financial markets define the opportunity costs incurred by all individuals when they make in- vestment decisions regardless of whether those investments are publicly traded or privately held. A private business owner would obviously be foolish to make a business investment promising a 5 percent return when comparable-risk investments promising 15 percent are available in public markets.

The second hurdle is one of measurement. Without market values for the company’s debt and equity and without equity returns on which to base a beta estimate, what do we do? I recommend the strategy described above for estimating project and divisional capital costs. Identify one or more public competitors, estimate their capital costs, and use the resulting average to represent the pri- vate firm’s cost of capital. In instances where the private business has a much different capital structure from the public competitors, it may be necessary to do some further adjusting of the kind described in the appendix. When the private firm is much smaller than the public competitors, it may also be appropriate to make an upward adjustment in the cost of capital, amounting to perhaps two percentage points, to reflect the added risks faced by small firms.



companies find their lower-risk divisions withering for lack of capital, while their higher-risk divisions are force-fed too much capital.

To avoid this dilemma, many multidivision companies use the methods just described to estimate a different hurdle rate for each division. They begin by identifying several primary division competitors—hopefully including a few pure-plays. They then estimate the weighted-average cost of capital of these competitors, and use an average of these numbers as the division’s cost of capital.

The third approach is more ad hoc. Many companies adjust for differing project risks by defining several risk buckets and assigning a different hur- dle rate to each bucket. For example, Stryker might use the following four buckets.

Type of Investment Discount Rate (%)

Replacement or repair 6.5 Cost reduction 7.0 Expansion 9.0 New product 14.0

Investments to expand capacity in existing products are essentially carbon- copy investments, so their hurdle rates equal Stryker’s cost of capital. Other types of investments have a higher or lower hurdle rate, depending on their risk relative to expansion investments. Replacement or repair in- vestments are the safest because virtually all of the cash flows are well known from past experience. Cost reduction investments are somewhat riskier, because the magnitude of potential savings is uncertain. New- product investments are the riskiest type of all, because both revenues and costs are uncertain.

Multiple hurdle rates are consistent with risk aversion and with the market line, but the amount by which the hurdle rate should be adjusted for each level of risk is largely arbitrary. Whether the hurdle rate for new product investments should be 3 or 6 percentage points above Stryker’s cost of capital cannot be determined objectively.

Four Pitfalls in the Use of Discounted Cash Flow Techniques

You now know the basics of investment appraisal: Estimate the opportu- nity’s annual, expected ATCFs and discount them to the present at a risk-adjusted discount rate appropriate to the risk of the cash flows. When the opportunity is a “carbon-copy” investment, the firm’s weighted-average cost of capital is the appropriate discount rate. In

Chapter 8 Risk Analysis in Investment Decisions 311



other instances, an upward or downward adjustment to the firm’s cost of capital is necessary.

In the interest of full disclosure, I will now gingerly mention four pit- falls in the practical application of discounted cash flow techniques. The first two are easily avoided once you are aware of them; the last two highlight important limitations of discounted cash flow techniques as conventionally applied. Collectively these pitfalls mean you need to mas- ter several more topics before attempting to pass as an expert.

The Enterprise Perspective versus the Equity Perspective Any corporate investment partially financed with debt can be analyzed from either of two perspectives: that of the company, commonly known as the enterprise perspective, or that of its owners, often referred to as the equity perspective. As the following example demonstrates, these two perspectives are functionally equivalent in the sense that when properly applied they yield the same investment decision—but woe be to him who confuses the two.

Suppose ABC Industries has a capital structure composed of 40 percent debt, costing 5 percent after tax, and 60 percent equity, costing 20 percent. Its WACC is therefore

KW � 5% � 0.40 � 20% � 0.60 � 14%

312 Part Four Evaluating Investment Opportunities

The Fallacy of the Marginal Cost of Capital Some readers, especially engineers, look at equation 8.1 and naively conclude that it is possible to reduce a company’s weighted-average cost of capital by using more of the cheap source of financ- ing, debt, and less of the expensive source, equity. In other words, they conclude that increasing leverage will reduce the cost of capital. This reasoning, however, evidences an incomplete under- standing of leverage. As we observed in Chapter 6, increasing leverage increases the risk borne by shareholders. Because they are risk averse, shareholders react by demanding a higher return on their investment. Thus, KE and, to a lesser extent, KD rise as leverage increases. This means that in- creasing leverage affects a company’s cost of capital in two opposing ways: Increasing use of cheap debt reduces KW, but the rise in KE and KD that accompanies added leverage increases it.

To review this reasoning, ask yourself how you would respond to a subordinate who made the following argument in favor of an investment: “I know the company’s cost of capital is 12 percent and the IRR of this carbon-copy investment is only 10 percent. But at the last directors’ meeting, we de- cided to finance this year’s investments with new debt. Since new debt has a cost of only about 4 percent after tax, it is clearly in our shareholders’ interest to invest 4 percent money to earn a 10 percent return.”

The subordinate’s reasoning is incorrect. Financing with debt means increasing leverage and in- creasing KE. Adding the change in KE to the 4 percent interest cost means the true marginal cost of the debt is well above the interest cost. In fact, it is probably quite close to KW.



The company is considering an average-risk investment costing $100 million and promising an ATCF of $14 million a year in perpetuity. If under- taken, ABC plans to finance the investment with $40 million in new bor- rowings and $60 million in equity. Should ABC make the investment?

The Enterprise Perspective The left side of the following diagram shows the investment’s cash flows from the enterprise perspective. Applying our now standard approach, the investment is a perpetuity with a 14 percent internal rate of return. Comparing this return to ABC’s weighted-average cost of capital, also 14 percent, we conclude that the investment is marginal. Undertaking it will neither create nor destroy shareholder value.

The Equity Perspective The right side of the diagram shows the same investment from the owners’ viewpoint, or the equity perspective. Because $40 million of the initial cost will be financed by debt, the equity outlay is only $60 million. Similarly, be- cause $2 million after-tax must be paid to creditors each year as interest, the residual cash flow to equity will be only $12 million. The investment’s internal rate of return from the equity perspective is therefore 20 percent.

Does the fact that the return is now 20 percent mean the investment is suddenly an attractive one? Clearly, no. Because the equity cash flows are levered, they are riskier than the original cash flows and hence require a higher risk-adjusted discount rate. Indeed, the appropriate acceptance crite- rion for these equity cash flows is ABC’s cost of equity capital, or 20 percent. (Remember, the discount rate should reflect the risk of the cash flows to be discounted.) Comparing the project’s 20 percent IRR to equity with ABC’s cost of equity, we again conclude that the investment is only marginal.

It is not an accident that the enterprise and equity perspectives yield the same result. Because the weighted-average cost of capital is defined to en- sure that each supplier of capital receives a return equal to her opportunity

1 2 3

$14 million per year

. . .

. . . . . .

. . . ∞

$100 million IRR = 14/100 = 14%

The enterprise perspective

1 2 3

$12 million per year

. . .

. . . . . .

. . . ∞

$60 million IRR = 12/60 = 20%

The equity perspective

Chapter 8 Risk Analysis in Investment Decisions 313



cost, we know that an investment by ABC earning 14 percent, from the enterprise perspective, will earn just enough to service the debt and gen- erate a 20 percent IRR on invested equity. Problems arise only when you mix the two perspectives, using KE to discount enterprise cash flows or, more commonly, using KW to discount equity cash flows.

Which perspective is better? Some of my best friends use the equity perspective, but I believe the enterprise perspective is easier to apply in practice. The problem with the equity perspective is that both the IRR to equity and the appropriate risk-adjusted discount rate vary with the amount of leverage used. The IRR to equity on ABC Industries’ invest- ment is 20 percent with $40 million of debt financing but jumps to 95 percent with $90 million of debt and rises to infinity with all-debt financing.

The interdependency between the means of financing and the risk- adjusted discount rate is easily handled in a classroom, but when real money is on the line, we often become so enthralled by the return-enhancing aspect of debt that we forget the required rate of return rises as well. More- over, even when we remember that leverage increases risk as well as return, it is devilishly hard to estimate exactly how much the cost of equity should change with leverage.

Life is short. I recommend that you avoid unnecessary complications by using the enterprise perspective whenever possible. Assess the eco- nomic merit of the investment without regard to how it will be financed or how you will divvy up the spoils. If the investment meets this funda- mental test, you can then turn to the nuances of how best to finance it.

Inflation The second pitfall involves the improper handling of inflation. Too often managers ignore inflation when estimating an investment’s cash flows but inadvertently include it in their discount rate. The effect of this mismatch is to make companies overly conservative in their investment appraisal, especially with regard to long-lived assets. Table 8.5 illustrates the point. A company with a 15 percent cost of capital is considering a $10 million, carbon-copy investment. The investment has a four-year life and is ex- pected to increase production capacity by 10,000 units annually. Because the product sells for $900, the company estimates that annual revenues will rise $9 million ($900 � 10,000 units), which, after subtracting pro- duction costs, yields an increase in annual after-tax cash flows of $3.3 million. The IRR of the investment is calculated to be 12 percent, which is below the firm’s cost of capital.

Did you spot the error? By assuming a constant selling price and con- stant production costs over four years, management has implicitly esti- mated real, or constant-dollar, cash flows, whereas the cost of capital as

314 Part Four Evaluating Investment Opportunities



calculated earlier in the chapter is a nominal one. It is nominal because both the cost of debt and the cost of equity include a premium for expected inflation.

The key to capital budgeting under inflation is to always compare like to like. When cash flows are in nominal dollars, use a nominal discount rate. When cash flows are in real, or constant, dollars, use a real discount rate. The bottom portion of Table 8.5 illustrates a proper evaluation of the in- vestment. After including a 5 percent annual increase in selling price and in variable production costs, the expected nominal cash flows from the investment are as shown. As one would expect, the nominal cash flows exceed the constant-dollar cash flows by a growing amount in each year. The IRR of these flows is 20 percent, which now exceeds the firm’s cost of capital.5

Real Options The third pitfall involves possible omission of valuable managerial options inherent in many corporate investments. Conventional dis- counted cash flow analysis fails to capture these options because it implicitly ignores managerial flexibility—the ability to alter an invest- ment in response to changing circumstances. This omission might be appropriate when dealing with passive stock and bond investments, but

Chapter 8 Risk Analysis in Investment Decisions 315

TABLE 8.5 When Evaluating Investments under Inflation, Always Compare Nominal Cash Flows to a Nominal Discount Rate or Real Cash Flows to a Real Discount Rate ($ millions)

(a) Incorrect Investment Evaluation Comparing Real Cash Flows to a Nominal Discount Rate

2013 2014 2015 2016 2017

After-tax cash flow $(10.0) $3.3 $3.3 $3.3 $3.3 IRR � 12% KW � 15%

Decision: Reject

(b) Correct Investment Evaluation Comparing Nominal Cash Flows to a Nominal Discount Rate

2013 2014 2015 2016 2017 After-tax cash flow $(10.0) $3.5 $3.8 $4.0 $4.3

IRR � 20% KW � 15%

Decision: Accept

5 An alternative approach would have been to calculate the firm’s real cost of capital and compare it to a real IRR. But because this approach is more work and is fraught with potential errors, I recommend working with nominal cash flows and a nominal discount rate instead.



can be quite inappropriate when managers are able to make various mid-course corrections. Examples of what are often called real options in recognition of their formal equivalence to traded financial options, include

• the option to abandon an investment if cash flows do not meet expectations, • the option to make follow-on investments if the initial undertaking is

successful, and • the option to reduce uncertainty by deferring investments to a later date.

In each instance, the option gives managers the ability to cherry pick: to act when the odds are in their favor but to walk away when they are not. (The appendix to Chapter 5 provides a brief overview of financial options, and the recommended readings at the end of the chapter offer more rig- orous treatments of real options and their valuation.)

Formal real options analysis has been slow to catch on in many busi- nesses, due primarily to its complexity.6 At a more informal level, how- ever, the realization that many corporate investments contain potentially valuable embedded options has altered the way executives think about these opportunities. An increasingly common item on an analyst’s check- list is to identify any real options embedded in a project and to estimate, at least qualitatively, their significance to the business. The next few pages offer an intuitive look at three common real options faced by businesses and illustrate how an understanding of real options can sharpen thinking about corporate investment decisions.

Decision Trees General Design Corporation is considering investing $85 million to launch a new line of high-speed semiconductors based on an emerging diamond film technology. This is a risky investment. Management thinks the odds of success are only about 50 percent and have decided to apply a risk-adjusted discount rate of 15 percent in their analysis. As shown in Panel (a) of Table 8.6, they estimate that if successful, the present value of expected free cash inflows over the life of the project will total $168 mil- lion, while if it is unsuccessful, the same figure will be negative $34 million. Should General Design make the investment?

Panel (a) contains a conventional discounted cash flow analysis of the investment in the form of what is known as a “decision tree,” a simple graphical technique to portray an uncertain decision. Decision trees are

316 Part Four Evaluating Investment Opportunities

6 Edward Teach, “Will Real Options Take Root? Why Companies Have Been Slow to Adopt the Valuation Technique,” CFO Magazine, July 2003, pp. 1–4.



Chapter 8 Risk Analysis in Investment Decisions 317

TABLE 8.6 General Design’s Diamond Film Project ($ millions)*

(a) Stage 1: Ignoring Option to Abandon, Probability of Success � 50%

Initial cost � $85 Discount rate � 15%

Present Expected After-Tax Cash Flows Value 1 2 3 4 5

Success $ 168 $ 50 $ 50 $ 50 $ 50 $ 50 Failure $ (34) $ (10) $ (10) $ (10) $ (10) $ (10)

NPV at 15% � �$18 million (�$18 � 0.50 � $168 � 0.50 � $34 � $85)

(b) Stage 1: Including Option to Abandon

Sell plant in year 3 for $50 million

Present Expected After-Tax Cash Flows Value 1 2 3 4 5

Success $ 168 $ 50 $ 50 $ 50 $ 50 $ 50 Failure $ 17 $ (10) $ (10) $ 50 $ � $ �

NPV at 15% � $7 million ($7 � 0.50 � $168 � 0.50 � $17 � $85)

*Totals may not add due to rounding.

Do not invest $0



p = .50

p = .50

–$85 –$34



Abandon $17


Do not invest $0



p = .50

p = .50





especially useful when the decision involves several interrelated decisions and chance events. Square nodes in the tree represent decisions, while circular nodes denote chance events. Here, there is only one decision: to invest or not, and one chance event: success or failure. Decision trees are drawn from the left, beginning with the most immediate decision and moving to the right along various branches to subsequent chance events,



decisions, and outcomes. Analysis of a decision tree, however, moves in the opposite direction—from right to left. Begin at the most distant out- comes, decide what they imply for the most distant decisions, and work progressively back along the branches to the current decision.

The two rightmost outcomes in Panel (a) promise cash flows of $168 million and �$34 million with equal probability, so working to the left along the “success” and “failure” branches, it is easy to calculate that the chance node has an expected value of $67 million ($67 � .50 � $168 � .50 � $34). Combining this expected inflow with the $85 million outlay appearing under the “Invest” branch yields a net present value of �$18 million.

The Option to Abandon The diamond film project is clearly unacceptable according to conven- tional analysis. But after reviewing the decision tree for a moment, one General Design executive observes that “this decision tree commits us to manufacturing the new semiconductors, even after we learn the product’s a bust. Wouldn’t we be smarter in that scenario to just close down the line and sell the plant?” In essence, the executive is suggesting that the con- ventional analysis in Panel (a) ignores a potentially valuable abandonment option: the right to terminate the project whenever the plant’s resale value exceeds the present value of operating cash flows generated by the plant.

Assuming General Design would abandon the project after two years of losses and sell the plant for $50 million, the decision tree in Panel (b) of Table 8.6 adds this abandonment option to the previous tree. Beginning at the right, General Design will clearly want to continue making semicon- ductors when sales are high, but should abandon the project when sales are low. According to the figures, including the abandonment option increases the project’s net present value by $25 million to $7 million (Revised NPV � .50 � $168 � .50 � $17 � $85 � $7). Recognizing that the company has the option to abandon the project when conditions warrant adds $25 million to its value and transforms it from a loser into a winner. The $25 million is the value of the abandonment option and also the amount by which con- ventional investment analysis understates the project’s worth.

Before considering the second type of real option companies frequently encounter, it is appropriate to say a few more words about the strengths and weaknesses of decision trees for analyzing real options. Decision trees are a handy tool for illustrating the compound, contingent nature of many investment decisions, and they help demonstrate how management flexi- bility can add value to investment opportunities. However, they also suffer from several conspicuous weaknesses. One is that decision trees quickly morph from well-behaved trees into unruly bushes as decisions become more complex and as chance events sprout more possible outcomes.

318 Part Four Evaluating Investment Opportunities



Decision trees are also unable to handle decisions with continuous as opposed to discrete outcomes and when uncertainty resolves gradually over time as opposed to all at once on a specific date. But the most serious weak- ness is that the solution technique of calculating probability-weighted ex- pected values of distant outcomes and rolling the results back to the present is only approximately correct when valuing real options.7 Taken together, these observations are a reminder that our discussion here is only an intro- ductory overview, and that rigorous real option analysis requires modeling and valuation techniques that are beyond the scope of this book.

The Option to Grow A chief attraction of many new-technology investments is that success today creates the option to make highly profitable follow-on investments tomorrow. To illustrate, assume General Design believes initial success in diamond film semiconductors will open the door to a larger stage 2, follow-on investment in two years. If the stage 2 investment were made today, it would be no more likely to succeed than would stage 1; after all, it is the same technology. But, of course, the company does not need to make the stage 2 decision today. It has the option to wait until the initial re- sults from stage 1 are in, and it is able to make a more informed choice based on what it learns in stage 1. The stage 1 investment effectively buys the company an option to grow if future conditions prove attractive.

