Buku Business Finance Pierson

BUSINESS FINANCE 12e

PEIRSO N BROW N EASTON HOW ARD PINDER

BUSINESS FINANCE Monash University

L

University of Melbourne University of Newcastle Monash University —

Graw Hill

Education

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Additional owners o f copyright are acknowledged in on-page credits. Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their apologies should any infringement have occurred. Reproduction and communication for educational purposes The Australian Copyright Act 1968 (the Act) allows a maximum o f one chapter or 10% o f the pages o f this work, whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes provided that the institution (or the body that administers it) has sent a Statutory Educational notice to Copyright Agency Limited (CAL) and been granted a licence. For details o f statutory educational and other copyright licences contact: Copyright Agency Limited, Level 15, 233 Castlereagh Street, Sydney NSW 2000. Telephone: (02) 9394 7600. Website: www.copyright.com.au Reproduction and communication for other purposes Apart from any fair dealing for the purposes o f study, research, criticism or review, as permitted under the Act, no part o f this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a database or retrieval system, without the written permission o f McGraw-Hill Education (Australia) Pty Ltd, including, but not limited to, any network or other electronic storage. Enquiries should be made to the publisher via www.mcgraw-hill.coin.au or marked for the attention o f the permissions editor at the address below. National Library o f Australia Cataloguing-in-Publication Data Author:

Peirson, Graham, author.

Title:

Business finance / Graham Peirson, Rob Brown, Steve Easton, Sean Pinder, Peter Howard.

Edition:

12th edition

ISBN:

9781743078976 (paperback)

Notes:

Includes index.

Subjects:

Business enterprises-Finance. Cash management. Corporations-Finance.

Other Authors/Contributors:

Brown, Rob, author. Easton, Stephen Andrew, author. Pinder, Sean, author. Howard, Peter, author.

Dewey Number:

658.15

Published in Australia by McGraw-Hill Education (Australia) Pty Ltd Level 2, 82 Waterloo Road, North Ryde NSW 2113 Publisher: Jillian Gibbs Senior product developer: Jane Roy Production editor: Tami Rex Permissions editor: Haidi Bernhardt Copyeditor: Jess Ni Chuinn Proofreader: Anne Savage Indexer: Russell Brookes Cover design: Christabella Designs Internal design: David Rosemeyer Typeset in Chapparal Pro 10/12 pt by diacriTech, India Printed in China on 70gsm matt art by China Translation and Printing Services Ltd

PUBLISHER'S FOREW ORD When this endeavour began 44 years ago, few could have foreseen the success of this publication, and few could have imagined how proud we would be to have published a resource that has guided well over 2 0 0 0 0 0 undergraduate students through their introduction to business finance. This title has become one of McGraw-Hill Education Australia's longest-standing and most successful textbooks. It is with the greatest pleasure that McGrawHill Australia now presents the twelfth edition of Business Finance by Graham Peirson, Rob Brown, Steve Easton, Peter Howard and Sean Pinder. This text is an original work—not an adaptation of US material. The founding authors, Graham Peirson and Ron Bird, embarked on an ambitious undertaking: to write a meaningful introduction to the fascinating field of business finance, specifically for students in Australia and New Zealand. They succeeded, and the first edition was published in 1972. As a testament to the consistent value of the work and its ongoing relevance for generations of students and instructors, Business Finance continues to sell thousands of copies each year. In a market increasingly crowded with competitive texts, it is a credit to our author team that Business Finance continues as the market leader in its field. To our authors and the academic community who have so staunchly supported this publication we say thank you. Quality content is clearly the key. The twelfth edition author team has worked hard, in consultation with instructors across Australia and New Zealand, to ensure that the text and its digital resource package provide recent data and up-to-date thinking in an accessible format that will engage students and instructors alike. This twelfth edition has done just that, demonstrating the authors, commitment to refining their text and ensuring that Business Finance not only retains a reputation for currency, but emerges once again as the standard setter. Our focus at McGraw-Hill is wholly on providing superior content. W ith Business Finance twelfth edition we are confident we offer you the best there is. M c G ra w -H ill Education A u stra lia , 2 0 1 4

