Ebook Financial management Concepts and applications Part 2

(BQ) Part 2 book Financial management Concepts and applications has contents Assessing the cost of capital What return investors require; understanding financing and payout decisions; designing an optimal capital structure; measuring and creating value,... and other contents.

Learning Objectives

of the efficient market hypothesis.

obj 9.6

Explain why understanding capital markets and long- term financing instruments

is relevant for managers.

Overview of Capital Markets:

Long-Term Financing

Instruments

There are two times in a man’s life when he should not

speculate: when he can’t afford it and when he can.

– Mark Twain

Earlier in this book, we focused on sizing up a firm’s prospects and

under-standing the short-term financial requirements of the firm In particular,

Chapter 5 introduced short-term financing instruments with maturities less

than one year, traded in what are known as money markets Then, Chapter

7 presented a bridge between short-term and long-term financing and

intro-duced the underpinnings of the valuation of financial securities such as

bonds and stocks Now, we’ll focus our attention on understanding the

long-term financing instruments issued by firms and the markets in which they

trade

This chapter is the first of four that examine various aspects of a firm’s

financial needs for more than one year, with securities such as bonds and

stocks traded in what are known as capital markets If a firm is not able to

meet its financial requirements through internally generated funds and

some short-term borrowing, then it must seek external financing through

capital markets

Later in the book, we’ll look at the cost of raising capital in Chapter 10,

financing and dividend decisions in Chapter 11, and how to determine an

appropriate mix of debt and equity in Chapter 12 But first, in this chapter, we

examine the distinctive features of three important types of financial

instru-ments that were briefly introduced in Chapter 7: bonds, preferred shares, and

common shares We then present an overview of capital markets, with a

gen-eral focus on the stock market because it is more complex than the bond

market Later, we focus on the efficiency of stock markets, or the extent to

which securities trade at fair prices, as this is an important consideration for

firms issuing stocks Finally, in the Appendix to this chapter, we present

addi-tional details on understanding bond and stock information from an

inves-tor’s perspective

Let’s see how financial instruments such as bonds and stocks fit in our

financial management framework, as depicted in Figure 9.1 As shown in the

figure, issuing financial instruments is part of a firm’s financing decisions, and

accessing external financing impacts a firm’s ability to grow, as well as its

over-all risk

money market: A financial market

in which very liquid, safe, term investments are traded

short-capital markets (securities markets): Markets for long-term

financing such as issuing bonds or equity

9

167

Assess the key features of

bonds and credit ratings.

Let’s begin our exploration of capital markets by looking at bonds, which were briefly introduced in Chapter 7 From a firm’s perspective, bonds are simply a form of borrow-ing At the most basic level, bonds are loan contracts or promises made by a firm indi-cating scheduled repayment of the principal amount—or the amount of money being lent—along with interest or coupon payments typically paid every six months Bonds are issued by a firm, and because they represent a major form of long-term financing, they are a type of financial instrument

Bond investors, also called bondholders, can be thought of as a type of lender The majority of these investors are commonly referred to as institutional investors, such as pension funds, mutual funds, endowment funds, and insurance companies However, once a firm has issued a bond, the bondholder can choose to sell or trade that bond to another party in exchange for money equal to the value of the bond In fact, there are usually active markets whereby corporate and government-issued bonds can be traded; these are known generically as securities markets (or capital markets) or specifically as bond markets

9.1.1 changing Bond Yields

As we saw in Chapter 7, bond prices move inversely to changes in yields or interest rates—or conversely, yields move inversely to bond price changes Let’s briefly examine the implications of this observation for firms that may be considering issuing bonds As

we do so, it is important for us to recognize that both short-term and long-term interest rates or yields change over time, sometimes substantially, usually in a similar direction

principal: The original or face

amount of a loan on which interest

is paid

bondholders: Owners of bonds.

securities markets: See capital

markets Markets for long-term

financing such as issuing bonds or

equity

but not always in lockstep As a result, firms may be facing different costs today if they

issue bonds with short maturities (such as one year) or long maturities (such as thirty

years) compared with, say, issuing such bonds next year

Corporate bond yields often move in a similar direction to yields on

government-issued bonds, but of course, corporate bond yields are higher than similar time-to-

maturity government bond yields because owning a corporate bond is riskier Figure 9.2

shows the yield on U.S treasuries (or government-issued bonds) with one-year and

thirty-year maturities, from 1962 to 2012 Notice that yields or interest rates peaked

around 1981, then steadily declined through 2012 As we will see in Chapter 10, this

decline in rates resulted in a dramatic decline in firms’ cost of capital, which in turn

impacted the attractiveness of projects in which firms considered investing From the

figure, we can also determine periods during which the yield curve was inverted by

look-ing for times when short-term rates exceeded long-term rates, such as around 1980, 1988,

2000, and 2006 Each of these periods occurred just prior to the last four U.S recessions,

which started in 1981, 1990, 2001, and 2007 Key takeaways from this figure are (1) for

investors, bond yields and hence prices can change dramatically over time; (2) firms may

face different costs over time—as indicated by the varying yields—when issuing bonds;

and (3) the relative cost of issuing short-term bonds (such as those with a one-year

matu-rity) versus long-term bonds (such as those with a thirty-year matumatu-rity) may change over

time, so firms need to carefully consider the length of the borrowing period

9.1.2 Bond Features

Issuing bonds is attractive from a firm’s perspective because any interest payments are

deductible as expenses for tax purposes, making bonds a relatively low-cost alternative for

obtaining capital Bonds are typically issued at face value with a particular maturity date

Generally, maturity dates range from one year to thirty years In rare cases, 100-year or

century bonds have been issued—for example, the Walt Disney Company issued century

bonds in 1993 that became known as Sleeping Beauty bonds In an even more extreme

example, the Toronto Grey and Bruce Railway issued a 1,000-year bond in 1883 That

Fig 9.2

U.S Treasury Yields Percent, One-Year and Thirty-Year Maturities, 1962–2012

Source: Federal Reserve http://www.federalreserve.gov/econresdata/statisticsdata.htm (accessed

March 1, 2012)

bond, which is due to mature in 2883, appears to have the longest term to maturity on record, and it remains on the books of the Canadian Pacific Limited.

Bonds differ by the types of features they have For example, some bonds include a

sinking fund feature, which requires the firm to repurchase a portion of its bonds on a

regular basis throughout the life of the bonds or set aside an equivalent amount This feature is intended to reassure bondholders that they won’t be left with losses if the firm

is unable to meet its principal repayment obligation at maturity In some cases, the firm may repurchase a portion of its bonds in the bond market, or it may buy back bonds directly from the bondholders by paying the face value

Although most bond contracts specify a fixed coupon rate—recall that the coupon rate reflects the annual amount of interest payments and is expressed as a percentage of the face value of the bond—other contracts indicate a variable rate For example, the contract might specify repayment at the prime rate plus a certain percent (often in the 1/2 to 3 percent range) The prime rate is a benchmark set by each financial institution

as the rate at which interest is charged to its most-favored (i.e., least risky) customers An alternative benchmark rate common in Europe (but used worldwide) is the London Interbank Offered Rate, or Libor Libor is the average rate at which major banks in London borrow among themselves and is a benchmark rate for trillions of dollars of mortgages, loans, and payments to individuals and businesses

sinking fund: A cash fund set aside

by the firm in order to meet future

debt obligations

variable rate: A floating or nonfixed

loan rate, often tied to changes in

the prime rate or LIBOR

prime rate: The rate offered

by lending institutions, such as

banks, to their most creditworthy

customers

LiBor (London inter-Bank offered

rate): The rate at which banks offer

to lend in the London inter-bank

market; often used as the basis for

floating-rate loans

in the news

On June 27, 2012, British investment bank Barclays PLC agreed to pay a fine of $453 million

to U.S and British authorities to settle allegations that the firm manipulated Libor over a period of at least five years Barclays’ CEO Robert Diamond was forced to resign Suspicions

of manipulation were originally raised by the Wall Street Journal in a May 29, 2008, article.

Libor borrowing rates are set daily for ten currencies and 15 maturities The most popular rate is the three-month dollar rate A panel of 18 London-based banks submits estimates of their costs for borrowing at each rate The actual rate is set as an average, excluding the four highest and four lowest submissions.

Investigations into the Libor scandal revealed two types of manipulation used by Barclays and other investment banks to influence Libor In one type of manipulation, which was used during the financial crisis of 2007–2009, Barclays submitted estimates that were lower than their true costs because they did not want to reveal to the market- place how costly borrowing had become for fear it might make the bank’s financial posi- tion appear weak In the other type, Barclays’ traders colluded with traders from other banks to influence certain Libor rates in order to increase profits or decrease losses on their exposure to products tied to Libor rates.

The fallout from the Libor scandal continues By early 2013, two other banks cated in the rate manipulation scandal—the large Swiss investment bank UBS and the Royal Bank of Scotland—agreed to large settlements with various regulatory authorities

impli-In mid-2013 it was announced that a subsidiary of NYSE Euronext was appointed as the new administrator of Libor, taking over from a subsidiary of the British Bankers Associa- tion, with a transfer expected in 2014.

The Libor scandal

Sources: D Enrich and M Colchester, “Embattled FSA Is Under Fire for Libor Policing,” Wall Street

Journal, July 6, 2012 and “NYSE Euronext Subsidiary to Become New Administrator Of Libor” (Press

release) NYSE Euronext, July 9, 2013

Another common feature of some bonds is a call provision With callable bonds

(also known as redeemable bonds), a firm can choose to pay back the investor at a

pre-specified date prior to the maturity date, usually at a prepre-specified price above the face

value, representing a premium to the bondholder For example, when interest rates have

declined and it is cheaper for the company to reissue new bonds with lower coupon

rates, it may choose to call its outstanding bonds This provision is beneficial to the firm

because it adds flexibility to its financial strategy and gives the firm the option of

refi-nancing its debt obligations at a lower rate if interest rates decline

Because bondholders do not have a direct say in how a firm is run, their interests

are protected to a degree through bond covenants These covenants place some

restric-tions on the firm in such a way as to improve the odds that the bondholders will be

repaid For example, covenants might specify a maximum allowable debt-to-equity ratio

for the firm, a minimum level of working capital, a maximum limit on annual capital

expenditures, or a limit on the amount of dividend payments

Figure 9.3 summarizes these features and other issue details for the Home Depot

bond introduced earlier in “Time Value of Money Basics and Applications.”

9.1.3 Bond ratings

When a company is planning to issue a bond, potential investors want a method of

assessing the perceived riskiness of the bond investment In other words, they want to

assess the possibility of default, or the firm’s failure to meet its interest and principal

repayment obligations Bond-rating agencies fulfill this need by providing an assessment

of the creditworthiness of the firm

Major rating agencies include Moody’s, Standard & Poor’s (S&P), and Fitch These

agencies assess the financial health of a firm by completing a process similar to the

busi-ness size-up process described in Chapter 2 They then assign the firm’s bonds a rating

based on their findings For long-term bonds (i.e., those with a maturity of more than one

year), these ratings are based on the likelihood of repayment of principal, the capacity and

willingness of the firm to meet its financial commitments, the nature of the financial

obli-gation (such as the maturity and any special features of the bond), and any protection

afforded to bondholders by the firm in the event of bankruptcy or reorganization

call provisions: A description of

terms under which a firm may redeem all or part of a bond or preferred share issue

callable (redeemable): A type

of bond whereby the firm can choose to pay back the lender at

a prespecified date prior to the maturity date

covenants: Provisions in a bond

or debt agreement specifying restrictions or requirements on the borrower

default: Failure to make debt

obligation payments

Fig 9.3

Home Depot Bond Features

Issue size: $3 billion

Face (par) value: $1,000

Maturity date: December 16, 2036

Coupon rate: 5.875%

Coupon frequency: Semiannually

Sinking fund: None

Callable: Yes

Type of rate: Fixed

Payment currency: U.S dollar

Day/count basis: 30/360*

*For the purposes of quoting yields, the U.S convention is to assume each month has 30 days and a year

has 360 days In some other countries, it is assumed that a year has 365 days for yield calculations.