Problem 17 at the end of this chapter provides the chance to work through an example of General Design’s option to grow. With a higher probability of success, it should be no surprise that stage 2 as described in the problem turns out to be much more valuable to the company than stage 1. Just as the option to abandon allows General Design to exit a los- ing project, the option to grow creates value by allowing General Design to expand when things go well.

The Timing Option The third common corporate real option is known as a timing option. In addition to passive managers, conventional discounted cash flow analysis also assumes investment decisions are “now or never.” Do we make the investment immediately or not at all? Many corporate decisions, however, are of a subtler “now or later” variety. Do we invest today or wait to some more propitious future date? Here is an example of a timing option.

Wind Resources, Inc. (WRI) designs, builds, and sells wind farms to financial investors interested in stable cash flows and lucrative tax shields. Key to the price WRI can charge for a completed wind farm is

Chapter 8 Risk Analysis in Investment Decisions 319

7 The problem lies with the risk-adjusted discount rate, which varies in complex ways throughout the tree depending on which options are exercised.



320 Part Four Evaluating Investment Opportunities

the long-term contract it is able to negotiate with an electric utility to purchase the wind farm’s power. The terms of this contract depend, in turn, on the prevailing price of natural gas, the utility’s most common alternative energy source. WRI is considering developing an attractive wind farm site it owns in Southern California.

Several company executives recommend immediate development. How- ever, one of the younger managers disagrees and favors waiting for a time. He reasons that natural gas prices might rise in the future, enabling WRI to get a better selling price if it waits. Others sharply disagree, arguing that “gas prices could just as easily go down as up in the future, and anyway, WRI isn’t in the business of speculating on natural gas prices.” The dissenter responds that there is more involved than just getting lucky on gas prices.

What should WRI do? Consider the choice between developing the site today or in one year. If natural gas prices rise, WRI can develop the wind farm in one year at an even better price than it can get today. If gas prices fall, the company can just postpone development at little or no cost until they improve, and if they do not improve, WRI can just walk away. The option to develop in the future if prices move in WRI’s favor, but to defer development if they do not, adds value to the project. Note, too, that the option’s value rises with uncertainty, so that the wider the dispersion in future natural gas prices, the higher the value of WRI’s option to wait. As mentioned in the appendix to Chapter 5, this is an important charac- teristic of all options, where value increases with the volatility of the underlying asset. Problem 18 at the end of this chapter enables you to work through an example demonstrating these facts.

The observation that the ability to postpone an investment is valuable raises an obvious question. If WRI should not invest now, when should it in- vest? When should management quit stalling and build the wind farm? Ironically, the answer to this question in many instances is that the company should wait as long as possible. Because a timing option can only be exer- cised once and because doing so destroys its value, development should only occur when the resulting gains exceed the value of the option sacrificed. With some opportunities, management may want to invest immediately to take advantage of short-lived profit opportunities, to capture first-mover advantages, or to avoid rising construction costs. But, unless these costs of waiting exceed the value of the option destroyed, it makes sense to wait. In WRI’s case, the only significant costs of waiting appear to be the threat of declining government subsidies and of rising construction costs.

In sum, this brief look at real options has demonstrated several important facts:

• Standard DCF analysis of investments containing embedded options systematically understates their value.



• The NPV of such investments equals their NPV ignoring the options, plus the NPV of the options.

• When opportunities contain timing options, it may make sense to defer investment even when the NPV of immediate investment is positive.

• Because option values rise with uncertainty, the incentive to acquire growth options via research and development or other means rises with uncertainty, as does the incentive to delay investing in opportunities con- taining timing options.

• The logic and vocabulary of real options are increasingly pervading cor- porate thinking and discussion, even in the absence of rigorous quantita- tive analysis.

• Smart managers think systematically about the presence of embedded options and assess their value in at least qualitative terms.

• Smart companies realize that embedded options are valuable and work systematically to maintain and acquire them.

The moral should be clear: Failure to appreciate the value of real options embedded in some corporate investment opportunities leads to inaccurate decision making and unnecessary timidity in the face of certain high-risk, high-payoff opportunities.

Excessive Risk Adjustment Our last pitfall is a subtle one concerning the proper use of risk-adjusted discount rates. Adding an increment to the discount rate to adjust for an investment’s risk makes intuitive sense. You need to be aware, however, that as you apply this discount rate to more distant cash flows, the arith- metic of the discounting process compounds the risk adjustment. Table 8.7 illustrates the effect. It shows the present value of $1 in one year and in 10 years, first at a risk-free discount rate of 5 percent and then at a risk-adjusted rate of 10 percent. Comparing these present values, note that addition of the risk premium knocks a modest 4 cents off the value of a dollar in one year but a sizable 23 cents off in 10 years. Clearly, use of a

Chapter 8 Risk Analysis in Investment Decisions 321

TABLE 8.7 Use of a Constant Risk-Adjusted Discount Rate Implies That Risk Increases with the Remoteness of a Cash Flow (risk-free rate � 5%; risk-adjusted rate � 10%)

Present Value of $1

Received in Received in 1 Year 10 Years

Discounted at risk-free rate $0.95 $0.61 Discounted at risk-adjusted rate 0.91 0.39

Reduction in present value due to risk $0.04 $0.23



constant risk-adjusted discount rate is appropriate only when the risk of a cash flow grows as the cash flow recedes farther into the future.

For many, if not most, business investments, the assumption that risk increases with the remoteness of a cash flow is quite appropriate, but as we will see by looking again at General Design’s diamond film project, this is not always the case.

Recall that General Design is contemplating a possible two-stage investment. The first stage, costing $85 million, is attractive chiefly because it gives management the option to make a much more lucrative follow-on investment. Both stages depend on relatively untested diamond film technology, so the discount rate used throughout the analysis was General Design’s hurdle rate for projects of this type, 15 percent.

Given the nature of this investment, many executives would argue that it is entirely appropriate to use this higher risk-adjusted discount rate throughout. But is it really? The investment clearly involves high risk, but because most of the risk will be resolved in the first two years, use of a constant risk-adjusted discount rate is overly conservative.

To see the logic, suppose you are at time 2, stage 1 has been successful, and the company is about to launch stage 2. Because the stage 2 cash flows are now relatively certain, the appropriate discount rate is lower, and the value of the cash flows at time 2 is correspondingly higher. As seen from time 0, the revised NPV for both stages of the General Design project is thus higher than originally calculated. Problem 19 at the end of the chap- ter works through a specific example.

To recap, whenever you encounter an investment with two or more dis- tinct risk phases, be careful about using a constant risk-adjusted discount rate, for although such investments may be comparatively rare, they are also frequently the type of opportunities companies can ill afford to waste.

Economic Value Added

More than 20 years ago, in late 1993, Fortune magazine ran a cover story entitled “The Real Key to Creating Wealth,” which trumpeted, “Re- warded by knockout results, managers and investors are peering into the heart of what makes businesses valuable by using a tool called Economic Value Added.”8 With publicity like this and a steady stream of laudatory articles since, many executives and investors alike remain interested in economic value added, or EVA.

Having mastered the intricacies of the cost of capital, you will find EVA to be little more than a restatement of what you already know. The

322 Part Four Evaluating Investment Opportunities

8 Shawn Tully, “The Real Key to Creating Wealth,” Fortune, September 20, 1993, p. 38.



central message of this and the preceding chapter has been that an investment creates value for its owners only when its expected return exceeds its cost of capital. In essence, EVA simply extends the cost of capital imperative to performance appraisal. It says that a company or a business unit creates value for owners only when its operating income exceeds the cost of capital employed. In symbols,

EVA � EBIT(1 � Tax rate) � KWC

where EBIT(1 � Tax rate) is the unit’s after-tax operating income, KW is its WACC, and C is the capital employed by the unit. KWC, then, repre- sents an annual capital charge. The capital-employed variable, C, equals the money invested in the unit over time by creditors and owners. As a first approximation, C is the sum of interest-bearing debt plus the book value of equity or, more generally, all sources of capital to the business on which it must earn a return.9

Plugging Stryker’s 2013 numbers into this expression, we find that

EVA13 � $1,295(1 � 17%) � 9.0%($2,764 � $9,047)

� $11.9 million.

Although estimating economic values from accounting data is always problematic, these numbers suggest that Stryker earned just enough in 2013 to cover the cost of capital employed and created $11.9 million in new value for its owners—a marginal performance.

EVA and Investment Analysis An important attribute of economic value added is that the present value of an investment’s annual EVA stream equals the investment’s NPV. This makes it possible to talk about investment appraisal in terms of EVA rather than NPV—provided, of course, there is something to be gained by doing so. The numerical example in Table 8.8 demonstrates this equality. Part a of the table is a conventional NPV analysis of a very simple invest- ment. The investment requires an initial outlay of $100, which will be de- preciated on a straight-line basis to zero over four years. Adding depreci- ation to prospective income after tax and discounting the resulting ATCF at 10 percent yields an NPV of $58.50.

Part b of the table presents a discounted EVA treatment of the same investment. To calculate EVA, we need a dollar figure for the annual opportunity cost of capital employed. This equals the percentage cost of capital times the book value of the investment at the beginning of each year.

Chapter 8 Risk Analysis in Investment Decisions 323

9 For details, see G. Bennett Stewart III, The Quest for Value (New York: HarperBusiness, 1991).



Subtracting this quantity from EBIT after-tax yields annual project EVA, which, discounted at 10 percent, yields a discounted EVA of $58.50— precisely the NPV calculated in part a. Thus, another way to evaluate investment opportunities, which is equivalent to NPV analysis, is to calcu- late the present value of the investment’s annual EVA. Still to be answered is why one might want to calculate discounted EVA instead of NPV.10

324 Part Four Evaluating Investment Opportunities

TABLE 8.8 Discounting an Investment’s Annual EVA Stream Is Equivalent to Calculating the Investment’s NPV

(a) Standard NPV Analysis Year

0 1 2 3 4

Initial investment �$100.00 Revenue $ 80.00 $80.00 $80.00 $80.00 Cash expenses 13.33 13.33 13.33 13.33 Depreciation 25.00 25.00 25.00 25.00

Income before tax 41.67 41.67 41.67 41.67 Tax at 40% 16.67 16.67 16.67 16.67

Income after tax 25.00 25.00 25.00 25.00 Depreciation 25.00 25.00 25.00 25.00

After-tax cash flow �$100.00 $ 50.00 $50.00 $50.00 $50.00 NPV at 10% $ 58.50

(b) Discounted EVA Analysis


0 1 2 3 4

Capital employed $100.00 $75.00 $50.00 $25.00 KW 0.10 0.10 0.10 0.10

KW � Capital 10.00 7.50 5.00 2.50 EBIT(1 � t ) 25.00 25.00 25.00 25.00 � KW � Capital 10.00 7.50 5.00 2.50

EVA $ 15.00 $17.50 $20.00 $22.50 EVA discounted at 10% $ 58.50

10 Why the equality? The difference between the two approaches lies in the treatment of the initial investment. NPV records the full cost of the investment at time zero. EVA ignores the initial cost but records an annual depreciation charge plus a carrying cost equal to the WACC times the undepreciated asset value. It turns out that the present value of these two annual charges always equals the initial cost of the investment, regardless of the method of depreciation employed. Therefore, the two methods must yield the same result.



Chapter 8 Risk Analysis in Investment Decisions 325

EVA’s Appeal If EVA looks vaguely familiar, it should. The fact that capital provided by creditors and owners is costly and this cost is relevant for measuring economic performance has been recognized for many years. Indeed, we made the point in Chapter 1 when we noted that accounting income over- states true, economic income because it ignores the cost of equity. So nov- elty cannot explain EVA’s appeal, nor can EVA’s superiority to return on investment, ROI, as a measure of business performance. For the problems with ROI, defined as operating income over operating assets, have also been widely known for a long while.11 So why the appeal of EVA after all these years?

The answer, I think, is that EVA, in its present incarnation, addresses a pervasive business problem, one that has greatly undermined many managers’ acceptance of modern finance. EVA’s appeal is that it integrates three crucial management functions: capital budgeting, performance appraisal, and incentive compensation. Together these functions are in- tended to positively influence management behavior, but too often, they work at cross-purposes, giving managers confusing and apparently con- flicting signals about what to do. Thus, in the absence of EVA, managers are told to use NPV, IRR, or BCR to analyze investment opportunities but to look at ROE, ROI, or earnings per share growth when assessing busi- ness unit performance. And all the while, the company’s incentive com- pensation plan relies on still other metrics, requires an advanced degree to fully comprehend, and changes more often than the Italian government. Is it any wonder, then, that many operating managers faced with this apparent confusion take none of it very seriously and rely instead on common sense to muddle through?

Contrast this with EVA-based management. The business goal is to create EVA. Capital budgeting decisions are based on discounted EVA at an appropriate cost of capital. Unit EVA, or change in EVA, mea- sures business unit performance, and incentive compensation depends on unit EVA relative to an appropriate target—clean, simple, and straightforward. Consultants Stern Stewart & Company have even de- veloped a clever method of distributing a manager’s bonus over several periods, known as the bonus bank, that puts middle managers at risk

11 Here is one problem with ROI. Imagine a division with an ROI of only 2 percent and ask what type of investments the division manager is apt to favor. Charged with the task of raising division ROI, the manager will naturally look favorably on any investment promising an ROI above 2 percent regardless of the investment’s NPV. Conversely, managers in divisions with high ROIs will be quite conservative in their investment decisions for fear of lowering ROI. A company in which unsuccessful divisions invest aggressively while successful ones invest conservatively is probably not what shareholders want to see.



326 Part Four Evaluating Investment Opportunities

12 See Stewart, The Quest for Value, Chapter 6. 13 Barbara W. Tuchman, Stilwell and the American Experience in China 1911–1945 (New York: Bantam Books, 1971), pp. 561–62.

much as though they were owners and also helps to discourage myopic, single-period decision making.12

EVA certainly has its own problems, and some of its virtues are more cosmetic than real. But it does address an important barrier to the accep- tance of the financial way of thinking in many companies, and for this reason alone deserves our attention. Or, as Fortune’s purple prose might put it, “EVA promises to complete the transformation of value creation from a mere slogan into a powerful management tool, one that may at last move modern finance out of the classroom and into the boardroom— perhaps even onto the shop floor!”

A Cautionary Note

An always present danger when using analytic or numerical techniques in business decision making is that the “hard facts” will assume exaggerated importance compared to more qualitative issues and that the manipulation of these facts will become a substitute for creative effort. It is important to bear in mind that numbers and theories don’t get things done; people do. And the best investments will fail unless capable workers are committed to their success. As Barbara Tuchman put it in another context, “In military as in other human affairs will is what makes things happen. There are cir- cumstances that can modify or nullify it, but for offense or defense its pres- ence is essential and its absence fatal.”13


Asset Beta and Adjusted Present Value Most companies have two betas: an observable equity beta, discussed at some length in the chapter, and an unobservable asset beta. Equity beta measures the systematic risk of a company’s shares, while asset beta mea- sures the systematic risk of its assets. In rare instances when a company is all-equity financed, the risk of its common stock equals that of its assets, and equity beta equals asset beta. For this reason, asset beta is also commonly referred to as the firm’s unlevered beta. It is the equity beta a firm would report if it were all-equity financed.



One important use of asset betas is to improve the accuracy by which equity betas are measured. To illustrate, when I estimated Stryker’s equity beta by regressing the company’s monthly, realized returns against those of the Standard & Poor’s 500 Stock Index, I calculated an equity beta of 0.89, as reported in the chapter. But I also found a standard error of esti- mate equal to 0.15. Standard error is a statistical indicator of the precision of the beta estimate. As a benchmark, when the deviations of the individ- ual observations from the regression line are distributed in a normal, bell- shaped pattern, we know there is a two-thirds chance that the true slope of the regression line is within plus or minus one standard error of the ob- served slope. This means we can state with some confidence that Stryker’s equity beta is somewhere in the range of 0.74 to 1.04—not an especially comforting conclusion.

A second important use of asset beta is in conjunction with a net present value technique called Adjusted Present Value, or APV. Together asset beta and APV offer a flexible alternative to the standard WACC- based approach to investment appraisal described in the chapter. This alternative is especially attractive when evaluating complex investment opportunities.

Beta and Financial Leverage

Our starting point in the consideration of asset beta and adjusted present value is the effect of financial leverage on equity beta. Recalling our dis- cussion of company financing decisions in Chapter 6, you know that shareholders face two distinct risks: the basic business risk inherent in the markets in which the firm competes, plus the added financial risk created by the use of debt financing. Asset beta measures the business risk, while equity beta reflects the combined effect of business and financial risks. To appreciate the tie between equity beta and financial leverage, recall from Chapter 6 that debt financing increases the dispersion in possible returns to shareholders, which in turn increases the firm’s equity beta.

Because most businesses are levered, it is generally impossible to ob- serve asset beta directly. However, with the aid of the following formula, we can easily calculate asset beta given equity beta, and vice versa.1

Chapter 8 Risk Analysis in Investment Decisions 327

1 We can express the market value of a levered firm in two ways: as the market value of its debt plus equity, and as the value of the same firm unlevered plus the present value of the tax shields from debt financing. Equating these two expressions,

D � E � Vu � tD

where D is interest-bearing debt, E is the market value of equity, Vu is the value of the firm without any debt, and t is the marginal tax rate.



where bA is asset beta, bE is equity beta, and is the equity-to-firm value ratio, measured at market. This equation says that bA � bE when debt is zero and that bE rises above bA by a growing amount as leverage increases. Plugging Stryker’s numbers into the equation, we learn that if the company’s equity beta is 0.89, its asset beta must be 0.81 [0.81 � ($28,403/$31,167) � 0.89]. Calculating asset beta from equity beta in this manner is known in the trade as unlevering beta, while applying the equation in reverse to calculate equity beta from asset beta is referred to as relevering beta.

Using Asset Beta to Estimate Equity Beta The ability to unlever and relever betas is the key to improving equity beta estimates. Three steps are required:

• Identify industry competitors of the target company, and calculate each competitor’s asset beta by unlevering its observed equity beta.