v

^1 ■

BRIEF C O N TEN TS

CHAPTER 1

Introduction

CHAPTER 2

Consumption, investment and the capital market

10

CHAPTER 3

The time value o f money: on introduction to financial mathematics

28

CHAPTER 4

A pplying the time value o f money to security valuation

74

CHAPTER 5

Project evaluation: principles and methods

103

CHAPTER 6

The application o f project evaluation methods

129

CHAPTER 7

Risk and return

772

CHAPTER 8

The capital market

210

CHAPTER 9

Sources o f finance: equity

232

CHAPTER 10

Sources o f finance: debt

275

CHAPTER 11

Payout policy

315

CHAPTER 12

Principles o f capital structure

3 56

CHAPTER 13

C apital structure decisions

3 93

CHAPTER 14

The cost o f capital

417

CHAPTER 15

Leasing and other equipment finance

450

CHAPTER 16

C apital market efficiency

477

CHAPTER 17

Futures contracts and swops

507

CHAPTER 18

Options and contingent claims

5 63

CHAPTER 19

Analysis o f takeovers

605

CHAPTER 2 0

Managem ent o f short-term assets: inventory

646

CHAPTER 21

Managem ent o f short-term assets: liqu id assets and accounts receivable

666

1

C O N TEN TS

Publisher's foreword

V

Preface

X X V //

About the authors

x x v iii

Acknowledgments

Chapter 1

Digital resources

xxx i

Highlights o f this edition

xxx ii

How to use this book

xxxiv

XXX

Introduction

Learning objectives ID

FINANCE AS AN AREA OF STUDY

2

IB

FINANCIAL DECISIONS

2

IB

BUSINESS STRUCTURES

3

1.3.1 Sole proprietorship

3

1.3.2 Partnership

3

1.3.3 Company

4

IQ

THE COMPANY'S FINANCIAL OBJECTIVE

5

IB

FUNDAMENTAL CONCEPTS IN FINANCE

5

ID

1.5.1 Value

5

1.5.2 The time value of money

5

1.5.3 Risk aversion

6

1.5.4 Nominal and real amounts

6

1.5.5 Market e仟iciency and asset pricing

6

1.5.6 Derivative securities

7

1.5.7 Arbitrage

7

1.5.8 Agency relationships

7

OUTLINE OF THE BOOK Summary

8 8

Key terms

8

Questions

9

Chapter 2

Consumption, investment and the capital market

10

Learning objectives

JO

m

INTRODUCTION

11

^

FISHERY SEPARATION THEOREM: A SIMPLIFIED EXAMPLE

11

2.2.1

11

Introduction to the example

2.2.2 Assumptions

11

2.2.3 The shareholders7 consumption opportunities and preferences

12

2.2.4 Solution: introduce a capital market

12

2.2.5 An analysis using rates of return

13

2.2.6 A solution requiring borrowing

13

C ontents

Q |

B |

2.2.7 Fisher's Separation Theorem and net present value

13

2.2.8 Fisher’s Separation Theorem: summary

14

FISHERS SEPARATION THEOREM: A FORMAL APPROACH

14

2.3.1

14

Assumptions

2.3.2 The company

15

2.3.3 The shareholders

15

2.3.4 The company’s decision

16

2.3.5 Solution: introduce a capital market

16

2.3.6 Proving there is an optimal policy

19

2.3.7 Identifying the optimal policy

21

2.3.8 Implications for financial decision making

22

INVESTORS'REACTIONS TO MANAGERS' 2.4.1

DECISIONS

Certainty

24 25

2.4.2 The introduction of uncertainty

25

Summary

26

Key terms

26

Questions

26

Problems

26

References

27

The time value of money: an introduction to financial mathematics

28

Learning objectives

28

m

INTRODUCTION

29

|B

FUNDAMENTAL CONCEPTS OF FINANCIAL MATHEMATICS

29

3.2.1 Cashflows

29

3.2.2 Rate of return

29

3.2.3 Interest rate

30

3.2.4 Time value of money

30

SIMPLE INTEREST

31

3.3.1 The basic idea of simple interest

31

3.3.2 Formula development: future sum

31

3.3.3 Formula development: present value

32

3.3.4 Applications of simple interest

32

COMPOUND INTEREST

33

3.4.1 The basic idea of compound interest

33

3.4.2 Formula development: future sum and present value

34

3.4.3 Nominal and effective interest rates

37

3.4.4 Compound interest: two special cases and a generalisation

40

VALUATION OF CONTRACTS WITH MULTIPLE CASH FLOWS

46

3.5.1

46

IQ

IB

Introduction

3.5.2 Value additivity

46 ix

C ontents

|Q

IB

|Q

3.5.3 Formula development: valuation as at any date

48

3.5.4 Measuring the rate of return

49

ANNUITIES

50

3.6.1

50

Definition and types of annuity

3.6.2 Formula development: present value of an ordinary annuity

51

3.6.3 Formula development: present values of annuities-due, deferred annuities and ordinary perpetuities

52

3.6.4 Future value of annuities

56

PRINCIPAL-AND-INTEREST LOAN CONTRACTS

58

3.7.1

58

Basic features of the contract

3.7.2 Principal and interest components

59

3.7.3 Balance owing at any given date

60

3.7.4 Loan term required

61

3.7.5 Changing the interest rate

62

GENERAL ANNUITIES

63

Summary

66

Key terms

66

Self-test problems

66

Questions

67

Problems

67

References

73

Applying the time value of money to security valuation 74 Learning objectives

74

ED

INTRODUCTION

75

IQ

FINANCIAL ASSET VALUATION UNDER CERTAINTY

75

m

VALUATION OF SHARES

76

4.3.1

Valuation of shares assuming certainly

76

4.3.2 Valuation of shares under uncertainty

77

4.3.3 Share valuation and the price-earnings ratio

79

|Q

VALUATION OF DEBT SECURITIES

80

EB

INTEREST RATE RISK

81

ED

THE TERM STRUCTURE OF INTEREST RATES 4.6.1

EB

W hat is the term structure?