Source: Morningstar Inc http://quicktake.morningstar.com/StockNet/Bondsquote.aspx?bid=09db65ea

9d26041b644453391d82de18&bname=Hm +Depot +5.875%25 +%7c +Maturity%3a2036&ticker=

HD&country=USA&clientid=dotcom (accessed September 17, 2012)

Ratings range from Aaa—the highest rating—to Aa, A, Baa, Ba, B, and below A summary of the various ratings, as provided by Moody’s investor service is presented in

Figure 9.4.1 Bonds with ratings of Baa- and higher are known as investment grade bonds Most institutional investors are restricted to investment grade bonds Investments rated below Baa- are known as speculative, high-yield, or junk bonds Prior to 1980,

most high-yield bonds were so-called fallen angels—bonds that initially received an investment grade but had since become riskier Since that time, due in part to financier Michael Milken, a huge market for firms to initially issue risky bonds has developed

In-depth

Credit-rating agencies such as Moody’s, S&P, and Fitch provide opinions about the itworthiness of debt issues such as bonds issued by companies or governments In short, these agencies assess the probability that an issuer may default on its obligation.

cred-Credit ratings are meant to be a forward-looking assessment that takes into account historical and current information about a firm, its industry, and general economic condi- tions These ratings focus strictly on credit quality, not on the suitability or merit of the investment The assignment of credit ratings is not an exact science, and much objective judgment is involved Credit ratings are useful because they facilitate the issuance and purchase of debt They also impact the cost of borrowing because an issuer with a higher rating is able to have a lower interest rate on its debt.

Most ratings are determined by a team of analysts who obtain information from lished sources (such as annual reports) and discussions with management The process starts with a request for a rating from an issuer, followed by an initial evaluation, a meeting with management, and the analysis Rating agencies typically have committees that review the analysis and vote on the rating to be assigned After the issuer is notified of the rating, the agency’s opinion is published and made public.

pub-A credit analysis usually involves assessment of both business risk and financial risk

Business risk assessment examines country risk, industry characteristics, and a firm’s position relative to its peers In comparison, financial risk assessment examines a firm’s

accounting data and various ratios, liquidity, cash flows, capital structure, and overall governance.

Rating agencies don’t offer their services for free; they have a financial incentive to

do so There are a variety of possible business models whereby rating agencies earn its The most common payment structure is the issuer-pay model, whereby the firm requesting the rating pays the credit-rating agency This model has been criticized because it creates a potential conflict of interest for the rating agencies, but the agencies try to mitigate this effect by separating the parts of the business that negotiate business terms from those that perform the analysis Potential conflicts of interest are also reduced

prof-by reputation effects In other words, any incentive an agency has to issue a biased rating

is offset by the likelihood that investors will come to see the agency’s ratings as biased and therefore no longer make decisions based on those ratings This, in turn, makes firms less likely to contract with the agency in the future.

What Credit-Rating

Agencies Do

Source: Much of this description is from Standard & Poor’s Guide to Credit Rating Essentials, 2010

1 Fitch uses the same scale as S&P Moody’s uses a similar but slightly different ratings scale: Aaa, Aa, A, Baa, Ba, B, and below Also, instead of plus/minus notches, Moody’s uses numbers So, within Baa, there

is Baa1 (similar to S&P’s BBB+), Baa2 (BBB), and Baa3 (BBB-).

FIG 9.4

General Summary of the Opinions Reflected by Moody’s Credit Ratings

Source: Moody’s Standing Committee on Rating Systems & Practices

The second type of financial instrument we will look at—and the least frequently used of

the three—is preferred shares Issuance of preferred shares is another long-term form of

financing available to firms Preferred shares are often described as hybrid securities, or

a mix of bonds and stocks They have some similarities to bonds, but they have some

major differences as well Although categorized on the balance sheet as a form of equity

(because from the debt holders’ perspective, preferred equity provides a cushion in the

event of bankruptcy), preferred shares are also very different from common shares

Like bonds, preferred shares are issued with a face value Unlike bonds, most

pre-ferred shares (known as perpetual prepre-ferreds) carry no obligation on the part of the firm to

Objective 9.2

Assess the key features of preferred shares.

Global Long-Term Rating Scale

Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk

Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk

A Obligations rated A are judged to be upper-medium grade and are subject to low credit risk

Baa Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as

such may possess certain speculative characteristics

Ba Obligations rated Ba are judged to be speculative and are subject to substantial credit risk

B Obligations rated B are considered speculative and are subject to high credit risk

Caa Obligations rated Caa are judged to be speculative of poor standing and are subject to very high

credit risk

Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some

prospect of recovery of principal and interest

C Obligations rated C are the lowest rated and are typically in default, with little prospect for

recovery of principal or interest

Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aaa through Caa The

modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a

mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category Additionally,

a “(hyb)” indicator is appended to all ratings of hybrid securities issued by banks, insurers, finance companies, and

securities firms.*

* By their terms, hybrid securities allow for the omission of scheduled dividends, interest, or principal payments, which can

potentially result in impairment if such an omission occurs Hybrid securities may also be subject to contractually allowable

write-downs of principal that could result in impairment Together with the hybrid indicator, the long-term obligation rating

assigned to a hybrid security is an expression of the relative credit risk associated with that security.

repay the initial investment of the preferred shareholders Instead, preferred shareholders receive a steady stream of dividends The dividend is specified at a predetermined rate, a percentage of the face value For example, if the preferred share is issued with a face value

of $40 and the dividend is specified as 6 percent of the face value, preferred shareholders can expect to receive $2.40 per share in dividends each year (i.e., $40 * 0.06) As with common shares, preferred share dividends are typically paid quarterly, so in this example the preferred shareholder would receive $0.60 every three months for each share owned.Preferred shareholders have different rights than common shareholders For example,

a firm must make dividend payments to preferred shareholders before paying any

divi-dends to common shareholders Many preferred shares also have a cumulative feature Here, if a firm is low on cash and can’t afford to make regularly scheduled preferred divi-dend payments, the dividends owed to preferred shareholders cumulate and must be paid before any further dividends can be paid to common shareholders In addition, in the event of bankruptcy and liquidation by a firm, all preferred shareholders receive any claims before common shareholders but after both secured and unsecured creditors (although in most bankruptcy-related liquidations, there is no money left for any equity holders).From a firm’s perspective, preferred shares are not as desirable as bonds because the firm is not able to deduct preferred dividend payments for tax purposes like it can for bond interest expenses As mentioned previously, preferred shares are generally the least common form of financing relative to bonds and common equity Preferred shares tend

to be issued by stable companies with expected steady cash flows, but they are also prevalent among private firms that have received funding from venture capitalists Fur-thermore, due to regulatory capital requirements, there tends to be a concentration of preferred shares in the banking industry

From a preferred shareholder’s perspective, there tends to be an inverse relationship between preferred share prices and interest rates, as we saw in Chapter 7 Just like bonds, as interest rates increase, the price of preferred shares tends to decrease, and vice versa How-ever, the relationship between preferred share prices and interest rates can become uncou-pled if a firm is experiencing financial distress and its long-term survivability is in ques-tion In this situation, the firm may be viewed as a high credit risk, so its preferred shares will decline in value regardless of the general level of interest rates in the overall economy

Objective 9.3

Assess the key features of

common shares, describe

historical returns of major

asset classes, and explain

the difference between

arithmetic and geometric

returns.

9.3 Common Shares

The third type of financial instrument we’ll consider is common shares or stocks The issuance of common shares represents a very different form of financing than bonds Common shareholders (or common equity holders) are the ultimate owners of a firm

They are often referred to as residual claimants because they have a claim on any of the

income earned by the firm only after other stakeholders—such as bondholders—have been paid (for example, after bondholders have received their interest payments) Com-mon shares are perpetual instruments, lasting as long as the firm itself lasts As with bonds, an active market has developed for trading common shares

Common shareholders benefit directly or indirectly through the earnings of a firm

If the firm has earnings available to common shareholders, it has two choices of what to

do with these earnings: It can either pay dividends to the common shareholders or retain the earnings to finance future projects and investments Typically, established firms have

dividend payout policies whereby a certain percentage of earnings, such as 30 percent,

is paid in dividends on average over a long period This is not to imply that firms strictly

cumulative feature: A feature

of preferred shares whereby any

missed dividend payments by

the firm are cumulated and paid

to preferred shareholders before

common shareholders receive

dividends

dividend payout: The amount

of dividends distributed to

shareholders

follow such a policy on a year-by-year basis, since earnings tend to fluctuate from year to

year Rather, we tend to observe that in the short run, firms stick to a stable dollar

divi-dend policy

For example, let’s suppose a firm had a target payout of 40 percent Let’s also suppose

that average earnings per share over the past three years were $5.00 The firm might

ini-tially pay out $2.00 per share per year for several years Then, a few years later, when

aver-age earnings per share have grown to, say, $6.00, the firm might increase its dividend to

$2.40, again in line with the 40 percent payout target Typically, dividends are paid on a

regular quarterly schedule However, in some cases, growing firms with frequent needs for

additional investments might elect not to pay out any dividends For instance, Microsoft

Corporation went public in 1986 but didn’t start paying dividends until 2003 Note that

although firms are obliged to make regular interest payments to bondholders, firms have

no contractual obligation to pay dividends to common shareholders on a regular basis

Still, as the ultimate owners of the firm, common shareholders do have rights One

of the major shareholder rights is the right to vote; this right highlights the collective

power that shareholders have over the firm Voting enables shareholders to elect a board

of directors to act in their best interest The mandate of the board of directors is to

ensure that management makes decisions that are consistent with maximizing the value

of common shares Thus, any action taken by the firm’s management team, including the

chief executive officer, must be justified to the board

It is also important to note that different countries engage in different practices

related to common shareholders and have different regulations governing shareholder

rights For example, in some countries, firms have more than one class of shares A

supe-rior class of shares is typically held by a founding individual or family, and multiple votes

may be associated with those shares A multiple class share structure like this allows the

individual or family to maintain control while still being able to raise capital through the

issuance of inferior voting shares This structure is not as common in the United States

as in other countries because some stock exchanges (including the New York Stock

Exchange) restrict dual class shares However, there have been some high profile cases of

dual class shares listed on the NASDAQ exchange, including Google and Facebook

9.3.1 historical returns

The return to investors from buying stocks varies considerably depending on the time

frame associated with the purchase and sale Figure 9.5 compares the average annual

return (including the reinvestment of dividends or interest payments) on a variety of

Fig 9.5

U.S Stock Returns, 30-Year Treasury Returns, 90-day T-Bill Returns, and Inflation, 1926–2012

compound returns mean returns volatility (geometric) (arithmetic) (standard deviation)

Source: The Center for Research in Security Prices database (CRSP)

note: Thirty-year treasury bond returns are since 1942

investments and the volatility (or standard deviation) of annual returns since 1926 Note that the figure looks at stocks of various sizes, long-term treasury (government) bonds, and short-term treasury bills (T-bills), as well as inflation.