• Average these asset betas, or use their median value, to estimate an industry asset beta.

• Relever this industry asset beta to the target company’s capital structure.

The logic of this approach is that firms in the same industry should face the same or similar business risks and should therefore have similar asset betas. Unlevering the observed equity betas removes the differential effects of financial leverage for each company, allowing us to estimate an industry asset beta based on observations from several firms. Then relevering this asset beta to the target’s capital structure produces an equity beta consistent with the target’s unique structure. The payoff from this approach is that an


bA = E V


328 Part Four Evaluating Investment Opportunities

1 (continued) An important property of beta is that the beta of a portfolio is the weighted-average of the

betas of the individual assets comprising the portfolio. Applying this insight to both sides of the equation above,

where bD is the beta of debt, bE is the beta of equity, bA is the beta of the unlevered firm, or equivalently, the firm’s asset beta, and bITS is the beta of the firm’s interest tax shields.

Assuming for simplicity (1) the firm’s debt is risk-free, so bD � 0, and (2) the risk of interest tax shields equals the risk of the firm’s unlevered asset cash flows, so bITS � bA , the above equation simplifies to the equation in the text.

A possible alternative, but to my mind no more plausible, assumption is bITS � bD � 0, which yields a more complex expression. For details, see Richard S. Ruback, ‘‘Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows,’’ Financial Management, Summer 2002, pp. 85–103.

D D + E

bD + E

D + E bE =

Vu Vu + tD

bA + tD

Vu + tD bITS



equity beta estimate based on data from a number of firms should reduce the unavoidable noise inherent in the conventional, single-firm approach.

Table 8A.1 illustrates the mechanics. It presents an estimate of Stryker’s industry asset beta based on numbers for six competitors of Stryker iden- tified in Chapter 2. To avoid giving undue weight to smaller firms, I weighted the firm asset betas by relative market value of equity in calcu- lating the industry figure. The resulting industry asset beta is 0.67. Relevering this industry beta to reflect Stryker’s unique capital structure yields an estimated equity beta of 0.74, about 17 percent below the num- ber reported in the chapter, [0.74 � ($31,167/$28,403) � 0.67].

Asset Beta and Adjusted Present Value In the standard WACC-based approach to investment appraisal described in the chapter, we ask the weighted average cost of capital to do double duty: to adjust for the risk of the cash flows being discounted, and to capture the tax- shield advantages of the debt financing used by the firm. We reflect these tax shield advantages by using the after-tax cost of debt in the weighted-average calculation. In most instances, this creates no problem; however, difficulties can arise when the firm’s capital structure is changing over time, or when the project’s debt capacity differs from that implicit in the WACC.

In these situations it becomes advantageous to use an APV approach, or what is sometimes called “valuation by parts.’’ First, abstract entirely from anything to do with debt financing by estimating the project’s NPV as- suming all-equity financing. Then capture the tax shield effects of debt financing, and any other “side effects,” in separate add-on terms. If the sum of these separate present value terms is positive, the opportunity is financially attractive, and vice versa. In symbols,

APV � NPVall-equity financing � PVinterest tax shields � PVany other side effects

Chapter 8 Risk Analysis in Investment Decisions 329

TABLE 8A.1 Estimate of Industry Asset Beta for Stryker Corporation

Market Equity Equity/Firm Asset Value % of Total Weighted-

Company Beta Value Beta Equity Market Value Asset Beta

Baxter International 0.56 81% 0.45 $37,745 21% 0.09 Becton Dickinson 0.66 84% 0.56 $21,433 12% 0.07 Covidien PLC 0.87 86% 0.75 $30,809 17% 0.13 Medtronic 0.89 82% 0.74 $57,295 32% 0.23 St. Jude Medical 0.88 84% 0.74 $18,078 10% 0.07 Zimmer Holdings 1.00 91% 0.91 $15,934 9% 0.08

Industry asset beta 0.67



At its root, APV is nothing more than a formalization of the idea that when evaluating investment opportunities, the whole should equal the sum of the parts.

Asset beta and APV are ideal partners because asset beta enables us to estimate the appropriate discount rate for valuing investments that are all-equity financed. A moment’s review of the WACC equation in the chapter will convince you that in the absence of debt financing, WACC collapses to the cost of equity. The discount rate for evaluating all-equity financed investments is therefore represented by equation 8.2 in the chapter, with bA replacing bE.

KA � ig � bA � Rp

where ig is a government bond rate, bA is the investment’s asset beta, and Rp is the risk premium, usually approximated by the excess return on com- mon stocks over government bonds.

To illustrate the combined use of APV and asset beta, consider the in- vestment opportunity under review by Delaney Pumps. Delaney Pumps manufactures and distributes an extensive line of agricultural irrigation sys- tems. In recent years, computerized control systems used to automate irri- gation and to conserve water have become increasingly important in selling high-end systems. And Delaney management is actively considering investing $160 million to develop a state-of-the-art, computerized controller that promises to leapfrog competition. Development work would be contracted to a software development company on a cost-plus basis. Revenue would come from a new product line featuring the controller and from license fees from selected competitors who elected to include the controller in their products. Projected cash flows for the investment appear in Table 8A.2. The projections extend for only four years because management anticipates that other, more advanced controllers will be available by this time.

330 Part Four Evaluating Investment Opportunities

TABLE 8A.2 Adjusted Present Value Analysis of Automated Irrigation Controller ($ millions)


0 1 2 3 4

Earnings before interest and taxes $50.0 $150.0 $80.0 $30.0 Expected free cash flow (160.0) 30.0 120.0 60.0 70.0 Interest expense 5.0 15.0 8.0 3.0 Interest tax-shield @ 40% tax rate 2.0 6.0 3.2 1.2 Asset beta 2.41

NPV all-equity 19.8 PV tax-shields 8.4

APV $ 28.2



Two challenges confronted Delaney management as they began their deliberations. Because the digital controller appeared much riskier than the company’s usual capital expenditures, managers were uncomfortable using the company’s 10 percent weighted-average cost of capital as the hurdle rate. In addition, Delaney had traditionally financed its business with the goal of maintaining a target times-interest-earned ratio of about 3 to 1. But because this project consisted almost entirely of intangible computer code and because its cash flows were quite uncertain, Delaney’s treasurer thought it prudent to target a higher interest coverage of 10 to 1 on this project.

To address these challenges, the treasurer decided to do an APV analysis. Reasoning that the digital controller would probably be an average-risk investment for software companies, she identified five smaller, publicly traded firms specializing in business automation software. She then unlev- ered the equity betas of these firms and calculated an industry average asset beta equal to 2.41, confirming her intuition that business automation software is indeed a risky business. Combining this asset beta with a 4.0 percent riskless borrowing rate and a 6.3 percent historical risk premium in the earlier equation, she calculated a hurdle rate for unlev- ered, business automation software investments equal to 19.2 percent (19.2 � 4.0% � 2.41 � 6.3%). Using this rate to discount the expected free cash flows in Table 8A.2, she found the project’s NPV assuming all- equity financing to be $19.8 million.

The investment’s principal side effect was the interest-tax shields it would generate over time. At a target times-interest-earned ratio of 10 to 1 and a 40 percent tax rate, the annual interest expense appearing in the table equals one-tenth of projected EBIT, while the corresponding tax shield is 40 percent of this amount. The discount rate used to calculate the present value of these tax shields should, of course, reflect the risk of the cash flows being discounted. Some executives argue that because interest tax shields are debt-like in terms of risk, they should be discounted at a corporate debt rate. Others maintain that while individual debt contracts may generate predictable cash flows, the total debt a business carries varies with its size and cash flows, in which case a discount rate more like KA is appropriate. Here, because the tax shields are tied mechanically to operating income, KA is the proper rate. Discounting at this rate, the tax shields are worth $8.4 million, so the investment’s APV is an attractive $28.2 million.

APV � NPVall-equity financing � PVinterest tax shields $28.2 million � $19.8 million � $8.4 million

Note carefully in this analysis that the treasurer’s tax shield calcula- tions had nothing to do with the way Delaney intended to finance the investment and everything to do with how much debt the treasurer

Chapter 8 Risk Analysis in Investment Decisions 331



332 Part Four Evaluating Investment Opportunities

believed the project could prudently support. For tactical reasons, companies routinely finance some investments entirely with debt and others entirely with retained profits, but this information is irrelevant to judging an investment’s debt capacity and its consequent claim to interest tax shields. To think otherwise would be to commit a variation of the “marginal cost of capital fallacy.”

This example deals with a straightforward investment possessing one simple side effect, but I hope it hints at the power of the technique. APV’s divide-and-conquer perspective makes it possible to break even very complex problems into a series of tractable, smaller problems, and to solve the complex problem by stringing together solutions to the smaller ones. We can thus analyze a cross-border investment involving several currencies and subsidized financing as the sum of separate NPV calcula- tions for cash flows in each currency translated into the home currency at prevailing exchange rates, plus a separate term capturing the value of the subsidized finance. And we can even apply a separate, customized hurdle rate to each cash flow stream. In a complicated world, APV and its cousin, asset beta, are indeed welcome additions to our tool kit.


1. An investment’s total risk • Refers to the range of possible returns. • Can be estimated for traded assets as the standard deviation of returns. • Can be avoided to some extent by diversifying.

2. Systematic risk • Is the part of total risk that cannot be avoided by diversifying. • Equals about half of total risk, on average, for stocks. • Is the only part of total risk that should affect asset prices and returns. • Is positively related to the return demanded by risk-averse investors. • Can be estimated as the product of total risk and the correlation co-

efficient between an asset’s returns and those on a well-diversified portfolio.

3. The cost of capital • Is a risk-adjusted discount rate. • Equals the value-weighted average of the opportunity costs incurred

by owners and creditors. • Is the return a firm must earn on existing assets to at least maintain

stock price.



Chapter 8 Risk Analysis in Investment Decisions 333

• Is relevant for private firms and not-for-profits as well as public firms. • Is the appropriate hurdle rate for evaluating carbon copy investments. • Can be an appropriate hurdle rate for evaluating non–carbon copy

investments when it is the cost of capital of other firms for which the investment is a carbon copy.

4. The cost of equity capital • Is the opportunity cost incurred by owners. • Is the most challenging variable to estimate when measuring a firm’s

cost of capital. • Is best approximated as the sum of an interest rate on a government

bond plus a risk premium. • Increases with financial leverage.

5. Beta • Measures an asset’s relative systematic risk. • Can be estimated by regressing an asset’s periodic realized returns

on those of a well-diversified portfolio. • When multiplied by the realized excess return on stocks relative to

bonds, yields a suitable risk premium for estimating the cost of equity. • Increases with financial leverage.

6. Four pitfalls to avoid in discounted cash flow analysis are • Confounding an enterprise perspective with an equity perspective. • Using a nominal discount rate to value real cash flows, or vice versa. • Ignoring possibly valuable real options embedded in firm investments. • Forgetting that a constant discount rate implies risk grows with the

futurity of the cash flow. 7. Economic Value Added

• Is a popular measure of firm or division performance. • Equals a unit’s operating income after tax less an annual charge for

capital employed. • Helps unify three apparently disparate topics:

– Investment evaluation. – Performance appraisal. – Incentive compensation.


Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. New York: John Wiley and Sons, 1998. 383 pages.

A stimulating history of man’s attempt to cope with risk in human affairs from the 13th century to the present. Bernstein



does a great job of explaining the principal tools of risk management in nonmathematical terms and putting them in a historical context. Believe it or not, an excellent read. Available in paperback for about $15.

Brotherson, W. Todd, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins. “ ‘Best Practices’ in Estimating the Cost of Capital: An Update.” Journal of Applied Finance, Spring/Summer 2013, pp. 15–33.

A look at the practical challenges of estimating capital costs and how some of America’s best companies and investment banks address them.

Copeland, Tom, and Vladimir Antikarov. Real Options: A Practitioner’s Guide, Revised Edition. New York: Texere, 2003. 384 pages.

A solid, practical introduction to real options with an emphasis on binomial decision trees. About $50.

Dixit, Avinash K., and Robert S. Pindyck. Investment under Uncertainty. New Jersey: Princeton University Press, 1994. 476 pages.

A rigorous, mathematically inclined introduction to real options analysis. About $85.

Dixit, Avinash K., and Robert S. Pindyck. “The Options Approach to Capital Investment.” Harvard Business Review, May–June 1995, pp. 105–115.

An overview of the practical implications of the real options perspective for capital budgeting.

Luehrman, Timothy A. “Using APV: A Better Tool for Valuing Operations.” Harvard Business Review, May–June 1997, pp. 132–154.

A practical introduction to adjusted present value, a simple variant of NPV useful for analyzing complex investments.

Trigeorgis, Lenos. Real Options: Managerial Flexibility and Strategy in Resource Allocation. Massachusetts: The MIT Press, 1996. 427 pages.

A rigorous introduction beginning with net present value and proceeding systematically through decision trees to real options analysis. Less mathematical than Dixit and Pindyck and with more on the strategic and competitive implications of the real options perspective. About $55.

WEBSITES; Two reliable sites to find an estimate of a company’s beta. On Yahoo!, enter the company’s stock ticker symbol and select “Key Statistics.” On Reuters, enter the company’s stock ticker symbol and select “Overview.”

334 Part Four Evaluating Investment Opportunities



Chapter 8 Risk Analysis in Investment Decisions 335 Need to find a company’s WACC on the quick? Enter the stock ticker symbol for any company, and this website pulls the necessary financial information and demonstrates the calculation of the company’s WACC. The site also allows you to interactively change assumptions to see how the WACC is affected. Skip the book ad and go directly to “Additional Resources” for numerous links to information about real options. Free, open-enrollment video courses on financial markets and financial theory by distinguished Yale faculty, including Nobel Prize winner Robert Shiller.


Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are avail- able in the Instructor Resources within McGraw-Hill’s Connect, con- (See the Preface for more information). 1. Is each of the following statements true or false? Explain your answers

briefly. a. Using the same risk-adjusted discount rate to discount all future

cash flows ignores the fact that the more distant cash flows are often riskier than cash flows occurring sooner.

b. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm.

c. If you can borrow all of the money you need for a project at 6 per- cent, the cost of capital for this project is 6 percent.

d. The best way to estimate the cost of debt capital for a firm is to di- vide the interest expense on the income statement by the interest- bearing debt on the balance sheet.

e. One reliable estimate of a privately held firm’s equity beta is the av- erage of the equity betas of several publicly held competitors.

2. The annual standard deviation of return on Stock A’s equity is 37 percent and the correlation coefficient of these returns, with those on a well- diversified portfolio, is 0.62. Comparable numbers of Stock B are 34 percent and 0.94. Which stock is riskier? Why?

3. An entrepreneur wants to purchase a particular small business. The asking price is $5 million. He expects to improve the business’s oper- ations over a period of five years and sell it at a handsome profit. To help him achieve this goal, a wealthy aunt is willing to loan the



entrepreneur $5 million for five years at zero percent interest. Given this loan, what is the lowest rate of return the entrepreneur should be willing to accept on purchase of the business? Why?

4. Your company’s weighted-average cost of capital is 11 percent. It is plan- ning to undertake a project with an internal rate of return of 14 percent, but you believe this project is not a wise investment. What logical argu- ments would you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with re- turns higher than the firm’s cost of capital will destroy value? If so, how?

5. ABC Corporation and XYZ Corporation are both bidding for an existing food processing plant located in Monterrey, Mexico. Both firms are highly profitable and have similar debt ratios and costs of debt, but XYZ operates in a more volatile industry than ABC and thus has a higher beta. As ABC and XYZ separately prepare their valua- tions of the plant, what difference would you expect to see in the appropriate weighted-average cost of capital each firm will use to discount the projected cash flows from the plant?

6. Looking at Figure 8.1, explain why a company should reject invest- ment opportunities lying below the market line and accept those lying above the line.

7. What is the weighted-average cost of capital for SKYE Corporation given the following information?

Equity shares outstanding 1 million Stock price per share $30.00 Yield to maturity on debt 7.68% Book value of interest-bearing debt $10 million Coupon interest rate on debt 9% Interest rate on government bonds 6% SKYE’s equity beta 0.75 Historical excess return on stocks 6.3% Tax rate 40%

8. You have the following information about Burgundy Basins, a sink manufacturer.

Equity shares outstanding 20 million Stock price per share $40.00 Yield to maturity on debt 7.5% Book value of interest-bearing debt $320 million Coupon interest rate on debt 4.8% Market value of debt $290 million Book value of equity $500 million Cost of equity capital 14% Tax rate 35%

336 Part Four Evaluating Investment Opportunities



Chapter 8 Risk Analysis in Investment Decisions 337

Burgundy is contemplating what for the company is an average-risk investment costing $40 million and promising an annual ATCF of $6.4 million in perpetuity. a. What is the internal rate of return on the investment? b. What is Burgundy’s weighted-average cost of capital? c. If undertaken, would you expect this investment to benefit share-

holders? Why or why not? 9. How will an increase in financial leverage affect a company’s cost of

equity capital, if at all? How will it affect a company’s equity beta? 10. What is the present value of a cash flow stream of $1,000 per year an-

nually for 15 years that then grows at 4 percent per year forever when the discount rate is 13 percent?

11. You are a commercial real estate broker eager to sell an office building. An investor is interested but demands a 20 percent return on her equity investment. The building’s selling price is $25 million, and it promises free cash flows of $3 million annually in perpetuity. Interest-only fi- nancing is available at 8 percent interest; that is, the debt is outstanding forever and requires no principal payments. The tax rate is 50 percent. a. Propose an investment-financing package that meets the investor’s

return target. b. Propose an investment-financing package that meets the investor’s

target when she demands a 90 percent return on equity. c. Why would an investor settle for a 20 percent return on this in-

vestment when she can get as high as 90 percent? 12. A security analyst has regressed the monthly returns on Berkshire

Hathaway equity shares over the past five years against those on the Standard & Poor’s 500 stock index over the same period. The result- ing regression equation is rBH = 0.04 + 0.72rSP. Use this equation and any other information you deem appropriate to estimate Berkshire Hathaway’s equity beta.