82 82

4.6.2 Using the term structure to price a bond

83

4.6.3 Term structure theories: expectations and liquidity (risk) premium

85

4.6.4 Empirical evidence

88

4.6.5 Inflation and the term structure

89

THE DEFAULT-RISK STRUCTURE OF INTEREST RATES

89

C ontents

W ED

OTHER FACTORS AFFECTING INTEREST RATE STRUCTURES

91

Summary

92

Key terms

92

Self-test problems

92

Questions

93

Problems

93

References

96

APPENDIX 4.1 DURATION AND IMMUNISATION

97

Introduction

97

Bond duration

97

Duration and interest elasticity

99

Duration and bond price changes

100

Duration and immunisation

100

I Project evaluation: principles and methods

103

Learning objectives

103

m

INTRODUCTION

104

Q

THE CAPITAL-EXPENDITURE PROCESS

104

E 9

METHODS OF PROJECT EVALUATION

104

5.3.1

107

0 3

Q

Q

Discounted cash flow methods

THE DISCOUNTED CASH FLOW METHODS COMPARED

108

5.4.1

108

Net present value

5.4.2 Internal rate of return

109

5.4.3 Choosing between the discounted cash flow methods

112

5.4.4 Benefit-cost ratio (profitability index)

1 17

OTHER METHODS OF PROJECT EVALUATION

118

5.5.1

1 18

Accounting rate of return

5.5.2 Payback period

120

5.5.3 Economic value added (EVA)

121

PROJECT EVALUATION AND REAL OPTIONS ANALYSIS

123

5.6.1

123

Real options analysis

5.6.2 W ho uses real options analysis?

124

Summary

125

Key terms

125

Self-test problems

125

Questions

125

Problems

126

References

128

xi

C ontents

Chapter 6

The application of project evaluation methods

129

Learning objectives

129

INTRODUCTION

130

APPLICATION 〇 F THE NET PRESENT VAUJE METHOD

130

6.2.1

130

Estimation of cash flows in projectevaluation

6.2.2 Illustration of cash-flow information in project evaluation

133

TAX ISSUES IN PROJECT EVALUATION

134

6.3.1

134

Effect of taxes on net cash flows

6.3.2 Illustration of cash-flow information inproject evaluation with taxes

137

COMPARING MUTUALLY EXCLUSIVE PROJECTS THAT HAVE DIFFERENT LIVES

139

DECIDING WHEN TO RETIRE (ABANDON) OR REPLACE A PROJECT

146

6.5.1

146

Retirement decisions

6.5.2 Replacement decisions

147

ANALYSING PROJECT RISK

149

6.6.1

149

Sensitivity analysis

6.6.2 Break-even analysis

151

6.6.3 Simulation

152

DECISION-TREE ANALYSIS

153

QUALITATIVE FACTORS AND THE SELECTION OF PROJECTS

156

PROJECT SELECTION WITH RESOURCE CONSTRAINTS

157

Summary

159

Key terms

159

Self-test problems

159

Questions

160

Problems

161

References

171

Chapter 7

Risk and return

172

Learning objectives

172

INTRODUCTION

173

RETURN AND RISK

173

THE INVESTORS UTILITY FUNCTION

176

THE RISK OF ASSETS

179

PORTFOLIO THEORY AND DIVERSIFICATION

179

7.5.1

180

Gains from diversification

7.5.2 Diversification with multiple assets

184

7.5.3 Systematic and unsystematic risk

186

7.5.4 The risk of an individual asset

187

7.5.5 The efficient frontier

189

C ontents

m

THE PRICING OF RISKY ASSETS

190

7.6.1

191

The capital market line

7.6.2 The Capital Asset Pricing Model (CAPM) and the security market line

192

7.6.3 Implementation of the CAPM

195

7.6.4 Risk, return and the CAPM

197

■

ADDITIONAL FACTORS THAT EXPLAIN RETURNS

197

Q

PORTFOLIO PERFORMANCE APPRAISAL

198

7.8.1

Alternative measures of portfolio performance

203

Key terms

204

Self-test problems

204

Questions

204

Problems

205

References

208

The capital market Learning objectives

211 21 1

8.1.2

The capital market

211

8.1.3

Types of financial market

212

8.1.4

Developments in Australia's financial markets

212

FINANCIAL AGENCY INSTITUTIONS 8.2.1

Brokers and the stock exchange

FINANCIAL INTERMEDIARIES 8.3.1

IQ

210

8.1.1 The flow of funds

8.2.2 Investment banks

HI

210

INTRODUCTION

8.1.5 Business funding ■

199

Summary

Banks

214 215 216 217 220 220

8.3.2 Money market corporations

223

8.3.3 Finance companies

223

8.3.4 Securitisation

223

INVESTING INSTITUTIONS 8.4.1

Insurance companies and superannuation funds

224 225

8.4.2 Unit trusts and investment companies

228

8.4.3 Overseas sources and markets

229

Summary

230

Key terms

230

Questions

230

References

231

C ontents

I Sources of finance: equity Learning objectives BD

INTRODUCTION

Q

THE CHARACTERISTICS OF ORDINARY SHARES 9.2.1

Fully paid and partly paid shares

9.2.2 Limited liability

d

233 234 234 234 234

9.2.4 The rights of shareholders

235

9.2.5 Advantages and disadvantages of equity as a source of finance

235

PRIVATE EQUITY

236

9.3.1

236

W hat is private equity?

9.3.2 Information problems and new ventures

237

9.3.3 Sources of finance for new ventures

237

9.3.4 Finance from business angels

238

9.3.5 Finance from private equity funds

238

INFORMATION DISCLOSURE Offers of unlisted securities

240 240

9.4.2 Offers of listed securities

241

9.4.3 Offers that do not need disclosure

241

FLOATING A PUBLIC COMPANY 9.5.1

242

Public versus private ownership

242

9.5.2 Initial public offering of ordinary shares

243

9.5.3 Pricing a new issue

243

9.5.4 Underwriting and managing a newissue

244

9.5.5 Selling a new issue

246

9.5.6 The costs of floating a company

246

9.5.7 Long-term performance of IPOs

250

SUBSEQUENT ISSUES OF ORDINARY SHARES

252

9.6.1

253

Rights issues

9.6.2 Placements (private issues)

260

9.6.3 Contributing shares and instalment receipts

262

9.6.4 Share purchase plans

262

9.6.5 Company-issued share options

262

9.6.6 Choosing between equity-raising methods

263

m

EMPLOYEE SHARE PLANS

B 3

INTERNAL FUNDS 9.8.1

®

232

9.2.3 No liability companies

9.4.1

Q

232

Dividend reinvestment plans

MANAGING A COMPANY'S EQUITY STRUCTURE 9.9.1

Bonus issues and share splits

9.9.2 Share consolidations

265 266 267 268 268 269

C ontents

Summary

270

Key terms

270

Questions

271

Problems

272

References

273

Chapter 10

Sources of finance: debt

Learning objectives

275 275

BT8B1 INTRODUCTION

276

1BH

GENERAL CHARACTERISTICS OF DEBT

277

10.2.1

The interest cost of debt

278

10.2.2

Effect of debt on risk

279

10.2.3

Effect of debt on control

279

10.2.4

Security for debt

280

10 3 ■ SHORT-TERM BORROWING FROM BANKS AND OTHER FINANCIAL INSTITUTIONS

282

10.3.1

Bank overdraft

282

10.3.2

Debtor finance

283

10.3.3

Inventory loans

284

10.3.4

Bridging finance

284

10 4 ■ LONG-TERM BORROWING FROM BANKS AND OTHER FINANCIAL INSTITUTIONS

285

10.4.1

Long-term loan choices available to borrowers

285

10.4.2

Variable-rate term loans

286

10.4.3

Fixed-rate term loans

287

10.4.4 Other features of term loans

287

10.4.5

288

W hy do borrowers use term loans instead of security issues?

10 5 ■ DEBT SECURITIES

289

10.5.1

Debt securities: the general principles

289

10.5.2

Commercial paper

290

10.5.3

Bills of exchange

292

10.5.4

Debentures

295

10.5.5

Unsecured notes

297

10.5.6 Corporate bonds

297

10 6 ■ PROJECT FINANCE

301

10.6.1

The main features of project finance

301

10.6.2

When is project finance attractive?

302

10 7 ■ HYBRIDS OF DEBT AND EQUITY

302

10.7.1

Convertible notes and convertible bonds

303

10.7.2

Preference shares

305

Summary

309

Key terms

309

C ontents

Self-test problems

310

Questions

310

Problems

311

References

313

Chapter 1 1

Payout policy

Learning objectives

3 75

INTRODUCTION

316

11.1.1

Dividend declaration procedures

317

11.1.3

317

IS

Legal and tax considerations

PAYOUT POLICY IMPORTANT TO SHAREHOLDERS?