As shown in Figure 9.5, returns may be measured either geometrically or cally Geometric returns compare the initial investment value with the final wealth

arithmeti-value in order to determine the rate of return over the intervening period The geometric

return over n periods is calculated as follows:

Geometric returnn = ainitial value bfinal value 1

1 2

- 1For example, if a nondividend paying stock was selling for $10 per share and three years later it was selling for $13, its geometric or average annual compound return is2:

a$13$10 b1

1 2

- 1 = 0.0914 = 9.14 percent

arithmetic returns, on the other hand, are the mean (or average) return across

each period (often a year) over n periods They are calculated using the following

Figure 9.6 compares the extent to which a dollar invested on December 31, 1925,

has grown over time if invested strictly in small stocks, large stocks, treasury bonds, or T-bills As we look at the 87-year span, we see the dramatic impact on wealth from investing in small stocks compared to other stock investments (Of course, there is no guarantee that that trend will continue in the future!) We also see the rather steady increase in the value of stock investments between the early 1940s and the late 1990s (as indicated on the chart by a fairly straight upward sloping line), but with flatter and bumpier performance since then We additionally see a clear superior performance of stock versus bond investments during the period from the early 1940s to the late 1990s Finally, we see how bond and T-bill investments have done somewhat better than infla-tion and stocks have done considerably better

geometric returns: A return

measure comparing initial wealth

and ending wealth and the rate at

which it grows

arithmetic returns: A return

measure that takes a simple

average of returns, summing

returns and dividing by the number

of observations

2 An alternative method of calculation is to use a spreadsheet such as Excel and insert into the “rate”

function the following information: Nper = 3, PMT = 0, PV = −10, FY = 13, or putting it all together, =

rate(3, 0, -10, 13).

Fig 9.6

Relative Wealth of One Dollar Invested on December 31, 1925; U.S Stock Returns (Small Stocks, Large Stocks, and All Stocks), 30-Year Treasury Returns, 90-Day T-Bill Returns, and Inflation, 1925–2012

note: Assumed initial investment is $1; 30-year treasury returns start in 1942 at 90-day T-bill wealth level

Source: The Center for Research in Security Prices database (CRSP)

Up to this point, we have examined the three major types of financial instruments or

securities: bonds, preferred shares, and common shares Now, we step back and examine

the overall markets in which these securities are issued and traded Most of our

discus-sion focuses on the preferred and common equity markets because these markets tend to

be more complex and garner more attention, and also because bonds still tend to be

traded predominately through investment banks that each hold their own inventory,

rather than through large organized exchanges

There are several reasons why a firm’s management needs to understand capital

markets First, from the firm’s perspective, the issuance of financial instruments may

seem like a one-time event; however, issuing bonds and shares is usually not a one-time

occurrence Most firms have ongoing financial needs, and even after a large bond

issu-ance, a firm may be presented with a new opportunity—such as the acquisition of a

competitor’s company—that requires additional long-term financing Second, because

active markets have developed for the trading of securities, management needs to

under-stand how these markets impact the firm’s constantly changing shareholder base Finally,

capital markets evolve over time, so management needs to be aware of any new methods

or new locations for issuing securities that may come available

Given their complexities and nuances, capital markets—and equity markets in

particular—can be segmented and described in countless ways Figure 9.7 presents

one such segmentation In the following sections, we will consider this segmentation

scheme in depth, and we will also describe the role of financial intermediaries

9.4.1 Private versus Public Markets

As mentioned earlier, capital markets can be segmented in a number of ways One

seg-mentation scheme is based on the method by which securities are issued Suppose a firm

wishes to raise capital via a bond issue In many cases, the easiest and quickest method firms can use to raise such capital is the private placement process A private placement involves the purchase of a large block of securities by a large institutional investor such

as a pension fund, an endowment fund, or an insurance company The process is very common with the issuance of debt securities but not with the issuance of equities Because private placement investors are deemed more sophisticated than other inves-tors, different regulations are involved in the security issuance process From the firm’s perspective, the private placement process is much quicker and less expensive than a public offering in terms of administrative and selling costs The private placement pro-cess does, however, place restrictions on institutional investors’ ability to resell the secu-rities they have purchased unless they are reselling to other large institutional investors Consequently, investors often demand a higher interest rate on bonds than would other-wise be charged

An alternative method for raising funds is a public offering In this process, ties are offered to both large institutional investors and smaller “retail” investors This is the most common process by which equities are issued This process often takes six months or more and is more expensive than private placement However, the result is typically a wider range of bondholders or stockholders In the case of stockholders, the breadth of ownership is often important because it determines who ultimately controls the firm

securi-9.4.2 venture capital and Private equity

Capital markets can also be segmented by the life cycle stage of the firm Initially, all firms are private At some point, firms may choose to become public companies (described in Section 9.4.3) Prior to this point, however, private firms often need capi-tal, just like public firms

When a firm is a very small start-up in need of capital, its riskiness may make it unable to borrow money In this situation, the firm may need to rely on the friends and family of the founding entrepreneur to provide much-needed cash Later, when the firm outgrows the ability of friends and family to supply capital, it may be able to secure

private placement: The sale of

securities to a selected group of

well-informed investors

public offering (public issue): The

sale of newly issued securities to

the public

Capital Markets

Domestic Cross-listing Organized

exchanges

Initial public offerings (IPOs)

Seasoned equity offerings (SEOs)

Rights offering

Shelf offering

Angel investors

Venture capital firms

counter

Over-the-Fig 9.7

Overview of Capital Markets

financing from angel investors who buy stakes in small private firms Angel investors

tend to invest locally and recognize the risk of investing in start-ups They do not expect

all of their investments to succeed, but they recognize that those investments that do

succeed may offer payouts of five to ten times the invested capital

When a firm reaches the next stage of growth or is unable to identify angel

inves-tors, it may turn to venture capitalists as a source of capital A venture capital firm is

organized as a limited partnership with a venture capitalist as the general partner and

various institutional investors—such as pension and endowment funds, as well as high

net worth individual investors—as limited partners The general partner runs the

busi-ness and typically receives a fee of about 2 percent of the fund’s capital and 20 percent or

more of any gains The general partner may also have expertise to offer to the firms in

which the partnership invests Venture capital is a form of private equity financing

pri-vate equity firms invest in venture capital, leveraged buyouts (which are discussed in

more detail in Chapter 11), and “distressed” firms that are experiencing financial

diffi-culties and are in need of a turnaround

Figure 9.8 shows the number of venture capital deals in the United States between

1995 and 2011, and Figure 9.9 indicates the dollar amount of these deals during the

same time period As shown, there has been a general upward trend in both the number

and amount of these deals with two notable exceptions First, venture capital deals and

funding peaked in 2000 at the height of the technology bubble Second, after resuming

an upward trend between 2004 and 2007, funding declined again in 2009 during the

recession that accompanied the financial crisis

9.4.3 initial offerings versus seasoned issues

In addition to the previous two schemes, capital markets can be segmented based on

the timing of securities issues For example, when a private firm makes its equity

available to the public in order to meet its need for equity capital, it undertakes a

pro-cess known as an initial public offering (IpO) “Going public” in this way is a major

step in the life of a firm because the initial owners of the firm are now effectively

sharing the ownership with a much larger group of shareholders Typically, IPOs

involve raising new capital by issuing new shares, but they may also involve selling

the shares of existing shareholders (in which case the money goes to the selling

shareholders)

angel investor: An investor who

buy stakes in small private firms

venture capital firm: An investment

firm that invests shareholders’ money in private start-up firms with high growth potential

private equity firm: An investment

firm that invests shareholders’ money in private firms, including those with high growth potential, leveraged buyouts, and distressed firms

initial public offering (iPo): The

initial sale of stock of a firm to the public

case stuDy

In August 2012, Sesac Inc., a privately held Nashville-based firm that acts as a man between music companies, songwriters, and music broadcasters, announced plans for a unique private placement of $300 million of bonds The firm had exclusive rights to the public broadcast of the music of Bob Dylan, Neil Diamond, Canadian rock band Rush, and others The bonds were being issued as a Rule 144a private placement, a rule

middle-administered by the SEC that allowed certain “qualified institutional buyers” deemed to

be large and sophisticated to trade with other such investors without having to register with the SEC Such issues were not offered to the general public The collateral for the five-year bond was the revenue that Sesac was to receive from the music rights.

Private Placement

example—sesac

inc and the Music of

Bob Dylan and Neil

Diamond

Source: L Moyer and A Yoon, “The Bonds, They Are A-Changin’,” Wall Street Journal, August 6, 2012

Fig 9.8

Number of Venture Capital

Deals in the United States,

6,000 7,000

5,000 4,000 3,000 2,000 1,000 0

Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report based on data

from Thomson Reuters

There are many advantages to going public First, the firm is able to raise capital in

order to make investments that can help it grow, and it has the ability to make

acquisi-tions using existing stock In addition, the initial owners have a much more liquid

mar-ket in which to sell their stake in the firm, usually at a much higher per-share price than

if the company were still private Beyond that, management is able to improve recruiting

by offering stock options and stock-related incentives to key employees Finally, there is

an overall increased public awareness of the firm

There are also a number of disadvantages to going public Because shares are more

dispersed, management must work with a more diverse group of stakeholders, including

institutional and retail investors The firm is more accountable to this larger group of

stakeholders and faces more rigorous disclosure of its financial situation, and this

disclo-sure requirement has both monetary and time costs Finally, management needs to be

more active in managing shareholder expectations and dealing with some investors who

have a short-term focus on profitability rather than long-term growth

The IPO process begins with approval by the firm’s board of directors, followed by

selection of a lead underwriter or investment bank to assist in structuring, pricing, and

distributing the IPO The underwriter is involved in conducting due diligence to ensure

that everything indicated in the prospectus is accurate The prospectus is a regulatory

document filed with the SEC that describes the details of the IPO and is meant to help

investors make informed decisions Once a preliminary prospectus is drafted and filed,

the firm applies for a stock exchange listing Then, the underwriter and senior

manage-ment conduct a “road show” by meeting with potential investors, explaining the purpose

of the IPO, and outlining the potential benefits to investors Throughout this process,

the underwriter “builds the book” that describes the number of shares potential

inves-tors desire and the price they are willing to pay This process allows the underwriter to

recommend a price and offering size Finally, just before the offering date, the IPO price

is determined and indicated in the final prospectus prospectus: A regulatory document

filed with authorities, such as the SEC, that describes the details of

a security offering in order to help investors make informed decisions

In Depth

The Sarbanes-Oxley Act (known as SOX) is a federal law passed in 2002 in the wake of numerous corporate scandals, including those at Enron, WorldCom, and Tyco International The law set new standards of accountability for public companies It included rules requir- ing more independent auditors, increased corporate responsibility, enhanced financial dis- closures, and increased white-collar crime penalties Senior management was also required

to certify the accuracy of a firm’s financial information In addition, Section 404 of the act mandated that firms establish internal controls and report on the scope and adequacy of these controls, and it required senior managers and boards to be comfortable enough with the firm’s processes and monitoring to attest to their effectiveness This section received considerable attention because of the cost associated with its implementation, which was severely underestimated when the law was enacted Prior to SOX, experts estimated that audit fees for small firms (i.e., those with market capitalization less than $75 million) were equal to 0.64 percent of revenues After SOX became law, this figure jumped to 1.14 percent—or nearly double the previous level 3 Thus, many listed public firms chose to

“go dark” and become private companies rather than face the steep costs of compliance.