13. An all-equity financed company has a cost of capital of 10 percent. It owns one asset: a mine capable of generating $100 million in free cash flow every year for five years, at which time it will be abandoned. A buyout firm proposes to purchase the company for $400 million fi- nanced with $350 million in debt to be repaid in five, equal, end-of- year payments and carrying an interest rate of 6 percent. a. Calculate the annual debt-service payments required on the debt. b. Ignoring taxes, estimate the rate of return to the buyout firm on the

acquisition after debt service. c. Assuming the company’s cost of capital is 10 percent, does the buy-

out look attractive? Why, or why not?



14. The following information is available about an investment opportu- nity. Investment will occur at time 0 and sales will commence at time 1.

Initial cost $28 million Unit sales 400,000 Selling price per unit, this year $60.00 Variable cost per unit, this year $42.00 Life expectancy 8 years Salvage value $0 Depreciation Straight-line Tax rate 37% Nominal discount rate 10.0% Real discount rate 10.0% Inflation rate 0.0%

a. Prepare a spreadsheet to estimate the project’s annual ATCFs. b. Calculate the investment’s internal rate of return and its NPV. c. How do your answers to questions (a) and (b) change when you

assume a uniform inflation rate of 8 percent a year over the next 10 years? (Use the following equation to calculate the nominal discount rate: in = (1 + ir)(1 + p) – 1, where in is the nominal discount rate, ir is the real discount rate, and p is expected inflation.)

d. How do you explain the fact that inflation causes the internal rate of return to increase and the NPV to decrease?

e. Does inflation make this investment more attractive or less attractive? Why?

15. The chapter discusses General Design’s option to expand its diamond film project. a. Is the option a call or a put? b. In qualitative terms, what is the option’s strike price?

16. Having just returned from a stimulating seminar stressing the virtues of EVA in strategic decision making, the Vice President of Corporate Development for Venture Telecommunications, Inc. asks his assis- tant to gather data necessary to calculate last year’s EVA for two com- pany divisions. The Voice Division is home to the company’s tradi- tional businesses, while the Data Division houses the firm’s newer initiatives. Voice is much larger than Data, but Data is growing more rapidly.

The assistant is uncertain about how to best measure the capital de- voted to each division but decides to use division assets as reported in the company’s annual report. To estimate each division’s cost of capital she uses the median cost of capital of several pure-play competitors of each

338 Part Four Evaluating Investment Opportunities



division. The company’s marginal tax rate is 40 percent. The following table contains the information compiled by the assistant.

($ millions)

Voice Division Data Division

Earnings before interest and taxes $ 220 $130 Division assets $1,000 $600 Division cost of capital 10% 15%

Within minutes of seeing these figures, the VP of Development ex- claims “I knew it. The Data Division is bleeding us dry. I’m going to recommend we dump that division immediately!” a. Estimate each division’s EVA. b. Do you agree with the VP of Development? Should the company

immediately eliminate the Data Division? Why, or why not? 17. Reconsider General Design’s diamond film project from Table 8.6(b).

Suppose that General Design now believes it also has an option to grow the project if things go well. Initial success in diamond film semiconductors will open the door to a stage 2, follow-on invest- ment in two years that will be five times as large as the initial stage 1. Stage 2 will be undertaken only if stage 1 is successful, and management believes the chance stage 2 will succeed, given that stage 1 has succeeded, is 90 percent. The discount rate is still 15 percent. a. What are the cash flows for the stage 2 investment? What is the

present value of the cash flows for the stage 2 investment if it succeeds? If it fails? What is the present value of the initial cost of the stage 2 investment?

b. If General Design were to evaluate the stage 2 decision today (before learning whether stage 1 is successful), what is its NPV?

c. Assuming General Design waits to learn whether stage 1 is successful: i. What is the NPV today of the stage 2 investment? ii. What is total project NPV, incorporating the option to grow? iii.What is the value of the option to grow?

18. Consider the problem of Wind Resources (described in the section “The Timing Option” in this chapter). WRI is contemplating devel- oping an attractive wind farm site it owns in Southern California. A consultant estimates that at the current natural gas price of 6 cents/kWh (cents per kilowatt hour), immediate development will yield a profit of $10 million. However, natural gas prices are quite volatile. Suppose the price in one year will be either 8 cents/kWh or

Chapter 8 Risk Analysis in Investment Decisions 339



4 cents/kWh with equal probability. According to the consultant, WRI’s profit will jump to $30 million at a price of 8 cents/kWh and fall to a loss of $10 million at 4 cents/kWh. Because the company won’t receive these profits for one year, discount them to the present at a high, risk-adjusted rate of 25 percent. WRI is now considering whether to wait to develop the wind farm. a. Draw a decision tree that captures WRI’s decision. b. What should WRI do? What is the resulting NPV of this

project? c. What is value of the option to wait? d. Suppose that the change in natural gas prices in one year will be

more dramatic than originally envisioned in the problem. In par- ticular, gas prices will either rise to 12 cents/kWh or fall to 2 cents/kWh with equal probability. According to the consultant, WRI’s profit will be $60 million at a price of 12 cents/kWh or fall to a loss of $30 million at 2 cents/kWh. What is the new value of the option to wait? How is the value of the option affected by the wider dispersion of natural gas prices?

19. Revisit General Design’s option to grow in Problem 17. Suppose you are at time 2, and stage 1 has been successful. Because the stage 2 cash flows are now relatively certain, their discount rate is now 10 percent (which is lower than the discount rate for stage 1). a. What is the revised NPV at time 2 of stage 2? b. What is the revised total NPV at time 0 for both stages?

20. The spreadsheet for this problem provides key facts and assumptions concerning Kroger Company, a large supermarket chain, on Decem- ber 12, 2007. It is available for download from McGraw-Hill’s Con- nect or your course instructor (see the Preface for more information). Using this information: a. Estimate Kroger’s cost of equity capital. b. Estimate Kroger’s weighted-average cost of capital. Prepare a

spreadsheet or table showing the relevant variables. The following four problems test your understanding of the chapter appendix.

21. The spreadsheet for this problem contains information about Kroger Company and four industry competitors in 2007. It is available for download from McGraw-Hill’s Connect or your course instructor (see the Preface for more information). Using this information: a. Estimate the industry asset beta, weighting each company by its

proportion of the sample total market value of equity. b. Relever the industry asset beta to reflect Kroger’s capital structure

to estimate an industry-based equity beta for Kroger.

340 Part Four Evaluating Investment Opportunities



Chapter 8 Risk Analysis in Investment Decisions 341

22. A group of investors is intent on purchasing a publicly traded company and wants to estimate the highest price they can reasonably justify paying. The target company’s equity beta is 1.20 and its debt- to-firm value ratio, measured using market values, is 60 percent. The investors plan to improve the target’s cash flows and sell it for 12 times free cash flow in year five. Projected free cash flows and selling price are as follows.

($ millions)

Year 1 2 3 4 5 Free cash flows $25 $40 $45 $50 $50 Selling price $600 Total free cash flows $25 $40 $45 $50 $650

To finance the purchase the investors have negotiated a $400 mil- lion, five-year loan at 8 percent interest to be repaid in five equal payments at the end of each year, plus interest on the declining bal- ance. This will be the only interest-bearing debt outstanding after the acquisition.

Selected Additional Information

Tax rate 40 percent Risk-free interest rate 3 percent Market risk premium 5 percent

a. Estimate the target firm’s asset beta. b. Estimate the target’s unlevered, or all-equity, cost of capital (KA). c. Estimate the target’s all-equity present value. d. Estimate the present value of the interest-tax shields on the acqui-

sition debt discounted at KA. e. What is the highest price the investors can reasonably justify pay-

ing for the target company? f. What does your estimated maximum acquisition price in question

(e) assume about the costs of financial distress? 23. You are valuing a project for Diamondback Corporation using the

APV method. You already found the net present value of free cash flows from the project (discounted at the appropriate cost of equity) to be $500,000. The only important side effect of financing is the pres- ent value of interest tax shields. The project will be partially financed by a constant $1 million in debt over the life of the project, which is three years. Diamondback’s tax rate is 50 percent, and the current



342 Part Four Evaluating Investment Opportunities

interest rate applicable for the project’s debt is 10 percent (assume this rate is also appropriate for discounting the interest tax shields). As- suming tax shields are realized at the end of each year, what is the APV of the project?

24. Dome Appliance, Inc., a private firm that manufactures home appli- ances, has hired you to estimate the company’s beta. You have ob- tained the following equity betas for publicly traded firms that also manufacture home appliances.

($ millions)

Market Value Firm Beta Debt of Equity

Black & Decker 1.19 $4,100 $6,300 Fedders Corp. 1.20 5 200 Helen of Troy Corp. 2.14 380 530 Salton, Inc. 3.25 375 115 Whirlpool 1.83 10,600 9,100

a. Estimate an asset beta for Dome Appliance. b. What concerns, if any, would you have about using the betas of

these firms to estimate Dome Appliance’s asset beta?




Business Valuation and Corporate Restructuring

To complete our merger negotiations, my attorneys will now mark scent your office. Fortune

On January 19, 2010, after a contentious four-month battle for control, Roger Carr, chairman of Cadbury PLC, announced his board was recom- mending to shareholders acceptance of an enhanced buyout offer from American food giant, Kraft Foods, Inc. The hostile takeover, valued at £14.0 billion ($22.9 billion), was one of the first large acquisitions initiated after the recession of 2008–09. It created a behemoth with almost $50 billion in revenue, and nudged aside the Mars/Wrigley pairing, formed three years earlier, to become the world’s largest confectionary company. Kraft paid 40 percent of the acquisition price in new shares and 60 percent in cash—$3.7 billion of which came from the last-minute sale of its DiGiorno Pizza operations to Nestle S.A.

Cadbury Plc was the storied 186 year-old British confectioner famous for its Cadbury chocolates, as well as Trident and Dentyne gums, and Halls candies. While nominally a British company, 80 percent of Cadbury’s business and 85 percent of its workers were outside the UK. In 2008, Cadbury had 45,000 employees and revenues of £5.4 billion, almost half from chocolate. Kraft Foods was America’s largest food com- pany. In 2009, it had some 100,000 employees, $40.4 billion in revenue, and $3 billion in net income. Kraft owned 10 brands with revenues in excess of $1 billion, including such household names as Kraft cheeses, Oscar Mayer meats, Oreo cookies, and Toblerone chocolates.

Although it will be years before we can say categorically that Kraft’s purchase of Cadbury was a wise move, some early winners are already ap- parent. Prominent among them are Cadbury shareholders who sold their shares at £8.50, a hefty 62 percent premium to the price immediately be- fore rumors of a possible bid began circulating. With the stock selling at around £5.25 before the bid and 1.4 billion Cadbury shares outstanding,



this translates into a pound sterling gain to shareholders of £4.6 billion ($7.4 billion) (£4.6 � 62% � 5.25 � 1.4). Other clear winners are the bankers and lawyers facilitating the transaction. Estimates are that the Kraft team, featuring Lazard, Citigroup, Deutsche Bank, and investment boutique Centerview Partners, split $53–$58 million in advisory fees and another $26–$32 million for arranging the financing. Cadbury advisors, Morgan Stanley, Goldman Sachs, and UBS pocketed an estimated $15 million each. In all, Kraft paid an estimated $390 million in fees and Cadbury’s tab was $50–$56 million. In addition, Todd Stitzer, Cadbury’s chief executive, booked about $30 million in shares and options, while Kraft chief executive, Irene Rosenfeld, received a $26.3 million award for “exceptional leadership” shortly after the transaction closed.

The Kraft buyout of Cadbury aptly illustrates an important phenome- non in business known broadly as corporate restructuring. Guided presumably by the financial principles examined in earlier chapters, senior executives make major, episodic changes in their company’s asset mix, capital struc- ture, or ownership composition in pursuit of increased value. In addition to hostile takeovers of the Kraft–Cadbury variety, corporate restructuring encompasses leverage buyouts, or LBOs, friendly mergers, purchases or sales of operating divisions, large repurchases of common stock, major changes in financial leverage, spin-offs, and carve-outs. (In a spin-off, the parent company distributes shares of a subsidiary to its stockholders much like a dividend, and the subsidiary becomes an independent company. In a carve-out, the parent sells all or part of the subsidiary to the public for cash.)

The Kraft–Cadbury deal and many other restructurings pose several important questions to students of finance, and indeed to all executives. In terms of the Cadbury takeover, they include the following:

1. What led Kraft chief executive Irene Rosenfeld to believe that Cadbury was worth as much as £8.50 a share?

2. If Ms. Rosenfeld was willing to pay as much as £8.50 a share for Cadbury stock, why was the market price immediately prior to the initial bid only in the low £5s? Does the stock market misprice compa- nies this drastically, or is something else at work?

3. If Cadbury stock really was worth £8.50, why didn’t Cadbury executives, who certainly knew more about their company than Ms. Rosenfeld did, realize this fact and do something to ensure that the value was reflected in Cadbury’s stock price?

4. Ultimately, who should decide the merits of corporate restructurings, management or owners? In the Cadbury buyout, Cadbury shareholders voted to approve the deal, but Kraft shareholders were not asked. More

344 Part Four Evaluating Investment Opportunities



broadly, who really controls today’s large corporations, and who should control them? Is it the shareholders who collectively bear the financial risk, or is it the managers who at least nominally work for the shareholders?

This chapter addresses these questions and, in the process, examines the principal financial dimensions of corporate restructuring. We begin by looking at business valuation, a family of techniques for estimating the value of a company or division. We then turn to what is known as “the market for corporate control,” where we consider why one company might rationally pay a premium to acquire another and how to estimate an aspiring buyer’s maximum acquisition price. Next, we examine three primarily financial motives for business restructuring predicated on the virtues of increased tax shields, enhanced management incentives, and shareholder control of free cash flow. The chapter closes with a brief re- view of the evidence on the economic merits of mergers and leveraged buyouts and a closer look at the Kraft–Cadbury transaction. The chapter appendix examines the venture capital method of valuation.

Valuing a Business

Business valuation merits our serious attention because it is the underly- ing discipline for a wide variety of important financial activities. In addi- tion to their use in structuring mergers and leveraged buyouts, business valuation principles guide security analysts in their search for undervalued stocks. Investment bankers use the same concepts to price initial public stock offerings, and venture capitalists rely on them to evaluate new in- vestment opportunities. Companies intent on repurchasing their stock also frequently use valuation skills to time their purchases. Business valu- ation principles are even creeping into corporate strategy under the ban- ner of value-based management, a consultant-spawned philosophy urging executives to evaluate alternative business strategies according to their predicted effect on the market value of the firm. It is thus not an exaggera- tion to say that although the details and the vocabulary differ from one setting to another, the principles of business valuation are integral to much of modern business.

The first step in valuing any business is to decide precisely what is to be valued. This requires answering three basic questions:

• Do we want to value the company’s assets or its equity?

• Shall we value the business as a going concern or in liquidation?

• Are we to value a minority interest in the business or controlling interest?

Let us briefly consider each question in turn.

Chapter 9 Business Valuation and Corporate Restructuring 345



Assets or Equity? When one company acquires another, it can do so by purchasing either the seller’s assets or its equity. When the buyer purchases the seller’s eq- uity, it must assume the seller’s liabilities. Thus, when Kraft acquired Cadbury, it paid £11.9 billion for Cadbury’s equity and assumed another £2.1 billion in Cadbury interest-bearing debt, making the total purchase price for Cadbury’s assets £14.0 billion. Although it is all too common to speak of Kraft paying £11.9 billion for Cadbury, this is incorrect. For the true economic cost of the acquisition to Kraft shareholders is £14.0 billion, £11.9 billion incurred in the form of newly printed stock certificates and cash, plus £2.1 billion in the form of a legal commitment to honor Cadbury’s existing liabilities. The effect on Kraft shareholders of assum- ing Cadbury’s debt is the same as paying £14.0 billion for Cadbury’s assets and financing £2.1 billion of the purchase price with new debt. In both cases, Cadbury’s assets need to generate future cash flows worth at least £14.0 billion or Kraft’s shareholders will have made a bad investment. Here’s a down-home analogy: If you purchased a house for $100,000 cash and assumption of the seller’s $400,000 mortgage, you presumably would never say you bought the house for $100,000. You bought it for $500,000 with $100,000 down. Analogously, Kraft bought Cadbury for £14.0 billion with £11.9 billion down.

Most acquisitions involving companies of any size are structured as an equity purchase; so the ultimate objective of the valuation, and the focus of negotiations, is the value of the seller’s equity. However, never lose sight of the fact that the true cost of the acquisition to the buyer is the cost of the equity plus the value of all the liabilities assumed.

Dead or Alive? Companies can generate value for owners in either of two states: in liqui- dation or as going concerns. Liquidation value is the cash generated by ter- minating a business and selling its assets individually, while going-concern value is the present worth of expected future cash flows generated by a business. In most instances, we will naturally be interested in a business’s going-concern value.

It will be helpful at this point to define an asset’s fair market value (FMV) as the price at which the asset would trade between two rational individuals, each in command of all of the information necessary to value the asset and neither under any pressure to trade. Usually the FMV of a business is the higher of its liquidation value and its going-concern value. Figure 9.1 illus- trates the relationship. When the present value of expected future cash

346 Part Four Evaluating Investment Opportunities



flows is low, the business is worth more dead than alive, and FMV equals the company’s liquidation value. At higher levels of expected future cash flows, liquidation value becomes increasingly irrelevant, and FMV de- pends almost entirely on going-concern value. It can also be the case that some of a company’s assets, or divisions, are worth more in liquidation, while others are more valuable as going concerns. In this instance, the firm’s FMV is a combination of liquidation and going-concern values as they apply to individual assets.