11.2.1

Alternative payout policies

318 319 319

1 1.2.2 Managers and payout decisions

320

11.2.3

321

The irrelevance of payout policy

1 1.2.4 The importance of full payout

323

11.2.5

324

Payout policy in practice

TRANSACTION COSTS AND FLOTATION COSTS

324

|

1 1.3.1 Transaction costs

324

1 1.3.2 Flotation costs

325

DIVIDENDS AND TAXES

325

1 1.4.1 Dividends and the imputation tax system

325

1 1.4.2 Imputation and capital gains tax

327

1 1.4.3 Dividend policy with imputation and capital gains tax

328

gl

1 1.4.4 The market value of franking credits

329

INFORMATION EFFECTS AND SIGNA山 NG TO INVESTORS

332

AGENCY COSTS AND CORPORATE GOVERNANCE

335

BEHAVIOURAL FACTORS AND CATERING THEORY

339

SHARE BUYBACKS

339

11.8.1

340

W hy do companies repurchase shares?

1 1.8.2 Share repurchases in Australia

343

DIVIDEND REINVESTMENT PLANS AND DIVIDEND ELECTION SCHEMES

346

PAYOUT POLICY AND COMPANY LIFE CYCLE

347

I

DD DD

316

11.1.2 Types of dividend

11.1.4 Repurchasing shares

DD

315

Summary

349

Key terms

349

Questions

350

Problems

351

References

353

C ontents

Chapter 12

Principles of capital structure

356

Learning objectives

356

INTRODUCTION

357

12.2

THE EFFECTS OF FINANCIAL LEVERAGE

357

12.3

THE MODIGLIANI AND MILLER ANALYSIS (NO TAX CASE)

361

12.3.1

|B |

12.4

12.5

12.6

12.7

Modigliani and Miller's Proposition 1

361

12.3.2 Modigliani and Miller's Proposition 2

365

12.3.3

368

Modigliani and Miller's Proposition 3

12.3.4 W hy is the M M analysis important?

369

THE EFFECTS OF TAXES ON CAPITAL STRUCTURE UNDER A CLASSICAL TAX SYSTEM

369

12.4.1

Company income tax

369

12.4.2 Company tax and personal tax

371

12.4.3

373

Miller's analysis

12.4.4 The scope of Miller's analysis

374

THE EFFECTS OF TAXES ON CAPITAL STRUCTURE UNDER AN IMPUTATION TAX SYSTEM

374

12.5.1

374

W hat is an imputation tax system?

12.5.2 The effects of tax on capital structure decisions under an imputation tax system

376

THE COSTS OF FINANCIAL DISTRESS

377

12.6.1

Bankruptcy costs

377

12.6.2

Indirect costs of financial distress

378

AGENCY COSTS

379

12.7.1

Conflicts of interest between lenders and shareholders

379

12.7.2

Conflicts of interest between shareholders and company managers

380

12.8

OPTIAAAL CAPITAL STRUCTURE: THE STATIC TRADE-OFF THEORY

381

12.9

CAPITAL STRUCTURE WITH INFORMATION ASYMMETRY

382

12.9.1

Pecking order theory

382

12.9.2

Information asymmetry and the undervaluation of a company's assets

383

12.9.3

Information asymmetry and the overvaluation of a company's assets

385

12.9.4 Implications of information asymmetry for financing policy

386

Summary

387

Key terms

387

Self-test problems

387

Questions

388

Problems

389

References

392

Capital structure decisions

13.1

393

Learning objectives

393

INTRODUCTION

394

13.1.1

394

Company financing: some initial facts

XVII

C ontents

13.2

13.3

EVIDENCE ON CAPITAL STRUCTURE

395

13.2.1

Evidence on taxes

395

13.2.2

Evidence on the costs of financial distress

397

13.2.3

Evidence on agency costs

399

13.2.4

Evidence on information costs and the pecking order theory

401

13.2.5

Evidence from dual issues and spin-offs

403

13.2.6

Evidence on the choice of maturity and priority of debt

404

13.2.7 Evidence from surveys

405

ASSESSING THE THEORIES OF CAPITAL STRUCTURE

406

13.3.1

How useful is the static trade-off theory?

406

13.3.2

How useful is the pecking order theory?