SOX and the Cost of

Being a Public Firm

3 See http://www.rand.org/pubs/research_briefs/RB9295/index1.html (accessed February 4, 2013).

The cost for issuing stock is not cheap In the United States, for issues less than

$500 million, the typical fee paid to underwriters is 7 percent of the amount of stock raised As this amount gets larger, underwriting costs might decline to around 3 percent (Given its prestige at the time of its IPO, Facebook was a rare exception with even lower fees—just over 1 percent.)

There are a number of methods by which shares may be distributed The most mon method is a “firm commitment,” whereby the underwriter guarantees the sale of all stock at the offer price Another method sometimes used in smaller IPOs is “best efforts,” whereby the underwriter doesn’t guarantee a particular price but attempts to get the highest price possible given current market conditions A third method is the auc-tion process, with Google as the best known example

2001, its leadership felt there was no need for a traditional underwriter, which typically costs 3 to 7 percent of the amount of funds raised There was also concern that firms tend to “leave money on the table” by underpricing IPOs, giving investors strong first-day returns to the firms’ detriment (because if the IPO had been priced higher, it could have raised the same amount of money with fewer shares issued and less loss of control) Google thus felt the auction process would result in lower overall costs and less “under- pricing” of the firm’s stock Even with the auction process, however, Google’s stock price rose 18 percent on its first day on the market, and by late 2007 Google was selling for over $700 a share By late 2008, its share price dropped below $300, but it later recov- ered to over $600 by early 2010, and by the spring of 2013 it was selling for over $800 Unlike Google, Facebook chose to use the traditional underwriting process when it went public in May 2012, raising $16 billion During its road show, underwriters increased the planned offer price range from $28 to $35 to a range of $34 to $38 Then, just prior to the IPO issue, Facebook decided to offer 25 percent more shares than originally planned

at the high-end price of $38 On their first day on the market, the firm’s shares opened at

$42 but promptly fell, ending the day at $38.23 Technical glitches in the NASDAQ system hampered trading, and the exchange apologized to customers who were not able to sell shares at posted prices, offering $40 million in compensation Shortly after the IPO, it was also revealed that several investment banks had told their major clients that they were reducing their forecasted earnings for Facebook By early June, share prices had fallen below $26 before recovering somewhat In August 2013 shares finally traded above the IPO price.

google and

Facebook iPos

Sources: Benjamin Edelman and Thomas R Eisenmann, “Google Inc.,” Harvard Business School

case study, 2010; Shayndi Raice, Anupreeta Das, and Gina Chon, “Inside Fumbled Facebook

Offering,” Wall Street Journal, May 23, 2012

As we see in Figure 9.10, IPOs tend to occur in waves of hot and cold markets Hot

markets with a high number of IPOs are often concentrated in certain industries For

example, in the mid-1990s, a vast number of IPOs were in the technology industry

Researchers have made several empirical observations—known as stylized facts—

related to investors’ IPO returns First, investors who receive shares as part of an IPO

tend to experience high returns on the first day of ownership Figure 9.11 shows

first-day IPO returns over time As you can see, negative average first-first-day returns have

occurred in only two of the past fifty years, and returns peaked at 70 percent during the

technology stock craze of the late 1990s Second, as Figure 9.12 shows, large first-day

returns are a worldwide phenomenon, and U.S first-day returns of just under 17 percent fall in the middle of the pack Finally, over the first three to five years following their issuance, IPOs tend to underperform relative to the market

In comparison, if a firm that is already public decides to issue additional common shares, the process is known as a seasoned equity offering (SeO) The SEO process is similar to the IPO process except there is already an established market price for the shares Unlike an IPO, a seasoned offering is a much less dramatic step for the firm How-ever, depending on its size relative to the number of existing shares, an SEO can affect the existing common share price Specifically, after the SEO, there will be more common shares outstanding If the firm is not able to utilize its new funds in a way that creates addi-tional profits and sufficient value for its common shareholders, then existing shareholders will find their claim on the firm’s profits has been diluted, and the share price will decline

In fact, one stylized fact noted by researchers is that stock prices tend to decrease upon the announcement of an SEO Thus, a firm must clearly articulate its reasons for issuing addi-tional shares and must indicate how the issuance will add value in the long term

Seasoned offerings may be available to the general public or offered to institutional investors through a private placement To facilitate quicker and more cost-efficient issu-ance of shares, a firm may file in advance for a shelf offering that allows it to issue more shares at a future date without issuing a new prospectus Also, to help protect existing shareholders against possible ownership dilution, a firm may issue a rights offer, which

is a new share offer only available to existing shareholders Although not very common

in the United States, rights offerings are common in other countries, including the United Kingdom

seasoned equity offering (seo):

The additional sale of equity

securities to the public by an

already-public firm

shelf offering: A regulatory

provision that allows a firm to issue

more shares at a future date without

issuing a new prospectus

rights offer: A type of seasoned

equity offering whereby shares are

offered only to existing shareholders

Large firms, particularly multinationals, may raise capital outside of their domestic

markets by cross-listing their shares on other exchanges (although cross-listing may

also take place without raising capital) For example, non-U.S firms may list on U.S

exchanges through American Depositary Receipts (ADRs), which are negotiable

cer-tificates issued by certain U.S commercial banks that represent an equivalent amount of

the foreign securities These firms may also raise capital through an SEO at the time of

cross-listing, or the cross-listing might be part of an IPO Firms tend to cross-list in

hopes of reducing their cost of capital or broadening their shareholder base, or as part of

planning for a merger or acquisition

Traditionally, organized exchanges have played a dominant role in the trading of

securi-ties However, organized equity or stock exchanges are much more prevalent than

organ-ized bond exchanges because bond trading tends to take place primarily among large

institutional investors One of the largest organized equity exchange operators is NYSE

Euronext, a holding company that combined the NYSE Group, Inc (including the New

York Stock Exchange) with the Dutch company Euronext N.V in 2007 NYSE Euronext

securities represent about one-third of the world’s equity trading Until the New York

Stock Exchange (NYSE) became a public company in 2006 and facilitated electronic

trading, NYSE membership was limited to those who purchased one of 1,366 “seats” on

the exchange Trading included face-to-face interactions on the exchange floor, with

specialists making markets for particular securities by matching buy and sell orders to

determine prices and ensuring that an orderly market transpired

The other large global equity exchange operator is NASDAQ OMX Group In 2007,

the National Association of Security Dealers Automated Quotation (NASDAQ) acquired

OMX, which dated back to various mergers of European exchanges, primarily in

Swe-den, Denmark, and Finland NASDAQ OMX has the most listed companies globally and

the most share value traded In contrast to the NYSE’s origins, NASDAQ originated in

1971 as an over-the-counter (OTC) market Instead of having one specialist in a

partic-ular location setting the price for a stock, an OTC market allows for greater participation

among a larger number of brokers who are prepared to make a market for a stock Most

bond markets are OTC From its beginnings as an OTC market, the NASDAQ system

grew to challenge the traditional dominance of the NYSE

On organized exchanges such as the NYSE or NASDAQ, firms must first apply to

have their stock listed There are strict listing requirements based on a firm’s size and

financial performance track record, including number of shares, market capitalization,

and earnings history In years past, a NYSE listing meant prestige, and most firms strived

to meet the qualifications for such a listing; consequently, more U.S trading volume

occurs on the NYSE than the NASDAQ However, some of the best-known firms in the

world—particularly in the technology sector—have chosen to list on NASDAQ rather

than the NYSE, including Google, Facebook, and Microsoft, although part of their

rea-son for doing so was probably that many other technology-related firms were already

listed on NASDAQ

9.4.5 Role of Intermediaries

Traditionally, financial intermediaries have played an important role related to the

issu-ance and trading of securities Financial intermediaries include the exchanges discussed

in the previous section, as well as investment banks such as Bank of America, Citigroup,

Goldman Sachs, JPMorgan Chase, and Morgan Stanley These intermediaries attempt to

facilitate the buying and selling process, first between corporations and investors, and

cross-listing: The process by which

a firm lists its shares on a foreign stock exchange

over-the-counter: A market for

stocks that is decentralized and not

financial intermediaries: Stock

exchanges, investment banks, or investment dealers that attempt

to facilitate the buying and selling

of securities, first between firms and investors and second among investors

second among investors For example, investment bankers have traditionally played a critical role in the IPO process They provide advice related to the appropriateness and timing of an IPO, and they determine an appropriate share price to be offered Then, they facilitate the issuing or underwriting process whereby the securities are actually sold to the public, often assuming the risk in the offer by buying the securities from the firm at a preset price and reselling them to the public at a (hopefully) higher price.The role of intermediaries is rapidly changing as the Internet provides more direct access to capital markets Firms are increasingly considering initial public offerings and seasoned equity offerings over the Internet For example, in 1999, investment banking firm W.R Hambrecht and Company created OpenIPO as an online auction process for IPOs and seasoned equity offerings OpenIPO has facilitated numerous offerings, includ-ing those of notable firms such as Google and Morningstar Trading by individuals—who have access to more information and low-cost online trading options than ever before—

is rapidly changing the role of intermediaries who must constantly assess how they can add value for their clients

Objective 9.5

Explain the concept of

market efficiency and

describe the various forms

of the efficient market

hypothesis.

Market efficiency is an important way of thinking about and comparing the prices for

securities in various types of markets, such as the bond market or the stock market ing to the efficient market hypothesis (EMH)4, a market is said to be efficient if prices fully and immediately reflect all relevant information In other words, a market is efficient if the price paid for a security is the true price reflecting the intrinsic value of that security.The concept of market efficiency is critical to both firms and investors In Chapter 1,

Accord-we said a key objective of any firm is to maximize shareholder value, using the current stock price as a measure of shareholder wealth If markets are efficient, this implies that the stock price should rise if the firm makes good decisions and fall if the firm makes bad deci-sions But if markets aren’t efficient and prices don’t reflect intrinsic values, then there won’t be a relationship between stock prices and the objective of maximizing shareholder value In addition, from a firm’s perspective, market efficiency has implications related to the timing of the issuance of securities For example, if markets are not efficient and if management deems that a firm’s stock is overvalued, then it might be a good time to issue equity if the firm is in need of capital From the investor’s perspective, efficiency has impli-cations for overall investment strategies For instance, it helps the investor determine whether to be passive and buy an index fund or actively trade in individual securities.Although the notion of market efficiency is fairly straightforward, it is important to note that market efficiency is not a statement of fact but rather a hypothesis put forward

to describe a particular market, such as the U.S stock market in general Because we can never know the true price or intrinsic value of a security, we can never know with cer-tainty whether a market is efficient The challenge faced by countless academic research-ers has been to develop empirical tests that yield results consistent or inconsistent with the notion of market efficiency without providing definitive proof

Researchers have developed three categories of hypotheses and tests related to

mar-ket efficiency: weak form, semistrong form, and strong form The words weak, trong, and strong are not meant to imply that one category is better than another; rather,

semis-each form relates to how we define relevant information

underwriting: The process, initiated

by investment banks, of marketing

new security issues to the public

market efficiency: The degree to

which a security market is deemed

to reflect all relevant information

efficient market hypothesis

(EMH), weak form, semistrong

form, strong form: An investment

theory that states that prices fully

and immediately reflect all relevant

information The weak form defines

relevant information as all historical

price information; the semistrong

form defines relevant information

as all public information; and

the strong form defines relevant

information as all forms of

information including private

information

4 In October 2013, University of Chicago finance professor Eugene Fama was announced as a ent of the Nobel Prize in Economics for his work in defining and testing the concept of market efficiency.