An exception to the general rule that FMV is the higher of a com- pany’s liquidation value and going-concern value occurs when the in- dividuals controlling the company—perhaps after reflecting on their alternative employment opportunities and the pleasures afforded by the corporate yacht—choose not to liquidate, even though the busi- ness is worth more dead than alive. Then, because minority investors cannot force liquidation, the FMV of a minority interest can fall below the liquidation value. This is represented in the figure by the shaded triangle labeled “value destroyed.” Additional latent value exists, but because minority owners cannot get their hands on it, the value has no effect on the price they are willing to pay for the shares. As minority shareholders see it, the individuals controlling the business are de- stroying value by refusing to liquidate. Later in the chapter, we will consider other instances in which price, as determined by minority in- vestors, does not reflect full value.

Chapter 9 Business Valuation and Corporate Restructuring 347

Fa ir

m ar

ke t v

al ue

o f

bu si

ne ss

( $)

Present value of future cash flows ($)

Going-concern value

Value destroyed Liquidation value

FIGURE 9.1 The Fair Market Value of a Business Is Usually the Higher of Its Liquidation Value and Its Going-Concern Value



When speaking of control, it is important to note that ownership of a company’s shares and control of the company are two vastly different things. Unless a shareholder owns or can influence at least 51 percent of a company’s voting stock, there is no assurance he or she will have any say at all in company affairs. Moreover, in most large American public com- panies, no shareholder or cohesive group of shareholders owns enough stock to exercise voting control, and effective control devolves to the board of directors and incumbent management. In these instances, share- holders are just along for the ride.

Minority Interest or Control? Oscar Wilde once observed that “Economists know the price of every- thing and the value of nothing.” And in a very real sense he is correct, since to an economist the value of an asset is nothing more or less than the price at which informed buyers and sellers are willing to trade it. The question of whether an asset has value beyond its selling price is one econ- omists are content to leave to philosophers.

If value is synonymous with selling price, one obvious indicator of the worth of a business is its market value, the aggregate price at which its eq- uity and debt trade in financial markets. Thus, just before Kraft’s bid for Cadbury became public in late 2009, it had 1.4 billion shares outstanding, each selling for £5.25, and £2.1 billion in debt, so its market value was £9.5 billion (£9.5 billion � £5.25 � 1.4 billion � £2.1 billion).

As noted in earlier chapters, the market value of a business is an impor- tant indicator of company performance and a central determinant of a company’s cost of capital. However, you need to realize that market value measures the worth of the business to minority investors. The stock price used to calculate the market value of a business is the price at which small numbers of shares have traded and is thus an unreliable indicator of the price at which a controlling interest might trade. The distinction between minority interest and controlling interest is sharply apparent in Cadbury’s case, where the market value of the firm was only £9.5 billion, yet con- trolling interest fetched a price of £14.0 billion from Kraft.

Other instances in which market value is inadequate to the business val- uation task include the following: The target is privately held, so market value does not exist. The target’s stock trades so infrequently or in such modest volume, that price is not a reliable indicator of value. The target’s stock trades actively, but the analyst wants to compare market value to an independent estimate of value in search of mispriced stocks.

In sum, we can say that market value is directly relevant in business valuation only when the goal is to value a minority interest in a public company. In all other instances, market value may provide a useful frame

348 Part Four Evaluating Investment Opportunities



of reference, but cannot by itself answer most interesting valuation ques- tions. For this we need to think more carefully about the determinants of business value.

Discounted Cash Flow Valuation

Having examined business valuation in the large, we turn now to the spe- cific task of estimating a company’s going-concern value. For simplicity, we will begin by considering the value of a minority interest in a privately held firm.

Absent market prices, the most direct way to estimate going-concern value, if not always the most practical, is to think of the target company as if it were nothing more than a giant capital expenditure opportunity. Just as with any piece of capital equipment, investing in a company requires the expenditure of money today in anticipation of future benefits, and the central issue is whether tomorrow’s benefits justify today’s costs. As in cap- ital expenditure analysis, we can answer this question by calculating the present value of expected future cash flows accruing to owners and credi- tors. When this number exceeds the acquisition price, the purchase has a positive net present value and is therefore attractive. Conversely, when the present value of future cash flows is less than the acquisition price, the purchase is unattractive.

In equation form,

FMV of firm � PV (Expected cash flows to owners and creditors)

This formula states that the maximum price one should pay for a business equals the present value of expected future cash flows to capital suppliers discounted at an appropriate risk-adjusted discount rate. Moreover, as in any other application of risk-adjusted discount rates, we know the rate should reflect the risk of the cash flows being discounted. Because the cash flows here are to owners and creditors of the target firm, it follows that the discount rate should be the target company’s weighted-average cost of capital.

A legitimate question at this point is: Why waste energy estimating firm value when the ultimate goal of the exercise is usually to value equity? The answer is simple once you recall that the value of equity is closely tied to the value of the firm. In equation form, we have our old friend

Value of equity � Value of firm � Value of debt

To determine the value of a company’s equity, therefore, we need only esti- mate firm value and subtract interest-bearing debt. Moreover, because the market value and the book value of debt are usually about equal to each

Chapter 9 Business Valuation and Corporate Restructuring 349



other, estimating the value of debt amounts to nothing more than grabbing a few numbers off the company’s balance sheet.1 If the fair market value of a business is $4 million and the firm has $1.5 million in debt outstanding, its equity is worth $2.5 million. It’s that simple.2 (We ignore non-interest-bearing debt such as accounts payable and deferred taxes here because they are treated as part of free cash flow, to be described momentarily.)

Free Cash Flow As in all capital expenditure decisions, the biggest practical challenge in business valuation is estimating the relevant cash flows to be discounted. In Chapter 7, we said the relevant cash flows are the project’s annual free cash flows (FCF), defined as EBIT after tax plus depreciation, less invest- ment. When valuing a company, this translates into the following:

� EBIT(1 � Tax rate) � Depreciation � �

where EBIT is earnings before interest and taxes. The rationale for using free cash flow goes like this. EBIT is the income

the company earns without regard to how the business is financed; so EBIT(1 � Tax rate) is income after tax excluding the effects of debt financing. Adding depreciation and any other noncash items yields after-tax cash flow. If management were prepared to run the company into the ground, it could distribute this cash flow to owners and creditors, and that would be the end of it. But in most companies, management retains some or all of this cash flow in the business to pay for new capital expenditures and additions to short-term assets. The annual cash flow available for distribution to owners and creditors is thus operating cash flow after tax less capital expenditures and working capital investments.

The working capital term in this expression can be tricky. Working cap- ital investment equals the increase in current assets necessary to support operations, less any accompanying increases in non-interest-bearing current liabilities, or what I referred to in Chapter 7 as “spontaneous

Working capital investments

Capital expenditures

Free cash flow

350 Part Four Evaluating Investment Opportunities

1 There are two instances in which the market value and the book value of debt will differ significantly: Default risk has changed significantly since issue, and the debt is fixed rate and market interest rates have changed significantly since issue. In these instances, it pays to estimate the market value of the debt independently. 2 An alternative approach to equity valuation is to estimate the present value of expected cash flows to equity discounted at the target’s cost of equity capital. Executed correctly, this equity approach yields the same answer as the enterprise approach described above; however, I find it more difficult to apply in practice. See the section “The Enterprise Perspective versus the Equity Perspective” in Chapter 8 for details.



sources.” This difference equals the net investment in current assets that must be financed by creditors and owners. A second challenge is how to treat any excess cash a company accumulates over and above the amount necessary to support operations. My advice is to omit excess cash from the discounted cash flow valuation and treat it as a separate add-on term.

The Terminal Value We now come to a serious practical problem. Our equation says that the FMV of a business equals the present value of all future free cash flows. Yet because companies typically have an indefinitely long life expectancy, the literal application of this equation would have us estimating free cash flows for perhaps hundreds of years into the far distant future—a clearly unreasonable task.

The standard way around this impasse is to think of the target company’s future as composed of two discrete periods. During the first period, of some 5 to 15 years, we presume the company has a unique cash flow pattern and growth trajectory that we seek to capture by estimating individual, annual free cash flows just as the equation suggests. However, by the end of this forecast period, we assume the company has lost its individuality—has grown up, if you will—and become a stable, slow-growth business. From this date forward, we cease worrying about annual cash flows and instead estimate a single terminal value representing the worth of all subsequent free cash flows. If the initial forecast period is, say, 10 years, our valuation equation becomes

FMV of firm � PV(FCF years 1�10 � Terminal value at year 10)

Introduction of a terminal value, of course, only trades one problem for another, for now we need to know how to estimate a company’s terminal value. I wish I could assure you that financial economists have solved this problem and present a simple, accurate expression for a company’s termi- nal value, but I can’t. Instead, the best I can offer are several plausible alternative estimates and some general advice on how to proceed.

Following are five alternative ways to estimate a company’s terminal value with accompanying explanatory comments and observations. To use these estimates effectively, note first that no single estimate is always best; rather, each is more or less appropriate depending on circumstances. Thus, liquidation value may be highly relevant when valuing a mining operation with 10 years of reserves but quite irrelevant when valuing a rapidly growing software company. Second, resist the natural temptation to pick what appears to be the best technique for the situation at hand, ignoring all others. Avoid too the simple averaging of several estimates. Instead, calculate a number of terminal value estimates and begin by asking why they differ. In some instances, the differences will be readily

Chapter 9 Business Valuation and Corporate Restructuring 351



explainable; in others, you may find it necessary to revise your assump- tions to reconcile the differing values. Then, once you understand why re- maining differences exist and feel comfortable with the magnitude of the differences, select a terminal value based on your assessment of the rela- tive merits of each estimate for the target company.

Five Terminal Value Estimates

Liquidation Value Highly relevant when liquidation at the end of the forecast period is under consideration, liquidation value usually grossly understates a healthy business’s terminal value.

Book Value Popular perhaps among accountants, book value usually yields a quite conservative terminal value estimate.

Warranted Price-to-Earnings Multiple To implement this approach, multiply the target firm’s estimated earnings to common stock at the end of the forecast horizon by a “warranted” price-to-earnings ratio; then add projected interest-bearing liabilities to estimate the firm’s terminal value. As a warranted price-to-earnings ratio, consider the multiples of publicly traded firms that you believe represent what the target will become by the end of the forecast period.3 If, for example, the target company is a startup but you believe it will be representative of other, mature companies in its industry by the end of the forecast period, the industry’s current price-to- earnings multiple may be a suitable ratio. Another strategy is to bracket the value by trying multiples of, say, 10 and 20 times. The approach gen- eralizes easily to other “warranted” ratios, such as market value to book value, price to cash flow, or price to sales.

No-Growth Perpetuity We saw in Chapter 7 that the present value of a no-growth perpetuity is the annual cash flow divided by the discount rate. This suggests the following terminal value estimate:

Terminal value of no-growth firm

where FCFT�1 is free cash flow in the first year beyond the forecast hori- zon and KW is the target’s weighted-average cost of capital. As further refinement, we might note that when a company is not growing, its capital expenditures should about equal its annual depreciation charges and its net working capital should neither increase nor decrease over time, both of which imply that free cash flow should simplify to EBIT(1 � Tax rate).

= FCFT + 1


352 Part Four Evaluating Investment Opportunities

3 For industry price-to-earnings ratios, see Select “Updated Data” and under “Data Sets” go to “Multiples.”



Because most businesses expand over time, if due only to inflation, many analysts believe this equation understates the terminal value of a typical busi- ness. I am more skeptical. For, as noted repeatedly in earlier chapters, growth creates value only when it generates returns above capital costs; and in com- petitive product markets over the long run, such performance is more the exception than the rule. Hence, even if many companies are capable of ex- panding, they may be worth no more than their no-growth brethren. The implication is that the no-growth equation is applicable to more firms than might first be supposed. I am also mindful of economist Kenneth Boulding’s observation that “Anyone who believes that exponential growth can go on forever in a finite world is either a madman or an economist.”

Perpetual Growth In Chapter 8, we saw that the present value of a per- petually growing stream of cash equals next year’s cash flow divided by the difference between the discount rate and the growth rate. Thus, another terminal value estimate is

where g is the perpetual-growth rate of free cash flow. A few words of caution are in order about this popular expression. It is

a simple arithmetic fact that any business growing faster than the econ- omy forever must eventually become the economy. (When I made this point one time at a Microsoft seminar, the immediate response was “Yeah! Yeah! We can do it!”) The intended conclusion for mere mortal firms is that the absolute upper limit on g must be the long-run growth rate of the economy, or about 2 to 3 percent a year, plus expected inflation. More- over, because even inflationary growth invariably requires higher capital expenditures and increases in working capital, free cash flow falls as g rises. This implies that unless this inverse relation is kept in mind, the preced- ing expression may well overstate a company’s terminal value—even when the perpetual growth rate is kept to a low figure.4

Terminal value of perpetually growing firm =

FCFT+1 KW – g

Chapter 9 Business Valuation and Corporate Restructuring 353

4 Here is a modestly more complex version of the perpetual-growth expression, to which I am partial:

Terminal value �

where r is the rate of return on new investment. One virtue of this expression is that growth does not add value unless returns exceed capital cost. To confirm this, set r � KW and note that the expression collapses to the no-growth equation. A second virtue is that growth is not free, for as growth rises, so must capital expenditures and net working capital. In the equation, higher g reduces the numerator, which is equivalent to reducing free cash flow. See page 39 in the Koller, Goedhart, and Wessels book referenced at the end of this chapter for a demonstration that this expression is mathematically equivalent to the earlier perpetual-growth equation.

EBITT + 1 (1 – Tax rate) (1 – g�r) KW – g



The Forecast Horizon Terminal values of growing businesses can easily exceed 60 percent of firm value, so it goes without saying that proper selection of the forecast horizon and terminal value are critical to the successful application of discounted cash flow approaches to business valuation. Because most tractable terminal value estimates implicitly assume the firm is a mature, slow-growth, or no-growth perpetuity from that date forward, it is important to extend the forecast hori- zon far enough into the future that this assumption plausibly applies. When valuing a rapidly growing business, this perspective suggests estimating how long the company can be expected to sustain its supernormal growth before reaching maturity and setting the forecast horizon at or beyond this date.

A Numerical Example Table 9.1 offers a quick look at a discounted cash flow valuation of our friend from earlier chapters, Stryker Corporation. It goes without saying

354 Part Four Evaluating Investment Opportunities

TABLE 9.1 Discounted Cash Flow Valuation of Stryker Corporation on December 31, 2013* ($ millions except per share)


2014 2015 2016 2017 2018 2019

Sales $9,652 $10,328 $11,051 $11,825 $12,652 EBIT 2,124 2,272 2,431 2,601 2,784 Tax at 23.9% 508 543 581 622 665 Earnings after tax 1,616 1,729 1,850 1,980 2,118 � Depreciation 319 341 365 390 418 � Capital expenditures 232 248 265 284 304 � Increase in working capital 193 207 221 236 253

Free cash flow $1,510 $ 1,616 $ 1,729 $ 1,850 $ 1,979 $2,038

PV@ 9.0% of FCFs 14�18 $ 6,676

Terminal value estimates: Terminal value in 2018

Perpetual growth at 3% [FCF’19/(KW � g)] $33,967 Warranted MV firm/Sales in 2018 = 3.5 times 44,283 Projected book value of debt & equity in 2018 16,566

Best guess terminal value 38,000

PV of terminal value $ 24,697

Estimated value of firm $ 31,374 Value of debt 2,764 Value of equity $ 28,610 Shares outstanding 378.0 million Estimated value per share $ 75.69

*Totals may not add due to rounding.



Chapter 9 Business Valuation and Corporate Restructuring 355

that if I were being paid by the hour to value Stryker and you were being similarly compensated to read about it, we would both proceed much more thoroughly and deliberately. In particular, we would want to know a great deal more about the company’s products, markets, and competitors, for a discounted cash flow valuation is only as good as the projections on which it is based. Nonetheless, the table should give you a basic understanding of how to execute a discounted cash flow valuation.

The valuation date is December 31, 2013. The free cash flows appear- ing in the table are percent-of-sales projections assuming 7 percent annual sales growth for the next five years. The percentages used in the forecast are based on careful review of the common-size historical financial state- ments appearing in Chapter 2, Table 2.3, while the tax rate is Stryker’s average effective rate for the last five years, and the growth rate reflects se- curity analysts’ expectations.5 The present value of these free cash flows discounted at Stryker’s 9.0 percent weighted-average cost of capital, esti- mated in the last chapter, amounts to $6,676 million.

The valuation considers three terminal value estimates. The first re- lies on the perpetual-growth equation and assumes that beginning in 2019 Stryker’s free cash flows will commence growing at 3 percent a year into the indefinite future. Free cash flow in 2019 will, thus, be $2,038 million [$2,038 � $1,979 � (1 � .03)]. Plugging these values into the perpetual growth equation, one estimate of Stryker’s terminal value at the end of 2018 is

Terminal value � � � $33,967 million

The second terminal value estimate assumes that at the end of the forecast horizon, Stryker will command a price-to-sales multiple of 3.5 times, a figure reflecting current valuations of comparable firms. I will say more about this multiple in a few pages. Applying this warranted price-to-sales ratio to Stryker’s sales in 2018 yields a second terminal value estimate:

Terminal value � 3.5 � $12,652 million � $44,283 million

Finally, I estimate that Stryker’s projected book value of interest-bearing debt and equity in 2018 will be $16,566. This constitutes a third estimate of the company’s terminal value, although certainly a low one.

After reflecting on the relative merits of these three estimates my best guess is that Stryker will be worth $38,000 in 2018. Discounting

$2,038 million 0.09 – 0.03

FCF in 2019 KW – g


5 See and



this figure back to 2013 and adding it to the present value of free cash flows in the first five years suggests that Stryker is worth $31,374 mil- lion on December 31, 2013:

FMVfirm � $6,676 million � $24,697 million � $31,374 million

The rest is just arithmetic. Stryker’s equity is worth $31,374 million less $2,764 million in interest-bearing debt presently outstanding, or $28,610 mil- lion. With 378 million shares outstanding, this equates to an estimated price per share of $75.69.