407

13.4

FINANCING AS A MARKETING PROBLEM

408

13.5

DETERMINING A FINANCING STRATEGY

409

13.5.1

Business risk

409

13.5.2 Asset characteristics

410

13.5.3 Tax position

410

13.5.4 Maintaining reserve borrowing capacity ('financial slack')

411

13.5.5

411

Other factors

Summary

412

Key terms

412

Questions

413

References

414

The cost of ca pital Learning objectives

417

|Q |

INTRODUCTION

418

B 〇

RISK, RETURN AND THE COST OF CAPITAL

418

14.2.1

Risk independence

419

14.3

TAXES AND THE COST OF CAPITAL

419

14.4

ALTERNATIVE APPROACHES TO ESTIMATION OF THE COST OF CAPITAL

421

14.4.1

421

14.5

14.6

Direct use of the CAPM

14.4.2 The weighted average cost of capital (WACC)

422

ESTIMATION OF THE COST OF CAPITAL: AN EXTENDED EXAMPLE

423

14.5.1

424

The cost of debt

14.5.2 The cost of preference shares

427

14.5.3 The cost of ordinary shares

427

14.5.4 The company's cost of capital

429

14.5.5

430

Issue costs and the cost of capital

PROJECT AND COMPANY COST OF CAPITAL

431

14.6.1

432

Calculating the cost of capital for divisions using the 'pure play7 approach

14.6.2 Calculating the cost of capital for divisions using the direct estimation approach x v iii

417

434

[ED

EVALUATION TECHNIQUES

436

USING CERTAINTY EQUIVALENTS TO ALLOW FOR RISK

437

Summary

440

Key terms

440

Self-test problems

441

Questions

441

Problems

442

References

446

APPENDIX 14.1 THE COST OF CAPITAL UNDER ALTERNATIVE TAX SYSTEMS Introduction

447

Deriving cost of capital formulae

447

Summary

449

Chapter 15

[Q l

447

Leasing and other equipment finance

450

Learning objectives

450

INTRODUCTION

451 451

15.2.1

Finance leases

15.2.2 Operating leases

452 453

15.2.3

Sale and lease-back agreements

453

15.2.4

Leveraged leasing

454

15.2.5

Cross-border leasing

455

[ Q | ACCOUNTING AND TAXATION TREATMENT OF LEASES 15.3.1

Accounting for leases

455 455

15.3.2 Taxation treatment of leases

456

15.4

SETTING LEASE RENTALS

456

15.5

EVALUATION OF FINANCE LEASES

458

15.5.1

Leasing decisions and investment decisions

460

15.5.2 The value of leasing in competitive capital markets

461

15.5.3

462

Establishing an advantage for leasing

15.5.4 Taxes and the size of leasing gains

463

15.5.5

464

Leasing and the imputation tax system

15.6

EVALUATION OF OPERATING LEASES

465

15.7

ADVANTAGES AND DISADVANTAGES OF LEASING

466

15.7.1

Possible advantages of leasing

466

15.7.2

Leasing policy

469

15.8

CHATTEL MORTGAGES AND HIRE-PURCHASE

471

15.8.1

471

Equipment finance and the goods and services tax

C ontents

Summary

472

Key terms

472

Self-test problems

472

Questions

473

Problems

474

References

475

Chapter 16

Capital market efficiency

477

Learning objectives

4 77

16.1

INTRODUCTION

478

16.2

THE EFFICIENT AAARKET HYPOTHESIS

478

16.2.1

479

16.3

16.4

A non-instantaneous price reaction

16.2.2 A biased price reaction

479

16.2.3

480

Categories of capital market efficiency

16.2.4 Market efficiency and the joint test problem

480

TESTS 〇 F RETURN PREDICTABILITY

481

16.3.1

481

The relationship between past and future returns

16.3.2 The presence of seasonal effects in returns

482

16.3.3

483

Predicting future returns on the basis of other forecast variables

EVENT STUDIES

487

16.4.1

487

The methodology of event studies

16.4.2

Evidence: profit and dividend announcements in Australia

491

16.4.3

Other events

493

TESTS FOR PRIVATE INFORMATION

493

16.6

MARKET EFFICIENCY AT THE MACRO LEVEL

495

16.7

BEHAVIOURAL FINANCE AND MARKET EFFICIENCY

495

16.8

IMPLICATIONS OF THE EVIDENCE WITH RESPECT TO MARKET EFFICIENCY

497

16.8.1

Implications for investors in securities

497

16.8.2

Implications for financial managers

499

Summary

501

Key terms

501

Questions

501

References

503

Chapter 17

Futures contracts and swaps

507

Learning objectives

5 07

17.1

INTRODUCTION

508

17.2

WHAT IS A FUTURES CONTRACT?

509

17.2.1

Forward contracts and futures contracts

509

17.2.2

How a futures market is organised

509

C ontents

17.2.3

Deposits, margins and the mark-to-market rule

51 1

17.2.4 The present value of a futures contract

512

17.3

THE AUSTRALIAN SECURITIES EXCHANGE

512

17.4

DETERMINANTS OF FUTURES PRICES

513

17.5

FUTURES MARKET STRATEGIES: SPECULATING AND HEDGING

515

17.5.1

Introduction

515

17.5.2

Speculating

516

17.5.3

Hedging

517

17.6

17.5.4 Some reasons why hedging with futures is imperfect

518

17.5.5

521

17.5.6 Selecting the number of futures contracts

522

FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE 90-DAY BANK-ACCEPTED BILL FUTURES CONTRACT

525

17.6.1

A brief review of bank bills

525

17.6.1

Specification of the bank-accepted bill futures contract

526

Uses of the bank bill futures contract

527

17.6.2 17.7

Hedging and regretting

FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE 10-YEAR TREASURY BOND FUTURES CONTRACT

532

17.7.1

A brief review of bond pricing

532

17.7.2

Specification of the 10-year bond futures contract

533

17.7.3

Uses of the 10-year bond futures contract

533

FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE 30-DAY INTERBANK CASH RATE FUTURES CONTRACT

535

FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE SHARE PRICE INDEX S&P/ASX 200 (SPI 200) FUTURES CONTRACT

536

17.9.1

A brief review of Australian Securities Exchange indices

536

17.9.2

Specification of the S&P/ASX 200 futures contract

537

17.9.3

Uses of the S&P/ASX 200 futures contract

537

17.10 VALUATION OF FINANCIAL FUTURES CONTRACTS

540

17.8

17.9

Valuation of bank bill futures contracts

540

17.10.2 Valuation of share price index futures contracts

541

FORWARD-RATE AGREEMENTS

542

SWAPS

544

17.10.1

17.12.1 17.1

W hat is a swap? 2.2 Interest rate swaps

544 544

CURRENCY SWAPS

551

Summary

556

Key terms

557

Self-test problems

557

Questions

557

Problems

558

References

562

C ontents

Chapter 18

(E D

Options and contingent claims

563

Learning objectives

563

INTRODUCTION

564 564

18.2.1

W hat is an option?

1 8.2.2 How options are created and traded

565

1 8.2.3 Option contracts and futures contracts

566

1 8.2.4 Payoff structures for calls and puts

566

1 8.2.5 Factors affecting call option prices

567

1 8.2.6 Some basic features of put option pricing

571

18.2.7

573

Put-call parity

1 8.2.8 The minimum value of calls and puts B H

^ 1

564

576

BINOMIAL OPTION PRICING

577

1 8.3.1 The basic idea: pricing a single-period calloption using the binomial approach

577

1 8.3.2 Risk neutrality as a solution method

579

1 8.3.3 Binomial option pricing with many time periods

579

1 8.3.4 Applying the binomial approach to other option problems

582

THE BLACK-SCHOLES MODEL OF CALL OPTION PRICING

582

18.4.1

Assumptions

1 8.4.2 The Black-Scholes equation 1 8.4.3

A brief assessment of the Black-Scholes model

582 583 587

OPTIONS ON FOREIGN CURRENCY

588

18.5.1

589

W hat is an option on foreign currency?

1 8.5.2 Combinations of options on foreign currency

590

18.6

OPTIONS, FORWARDS AND FUTURES

591

18.7

OPTIONS ON FUTURES

593

1 8.7.1

W hat is an option on a futures contract?

593

Uses of options on futures

593

1 8.7.2

18.8

18.7.3

Pricing options on futures

594

18.7.4

Specification of the SPI 200 futures options contract

594

CONTINGENT CLAIMS

595

18.8.1

W hat is a contingent claim?