co-recipi-9.5.1 weak Form

The weak form of the efficient market hypothesis (EMH) states that market prices fully

and immediately reflect all historical price (and trading volume) information If the

weak form of the EMH is deemed to be true—or more precisely, if the hypothesis is not

rejected based on empirical tests—then this implies that the current price of a security

already incorporates information regarding historical prices and volume Thus, knowing

the pattern of stock prices (for example, whether the current price is much lower or

higher than the price one year ago) does not provide any insight about the future stock

price In other words, if the weak form is true, then technical analysis—or examining

patterns and trends in historical stock prices—is not a fruitful investment strategy

Many tests that attempt to evaluate the weak form by replicating technical analysis

strategies have failed to uncover reliable methods for outperforming the market over a

long period of time However, more recent studies have uncovered some viable strategies

related to momentum investing (i.e., buying stocks that have done particularly well over

the last six months or so and holding them for the next six months)

The semistrong form of the EMH states that prices fully and immediately reflect all

public information If the semistrong form is deemed to be true based on empirical tests,

then this implies that trading based on publicly available information in annual reports,

in the newspaper, or on the Internet—known as fundamental analysis of a company—is

not a viable investment strategy (Fundamental analysis often refers to a top-down

approach of investigating the economic outlook, the industry prospects, and the

firm-level analysis of growth and risk in order to estimate an intrinsic value of a firm compared

to its actual selling price.) In other words, if the publically available information is

rele-vant, then it should be incorporated into the stock price immediately, not through a

gradual process

Semistrong form tests have focused on the immediacy of market reaction to events that

provide new public information These event studies have examined good-news

announce-ments, such as an increase in dividends, and have found support related to the quickness

with which this information is incorporated into the stock price Figure 9.13 shows

technical analysis: A method of

evaluating the worth of securities based on examining patterns and trends in historical prices

fundamental analysis: A method

of evaluating the worth of securities based on publicly available information such as news stories and annual reports

event study: A research

methodology for analyzing the impact of certain types of events, such as the announcement of dividend increases on security prices

hypothetical results for event studies The vertical axis shows a price index The horizontal axis shows days relative to the event on day 0, such as an announcement of a proposed acquisition If the price index follows the solid line, with a spike in prices on the day of the announcement, then the test result is consistent with semistrong market efficiency In con-trast, if the price index follows the dotted line with a more gradual price increase after the announcement, then the result is not consistent with semistrong market efficiency.

9.5.3 strong Form

The strong form of the EMH states that prices fully and immediately reflect all tion, both public and private If the strong form is deemed to be true, then this implies that insiders—senior management, the board of directors, and anyone with private information about a firm—would not be able to benefit from their knowledge In other words, if a member of the board of a firm had private and nonpublic information about the firm—say, some pending good news about a new product development—and bought shares of stock before the information became public, the strong form of the efficient market hypothesis suggests the individual would not be able to earn excess profits (com-pared to noninsiders) on the stock purchase

informa-Studies on the strong form have focused on the ability of insiders to capitalize on their ability to buy shares in their company prior to a rise in the stock price and sell prior

to a decline Not surprisingly, these studies have refuted the notion of strong form EMH

In other words, insiders do appear to have the ability to develop superior investment strategies and earn excess profits

9.5.4 U.s stock Market efficiency

Empirical tests have focused on U.S stock markets in particular, and they have provided mixed results These studies appear to suggest that U.S stock markets are generally efficient (but certainly not in the strong form); however, there may be pockets of ineffi-ciency whereby investors may be able to profit It should be emphasized that these stud-ies are never free from controversy, given the challenges of empirical research and the lack of one agreed-on model related to the determination of stock prices If stock mar-kets are truly efficient, then managers should be less concerned with the timing of the issuance of securities, and investors should be less concerned with trying to pick one or two winning stocks than simply investing in a passive index fund strategy In other words, investors should focus on buying a well-diversified portfolio of stocks and hold-ing them for a long period of time

objective 9.6

Explain why understanding

capital markets and

long-term financing instruments

is relevant for managers.

9.6 relevance for Managers

Very few firms can exist in a vacuum without external sources of funds As such, it is critical for managers to understand the nuances associated with financial instruments such as bonds, preferred shares, and common stocks, as well as the markets in which they trade In fact, most firms need to access capital markets on a regular basis, particu-larly if they are growing or if they wish to acquire other firms and need to finance these purchases Managers must appreciate the perspective of the firm’s lenders and investors and understand the trading environment, recognizing that their shareholder base is con-stantly changing In addition, managers need to keep abreast of the evolution of capital markets, including new trading venues

Managers should also appreciate the concept of market efficiency For many of us,

when it comes to our own firm’s stock price, we often feel like comedian Rodney

Dan-gerfield: “I don’t get no respect!” In other words, we often feel that the market doesn’t

appreciate the true value of our stock and that it is constantly undervalued (After all,

how often do you hear of CEOs who are kept awake at night worrying about their

over-valued stock?) Although it is true that on some occasions, stocks may be underover-valued—

or in the case of technology stocks in the late 1990s, overvalued—it is generally

reason-able to assume that markets are somewhat efficient and stock is being fairly valued

1. A firm raises long-term financing by issuing

securities such as bonds, common shares, or

preferred shares

2. Bonds are usually issued at face value and pay

interest or coupons every six months The principal

amount is also repaid on the maturity date The type

of features associated with bonds often distinguishes

them from one another

3. The credit risk of bonds is assessed by various

bond-rating agencies Ratings typically range from

AAA (most creditworthy) to C (least

creditwor-thy) Bonds rated BBB and above are said to be

investment grade, whereas bonds rated BB and

below are referred to as speculative, high-yield,

or junk bonds

4. Common shareholders are the residual claimants of

any earnings after other stakeholders, such as

bondholders, have been satisfied Common

shareholders are collectively the owners of the

firm Any earnings available to common

share-holders are either paid out as common dividends

or retained in the business in order to generate

future profits

5. Preferred shares represent a hybrid security with some features of both bonds and common stocks Preferred shares pay regular dividends, but the dividends are not tax deductible from the firm’s perspective Typical preferred shares have no maturity and, consequently,

no principal repayment Preferred shareholders must typically receive their dividends before any dividends are paid to common shareholders

6. Historically, stocks have outperformed bonds but have exhibited more volatility Small stocks have outperformed large stocks Both stocks and bonds have provided positive real returns over the long run

7. Capital markets represent the markets in which securities are issued and traded Markets can be distinguished by the method of issue, either to private investors such as pension funds and insurance compa-nies or to the public at large Most stocks are traded on organized exchanges and most bonds are not Interme-diaries such as investment banks play an important role

in facilitating the buying and selling process

8. Markets are said to be efficient if the prices of securities fully and immediately reflect all relevant information

summary

a useful overall investments book is: Bodie, Zvi, Alex Kane, and Alan

Marcus Essentials of Investments, 8th ed New York: McGraw-Hill Ryerson,

2010

an interesting book focusing on bonds and fixed income securities is: Fabozzi,

Frank Bond Markets: Analysis and Strategies, 7th ed Englewood Cliffs, NJ:

Prentice Hall, 2009

a classic investment book with an efficient market perspective is: Malkiel, Burton

A Random Walk Down Wall Street, 10th ed New York: W W Norton, 2010.

aDDitiOnaL reaDings anD inFOrmatiOn

1. All things being equal, would you expect to receive a

higher or lower interest payment if a bond had a

sinking fund?

2. All things being equal, would you expect to receive a

higher or lower interest payment if a bond had a call

provision?

3. Twice Lucky, Inc was planning a 10-year bond issue

with a 6% coupon rate Just prior to the issue, a

major credit rating agency announced a surprise

upgrade in its rating How might this announcement

impact the planned bond issue? Explain

4. What is the average annual compound (geometric)

return over two years for a stock that goes from $10

to $20, then back to $10?

5. What is the average arithmetic return over two years

for a stock that goes from $10 to $20, then back to $10?

6. Historical U.S market returns tend to approximately

follow a normal distribution, which implies that

returns are plus or minus one standard deviation

from the mean (arithmetic return) two-thirds of the

time and are plus or minus two standard deviations

from the mean 95% of the time Based on the

information in Figure 9.5 and focusing on the mean

returns for “all stocks,” what is the range of returns

that are one standard deviation from the mean?

7. Based on the information in Figure 9.5 and focusing on

mean returns for “all stocks,” what is the range of returns

that are two standard deviations from the mean?

8. What factors would impact the price of preferred

1, 2024; price = $103.42; yield = 5.94 percent

10. On the basis of the following stock information, describe the features of the stock and assess its performance: dividends per share = $0.80, current share price = $28.50, current dividend yield = 2.8 percent, current P/E multiple = 24.5, share price one year ago = $24.00, and market total return over the past year = 16.5 percent

11. What type of investor is most likely to purchase a private placement?

12. Given the “stylized facts” related to IPO performance,

if you were able to obtain IPO shares at the issue price, when might be the best time to sell the shares: after the first day of trading or three-to-five years later?

13. If research employs an event study, what form of the efficient market hypothesis is it most likely testing?

14. Suppose an investor uncovers a strategy by which she

or he is able to predict future stock prices by ing trends in past prices What form of the efficient market hypothesis would this be evidence against?

observ-15. Suppose a firm is involved in major litigation and is expected to lose its case, which would cost the firm millions of dollars Surprisingly the firm wins the case and immediately the stock price jumps Is the observa-tion of the price increase consistent with the semi-strong form of the efficient market hypothesis? Explain

prObLems

Some important studies of market efficiency can be found in: Fama, Eugene

“Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of

Finance 25 (1970): 383–417.

Fama, Eugene “Market Efficiency, Long-Term Returns, and Behavioral Finance.”

Journal of Financial Economics 49 (1998): 283–306.

In order to assist you in understanding more about the workings of capital markets, let’s

examine bonds and stocks from the perspective of the investor rather than the firm

Whereas the firm is concerned with raising a particular amount of capital at one

particu-lar time, the investor is concerned with the day-to-day value of the investment

Informa-tion regarding the value of securities is available from a variety of sources, as described

in the following sections

Bond information

Given the predominance of large institutional bondholders (versus smaller retail

inves-tors), much less financial information is readily available about corporate bonds than

stocks Nevertheless, an example of corporate bond information is presented in

Figure a9.1 In this example, Home Depot issued $1 billion worth of these bonds in late

March 2011 The 30-year bond matures on April 1, 2041 Based on a face value of $100,

annual coupon payments are $5.95, or $2.975 every six months The current price of this

bond is $131.50 Since most (but not all) bonds are issued at a price near the face or par

value, we can surmise that when the bond was initially issued, interest rates were at a

higher level than they are currently—because as rates have declined, the bond price has

increased It may also have been the case that Home Depot was viewed as a higher credit

risk at issue compared to the current quote

Note that the bond represents a promise of fixed payments Because interest rates

have fallen, this bond with fixed annual coupon payments looks more attractive than a

similar (in terms of creditworthiness) bond issued today with lower annual coupon

payments This is why the bond price is more than $100 The bond yield essentially

indicates the coupon rate that would be attached to a similar bond if it were issued at

par today Given that the Home Depot bond is selling for $131.50, it turns out that

buying this bond for that price is just like paying $100 for a bond that pays a coupon

rate of 4.08 percent, which is also the yield to maturity of the bond, as discussed in

Chapter 7

stock information

The most common source of stock information is the Internet An example of Home

Depot stock information is presented in Figure a9.2 The figure examines information

from a variety of sources, including Yahoo!Finance, Morningstar, Bloomberg, and NYSE

(the stock exchange on which Home Depot is listed) Note that the different sources

include different types of information, and there may be some slight discrepancies in

terms of different measures (for example, trading volume)