My discounted cash flow valuation thus indicates that Stryker is worth $75.69 a share provided the projected free cash flows accurately reflect expected future performance. I take the fact that the company’s actual price at the time was $75.14 as evidence that investors were about as enthusiastic about the company’s prospects as I am. (I will let you decide whether these two numbers are so close because I am really good at this or really lucky. I know where my vote lies.)

356 Part Four Evaluating Investment Opportunities

The Problem of Growth and Long Life In many investment decisions involving long-lived assets, it is common to finesse the problem of forecasting far distant cash flows by ignoring all flows beyond some distant horizon. The justification for this practice is that the present value of far distant cash flows will be quite small. When the cash flow stream is a growing one, however, growth offsets the discounting effect, and even far distant cash flows can contribute significantly to present value. Here is an example.

The present value of $1 a year in perpetuity discounted at 10 percent is $10 ($1�0.10). The pres- ent value of $1 a year for 20 years at the same discount rate is $8.51. Hence, ignoring all of the perpetuity cash flows beyond the 20th year reduces the calculated present value by only about 15 percent ($8.51 versus $10.00).

But things change when the income stream is a growing one. Using the perpetual-growth equa- tion, the present value of $1 a year, growing at 6 percent per annum forever, is $25 [$1�(0.10 � 0.06)], while the present value of the same stream for 20 years is only $13.08. Thus, ignoring growing cash flows beyond the 20th year reduces the present value by almost half ($13.08 versus $25.00).

The Sensitivity Problem At a 10 percent discount rate, the fair market value of a company promising free cash flows next year of $1 million, growing at 5 percent a year forever, is $20 million [$1 million�(0.10 � 0.05)].

Assuming the discount rate and the growth rate could each be in error by as much as 1 percentage point, what are the maximum and minimum possible FMVs for the company? What do you conclude from this?

Answer: The maximum is $33.3 million [$1 million�(0.09 � 0.06)], and the minimum is $14.3 million [$1 million�(0.11 � 0.04)]. It is difficult to charge a client very high fees for advising that a business is worth somewhere between $14.3 and $33.3 million.



Problems with Present Value Approaches to Valuation If you are a little hesitant at this point about your ability to apply these dis- counted cash flow techniques to anything but simple textbook examples, welcome to the club. While DCF approaches to business valuation are conceptually correct, and even rather elegant, they are devilishly difficult to apply in practice. Valuing a business may be conceptually equivalent to any other capital expenditure decision, but there are several fundamental differences in practice:

1. The typical investment opportunity has a finite—usually brief—life, while the life expectancy of a company is indefinite.

2. The typical investment opportunity promises stable or perhaps declin- ing cash flows over time, while the ability of a company to reinvest earnings customarily produces a growing cash flow.

3. The cash flows from a typical investment belong to the owner, while the cash flows generated by the company go to the owner only when management chooses to distribute them. If management decides to in- vest in Mexican diamond mines rather than pay dividends, a minority owner can do little other than sell out.

As the problems in the accompanying box illustrate, these practical dif- ferences introduce potentially large errors into the valuation process and can make the resulting FMV estimates quite sensitive to small changes in the discount rate and the growth rate employed.

Valuation Based on Comparable Trades

Granting that discounted cash flow approaches to business valuation are conceptually correct but difficult to apply, are there alternatives? One pop- ular technique involves comparing the target company to similar, publicly traded firms. Imagine shopping for a used car. The moment of truth comes when the buyer finds an interesting car, looks at the asking price, and pon- ders what to offer the dealer. One strategy, analogous to a discounted cash flow approach, is to estimate the value of labor and raw materials in the car, add a markup for overhead and profit, and subtract an amount for depreci- ation. A more productive approach is comparison shopping: Develop an es- timate of fair market value by comparing the subject car to similar autos that have recently sold or are presently available. If three similar-quality 1982 T-Birds have sold recently for $3,000 to $3,500, the buyer has reason to be- lieve the target T-Bird has a similar value. Of course, comparison shopping provides no information about whether 1982 T-Birds are really worth $3,000 to $3,500 in any fundamental sense; it indicates only the going rate.

Chapter 9 Business Valuation and Corporate Restructuring 357



This was amply demonstrated in the dot-com bubble when knowledge that Infospace was fairly priced relative to AOL, Amazon, and Webvan did not prevent Infospace shareholders from losing their shirts when the whole industry cratered. However, in many other instances knowing relative value is sufficient. (Another tactic recommended by some is to skip the valuation process altogether and proceed directly to bargaining by asking the dealer what he wants for the car and responding, “B———t, I’ll give you half of that.” This probably works better for cars than for companies, but don’t rule it out entirely.)

Use of comparable trades to value businesses requires equal parts art and science. First, it is necessary to decide which publicly traded compa- nies are most similar to the target and then to determine what the share prices of the publicly traded companies imply for the FMV of the firm in question. The discounted cash flow valuation equations just considered offer a useful starting point. They suggest that comparable companies should offer similar future cash flow patterns and similar business and financial risks. The risks should be similar so that roughly the same discount rate would apply to all of the firms.

In practice, these guidelines suggest we begin our search for comparable companies by considering firms in the same, or closely related, industries with similar growth prospects and capital structures. With luck, the out- come of this exercise will be several more or less comparable publicly traded companies. Considerable judgment will then be required to decide what the comparable firms as a group imply for the fair market value of the target.

As an illustration, Table 9.2 presents a comparable trades valuation of Stryker. The valuation date is again December 31, 2013, and the chosen comparable companies are the representative competitors in the medical technology industry introduced in Chapter 2. Stryker competes in mul- tiple lines of business in the medical technology area, with special strength in orthopedic products. Among the peers introduced in Chapter 2, Becton Dickinson (BDX), Medtronic (MDT), and Smith & Nephew (SNN) have the most overlapping business segments. Stryker’s size puts it in the mid- dle of the group; MDT, the largest competitor, is over twice as large in terms of total assets, and SNN is much smaller.

The first set of numbers in Table 9.2 looks at Stryker’s growth and fi- nancial risk relative to peers. The numbers indicate that Stryker’s five-year growth in sales is the highest in the group. The comparable figure for growth in earnings per share is modestly above the peer group mean, but as noted below, the earnings numbers on which this calculation rests are open to question. Security analysts appear rather enthusiastic about Stryker’s future growth prospects, placing the company in the upper half of the group. (The website providing these projected growth rates does

358 Part Four Evaluating Investment Opportunities



Chapter 9 Business Valuation and Corporate Restructuring 359

TABLE 9.2 Using Comparable Public Companies to Value Stryker Corporation (December 31, 2013)

Excluding Ticker Symbols* Stryker


Comparison of Stryker with Comparable Companies: Growth Rates, Financial Risks, Size

5-year growth rate in sales (%) 6.1 4.3 2.4 0.6 4.2 2.7 4.7 2.9 2.9 3 .1 5-year growth rate in EPS (%) 8.4 3.0 0.9 3.5 11.6 7.7 17.8 4.5 4.5 7 .0 Analysts’ projected growth (%)** 9.1 8.0 9.0 n.a. 6.6 9.9 10.7 8.4 8.7 8 .8 Interest coverage ratio (X) 15.6 12.2 7.8 10.8 12.0 81.2 10.7 15.0 12.0 21.4 Total liabilities to assets (%) 42.5 67.2 58.5 53.6 46.4 30.5 57.0 34.2 53.6 49.6 Total assets ($ millions) 15,743 25,869 12,035 19,619 37,231 5,819 10,248 9,581 12,035 17,200

Indicators of Value

Price/earnings (X) 17.8 18.8 23.1 20.3 15.8 23.2 24.6 20.8 20.8 20.9 MV firm/EBIT(1 � Tax rate) (X) 18.5 21.7 23.9 20.5 17.7 23.5 28.1 21.5 21.7 22.4 MV firm/sales (X) 3.5 3.1 3.1 3.5 4.1 3.0 3.9 3.8 3.5 3.5 MV equity/BV equity (X) 3.1 4.5 4.2 3.3 2.9 3.2 4.1 2.5 3.3 3.5 MV firm/BV firm (X) 2.0 1.8 2.1 1.8 1.8 2.3 2.1 1.8 1.8 2.0

My Estimated Indicators of Value for Sensient Implied Value of Stryker’s Common Stock per Share

Price/earnings (X) 20.8 $ 88.92 � 20.8 � Net income / # shares MV firm/EBIT(1 � Tax rate) (X) 22.0 $ 90.50 � [22 � EBIT(1 � Tax rate) � Debt] / # shares MV firm/sales (X) 3.5 $ 76.22 � [3.5 � Sales � Debt] / # shares MV equity/BV equity (X) 3.4 $ 81.38 � 3.4 � BV equity / # shares MV firm/BV firm (X) 1.9 $ 71.82 � [1.9 � BV firm � Debt] / # shares

My best guess $77.00 Actual stock price $75.14

*BAX � Baxter International, BDX � Becton Dickinson, COV � Covidien PLC, MDT � Medtronic, SNN � Smith & Nephew PLC, STJ � St. Jude Medical, ZMH � Zimmer Holdings **Mean value of security analysts’ long-run growth estimates. Available at MV � Market value; BV = Book value. Market value is estimated as book value of interest-bearing debt � market value of equity. Earnings are previous 12 months earnings. n.a. � not available

not indicate what they refer to, or the length of the projection.) Looking at financial leverage, Stryker has among the stronger interest coverage ra- tios in a conservatively financed industry.

An important question when valuing Stryker is what earnings number to use. Stryker’s net income according to Generally Accepted Accounting Prin- ciples (GAAP) in 2013 was $1,006 million (see Table 1.3). However, as pre- viously noted, this figure includes losses due to large liability claims, which management believes are nonrecurring. To remove the presumably distort- ing effect of these losses, the company highlighted what it calls “adjusted”



net earnings of $1,616 million in all its communications—a figure fully 60 percent above GAAP earnings. Consistent with common practice among analysts and investors, Table 9.2 uses the higher number. However, this is not the last word on Stryker’s earnings ambiguity, for the issue will recur in a few pages when asking what Stryker’s earnings imply for its value.

The second set of numbers in the table show five possible indicators of value for the comparable firms. Broadly speaking, each indicator expresses how much investors are paying per dollar of current income, sales, or in- vested capital for each firm. Thus, the first indicator says that $1.00 of Baxter International’s (BAX) current income is worth $18.80, while St. Jude Medical’s (STJ) goes for $24.60. Similarly, the third indicator says that $1.00 of MDT’s sales costs $4.10, and the last indicator says $1.00 of Zimmer Holding’s (ZMH) assets, measured at book, costs $1.80. The first and fourth indicators focus on equity value, while the other three concen- trate on firm value.

Reflecting on how Stryker stacks up against its peers in terms of growth and risk, the valuation challenge is to decide what indicators of value are appropriate for Stryker. The third group of numbers on the lower left contains my necessarily subjective estimates. In coming to these estimates, I considered several factors. First, I customarily believe the first two indi- cators of value are more reliable than the others because they tie market value to income as opposed to sales or assets. With rare exceptions, in- vestors are interested in a company’s income potential when they buy its shares, not its sales or the assets it owns. Asset-based indicators of value are more relevant when liquidation is contemplated. Sales-based ratios tend to be of interest when current earnings are unrepresentative of long- run potential or when investors lose faith in the accuracy of reported earn- ings. This is not to say that sales are immune to manipulation but only that they are somewhat less manipulable than earnings.

Second, when choosing between indicators focusing on equity value or firm value, I prefer the firm value ratios because they are less affected by the way a business is financed. The problem with the equity approach is that leverage affects a company’s price-to-earnings ratio in complex ways, so that, for example, inferring a highly levered firm’s price-to-earnings ratio from those of more modestly levered peers can lead to errors.

Third, it makes sense to assign more importance to those indicators of value that are more stable across peer companies. If the calculated value of one indicator was 10.0 for every comparable company, I would deem it a more reliable indicator of value than if it varied from 1.0 to 30.0 from firm to firm. Here, all of the ratios are surprisingly stable, with no obvious outliers.

Fourth, Stryker’s strong growth rates and modest leverage suggest it may be in the upper half of the indicated valuation range. On the other

360 Part Four Evaluating Investment Opportunities



hand, the calculated historical growth rate in earnings per share is based on previously questioned adjusted earnings, so I will discount the strong growth somewhat and use indicators close to the middle of the range.

The last set of numbers on the lower right of Table 9.2 presents the price of Stryker’s stock implied by each chosen indicator of value. To the right of each stock price is an equation demonstrating how I translated the chosen indicator into an implied stock price. To illustrate the third equa- tion, I estimated that Stryker’s total firm value should be 3.5 times its sales. Stryker’s sales in 2013 were $9,021 million, so its implied firm value is $31,574 million. Subtracting interest-bearing debt of $2,764 million and dividing by 378 million shares yields an estimated stock price of $76.22 a share. The other implied share prices are calculated similarly.6

Looking at the resulting five estimates of Stryker’s stock price, note that the bottom three are quite similar at around $70.00 to $80.00 a share, while the top two, those based on adjusted earnings, produce higher esti- mates of about $90.00. Before accepting these earnings-based estimates at face value, however, it is useful to know that repeating the calculations using Stryker’s GAAP earnings instead of its adjusted earnings knocks the estimates clear down to about $55.00 a share. Due to this ambiguity, I will put more weight on the last three estimates, despite my usual preference for income-based indicators of value. Reflecting on all of these observa- tions, my best guess of a fair price for Stryker’s shares on the valuation date is $77.00 a share, or about 2 percent above the actual price of $75.14. This differential is well within my expectations of +/–15 percent.

Lack of Marketability An important difference between owning stock in a publicly traded com- pany and owning stock in a private one is that the publicly traded shares are more liquid; they can be sold quickly for cash without significant loss of value. Because liquidity is a valued attribute of any asset, it is necessary to reduce the FMV of a private company estimated by reference to publicly traded comparable firms. Without boring you with details, a representative lack of marketability discount is on the order of 25 percent.7 Of course, if the purpose of the valuation is to price an initial public offering of common stock, the shares will soon be liquid, and no discount is required.

Chapter 9 Business Valuation and Corporate Restructuring 361

6 In its 2013 financial reports, Stryker discloses adjusted net earnings of $1,616 and an adjusted effective tax rate of 22.3%. Using their actual interest expense of $83 for 2013 and working backwards implies an adjusted EBIT of $2,163:

Earnings � (EBIT � Interest) � (1 � Tax rate) � ($2,163 � 83) � (1 � 0.223) � $1,616

The top two valuation estimates use these adjusted numbers. 7 Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. (New York: Irwin/McGraw-Hill, 2007).



A second possible adjustment when using the comparable-trades ap- proach to valuation is a premium for control. Quoted prices for public companies are invariably for a minority interest in the firm, while many valuations involve transactions in which operating control passes from seller to buyer. Because control is valuable, it is necessary in these instances to add a premium to the estimated value of the target firm to reflect the value of control. Estimating the size of this control premium is our next task. But first, I want to call your attention to a close cousin of comparable trades valuation known as comparable transactions valuation. The two tech- niques are identical except that the latter substitutes prices struck in recent corporate acquisitions for publicly quoted stock prices. Transactions prices are obviously much less common than quoted stock prices and are often proprietary. However, in most instances, they are probably a better reflec- tion of the value inherent in an acquisition candidate, and they already contain a premium for control.

The Market for Control

We have noted on several occasions that buying a minority interest in a company differs fundamentally from buying control. With a minority in- terest, the investor is a passive observer; with control, she has complete freedom to change the way the company does business and perhaps increase its value significantly. Indeed, the two situations are so disparate that it is appropriate to speak of stock as selling in two separate markets: the market in which you and I trade minority claims on future cash flows and the market in which Kraft Foods and other acquirers trade the right to control the firm. The latter, the market for control, involves a two-in-one sale. In addition to claims on future cash flows, the buyer in this market also gains the privilege of structuring the company as he or she wishes. Because shares trading in the two markets are really different assets, they naturally sell at different prices.

The Premium for Control Figure 9.2 illustrates this two-tier market. From the perspective of mi- nority investors, the fair market value of a company’s equity, represented in the figure by m, is the present value of cash flows to equity given cur- rent management and strategy. To a corporation or an individual seeking control, however, the FMV is c, which may be well above m. The differ- ence, (c � m), is the value of control. It is the maximum premium over the minority fair market value an acquirer should pay to gain control. It is also the expected increase in shareholder value created by acquisition. When an acquirer pays FMVc for a target, all of the increased value will

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be realized by the seller’s shareholders, while at any lower price, part of the increased value will accrue to the acquirer’s shareholders as well. FMVc is therefore the maximum acquisition price a buyer can justify pay- ing. Said differently, it is the price at which the net present value of the acquisition to the buyer is zero.

What Price Control? There are two ways to determine how large a control premium an acquirer can afford to pay. The brute force approach values the business first assum- ing the merger takes place and then assuming it does not. The difference between these values is the maximum premium an acquirer can justify paying. The second, often more practical approach focuses on the antici- pated gains from the merger. In equation form,

FMVc � FMVm � Enhancements

where c and m again denote controlling and minority interest, respec- tively. This expression says the value of controlling interest in a business equals the business’s FMV under the present stewardship, or what is often called the business’s stand-alone value, plus whatever enhancements to value the new buyer envisions. If the buyer intends to make no changes in the business now or in the future, the enhancements are zero, and no

Chapter 9 Business Valuation and Corporate Restructuring 363

FIGURE 9.2 FMV of a Corporation to Investors Seeking Control May Exceed FMV to Minority Investors

Value created by change in control



Fa ir

m ar

ke t v

al ue

o f

bu si

ne ss

( $)



Existing control

New control

Present value of future cash flows ($)



premium over stand-alone value can be justified. On the other hand, if the buyer believes the merging of two businesses will create vast new profit opportunities, enhancements can be quite large.