595

18.8.2

Rights issues

595

18.8.3 Convertible bonds

596

1 8.8.4 Valuation of levered shares and risky zero-coupon debt

596

1 8.8.5 Valuation of levered shares and risky coupon-paying debt

596

1 8.8.6

597

Project evaluation and Veal’ options

Summary

599

Key terms

599

Self-test problems

599

C ontents

Questions

600

Problems

601

References

604

.； ,

19.2

19 3

19 4

19 5

1 Analysis of takeovers

I

Learning objectives

605

INTRODUCTION

606

19.1.1

606

Fluctuations in takeover activity

19.1.2 Types of takeover

607

REASONS FOR TAKEOVERS

608

19.2.1

Evaluation of the reasons for takeovers

609

19.2.2

Survey evidence of the motives for takeovers

613

19.2.3

The roles of takeovers

613

■ECONOMIC EVALUATION OF TAKEOVERS Comments on estimation of takeover gains

615

19.3.2

Comparing gains and costs

616

19.3.3

Estimating cost for a share-exchange takeover

617

■ALTERNATIVE VALUATION APPROACHES

618

19.4.1

Valuation based on earnings

618

19.4.2

Valuation based on assets

619

■REGULATION AND TAX EFFECTS OF TAKEOVERS

7 |

614

19.3.1

619

19.5.1

Off-market bids

620

19.5.2

Market bids

621

19.5.3

Disclosure requirements

621

19.5.4

Creeping takeover

622

19.5.5

Partial takeovers

622

19.5.6

Schemes of arrangement

622

19.5.7 Other controls on takeovers

623

19.5.8 Tax effects of takeovers

623

19.5.9

624

Break fees, takeovers and corporate governance

1 1 9 . 6 1 TAKEOVER DEFENCES

W

605

625

19.6.1

Poison pills

625

19.6.2

Acquisition by friendly parties

625

19.6.3

Disclosure of favourable information

625

19.6.4 Claims and appeals

626

19.6.5 The effects of takeover defences

626

CORPORATE RESTRUCTURING

627

19.7.1

Divestitures

627

19.7.2

Spin-offs

627

19.7.3

Buyouts

628

XXIII

C ontents

EMPIRICAL EVIDENCE ON TAKEOVERS

630

19.8.1

631

The target company

19.8.2 The acquiring company

631

19.8.3

Are takeovers poor investments?

633

19.8.4

Distinguishing between good and bad takeovers

636

19.8.5 The net effects of takeovers

636

19.8.6 The sources of gains from takeovers

637

Summary

639

Key terms

639

Self-test problems

640

Questions

640

Problems

642

References

643

Chapter 20

B Q

Management of short-term assets: inventory

646

Learning objectives

646

INTRODUCTION

647

THE IMPORTANCE OF SHORT-TERM FINANCIAL DECISIONS

647

TYPES OF SHORT-TERM ASSET

648

20.3.1

Inventory

648

20.3.2

Liquid assets (cash and short-term investments)

648

20.3.3

Accounts receivable (debtors)

648

B Q

THE NEED FOR SHORT-TERM ASSET MANAGEMENT

648

Q fl

SHORT-TERM ASSETS AND SHORT-TERM LIABILITIES

649

E H

OVERVIEW OF INVENTORY MANAGEMENT

650

B Q

E 0

INVENTORY COSTS: RETAILING AND WHOLESALING

650

20.7.1

Acquisition costs

650

20.7.2

Carrying costs

651

20.7.3

Stockout costs

651

INVENTORY COSTS: MANUFACTURING

651

20.8.1

Inventories of raw materials

651

20.8.2

Inventories of finished goods

652

in v e n t o r y

MANAGEMENT UNDER CERTAINTY

652

20.9.1

The economic order quantity (EOQ) model

652

20.9.2

Cost estimation

655

20.9.3

The EOQ model with positive lead time

656

20.9.4 The EOQ model with quantity discounts

657

E S S INVENTORY MANAGEMENT UNDER UNCERTAINTY 20.10.1

658

Specifying an acceptable probability of stockout

660

20.10.2 Specifying an acceptable expected customer service level

660

20.11 INVENTORY MANAGEMENT AND THE 'JUST-IN-TIME' SYSTEM

661

Summary

662

Key terms

663

Self-test problems

663

Questions

663

Problems

664

References

665

Chapter 21

Management of short-term assets:丨 iquid assets and accounts receivable

666

Learning objectives

666

O H

INTRODUCTION

667

w xn

OVERVIEW OF LIQUIDITY MANAGEMENT

667

21.2.1

W hat are liq u id ' assets?

667

21.2.2

Liquidity management and treasury management

667

21.2.3

Centralisation of liquidity management

668

Q Q

Q Q

21.2.4 Motives for holding liquid assets

669

21.2.5

669

Major issues in liquidity management

CASH BUDGETING

670

21.3.1

Forecasting cash receipts

670

21.3.2

Forecasting cash payments

671

THE CHOICE OF SHORT-TERM SECURITIES

673

TYPES OF SHORT-TERM INVESTMENT

674

21.5.1

Deposits of funds with financial institutions

674

21.5.2

Discounting of commercial bills

674

21 6 | THE CORPORATE TREASURER AND LIQUIDITY MANAGEMENT Q Q

Q Q

675

OVERVIEW OF ACCOUNTS RECEIVABLE MANAGEMENT

675

21.7.1

675

What are accounts receivable?