As you can see in the figure, the first section of information focuses on price

Price information is important because it is an indication of the market value of the

firm’s stock (Valuation is discussed in more detail in Chapter 13.) While the stock

appenDix: unDerstanDing bOnD anD stOck investment inFOrmatiOn

Fig a9.1

Home Depot Bond Information

Issuer amount coupon % maturity price Yield

Home Depot $1,000 mil 5.95 April 1/41 131.50 4.08

June 29, 2012

Source: Morningstar.com

exchange is open and trading is occurring, the current price is updated throughout the day Assuming the information in the figure is from today, we see that the change in the price (as well as the percentage change) is given relative to yesterday’s closing price (indicated in the figure as “previous close”), and yesterday’s closing price is indicated along with today’s opening price During the day, the bid and ask prices are updated—the

Ask $ 51.67 51.671-year target est $ 55.39

Day’s range $ 51.38–52.61 51.38–52.61 51.38–52.61 51.38–52.6152-week range $ 28.13–53.28 28.13–53.28 28.13–53.28 28.13–53.2852-week high date 20-Jun-1252-week low date 09-Aug-11Volume 8,399,954 8,900,000 9,939,011 9,939,011Average volume (3m) 11,976,200 11,500,000 11,976,200

Dividend amount $ 1.16 1.16 1.16 1.16Dividend yield 2.24% 2.24% 2.24% 2.24%EPS $ (ttm) 2.65 2.65 2.65Next earnings date 14-Aug-12 16-Aug- 12

Shares outstanding mil 1,531 1,531Enterprise value $mil (ttm) 87,570 86,799

Market cap $mil 79,090 79,000 79,089 79,089l-year return 46.12%

Beta coefficient 1.03 0.79P/E (ttm) 19.50 19.7 19.81 19.72Forward P/E 15.57 15.3

P/B (ttm) 4.45 4.4 4.4023P/S (ttm) 1.12 1.1 1.1157P/CF (ttm) 11.4

Operating margin % (ttm) 9.74 9.7ROE (ttm) 22.7 22.7ROA (ttm) 10.1 9.54Debt/equity 0.6EV/EBITDA (ttm) 10.16

note: ttm = trailing twelve months

Source: finance.yahoo.com, morningstar.com, Bloomberg.com, nyse.com (accessed July 11, 2012)

“bid” indicates the price at which a market maker is willing to buy a certain quantity of

shares, whereas the “ask” is the price at which the market maker is willing to sell A

one-year target estimate is the price at which analysts expect the stock to be selling one one-year

from now Stock price trading ranges are presented for both today and the past 52 weeks

The second section of the figure indicates the trading volume (number of shares)

for today The average daily trading volume over the past three months is also indicated

Trading volume indicates the amount of liquidity for the stock

The third section presents information related to dividends, earnings, and shares

outstanding The dividend amount of $1.16 represents the annual anticipated dividend

based on the most recent quarterly dividend:

Quarterly dividend: $0.29

Times number of quarters: 4

Equals annual dividend: $1.16

The dividend yield of 2.24 percent is the annual dividend divided by today’s price:

Divided by today’s price: $51.65

Equals dividend yield: 2.24%

Earnings per share (EPS) of $2.65 are the total earnings of Home Depot divided by

the number of shares outstanding:

Total earnings last 4 quarters (millions): $4,057

Divided by number of shares (millions): 1,531

Equals earnings per share (EPS): $2.65

Firms tend to release information about quarterly earnings on a regular basis; thus,

Yahoo!Finance and Bloomberg have separate estimates (differing by a couple of days) as

to when the next quarterly earnings will be reported

In the fourth section of Figure A9.2, enterprise value is the market value of the

entire firm, including the value of both equity and debt, or the value of the firm’s assets

Market capitalization (or “market cap” for short) is the value of the equity of the firm and

is the current share price multiplied by the amount of shares outstanding The one-year

return is the return to an investor who bought the stock one year previous and

repre-sents the capital gain (in the case of a price increase) or capital loss (in the case of a price

decrease) plus any dividends received

The beta coefficient is an estimate of the volatility of the stock relative to the

volatil-ity of the stock market as a whole (such as the S&P 500) By definition, the market has a

beta of 1.00 There is no single method by which to estimate beta (which is why

esti-mates may vary across information sources), but it is often estimated by examining

his-torical information The NYSE estimate of 0.79 for Home Depot implies that as the stock

market as a whole goes up (or down) by 1 percent, then we would expect Home Depot’s

stock price to go up (or down) by 0.79 percent

The last section of the figure presents information about various financial ratios,

some of which were discussed in Chapter 4, including the operating margin, return on

equity (ROE), return on assets (ROA), and the debt-to-equity ratio Other valuation

metrics (which will be discussed further in Chapter 13) include the price-earnings (P/E)

ratio, price-to-book (P/B) ratio, price-to-sales (P/S) ratio, price-to-cash flow (P/CF)

ratio, and enterprise value (EV)-to-EBITDA

Describe various ways

to interpret the cost of

Explain how to estimate

the cost of debt.

Obj 10.5

Explain how to estimate

the cost of preferred

shares.

Obj 10.6

Explain how to estimate

the cost of equity using the

dividend model approach

and the capital asset

pricing model approach.

Obj 10.7

Explain how to estimate

the component weights

when estimating the cost

of capital.

Obj 10.8

Describe the process for

estimating Home Depot’s

cost of capital.

Obj 10.9

Explain what a hurdle rate

is and how it is used.

Obj 10.10

Explain why assessing the

cost of capital is relevant

for managers.

This chapter is the second of three examining the various aspects of a firm’s long-term financing needs Chapter 9 provided an overview of financial instruments such as bonds, preferred shares, and common shares

In this chapter, we’ll focus on the explicit cost—from the firm’s tive—associated with issuing each type of instrument Later, in Chapter 11,

perspec-we will examine the trade-offs a firm faces when issuing debt versus equity

The average cost of raising funds is known as the cost of capital The cost of capital is a key driver of the overall value of a firm If a firm is able to lower its cost of capital, then all of its potential investments appear more attractive From a different perspective, the cost of capital reflects what inves-tors (and lenders) require A simple example of the cost of capital is presented

at the beginning of this chapter, followed by a more detailed discussion of cost of capital implications We then define risk and focus on the components

of the cost of capital and the weights attributable to each component These sections highlight the risk (from the perspective of the buyer) associated with each component or financial instrument Next, we make the connection between the measure of the cost of capital and hurdle rates used by a firm’s management to assess the viability of projects An actual example of the cost

of capital calculation is then presented using information from Home Depot Finally, the chapter concludes with a discussion of the relevance of these con-cepts to managers

The cost of capital is a key element of our financial management

framework and the unifying theme of this book, presented in Figure 10.1

Note that the three decision-making areas within the firm—operating, investing, and financing—all involve some element of risk For example, business risk affects a firm’s ability to make profits from its operations Similarly, any investment decisions are impacted by the riskiness of the par-ticular type of investment, whether a simple capital expenditure to replace a piece of equipment or the expansion of business into a new market Most importantly, financial risk is inherent in the mix of debt and equity within a firm, as captured by the financial leverage measure Thus, the cost of capital reflects the cost of raising funds as well as the overall perceived riskiness of the firm

Learning

Objectives

Assessing the Cost of Capital: What Return Investors Require10

Fig 10.1

Financial Management Framework: Cost of Capital

risk

Managing the risk profile Cost of capital

the enterprise

operating

Profit Margin

investing

Asset Turnover

financing

Financial Leverage

To better understand what the cost of capital entails, let’s start with a simple example

Suppose an individual wants to start a new company and has identified the need for a

$1 million capital outlay After much deliberation, our entrepreneur determines that

funds can be raised from three sources, in the following amounts: $200,000 through the

issuance of a bond (debt financing), $100,000 through the issuance of preferred shares,

and $700,000 through the issuance of common shares

To determine the cost of each source of financing, our entrepreneur must think of

the terms cost and return interchangeably, or as different sides of the same coin This is

because cost to the firm can also be interpreted as return from a potential investor’s (or

lender’s) perspective Instead of considering costs, investors consider their potential

return when choosing investments So, to measure the cost to the firm of raising funds,

our entrepreneur can examine the required return that would entice potential investors

to buy the firm’s newly issued bonds (or debt), preferred shares, and common equity (or

stocks) The general relationships between costs and returns for all three types of

finan-cial instruments are outlined in Figure 10.2.

However, there is one wrinkle with this approach, caused by corporate taxes:

Inter-est expenses reduce the amount of taxes payable by a firm Thus, in the case of bonds (or

debt issued by the firm), we must further distinguish between the firm’s cost and the

investors’ required return From the firm’s perspective, in terms of the cost of debt, what

really matters is the after-tax cost.

cost of capital (weighted-average cost of capital or Wacc): The

weighted average of the cost to a firm of all the forms of long-term financing, including debt, preferred shares, and common shares

To illustrate, suppose our entrepreneur determines that the firm can issue a bond that pays interest at a rate of 5 percent, which is the return required by bond investors Because the debt interest payments are a tax-deductible expense for the firm, and

because the firm anticipates a tax rate of 35 percent, the effective after-tax cost of this

debt to the firm is 3.25 percent (or the before-tax cost of 5 percent multiplied by 1 minus the tax rate of 0.35—since the firm effectively saves 35 cents of taxes for every dollar of interest expenses) In comparison, the entrepreneur decides the firm’s preferred shares can be issued to pay a dividend of 7 percent, as this is the return required by preferred share investors (because preferred dividends are not tax deductible for the firm) Finally, our entrepreneur also determines that the firm’s equity investors will expect (or require)

a 15 percent return on their investment

The overall cost of raising capital from these sources (bonds, preferred shares, and common equity) can be determined by taking a weighted average of the three costs The

related calculations are presented in Figure 10.3 The resulting weighted-average cost of

capital, also known as the WACC (which has a nice ring to it, like “whack!”), is 11.85 percent

after tax Later in the chapter, we’ll discuss how weights are determined; for now, simply note that the weights from all sources must add up to 1 (or 100 percent)

We can generalize these calculations with some commonly used notations,

whereby the weight of each component is represented by w and cost is represented

by k (I’m not really sure how the convention got started and why we don’t represent cost by C, but that’s the convention so we’ll run with it!) The generalized form of the

weighted-average cost of capital formula is presented in Figure 10.4 Note in

partic-ular that we are representing k d as the after-tax cost of debt that recognizes the firm

can deduct bond-related interest expenses for tax purposes (As previously tioned, no such adjustments are necessary for the cost of preferred shares and com-mon equity.)

men-Of course if a firm doesn’t have any preferred shares (and has no plans to issue

any preferred shares), then w p is equal to zero and the WACC formula simplifies to:

k c = (w d * k d ) + (w e * k e)

Fig 10.2

Relationships between Firm

Costs and Investor-Required

Returns

FIRM INVESTORS Cost of raising funds = Investor-required return

Cost of debt (before tax) = Required return on bond investmentCost of preferred shares = Required return on preferred shares

Cost of equity = Required return on equity investment

Fig 10.3

Simple Cost of Capital

Total weighted cost k c = (w d × k d ) + (w p × k p ) + (w e × k e )

Now that we have a basic understanding of how the cost of capital is calculated, it is

worthwhile to reflect on the importance of this cost to a firm before considering the

costs of each component The cost of capital can be interpreted in a number of ways

First, it can be thought of as a key value driver: At a firm level, the lower the cost of

rais-ing funds, the more valuable the firm will be At a project level, a firm often faces many

potential investments or projects and must determine which ones to take on And so the

lower the cost of undertaking these investments, the more profitable and attractive the

investments are For example, suppose a firm has three project opportunities within a

similar class of risk: Project A offers a potential return of 7 percent, Project B offers

11 percent, and Project C offers 13 percent If the cost of capital is 11.85 percent, then

only Project C looks attractive, because it is the only project with a potential return

greater than the firm’s cost of capital However, if the firm had a lower cost of capital of

10 percent, then Project B would also look attractive

A second interpretation, as described in the example of our fictitious entrepreneur,

is that the cost of capital is the average cost of financing the various investments or

pro-jects facing the firm In that example, by accounting for the three sources of financing—

debt, preferred shares, and common equity—and their relative weights, we found the

firm’s average financing costs were 11.85 percent

A third interpretation, from an investor’s perspective, is that the cost of capital

rep-resents the minimum rate of return that must be earned on a firm’s investments in order

to satisfy all its investors For example, suppose we calculate our example firm’s after-tax

cost of capital to be 11.85 percent, as indicated in Figure 10.3 On the basis of the

$1 million capital outlay that was required to start the new company, suppose the firm

generates a before-tax (and before financing costs) return of 18.23 percent (This

num-ber is carefully chosen to be the “grossed-up” or pretax cost of capital equivalent:

11.85 percent divided by 1 minus the tax rate = 0.1185>(1 - 0.35) = 0.182308.) The

resulting financial situation is presented in Figure 10.5.