Putting a price tag on the value of enhancements resulting from an ac- quisition is a straightforward undertaking conceptually: Make a detailed list of all the ways the acquisition will increase free cash flows, estimate the magnitude and timing of the cash flows involved, calculate their present values, and sum:

Enhancements � PV (All value-increasing changes due to acquisition)

Controlling Interest in a Publicly Traded Company An important simplification of our expression for FMVc is possible when the seller is publicly traded. If we are willing to assume that the preacqui- sition stock price of the target company reasonably approximates its FMVm, or at least that we are unable to detect when the approximation is unreasonable, the expression reduces to

FMVc � Market value of business � Enhancements

where the market value of the business is our old friend the stock market value of equity plus debt. A particular virtue of this formula for valuing acquisition candidates is that it forces attention on the specific improvements anticipated from the acquisition and the maximum price one should pay to get them, a perspective that reduces the possibility that an exuberant buyer will get carried away during spirited bidding and overpay. In other words, it helps to keep animal spirits in check during the negotiation process.

That animal spirits might need an occasional reining in is suggested by Table 9.3. It shows the number of mergers in the United States from 1995 through 2013 and the median premiums paid. Note that the num- ber of acquisitions rose from a cyclical low of about 3,500 in 1995 to an all time high of over 10,600 in 2006 and then dropped by about 40 per- cent during the recession. In addition, the number of big-ticket purchases of more than $1 billion followed a similar pattern, rising to 250 in 2007 and then falling sharply. Looking at the acquisition premiums, we see that the median premium paid was 20 to 40 percent of the seller’s share price five days before the announcement. Evidently, acquirers are quite confident of their ability to wring large enhancements out of their acquisitions.

Financial Reasons for Restructuring We conclude (or at least I conclude) that the best way to value a public company for acquisition purposes is to add the present value of all bene- fits attributable to the acquisition to the target’s current market value.

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Chapter 9 Business Valuation and Corporate Restructuring 365

TABLE 9.3 Number of Mergers and Median Acquisition Premiums, 1995–2013

Source: 2013 Mergerstat Review, FactSet Mergerstat, LLC, Newark, 2014. FactSet Mergerstat Global Mergers and Acquisitions Information. Newark, NJ. 800-455-8871

Number of Number over Median 5-Day Year Transactions* $1 Billion Premium (%)**

1995 3,510 74 29.2 1996 5,848 94 27.3 1997 7,800 120 27.5 1998 7,809 158 30.1 1999 9,278 195 34.6 2000 9,566 206 41.1 2001 8,290 121 40.5 2002 7,303 72 34.4 2003 7,983 88 31.6 2004 9,783 134 23.4 2005 10,332 170 24.1 2006 10,660 216 23.1 2007 10,559 250 24.7 2008 7,807 97 36.5 2009 6,796 78 39.8 2010 9,116 153 34.6 2011 9,519 163 37.8 2012 9,610 198 37.1 2013 8,777 172 29.7

* Net number of transactions announced. ** Premiums are based on seller’s closing market price five business days before the initial announcement. These calculations exclude negative premiums.

“So,” you ask perceptively, “what types of benefits might motivate an acquisition or other form of restructuring?” The list is truly lengthy, ranging from anticipated savings in manufacturing, marketing, distribu- tion, or overhead to better access to financial markets to enhanced in- vestment opportunities; and the perceived sources of value vary from merger to merger. So instead of trying to catalog the myriad possible benefits to a restructuring, I will concentrate on three finance-driven po- tential enhancements that are sufficiently common and controversial to warrant inquiry. I will refer to them as tax shields, incentive effects, and con- trolling free cash flow.

Tax Shields A number of takeovers and restructurings, especially those involving mature, slow-growth businesses, are driven in part by the desire to make more extensive use of interest tax shields. As noted in Chapter 6,



the tax deductibility of interest expense reduces a company’s tax bill and hence may add to value. A second, more recent tax ploy is known as in- version. A U.S. company seeking a lower tax rate and a way to redeploy overseas earnings without triggering stiff domestic taxes acquires a firm located in a low-tax country, such as Ireland, and then adopts the tar- get’s foreign address and accompanying tax advantages. Before packing, be aware that it is not clear how long Congress will allow this loophole to remain open.

To illustrate the appeal of interest tax shields, consider the following restructuring of Mature Manufacturing, Inc. (2M). Pertinent data for 2M, a publicly traded company, follows.

Mature Manufacturing, Inc. ($ millions)

Annual EBIT $ 25 Market value of equity 200 Interest-bearing debt 0 Tax rate 40%

Global Investing Partners believes 2M’s management may be inter- ested in a leveraged buyout (LBO) and has approached it with a proposal to form a new corporation, invariably called NEWCO, to purchase all of 2M’s equity in the open market. Because 2M’s cash flows are very stable, Global figures it can finance most of the purchase price by borrowing $190 million on a 10-year loan at 10 percent interest. The loan will be interest-only for the first five years. In the longer run, Global believes 2M can easily support annual interest expenses of $10 million. The value

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Kissing Toads The Oracle of Omaha, Warren Buffett, attributes corporate executives’ willingness to pay large con- trol premiums to three very human factors: an abundance of animal spirits, an unwarranted emphasis on company size as opposed to profitability, and overexposure during youth to “the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. [From this tale, executives] are certain their managerial kiss will do wonders for the profitability of Company T(arget).” Why else, Buffett asks, would an acquiring company pay a premium to control another business when it could avoid the premium altogether by simply purchasing a minority interest?

“In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nonetheless, many managerial princesses remain serenely confident about the future potency of their kisses—even after their corporate backyards are knee-deep in unresponsive toads.”

Source: Warren Buffett, Berkshire Hathaway, Inc. 1981 annual report.



of the anticipated interest tax shields to NEWCO, discounted at a 12 percent rate, is as follows:

Tax Shield at Year Interest Expense 40% Tax Rate

1 $19.00 $ 7.60 2 19.00 7.60 3 19.00 7.60 4 19.00 7.60 5 19.00 7.60 6 19.00 7.60 7 15.89 6.36 8 12.46 4.98 9 10.00 4.00

10 10.00 4.00

Present value of tax shields years 1�10 at 12% � $38.87 Present value of tax shields years 10 and beyond at 12% � 10.73

Total $49.60 million

Ignoring the increased costs of financial distress that customarily accom- pany higher financial leverage, these figures suggest that NEWCO can bid up to $249.60 million to purchase Mature Manufacturing, a 25 percent premium over the current market price ($249.60 million � $200 million stand-alone value � $49.60 million of enhancements). Moreover, Global’s required equity investment at this price would be only $59.60 million ($249.60 million acquisition price � $190 million in new debt), implying a post acquisition debt-to-assets ratio of 76 percent. This, believe it or not, is representative financing by LBO standards. LBOs are indeed aptly named.

A final judgment on the value of interest tax shields in leveraged re- structurings, of course, rests on a qualitative weighting of the indicated tax savings against the costs of financial distress as discussed in Chapter 6. A reduced tax bill isn’t especially attractive when the added debt frightens customers, drives away creditors, and emboldens competitors.

Note that if increased interest tax shields are the objective, an LBO is not the only way to obtain them. 2M can generate much the same effect by simply issuing debt and distributing the proceeds to owners as a large dividend or by a share repurchase. This was Colt Industries’ strategy (described in Chapter 6) when it floated a huge debt issue to finance dis- tribution of a special dividend and ended up with $1.6 billion in long-term debt and a negative net worth. But what’s to fear from a mountain of debt as long as you have the cash flow to service it? And if you don’t, your cred- itors have so much at stake in your company that they are more likely to behave like partners than police.

Chapter 9 Business Valuation and Corporate Restructuring 367



368 Part Four Evaluating Investment Opportunities

Nor must a leveraged buyout necessarily involve a takeover. Many LBOs are initiated by incumbent management who team up with outside investors to purchase all of the company’s stock and take it private. (An LBO in which incumbent management takes an active role is known as a management buyout, or MBO.) Management risks its own money in re- turn for a sizable equity position in the restructured company.

Incentive Effects Tax shield enhancements are clearly just a game: To the extent that share- holders win, “we, the people” (in the form of the U.S. Treasury) lose. If this were the only financial gain to takeovers and restructurings, the phe- nomena would not command serious public attention. Best that we elimi- nate the tax benefits and get back to producing goods and services instead of stocks and bonds.

The other two potential enhancements are not so easily dismissed. Both involve free cash flow, and both are premised on the belief that restructuring powerfully affects the performance incentives confronting senior management. To examine the incentive effects of restructuring in more detail, let’s return to Mature Manufacturing, Inc.

Before restructuring, the life of a senior manager at Mature Manufac- turing, Inc., may well have been an enviable one. With very stable cash flows, a mature business, and no debt, managers had no pressing reason to improve performance. They could pay themselves and their employees generously, make sizable corporate contributions to charity, and, if the president was so inclined, sponsor an Indy race car or an unlimited hy- droplane. Alternatively, if they wanted 2M to grow, the company could ac- quire other firms. This might involve some uneconomical investments, but hey—as long as cash flows are strong, almost anything is possible.

Samuel Johnson once observed, “The certainty of hanging in a fortnight focuses the mind wonderfully.” Restructuring can have a similar effect, for it fundamentally changes the world of 2M senior executives. Because they probably have invested much of their own resources in the equity of the newly restructured company, their own material well-being is closely tied to that of the business. Moreover, the huge debt service burden restructuring frequently creates forces management to generate healthy cash flows or face bankruptcy—no more “corpocracy” at 2M. The carrot of ownership and the stick of possible financial ruin create significant incentives for manage- ment to maximize free cash flow and spend it for the benefit of owners.

Controlling Free Cash Flow In addition to interest tax shields and incentive effects of high leverage, a third possible enhancement in restructurings rests on the perception that



public companies are not always run solely for the benefit of owners. In this view, value can be created by gaining control of such firms and refocusing the business on the single goal of creating shareholder value. Adherents of this view see shareholder-manager relations as an ongoing tug-of-war for control of the firm’s free cash flow. When shareholders have the upper

Chapter 9 Business Valuation and Corporate Restructuring 369

Avoiding Dilution in Earnings per Share An all-too-popular alternative approach to determining how much one company can afford to bid for another looks at the impact of the acquisition on the acquirer’s earnings per share (EPS). Popularity is about all this approach has to recommend it, for it grossly oversimplifies the financial effects of an acquisition, and it rests on an inappropriate decision criterion.

Suppose the following data apply to an acquiring firm, A, and its target, T, in an exchange-of- shares merger; that is, A will give T’s shareholders newly printed shares of A in exchange for their shares of T.

Company Company Merged A T Company

Earnings ($ millions) $ 100 $ 20 $130 Number of shares (millions) 20 40 26 Earnings per share $ 5 $0.50 $ 5 (minimum) Stock price $ 70 $ 5 Market value of equity (millions) $1,400 $ 200

The suggested decision criterion is that A should avoid dilution in EPS. If earnings of the merged firm are forecasted to be $130 million, the figures above indicate that A can issue as many as 6 million shares without suffering dilution [6 million shares � ($130 million/$5) � 20 million]. At $70 a share, this implies a maximum price of $420 million for T ($70 � 6 million), or a 110 percent premium [(420 � 200)�200]. It also suggests a maximum exchange ratio of 0.15 shares of A for each share of T (6 million/40 million).

The obvious shortcomings of this simplistic approach are, first, that earnings are not the cash flows that determine value and, second, that it is grossly inappropriate to base an acquisition deci- sion on only one year’s results. Doing so is comparable to making investments because they prom- ise to increase next year’s profits. If T’s growth prospects are sufficiently bright, it may be perfectly reasonable to sacrifice near-term EPS in anticipation of long-run gains.

Academics have been stamping on this weed for decades, but it never seems to die. Witness the following from The Wall Street Journal announcing the Daimler-Chrysler merger in 1998. “[T]he cross-border union is actually typical of the stock-for-stock deals that have made the 1990s merger boom so fertile: a combination using favorable accounting in which the buyer has a high price-to- earnings ratio that can make a deal ‘accretive’ because the seller has a low P/E. Chrysler’s price-to- earnings ratio has long been around eight times earnings, analysts say, and has only recently crept up to nine times. Daimler’s P/E, meanwhile, is more like 20 times profits, giving the buyer the finan- cial firepower to pay 11 to 12 times earnings and still have the transaction ‘accretive,’ or beneficial to the earnings of the new DaimlerChrysler.”* Business valuation is tough in practice, but there is no reason to use flawed techniques just because they are tractable.

* Steven Lipin and Brandon Mitchener, “Daimler-Chrysler Merger to Produce $3 Billion in Savings, Revenue Gains Within 3 to 5 Years,” The Wall Street Journal, May 8, 1998.



hand, companies are run to maximize shareholder value; but when manage- ment is in the driver’s seat, increasing value is only one of a number of com- peting corporate goals. After more than 50 years on the losing end of this tug-of-war, the emergence of the hostile raider in the mid-1980s enabled shareholders to gain the ascendancy and force companies to restructure. According to this view, the hostile acquisitions and restructurings during the latter half of the 1980s were a boon not only to shareholders but to the entire economy; for to the extent that shareholders can force management to increase firm value, the economy’s resources are allocated more efficiently.

Consistent with this adversarial view of corporate governance, many takeovers and restructurings occur in mature or declining industries. Because investment opportunities in these industries are low, affected businesses often have large free cash flows. At the same time, industry decline creates real concern in the minds of executives about the con- tinued survival of their organization. And although the proper strategy from a purely financial perspective may be to shrink or terminate the business, management often takes another tack. Out of a deep commit- ment to the business and concern for employees, the community, and their own welfare, some managers continue to fight the good fight by reinvesting in the business despite its poor returns, or by entering new businesses despite any convincing reasons to expect success. The pur- pose of restructuring in these instances is brutally basic: Wrest control of free cash flow away from management and put it in the hands of owners.

How, you might ask, does incumbent management ever gain control of a business in the first place? In theory, managers should be incapable of acting in opposition to owners for at least two reasons. First, if a company operates in highly competitive markets, management has very little dis- cretion; it must maximize value or the firm will be driven from the in- dustry. Second, all corporations have boards of directors with the power to hire and fire management and the responsibility to represent owners’ interests.

Theory, however, often differs from reality. Many corporations operate in less than perfectly competitive markets, and corporate boards have not always been an effective, independent shareholder voice. One reason is that most senior executives, usually supported by the courts, believe that a board’s primary responsibility is to help incumbent management run the business, not to represent shareholder interests. As a result, boards are often more closely affiliated with management than with owners. Many di- rectors are company insiders; other directors have important ties to the en- terprise other than ownership and are more beholden to the chief executive than to shareholders for their seat on the board. Consequently, while such

370 Part Four Evaluating Investment Opportunities



boards may help keep the shelves stocked, they are not about to recom- mend selling the store.

A second reason directors do not always represent shareholder interests traces to the process by which they are chosen. In the great majority of instances, the proxy materials sent annually to shareholders propose a single, unopposed slate of board candidates nominated by management. And even then, shareholders may not vote against a candidate, but may only withhold approval. The only way disaffected shareholders can contest a board seat is to propose their own candidate and use their own money to campaign against management’s choice in a proxy contest. Meanwhile, management is free to use corporate funds to defeat its ri- vals. Little wonder then that management effectively controls most company boards.

In 2010, following passage of the Dodd-Frank Act, the SEC sought to reduce management control of board elections by forcing companies to accept limited shareholder nominations under certain specified condi- tions. However, a federal appeals court struck down the controversial regulation before it could be implemented, and so far the SEC has not proposed an alternative rule.

The new drive for proxy regulations is the product of a long-simmering shareholder rights movement initiated by activist investors. Having tasted the fruits of control in the form of unusually high returns during the hostile takeover era, these investors have found new ways to challenge in- cumbent managers for free cash flow. Unlike hostile acquirers of the 1980s, the goal of activist investors is not to gain control of a target com- pany, but to browbeat management into actions investors believe will in- crease shareholder value. These actions usually involve repurchasing shares with excess cash, selling underperforming assets, or putting the company itself up for sale. Many believe activist investing got its start when shareholders grew tired of watching buyout firms make large for- tunes executing strategies that incumbent managers could just as easily implement themselves. The goal of activist investors is to provide the req- uisite motivation. Or in the words of meta-activist Carl Icahn, “We do the job the LBO guys do, but for all the shareholders.”

Does activist investing work? Accumulating evidence indicates it does. Writing in 2009, April Klein and Emanuel Zur looked at the campaigns of 151 hedge fund activists and 154 other types of activists. Hedge funds are lightly regulated, private equity partnerships that have grown rapidly in the past several decades, to the point where there are now thought to be upward of 8,000 in existence. The authors found that the activist’s targets experienced abnormal returns of 5.1 to 10.2 percent, depending on the sample, in the period immediately surrounding public announcement of

Chapter 9 Business Valuation and Corporate Restructuring 371



372 Part Four Evaluating Investment Opportunities

the activists’ intentions and generated additional abnormal returns of 11.4 to 17.8 percent over the following year. They also found that ac- tivists were successful 60 to 65 percent of the time in getting incumbent management to acquiesce to their demands. Other studies have found that activist investors also earn higher risk-adjusted returns than their more passive brethren.8

As debate topics go, the question of whether management should have broader social responsibilities than simply creating shareholder value is among the more intriguing. Like many important societal questions, however, the issue tends to be resolved more on the basis of power than of logic. Throughout most of the twentieth century, incumbent manage- ment retained the power to interpret its responsibilities broadly and to treat shareholders as only one of several constituencies possessing a claim on the corporation. The balance of power shifted abruptly in sharehold- ers’ favor during the era of the hostile takeover. Although corporations have largely neutralized the threat of hostile takeover, the rise of the ac- tivist shareholder and his ally, the activist board member, suggests that the battle is far from over.