CREDIT POLICY

677

21.8.1

The decision to offer credit

677

21.8.2

Selection of credit-worthy customers

677

21.8.3

Limit of credit extended

680

21.8.4 Credit terms

680

COLLECTION POLICY

681

EVALUATION OF ALTERNATIVE CREDIT AND COLLECTION POLICIES

682

Summary

686

Key terms

687

Self-test problems

687

Questions

687

C ontents

Problems

688

References

689

APPENDIX 21.1 FINANCIAL STATEMENT ANALYSIS

xxvi

690

Introduction

690

Measurement and interpretation of several financial ratios

690

Usefulness of financial ratio analysis

695

Financial ratios and short-term asset management

696

Appendix A Numerical tables

698

Appendix B Solutions to self-test problems

709

Glossary

725

Index

736

PREFACE W This book is designed primarily for use in a first subject in the principles and practice of finance. Our main objectives are to introduce readers to finance theory and to the tools of financial decision making in the context of the Australian institutional environment. Nevertheless, it is also suitable for students who have completed an introductory subject on capital markets and financial institutions. It also contains sufficient material for two subjects in finance. Readers who are familiar with previous editions of the book will notice changes that go well beyond the updating that might be expected from a new edition. New finance theories and new empirical evidence are presented with each edition. For example, in this edition both new theoretical material and related empirical evidence have been incorporated on the determinants of payout policy (Chapter 1 1), the capital structure decision (Chapter 13) and the analysis of takeovers (Chapter 19). Some of this new material provides more detailed coverage, compared with previous editions, of the expanding area of behavioural finance—an area where investor psychology is incorporated into research design. Theories and evidence with respect to market efficiency (Chapter 16) are also updated. Since the eleventh edition, Eugene Fama and Robert Shiller have each been awarded the Nobel Memorial Prize in Economic Sciences for their work examining market efficiency. Both have made a fundamental contribution to our understanding of market efficiency yet they have different views as to the extent that markets are efficient. Like the Nobel Prize Committee, the approach we take is to highlight the range of evidence in this area. Practice in finance also necessitates updates. For example, since the last edition there have been on-going developments in financial markets, including in Australia, and changes in the functions of banks. M any of these developments result from the Global Financial Crisis and are incorporated in Chapter 8. Rather than distort the coherent flow of the book by altering its structure to reflect these changes in principles and practice, new material is embedded into the existing structure. Indeed, the major structural change in this edition is the omission of international finance as a separate chapter and instead embedding material where appropriate into relevant chapters; in particular into Chapter 17, which now incorporates a detailed discussion of swaps. Finally, we wish to express our special thanks to Graham Peirson and Peter Howard who have both retired from active authorship but have made a substantial contribution to the foundations of the book. Graham deserves particular mention. Having been central to the book from the first edition, he continues to make a great contribution to each new edition by providing valuable comments on the draft of each chapter. Graham brings not only a deep knowledge but also an uncanny ability to detect flaws in logic and in writing style. His thoroughness has again prevented many such flaws from appearing in print. ROB BROWN

♦

STEVE EASTON

♦

SEAN PINDER

August 2014

x x v ii

ABO U T THE AUTHORS G rah am Peirson Graham Peirson is Emeritus Professor of Accounting and Finance at Monash University. He has published widely in academic and professional journals and is also coauthor of Issues in Financial Accounting; Accounting: An Introduction; Financial Accounting: An Introduction; and Financial Accounting Theory. Graham is a graduate of Adelaide University, and has taught at Adelaide University, the University of California (Berkeley), the University of Illinois, the University of Florida and the University of Washington. He has also taught short courses for a range of clients, including the Australian Competition and Consumer Commission and the National Australia Bank.

Rob Brown Rob Brown is Emeritus Professor of Finance at the University of Melbourne. He has published many research papers in international journals, including Economica, the Journal o f Banking and Finance, the Journal o f Multinational Financial Monogementand \he Journal o f Fixed Income. He is a former associate editor (finance) of Accounting and Finance, the research journal of the Accounting and Finance Association of Australia and New Zealand. Rob has taught at the University of Sydney, Lancaster University and Monash University, and been a visiting scholar at the University of British Columbia (Canada) and the University of Manchester (UK). His current research interests are analysts' investment recommendations.

Steve Easton Steve Easton is Professor of Finance at the University of Newcastle, where he previously served as Head of the Department of Accounting and Finance and Dean of the Faculty of Economics and Commerce. His research work has been accepted for publication in a wide range of journals, including the Journal o f Futures Markets, Economico and the Journal o f Banking and Finance. Steve has taught at Adelaide University, Lancaster University and Monash University. He has also provided short courses for a range of private and public sector organisations, including Australia Post, Macquarie Generation, State Forests of New South Wales and the Tasmanian Chamber of Commerce and Industry. His current research interests are in asset pricing, portfolio management and corporate governance.

XXVIII

Peter H o w a rd Peter Howard taught finance at Monash University for more than 25 years. Before this he worked for eight years as an engineer in the petrochemical and mining industries. He has extensive experience in project evaluation and has taught on short courses for a range of clients, including BHP Billiton and the National Australia Bank. Peter has published in academic and professional journals on lease evaluation and the effects of imputation on payout and financing decisions. He has extensive teaching experience at both postgraduate and undergraduate levels. Since retiring from Monash University he has maintained a strong interest in the finance literature and the operation of Australian financial markets.

Sean Pinder Sean Pinder is an Associate Professor in the Department of Finance at the University of Melbourne. Prior to this he held positions at Monash University and the University of Newcastle and taught at the postgraduate level at Lancaster University in England and the Melbourne Business School. He has undertaken a range of consulting activities for international firms and has developed and delivered professional short courses on treasury risk management, derivatives and capital budgeting issues for major Australian and international companies. Sean has an extensive research profile, with his work appearing in leading Australian and international journals. He has received a number of prizes for his research and teaching.

A C K N O W LE D G M E N T S We have received valuable assistance from a number of people, including Philip G. Brown, Chris Deeley, Paul Docherty, Stefan Petry and Michael Seamer. We would like to join McGraw-Hill in thanking academic colleagues who provided their valuable time and expertise in aligning the learning resources with this edition of our book. They include: ♦ Mariya Yesseleva-Pionka, Monash University ♦

Neil Hartnett, University of Newcastle

♦ Damian Bridge, Macquarie University ♦ Md Akhtaruzzaman, University of Newcastle We also owe a debt of thanks to the following reviewers of earlier editions who have helped us shape the text you hold today: John Ablett (University of Western Sydney), David Allen (Edith Cowan University), Vicki Baard (Macquarie University), Robert Bianchi (Griffith University), Barry Burgan (University of Adelaide), Nicholas Carline (Lancaster University, UK), Meena Chavan (Macquarie University), Andrew Child (Monash University), Scott Dobbs (University of Wollongong), Samson Ekanayake (Deakin University), Don Geyer (Charles Sturt University), Abeyratna Gunasekarage (Monash University), Neil Hartnett (University of Newcastle), Darren Henry (La Trobe University), Ben Jacobsen (James Cook University), Sian Owen (University of New South Wales), Judy Paterson (University of Canberra), Alex Proimos (Macquarie University), Boyd Scheuber (University of Southern Queensland), Chander Shekhar (University of Melbourne), Jing Shi (Australian National University), Yew Lee Tan (Victoria University), Madhu Veeraraghavan (Monash University) and David W oodliff (University of Western Australia). In addition, we thank publisher Jillian Gibbs and senior product developer Jane Roy. Thanks also to Kate Easton for her suggestions for the cover design of this book. Finally, and most importantly, we thank our wives—Chris, Rayna, Diane, Dawn and Debra—for their support during this project.