This example highlights some important implications related to an understanding

of the cost of capital Note that in this example, all the investors or stakeholders are

satis-fied with their investments The bondholders receive their interest payments as expected,

and as such, they are satisfied The IRS is satisfied with the taxes it receives The

pre-ferred shareholders receive their prepre-ferred dividends as expected and are also satisfied

Finally, just enough earnings are left available to the common shareholders to satisfy

their required return of 15 percent So everyone is satisfied

Suppose, however, that the amount available to common shareholders was only

$70,000, or an amount less than the expected $105,000 Although still profitable from an

accounting perspective, the firm would not be earning sufficient profits to satisfy all

Objective 10.2

Describe various ways

to interpret the cost of capital.

of the cost of capital

investors, particularly the ultimate owners of the firm, the common shareholders (These common shareholders might have to resort to singing the catchy but grammatically incorrect refrain from that old Rolling Stones tune, the one about not getting satisfac-tion.) In other words, the return on equity—in this case, $70,000 on an investment of

$700,000, or 10 percent—would be less than the cost of equity or expected equity return

of 15 percent Conversely, if more than $105,000 was available—say $140,000—common shareholders would be more than satisfied because their return on investment would be

20 percent, or greater than what they required or expected This result would make their ownership stake more valuable, thus increasing the overall value of their shares Accord-ingly, the goal of the firm should be to maximize the value of its common shares This can be achieved in part by minimizing the overall cost of raising funds or minimizing the overall cost of capital, WACC

We have now addressed why a firm should care about the cost of capital To marize, we can think of the cost of capital, in general, as the average minimum rate of return on future-oriented investments the firm makes today The cost of capital is used

sum-to evaluate these future or incremental projects or investments Thus, the overall cost of

capital impacts which investments the firm makes

In these simple examples, we have intentionally glossed over a number of important issues related to the cost of capital For example, what do we mean by risk, and what is the role of risk in the calculation of these costs? How do we estimate the cost of each of the components? And where did the component weights come from? We now address each of these issues in Sections 10.3 through 10.7

Fig 10.5

Cost of Capital Implications Earnings before interest and taxes (EBIT) $1 million × 18.23% $182,308

Interest (paid to bondholders) $200,000 × 5% 10,000Earnings before taxes (EBT) $182,308 – $10,000 $172,308Tax (at 35% rate) $172,308 × 0.35 60,308Earnings after tax (EAT) $172,308 – $60,308 $112,000Preferred dividends $100,000 × 7% $7,000Earnings available to common shareholders $112,000 – $7,000 $ 105,000Common shareholder required return $700,000 × 15% $ 105,000Residual after required return $105,000 – $105,000 $0

$10 million in each of the next eight quarters, and this expectation is incorporated into the firm’s budget for planning purposes There is a risk, however, that the actual sales in

pure risk: The chance of a loss but

no chance of a gain

each quarter will be greater than or less than $10 million The extent to which the actual

sales deviate from budgeted sales is known as speculative risk, or the uncertain

pros-pects of gain or loss

When investors consider buying bonds, stocks, or any other financial instrument,

they consider speculative risk (which we will simply refer to as risk for the remainder of

this chapter)—and the greater the perceived risk of an investment, the greater the

expected return We can see this relationship in Figure 10.6, whereby we can think of

government bonds (at least U.S government bonds) as being risk-free and thus

corre-sponding to the lowest expected returns; followed by investment-grade corporate bonds;

then good quality, well-known “blue-chip” stock; and finally, more speculative stocks

So, our first key observation is that there is a risk-return trade-off In other words,

increased risk goes hand in hand with increased expected returns

We can also think of measures of risk as trying to capture the dispersion of possible

outcomes For example, Figure 10.7 presents possible return outcomes from the four

categories of investments shown in Figure 10.6 Note that we view government bonds as

riskless; in other words, there is no dispersion of possible outcomes if we buy and hold to speculative risk: The chance of a loss or gain

Risk

Corporate bonds

Blue-chip stocks

Speculative stocks

Government

bonds

Fig 10.6

Expected Return and Risk Trade-Offs

Government bonds

Blue-chip stocks

–20 0 20 40 60 80

80

Speculative stocks

Corporate bonds

Fig 10.7

Dispersion of Expected Returns

maturity As we move to riskier investments, however, the dispersion of expected returns increases.

Mathematicians have a way of measuring this dispersion, known as the standard

deviation, which captures the extent to which actual outcomes deviate from average or

expected outcomes Although we won’t get into details about how to calculate standard deviation (which is available as a function in spreadsheet software), we should note that

it is measured as a percent Moreover, the riskier a security is, the higher its standard deviation will be In fact Figure 9.5 presented standard deviations—which we referred to

then more generically as volatility—of historical returns of various types of investments

Now that we understand how risk or dispersion of expected returns is measured, our second key observation is that, by nature, most of us don’t like risk—in other words, we are risk averse All else equal, we prefer potential outcomes that have lower dispersions.Another concept related to risk is diversification, which refers to combining assets

or investments in order to reduce risk Suppose, for instance, you are planning to buy

20 stocks If you choose all 20 from the oil and gas industry, your portfolio will not be diversified Every stock in your portfolio will thus be expected to react the same way as general world oil prices change—increasing when the price of oil goes up, and decreas-ing when the price of oil goes down But if you choose 20 stocks in 20 different indus-tries, your portfolio will not be as volatile and will not be as susceptible to changes in oil prices Researchers have shown the impact of adding more (randomly chosen) stocks to

a portfolio The general result is captured in Figure 10.8 The vertical axis is labeled

“Portfolio Risk (Normalized).” Let’s see what this means Let’s suppose we had a sample

of 500 stocks and we measure the standard deviation of returns of holding any one stock, then take an average of these standard deviations We can then “normalize” that average to be 1.0

Now consider new experiments by randomly choosing two-stock portfolios, then three-stock portfolios, and so on As the portfolio size increases, there is a tendency for the overall portfolio risk or standard deviation to decline For example, once we have, say,

a 20-stock portfolio, we may have reduced a substantial proportion of the portfolio risk The intuition is that firm-specific risk or risk specific to each individual stock, such as the risk that the CEO might suffer from a heart attack—also known as unsystematic risk in investment lingo—is reduced as more stocks are added because there tend to be offsetting ups and downs in their performance Ultimately, we are left with a well-diversified portfo-lio that has eliminated virtually all of the unsystematic risk Thus, we are left only with systematic or market risk—meaning the risk of investing in the market as a whole

standard deviation: A statistical

measure that captures the extent to

which actual outcomes deviate from

average or expected outcomes

diversification: The process or

strategy of combining assets or

investments in order to reduce risk

Number of Securities in Portfolio

10

Total risk

Market (systematic) risk

Firm-specific (unsystematic) risk

30

Fig 10.8

Stock Portfolios and Diversification

Accordingly, our third key observation is as follows: If investors are well diversified, the

only risk that matters is systematic risk We will see why this is the case in Section 10.6,

when we examine the cost of equity or the required equity return

Now that we understand the concept of risk, calculating the cost of debt is fairly

straight-forward From the potential bond investor’s perspective, we begin by asking what the

appropriate bond (or more generally, debt instrument) return is If the firm has existing

publicly traded debt, then the current yield to maturity—as described in Chapter 7—

represents the before-tax cost of debt (Technically, this is an approximation, but close

enough for our purposes.) In some cases, the firm may have numerous outstanding

bonds with different times to maturity and different yields In those cases, a guideline is

to match the bond maturity with the average length of the projects the firm is planning

to undertake with any new funds In almost all situations, firms tend to have long-term

projects, so a long-term bond would be a match (Long-term bonds typically mature in

10 or more years.)

After the before-tax cost of debt has been estimated, this estimate is multiplied by 1

minus the estimated (future) tax rate In most cases, the tax rate can be estimated by

exam-ining the amount of taxes paid in the last fiscal year relative to the before-tax earnings in

that year If the firm had unusual losses and did not pay taxes that year, then a simple

esti-mate of future taxes—usually around 35 percent—will suffice (Technically we are

estimat-ing the marginal tax rate or the corporate taxes paid on an incremental dollar of pretax

income.) For example, if a firm’s long-term bond yield was 8 percent and the firm was

expected to pay taxes at a rate of 35 percent, then the after-tax cost of debt would be

calcu-lated as follows: 8 percent * (1 - 0.35) = 5.2 percent Of course, there would be some

costs associated with the bond sale (such as fees to investment banks), but these are

gener-ally of secondary consideration and typicgener-ally ignored in cost of debt estimates

If a firm does not have existing publicly traded debt, then an estimate must be made

of the appropriate cost of debt The usual approach is to examine the current yield to

maturity on risk-free long-term government bonds, such as the 10-year treasury bond,

then add an appropriate premium (Recall from Chapter 2 that we can find the 10-year

yield by examining the treasury yield curve.) This premium reflects the riskiness of the

firm’s ability to repay its principal and make its interest payments A firm’s premium is

directly related to its bond rating (as discussed in Chapter 9) or to its perceived bond

rat-ing relative to similar firms if the firm has not currently issued any bonds Thus, an AAA

firm will have a very small premium, perhaps less than 0.5 percent, whereas a riskier

firm rated BB or lower may have a premium of 2 to 3 percent or more

A firm often has numerous debt instruments with different maturities, some short

term and others long term One approach to estimating the cost of debt is to estimate a

cost associated with each An alternative approach is both simpler and intuitively

appeal-ing: Rather than estimating a separate cost associated with each debt instrument, we can

estimate the firm’s amount of “permanent” debt—both short term and long term—and

use one long-term yield to estimate the overall cost of debt Here, we don’t mean

“per-manent” in the literal sense because, by nature, debt is always maturing Rather, we

con-sider debt permanent if our expectation is that the firm will always have debt In other

words, once the current debt matures, we expect the firm to “roll over” the obligation by

issuing new debt of a similar amount

The logic behind using just one rate—a long-term yield—for both short-term and long-term debt is that although short-term yields may differ from long-term yields (usu-ally lower), over a long period, short-term rates on average tend to be similar to long-term rates This logic is consistent with the “unbiased expectations theory” we used in Chapter 2 (Section 2.1.3) to explain the shape of the yield curve.