The Empirical Evidence

A final question remains: Do corporate restructurings create value? Do they provide any benefit to society? In the aggregate, the answer is yes. Looking first at mergers, the median five-day acquisition premiums of 20 to 40 percent reported in Table 9.3 leave no doubt that owners of ac- quired firms benefit handsomely from mergers. Whether the owners of acquiring firms also benefit is more problematic. After reviewing scores of studies completed over the past 30 years, Robert Bruner concludes that, on balance, they do, but that the average gain is small and the range of outcomes is large.9 A recent paper using the event study methodology described in Chapter 5 blames the mediocre performance on what the authors call “mega-mergers,” defined as the largest 1 per- cent of mergers by transaction size.10 Over the period 1980 to 2007, mega-mergers accounted for 43 percent of all merger outlays and gen- erated a strongly negative average abnormal return to acquirers of

8 April Klein and Emanuel Zur, “Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors,” Journal of Finance, February 2009, pp. 187–229. See also Nicole M. Boyson and Robert M. Mooradian,”Corporate Governance and Hedge Fund Activism,” Review of Derivatives Research, July 2011, pp. 169–204. 9 Robert F. Bruner. Applied Mergers & Acquisitions (New Jersey: John Wiley & Sons, 2004), Chapter 3.

10 Dinara Bayazitova, Matthias Kahl, and Rossen I. Valkanov, “Value Creation Estimates Beyond Announcement Returns: Mega Mergers versus Other Mergers,” Working Paper, 2012. Available at



–3.2 percent. In aggregate dollar amount, these losses totaled $415.5 billion. In contrast, the average abnormal return to acquirers in the other 99 percent of mergers was �1.5 percent. Moreover, the difference in these percentages has increased since 2002.

The best early study of whether leveraged buyouts create value is by Steven Kaplan, who examined 48 large management buyouts executed be- tween 1980 and 1986.11 Looking first at return on operating assets, Kaplan found that relative to overall industry performance, the median buyout firm increased return on operating assets by a healthy 36.1 percent in the two years following the buyout. A similar look at capital expenditures re- vealed that on an industry-adjusted basis, the typical buyout firm reduced its ratio of capital expenditures to assets by a statistically insignificant 5.7 percent over the same period. Reflecting both improved operating per- formance and reduced investment, Kaplan found that the typical buyout firm increased an industry-adjusted measure of free cash flow to total assets an enormous 85.4 percent in the two years following the buyout. Realized returns to investors were equally impressive. Of the 48 firms in his sample, Kaplan was able to find post-buyout valuation data on 25 because they ei- ther issued stock to the public, repurchased stock, were liquidated, or were sold. Recognizing that these 25 may be the cream of the crop, he nonetheless observed impressive performance. The median, market- adjusted return to all sources of capital over the 2.6 years from the buyout date to the valuation date was 28 percent. Moreover, the median internal rate of return to equity on these firms was a staggering 785.6 percent, demonstrating yet again the power of extensive debt financing when things go well.

A more recent study indicates that although the eye-popping numbers observed by Kaplan two decades ago have diminished substantially, LBOs are still generating superior performance.12 Looking at 94 LBOs between 1990 and 2006, the authors found median market and risk-adjusted returns to total capital of 40.9 percent, which they attributed in roughly equal mea- sure to improved operating performance, increased industry valuation multi- ples, and tax benefits from greater financial leverage. Interestingly, the study observes that the greatest improvement in operating performance occurred when the buyout firm replaced the CEO soon after the purchase and when fi- nancial leverage was high. Evidently, aggressive oversight and the discipline of heavy debt service obligations really do focus management’s attention.

Chapter 9 Business Valuation and Corporate Restructuring 373

11 Steven Kaplan, “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Financial Economics, October 1989, pp. 217–254. 12 Shourun Guo, Edith S. Hotchkiss, and Weihong Song, “Do Buyouts (Still) Create Value?” Journal of Finance, April 2011, pp. 479–518.



On balance, the evidence suggests that financial restructurings are not just tax gimmicks. Rather, the increased managerial incentives that often accompany such transactions appear strong enough to stimulate meaning- ful improvements in operating performance and in shareholder value.13

Beyond explaining why buyout firms have become so popular, this evi- dence also poses a stark challenge to those who argue that management alone should control America’s corporations.

The Cadbury Buyout

Kraft Foods’ buyout of Cadbury should no longer hold much mystery. Cadbury’s £5.25 pre-takeover stock price was its value to minority investors given Cadbury’s potential as a stand-alone entity under the direction of incumbent management, while the £8.50 price paid by Kraft included a sizable premium for control. Clearly, neither price was necessarily incorrect or irrational. Although we might wonder whether Kraft paid too much or too little for Cadbury, I can assure you that having paid an estimated $440 million in combined fees, Kraft and Cadbury had numerous valua- tion studies of the type described here supporting the acquisition pricing. Whether the assumptions and forecasts underlying those studies were ac- curate remains to be seen.

To most observers, Kraft’s justification for buying Cadbury read like the syllabus of a business strategy course, replete with appropriate buzzwords. The company spoke of “a compelling financial rationale” based on “in- creased scope and scale, complementary brands, a strengthened geographic footprint, and complementary routes to market producing meaningful cost savings and synergies.” Setting aside the rhetoric, Cadbury’s most com- pelling attraction appeared to be its distribution network in emerging mar- kets, especially India and Mexico. Kraft seemed convinced that emerging market consumers were anxious to eat a lot more Kraft cheeses and Oreo cookies if just given a proper chance. In more concrete terms, Kraft’s chief executive claimed to have identified annual cost savings of $675 million achievable within three years. (At a 35 percent tax rate, a 10 percent dis- count rate, and 3 percent perpetual growth, the present value of these sav- ings totals roughly $6 billion or about 80 percent of the acquisition pre- mium paid [$6 billion � (1 � .35) � $675 million/(.10 � .03)].)

Despite statements to the contrary, Cadbury appeared to have been grooming itself for a takeover since early 2007 when activist investor Nelson Peltz first took an interest in the company. Mr. Peltz’s investment

374 Part Four Evaluating Investment Opportunities

13 For a thorough review of corporate restructurings, see Espen B. Eckbo, and Karin S. Thorburn, “Corporate Restructuring: Breakups and LBOs,” Handbook of Corporate Finance: Empirical Corporate Finance, Vol. 2, Chapter 16, 2008, pp. 431–496. Available at



vehicle, Trian Fund Management, frequently buys into poorly performing companies, often in the food business, and exerts increasing public pres- sure on management to take actions Trian perceives will improve per- formance. When Trian first bought into Cadbury, the company was known as Cadbury Schweppes and consisted of an attractive confectionary business married to a dead-end soft drinks operation. Some even spoke of the drinks business as Cadbury’s personalized “poison pill,” reasoning that no suitor would be interested in the company as long as it held on to soft drinks. Almost immediately after Trian purchased shares in Cadbury, the company announced its intention to dispose of soft drinks, and in mid- May 2008, it did so by spinning the operation off into a new company, Snapple Group, Inc. This set Cadbury up as an attractive, pure-play ac- quisition target for the likes of Hershey, Nestlé, or Kraft.

Kraft ran into two unanticipated problems in its pursuit of Cadbury. Just as the company was finalizing its offer preparatory to a shareholder vote, Warren Buffett of Berkshire Hathaway, Kraft’s largest shareholder, strongly condemned the deal and announced he would vote against it. He noted that Kraft’s shares were currently undervalued by his reckoning and, thus, made an expensive currency to pay in an acquisition. Although criti- cal of Kraft, Mr. Buffett’s comments drove Kraft’s stock up and Cadbury’s down as investors perceived that Kraft would now have to exercise more restraint in bidding up the acquisition price—perhaps Mr. Buffett’s intent all along. Kraft responded by quickly selling its DiGiorno Pizza operations to Nestlé and using the proceeds to increase the cash portion of its offer. This assuaged Mr. Buffett’s concern directly by reducing the number of shares Kraft needed to issue, and, quite fortuitously, I am sure, eliminated the need for a shareholder vote at all by cutting the issue size below 20 percent of shares outstanding. Mr. Buffett was now free to have his own opinion about the deal but was powerless to prevent it.

Kraft’s second problem was more embarrassing. As the much beloved Cadburys of their youth—the makers of Crème Eggs no less—many British were upset to think of yet another British institution being gob- bled up by a crass American giant, this time by the maker of what one critic called “plastic cheese.” To polish its image a bit during negotiations, Kraft magnanimously announced that if successful, it was prepared to save 400 local jobs by keeping open an elderly Cadbury facility, known as the Somerdale plant, located in Southwest England. Cadbury management had recently announced their intention to close the plant and move all the work to Poland. Unfortunately, applause soon turned to jeers when just seven days after closing the deal Kraft announced they had changed their minds and would be closing the plant and moving the work to Poland after all. It seems that Kraft had been lax in its due diligence and had not

Chapter 9 Business Valuation and Corporate Restructuring 375



realized Cadbury was so close to completing the move. On closer inspec- tion, keeping the Somerdale plant open now looked too expensive.

Sometimes timing is more important than skill. In this instance, Kraft committed its blunder right in the middle of heated British national elec- tions. Politicians of all stripes instantly seized on the event to excoriate un- scrupulous foreign raiders, short-term speculators, greedy business execu- tives, outrageous salaries, lax takeover regulations, and all the other usual suspects. The Economist aptly caught the fervid atmosphere in its headline “Small Island for Sale.” In retrospect, Kraft’s faux pas did not affect the terms of the acquisition, but it did decimate the company’s reputation in Britain and set back the cause of an open market for corporate control in Britain. There was wide call for what would have become known as “Cadbury’s Law,” to protect British companies from hostile foreign buyers. Although the British government resisted this proposal, the takeover code was amended to improve transparency. Only Kraft can say how badly the Somerdale fiasco hurt efforts to integrate the two companies.

Notwithstanding Kraft’s justification that Cadbury was part of an inte- grated long-term strategy, Cadbury’s parentage changed yet again less than three years later. In October 2012, Kraft split itself into two companies, a rapidly growing global snacks business and a slower-growth North Ameri- can grocery business. The grocery business, now Kraft Foods Group, Inc., retained brands such as Maxwell House coffee and Kraft cheeses as well as the original Kraft name. Cadbury became part of the global snack business, along with Oreo cookies, Ritz crackers, and Kraft chief executive Irene Rosenfeld. This business was renamed Mondelez International, which ac- cording to Kraft executives derived from a combination of the Latin word for “world” and “delez,” a “fanciful expression of ‘delicious.’”14


The Venture Capital Method of Valuation Venture capitalists are the carrier pilots of corporate finance. They make high-risk, high-return investments in new or early-stage companies thought capable of growing rapidly into sizable enterprises. Their invest- ment horizon is typically five or six years, at which time they expect to cash out as the target company goes public or sells out to a competitor. To manage risk, venture capitalists typically make staged investments in

376 Part Four Evaluating Investment Opportunities

14 Julie Jargon, “What’s a Mondelez? A Krafty New Name for Snack Maker,” The Wall Street Journal, March 22, 2012.



which the company must meet a stated business milestone before quali- fying for the next financing round. Venture capitalists often specialize in a particular financing round, such as startup, early stage, or mezzanine. The mezzanine round is the company’s last private financing round prior to going public, or merging. In most instances, the risk to new investors and, hence, the return demanded, diminishes from one financing round to the next.

The standard discounted cash flow valuation technique discussed in the chapter is ill-suited to venture investing for several reasons. First, the cash infusions from venture investors are intended to cover near-term, nega- tive free cash flows, so projecting and discounting annual free cash flows is not relevant. Second and more fundamentally, the standard approach to business valuation does not gracefully accommodate multiple financing rounds at different required rates of return.

Rather than use the standard approach, venture capitalists employ a specialized discounted cash flow technique that is better suited to their needs. Our purpose here is to illustrate the venture capital method of valuation, to indicate the level of target returns used in the industry, and to offer several explanations of why these targets appear so outlandishly high. We begin with a simple example of a company in need of only one financing round. We then build on this example to consider a more real- istic situation involving multiple financing rounds.

The Venture Capital Method—One Financing Round

Jerry Cross and Greg Robinson, two veteran computer programmers, have what they believe is a pathbreaking idea for a new product. Soon after incorporating as ZMW Enterprises and arbitrarily awarding them- selves 2,000,000 shares of common stock, Cross and Robinson prepared a detailed business plan and began talking to venture capitalists about funding their company. The business plan envisions an immediate $6 million venture capital investment, profits of $5 million in year 5, and rapid growth thereafter. The plan indicates that $6 million will be suffi- cient to commence operations and to cover all anticipated cash needs until the company begins generating positive cash flows in year 5.

After hearing the entrepreneurs’ pitch, a senior partner at Touchstone Ventures, a local venture capital company, expressed interest in financing ZMW but demanded 3.393 million shares in return for his firm’s $6 million investment. He also mentioned in passing that his offer implied a pre- money valuation for ZMW of $3.537 million and a post-money value of $9.537 million. Determined not to be intimidated, Greg Robinson challenged the venture capitalist to justify his numbers, hoping in the process to learn what he meant by pre- and post-money.

Chapter 9 Business Valuation and Corporate Restructuring 377



378 Part Four Evaluating Investment Opportunities

Panel A of Table 9A.1 presents a valuation of ZMW using the venture capital method. Three steps are involved.

1. Estimate ZMW’s value at some future date, often based on a conven- tional comparable trades or comparable transactions analysis.

2. Discount this future value to the present at the venture capitalist’s target internal rate of return.

3. Divide the venture capitalist’s investment by ZMW’s present value to calculate the venture capitalist’s required percentage ownership.

As shown in Panel A, Touchstone accepted the entrepreneurs’ projection that ZMW would earn $5 million in year 5. They then multiplied this amount by a “warranted” price-to-earnings ratio of 20 to calculate a firm value of $100 million. The price-to-earnings ratio used here typically reflects the multiples implied by other recent venture financings or the multiples presently commanded by public companies in the same or related industries.

Discounting the year 5 value to the present at Touchstone’s 60 percent target rate of return yields a present value for ZMW of $9.537 million

TABLE 9.A1 The Venture Capital Method of Valuation

Panel A: One Financing Round

Facts and Assumptions (000 omitted)

Net income year 5 $ 5,000 Price-to-earnings ratio in year 5 20 Investment required at time 0 $ 6,000 Touchstone Ventures’

target rate of return 60% Time 0 shares outstanding 2,000

Cash Flow and Valuation

Year 0 1 2 3 4 5

Investment $ 6,000 ZMW value in year 5 $100,000 PV at time 0 of year 5 value

discounted at 60% $ 9,537 Time 5 Touchstone ownership

to earn target return 62.9% Shares purchased

by Touchstone1 3,393 Price per share $ 1.77 Pre-money value of ZMW $ 3,537 Post-money value of ZMW $ 9,537



Chapter 9 Business Valuation and Corporate Restructuring 379

Panel B: Two Financing Rounds

Facts and Assumptions (000 omitted)

Net income year 5 $ 5,000 Price-to-earnings ratio in year 5 20 Investment required at time 0 $ 6,000 Investment required at time 2 $ 4,000 Touchstone Ventures’

target rate of return 60% Second-round investor’s

target rate of return 40% Time 0 shares outstanding 2,000

Cash Flow and Valuation

Year 0 1 2 3 4 5 Investment $ 6,000 $ 4,000 Terminal value year 5 $100,000

Second-Round Investor

PV at time 2 of year 5 value discounted at 40% $36,443 Time 5 ownership to earn target return 11.0%

Touchstone Ventures

PV at time 0 of year 5 value discounted at 60% $ 9,537

Time 5 Touchstone ownership to earn target return 62.9%

Retention ratio2 89.0% Time 0 Touchstone ownership

to earn target return 70.7% Shares purchased by Touchstone1 4,819 Price per share $ 1.24 Pre-money value of ZMW $ 2,490 Post-money value of ZMW $ 8,490

Second-Round Investor

Shares purchased by second round investor1 841 Price per share $ 4.76 Pre-money value of ZMW $32,443 Post-money value of ZMW $36,443

1 If x equals the number of shares purchased by new investors, y is the number of shares currently outstanding, and p is the percentage of the firm purchased by new investors, then x/(y � x) � p, and x � py/(1 � p).

2 Retention ratio � (1– second round investor’s percentage ownership) � (1 � 11.0%).



[$9.537 million � $100 million/(1 � 0.60)5]. This, in turn, implies a per- centage ownership for Touchstone of 62.9 percent. The logic here is that if the company is worth $9.537 million after the investment, and if Touch- stone contributes $6 million to this total, its fractional ownership should be $6 million/$9.537 million, or 62.9 percent. To confirm this logic, note that if ZMW is worth $100 million in five years, Touchstone’s 62.9 per- cent ownership will be worth $62.9 million, which translates into an in- ternal rate of return of precisely 60 percent.

The rest is just algebra. If Touchstone is to own 62.9 percent of ZMW and the company presently has 2 million shares outstanding, Touchstone needs to receive 3.393 million new shares [62.9% � 3.393/(2 � 3.393)], which, in turn, implies a per share price of $1.77 ($6 million/3.393 million shares). ZMW’s estimated value before Touchstone’s investment, or its pre-money value, is, thus, $3.537 million ($1.77 per share � 2 million shares), and its value after the investment, or its post-money value, is $9.537 million (1.77 per share � 5.393 million shares).

Cross and Robinson are likely to be of two minds about this valuation: flabbergasted that Touchstone would demand a 60 percent return when all they do is put up money, but pleased to learn that Touchstone appar- ently puts a $3.537 million price tag on their idea.

The Venture Capital Method—Multiple Financing Rounds

The venture capital method is easy to apply when there is only one financ- ing round prior to the valuation date. Things get more complicated, and more realistic, when there are multiple rounds. To illustrate, let’s change the ZMW example by supposing that Cross and Robinson’s business plan calls for two financing rounds: the original $6 million at time 0, plus a sec- ond investment of $4 million at time