One final issue concerning calculation of the cost of debt is the treatment of current liabilities such as accounts payable, which are related to the firm’s operating activities Recall from Chapter 5 that there is an opportunity cost to forego any discounts on early payment to suppliers (for example, a typical 2 percent discount for paying in 10 days) Should we be incorporating this cost explicitly in our estimate of the cost of debt? The answer is generally no Recall our discussion of working capital—the relationship among inventory, receivables, and payables—related to the firm’s operating activities in Chapter

5 There is a flip side to our discussion of accounts payable On the current asset side, we have accounts receivable In effect, we can think of current assets and current liabilities

as netting out, to form net working capital Thus, we can think of a revised balance sheet

(as in Figure 10.9), whereby our costs, associated with the right-hand side of the balance

sheet, are related to permanent capital: long-term debt (that we assume will be rolled over when it matures), preferred shares, and common equity

permanent capital: The amount of

interest-bearing debt plus preferred

and common equity

Long-term debt Preferred shares Common equity

Current liabilities Current

assets

Fixed assets Other assets

Long-term debt Preferred shares Common equity

Net working capital Fixed assets Other assets

Fig 10.9

Permanent Capital

Objective 10.5

Explain how to estimate

the cost of preferred

shares.

10.5 estimating the cost of preferred shares

Preferred shares are often issued by financial institutions and public utilities Recall from our discussion in Chapter 7 that preferred shares generally trade like bonds, increasing in price when interest rates decline and vice versa, unless the firm is undergoing financial distress For

example, Figure 10.10 shows the price of Pacific Gas & Electric Company’s 5 percent

cumula-tive redeemable preferred share compared with the yield on 10-year treasuries We see a eral trend of decreasing prices when treasury yields increase—in the 1973 to 1981 period—and increasing prices when treasury yields decline—in the post-1981 period Based on a recent price of $25.36, the preferred shares were trading with a dividend yield of 4.9 percent (based on $1.25 annual dividends), whereas the trea suries were yielding only 1.5 percent

gen-Of course, from an investor’s perspective, there is risk in holding preferred shares, as Pacific Gas & Electric could experience financial distress and, in the event of bank-ruptcy, could even stop making preferred dividend payments For example, between mid-1999 and early 2001, Pacific Gas & Electric’s common share price fell from over $32 per share to under $9 per share As we see in the figure, the preferred share price fell substantially as well, which confounded the general inverse relationship between interest

rates and preferred share prices Thus, we need to keep in mind that the preferred

divi-dends are not guaranteed

Calculation of the cost of preferred shares is relatively straightforward Recall from

our discussion in Chapter 7 that the price of a preferred share is the present value of a

perpetual stream of dividends—see the general formula in Figure 7.13 We now

repro-duce that formula in Figure 10.11, using a slightly modified notation.

Using simple algebra, we can rearrange the equation in Figure 10.11 to solve for k p ,

or the expected return for the common equity investor, as shown in Figure 10.12.

In other words, if a firm has existing preferred shares, such as with Pacific Gas &

Electric Company, then the estimate of the cost of preferred shares is simply the current

yield on existing preferred shares For example, we noted that Pacific Gas & Electric

Company was recently paying annual preferred dividends of $1.25 per share and the

preferred shares were selling for $25.36 per share Therefore, the current yield on the

firm’s preferred shares is:

PG&E preferred price

10-year treasury yield

Fig 10.10

Pacific Gas & Electric Preferred Share Price and 10-Year Treasury Yields, 1973–2012

Source: Preferred share prices from Datastream; 10-year treasury bond yield data from the Federal

Reserve Board website, http://www.federalreserve.gov/releases/h15/data.htm (accessed August 21, 2012)

where P 0 = price of a preferred share

DIV = annual preferred dividend

k p = expected or required return by preferred share investors

But what if a similar firm—also in the gas and electric industry—did not have existing preferred shares but was planning to issue them? In this situation, one key question must be addressed: What yield does the firm need to offer if it issues new pre-ferred shares today? Suppose, for example, the firm decides to issue new (perpetual) preferred shares today with a face value of $100 per share Consequently, the annual dividend on the new preferred shares would be $4.90, for an identical (to Pacific Gas & Electric Company) yield of 4.9 percent Note that, unlike the cost of debt, there is no after-tax adjustment needed because preferred dividends are already paid in after-tax dollars.

Thus, if a firm does not currently have any outstanding preferred shares, then the appropriate cost can be estimated by examining the current yield of similar firms, such

as those with similar debt ratings Recall that the two main drivers of the current yield

on preferred shares are current interest rates (because preferred shares are typically like bonds that have no maturity date) and the perceived riskiness of the firm

Objective 10.6

Explain how to estimate

the cost of equity using the

dividend model approach

and the capital asset

pricing model approach.

Estimating the cost of debt and the cost of preferred shares is relatively straightforward—particularly if a firm has existing publicly traded debt and preferred shares—but the same cannot be said for estimating the cost of common equity The estimation problem arises because, unlike bonds and preferred shares, common shares do not have a similar “guaran-tee” or implicit promise of returns Instead, common shareholders are the residual claim-ants and own any remaining earnings after the other investors have received payment Based on Figure 10.2, instead of focusing on the cost to the firm, we will take the approach

of estimating the cost of equity by focusing on the investor Thus, we need somehow to

esti-mate what a common equity investor expects or requires when he or she is making an

invest-ment In other words, we need a model of what drives stock prices and hence what drives expected returns

Researchers have uncovered a number of approaches that provide us with mates of common equity investor expected returns, and thus an estimate of the cost of equity One of the simplest approaches is to measure the average historical common equity return; however, such an approach does not necessarily capture expected returns and is not widely used Instead, we examine two well-known approaches here: the divi-dend model approach, which is intuitively appealing and relates to our earlier time value of money discussions, and the capital asset pricing model, which is the most widely used

We introduced the dividend model in Chapter 7 The simplest form of the dividend model approach (presented in Figure 7.23), also known as the constant growth dividend discount model, is based on the premise that equity investors generally intend to hold a stock for a long period of time (perhaps even bequeathing it to their children) In this model, what matters to investors is the cash flow or dividends that they expect to receive

over the life of owning the stock We reproduce the Chapter 7 model in Figure 10.13

(using slightly modified notations with k e2

Using simple algebra, we can rearrange the equation in Figure 10.13 to solve for k e,

or the expected return for the common equity investor, as indicated in Figure 10.14.

Note that the expected returns are determined by the expected dividend yield as

well as the expected growth in dividends over time The expected growth in dividends

can be thought of as the capital gain that investors expect (if they were to sell their

stock) As an example, suppose a firm is expected to pay cash dividends of $1.50 per

share over the next year The current stock price is $37.50, so the expected dividend yield

is 4 percent In addition, it is estimated that the dividends will grow, on average, by about

8 percent per year for the foreseeable future This estimated growth rate of dividends

may be determined from the historical growth in dividends or from a current

assess-ment of the firm by analysts Adding these two components, the estimated required

return to equity investors, and hence cost of equity, is 12 percent:

k e = $1.50>$37.50 + 0.08

= 0.04 + 0.08

= 0.12 or 12 percent

Of course, there are limitations to the dividend model approach For one, if a firm

does not currently pay dividends, it is difficult to estimate expected future dividends

Moreover, even if a firm does pay dividends, if future dividends are not expected to grow

at a constant rate, then estimating the cost of equity becomes much more complicated

While the dividend yield component is generally easy to estimate, the anticipated growth

in dividends is not Fortunately, there is an alternative (and much more widely used)

approach, as described in the next section

10.6.2 capital asset pricing Model

The capital asset pricing model, or CAPM as it is affectionately known (pronounced

“cap-M”), is an intuitively appealing model developed by Nobel Prize–winning financial

economist Bill Sharpe Sharpe’s work is an extension of the work of his mentor, Nobel

Prize–winning financial economist Harry Markowitz Markowitz showed that there

were benefits to investing in a well-diversified basket of stocks, particularly in terms of

enhancing potential rewards relative to risk exposure Essentially, Markowitz’s key

insight was the same as your mother’s when she told you: “Don’t put all of your eggs in

one basket.” (Unfortunately, no matter how well-deserving, your mother did not receive

a Nobel Prize.) Sharpe followed up on this idea, looking specifically at the expected

stock returns to an investor who is well diversified among risky securities and has an

opportunity to invest in risk-free securities as well

Although CAPM is called a “pricing” model, it actually refers to expected returns

There are three components to CAPM—the risk-free rate, the market risk premium, and

where P 0 = current price (at time = 0) of common share

DIV 1 = anticipated dividend in one period

k e = expected or required return by common share investor

g = constant growth rate of dividends

beta, which we will explain in detail shortly The intuition behind the model is as lows: If an investor is considering a risky investment in equities, there is always a risk-free alternative, and that would be government bonds This is a minimum starting point for an investor’s expected return on an equity investment The common notation for the

fol-return on a risk-free investment is R f

Given that stocks, in general, are viewed as riskier than government bonds, in order to

be enticed into investing in the stock market as a whole, investors will expect a premium over government bonds This premium is known as the market risk premium (MRP).Individual stocks can be viewed as being either more risky or less risky than the overall market To capture the relative riskiness of an individual stock relative to the overall market, a stock’s beta (b) is estimated The capital asset pricing model assumes investors are well diversified and therefore care only about market risk or systematic risk, which is captured by beta By definition—and as our starting point—the market has

a beta of 1 Riskier stocks have betas greater than 1, whereas less risky stocks have betas less than 1 The beta factor then acts as a multiplier for the market risk premium, provid-

ing an upward or downward adjustment This overall model is presented in Figure 10.15.

As an example, suppose the risk-free rate is currently 4 percent, a stock’s beta is mated to be 1.2, and the market risk premium is estimated to be 5 percent The resulting expected equity return or cost of capital is 10%, as shown here:

esti-E(R s ) = k e = 4% + 1.2 * 5% = 4% + 6% = 10%

market risk premium: The

difference between the expected

return on a stock investment in the

market and the expected return on a

risk-free investment

beta (b): A measure of the

riskiness of a firm’s common equity

relative to the risk of the overall

stock market

in-Depth

When we talk about stocks, what do we really mean by investing in “the market”? In CAPM theory, the market involves all global assets, including stocks, bonds, real estate, and more In practice, however, we think of the market as a broad measure of domestic stocks There are thousands of stocks listed on U.S exchanges, and it would be imprac- tical (and costly) for investors to buy shares in each and every one Fortunately, there are funds that provide diversification benefits from investing in a large number of firms.

Traditional mutual funds invest in stocks according to the fund’s mandate For ple, one fund manager might invest strictly in technology stocks, while another might invest only in stocks that pay dividends Other funds that are actively managed might try

exam-to beat the performance of a particular sexam-tock market benchmark such as the S&P 500 Index In contrast, yet other types of funds are known as passive or index funds: Rather than trying to beat the market, the fund manager’s mandate is simply to replicate the benchmark performance Also, in recent years, a new class of funds has emerged to chal- lenge traditional mutual funds, generally by offering lower commissions These funds are called exchange traded funds, or ETFs Thus, when we talk about buying into “the mar- ket” as a whole, we can think of buying a market index ETF.

Investing in “the

Market”

E (R s) = Rf + b s× MRP

where E(R s) = expected return on stock s = ke = estimated cost of equity

R f = risk-free rate of return

bs = beta for stock s

MRP = market risk premium

Fig 10.15

Capital Asset Pricing Model