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HIGHLIGHTS OF THIS EDITION CHAPTER 1

CHAPTER 8

►

►

Delivers a simple, concise overview of the essential

Update on developments in Australian financial markets.

concepts of corporate finance. ►

Expanded discussion of the functions of banks.

CHAPTER 2 ►

Provides detailed coverage of Fisher’s Separation Theorem and the company’s objective to maximise

CHAPTER 9 ►

Provides greater detail on the various accelerated rights issue structures that have developed in the

current value.

Australian market and recent evidence on the

CHAPTER 3

popularity of, and costs associated with, the main

►

methods of raising equity capital.

Introduces simple interest, compound interest and the time value of money in one logically structured chapter.

CHAPTER 10 ►

►

Greater emphasis on zero-coupon rates and the zero-rate curve.

► ►

New section on pricing off the zero curve.

Features a new Finance in action piece on the failure of the Banksia Financial Group.

CHAPTER 4 ► ►

Updating of discussion of debtor finance. Expanded overview of the growth of the debenture and corporate debt markets in Australia.

Includes estimates of the Australian zero-rate curve.

►

Updates Australian corporate and government

►

ratings. Expanded explanation of liquidity (risk) premium approach to the term structure.

BRIEF CONTENTS CHAPTER 1 CHAPTER 2 CHAPTER 3

CHAPTER 5 ►

Provides international survey evidence of capital

CHAPTER 4

budgeting practices. ►

Features an in-depth discussion of the application

CHAPTER 5

of real options analysis as well as evidence of the extent of usage of the technique.

CHAPTER 6 ►

Is dedicated specifically to applying methods of project evaluation.

►

Includes a new section dealing specifically with how taxes should be incorporated into project evaluation techniques.

CHAPTER 7 ►

Updates empirical evidence concerning the market risk premium in an international and domestic context.

►

Includes a detailed discussion of models that incorporate factors other than systematic risk in explaining expected returns.

►

CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

7 8 9 10 11 12 13 14 15

CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

16 17 18 19 20

Updates estimates of the systematic risk of Australian firms.

►

CHAPTER 6

Addresses alternative methods of appraising the performance of an investment portfolio.

CHAPTER 21

Introduction ...................................... 1 Consumption, investment and the capital market ................................ 10 The time value of money: an introduction to financial mathematics....................................28 Applying the time value of money to security valuation ...................... 74 Project evaluation: principles and methods ......................................103 The application of project evaluation methods.................... 129 Risk and return ........................... 172 The capital market .......................210 Sources of finance: e q u ity ...........232 Sources of finance: debt ............. 275 Payout policy ...............................315 Principles of capital structure ...... 356 Capital structure decisions ..........393 The cost of capital ...................... 417 Leasing and other equipment finance ..........................................450 Capital market efficiency ............477 Futures contracts and swaps........ 507 Options and contingent claims ..563 Analysis of takeovers ..................605 Management of short-term assets: inventory .....................................646 Management of short-term assets: liquid assets and accounts receivable..................................... 666

H ighlights

^ ►

Expanded discussion of convertible securities and

►

of this edition

Features a new Finance in action piece illustrating

why they are issued.

the impact of expectations in share market reaction

Restructure of the discussion of preference shares.

to announcements.

CHAPTER 1 1

CHAPTER 17

►

Includes changes in the legal requirements for payment of dividends.

►

Includes updated exchange contracts values and

►

Emphasises the importance of a 'full payout' policy

►

exchange indices throughout. The chapter now includes a detailed discussion

► ►

and de-emphasises the dividend irrelevance theorem.

of swaps, including a comprehensively revised

Highlights recent evidence on the market value of

discussion of interest rate swaps which emphasises

franking credits.

the different uses of swaps.

Discusses recent research on the growing importance of share buybacks and the substitution of buybacks for dividends.

於

CHAPTER 1 8 ►

relationship between an option's market price

Includes an explanation of behavioural factors that

and characteristics such as its term-to-expiry and

may affect payout policy. ►

exercise price.

Features a new Finance in action piece on ANZ Bank’s dividend announcement.

Includes updated examples illustrating the

►

Features a Finance in action piece describing how

CHAPTER 12

options written on a share price index are used to create a Volatility Index (VIX), which then provides

►

useful information to investors about the level of

Updates of examples.

uncertainty in the market.

CHAPTER 13 ►

Features a new Finance in action piece on the benefits of the no-debt decision of a company that

CHAPTER 19 ►

►

Includes recent Australian evidence on surveys of

►

activity.

Includes recent empirical evidence on the costs of ►

►

financial distress. Includes recent empirical evidence with respect to agency costs.

►

Updates the discussion of the regulation of takeover activity. Extensively updates the empirical evidence presented on the wealth effects of alternative forms

CHAPTER 14

►

Includes a new section providing survey evidence of the motives of acquiring managers for takeover

chief financial officers. ►

►

Updates empirical evidence on the fluctuations in takeover activity over time.

had previously experienced a financial collapse.

of takeovers and corporate restructuring including

Updates empirical evidence on the value of

the role of investor psychology in determining what

imputation tax credits in Australia.

an appropriate bid price may need to be in order

A streamlined discussion of the impact of taxes on

to ensure success of a bid.

the process of project evaluation. ►

Features a new Finance in action piece dealing with

CHAPTER 2 0

the new approach taken by the Australian Energy

►

CHAPTER 15 ► ►

or advanced student. ►

A new Finance in action piece on inventory management problems at Treasury W ine Estates.

Updated evidence on the use of lease finance by Australian companies.

CHAPTER 21

Includes a discussion of the proposed changes to the

►

by the International Accounting Standards Board CHAPTER 16

Provides concise but thorough coverage of short­ term assets, focusing on liquid assets and accounts receivable, for the curious or advanced student.

accounting standards relating to leases as put forward

►

Provides concise but thorough coverage of short­ term assets, focusing on inventory, for the curious

Regulator to estimate an appropriate weighted average cost of capital for energy distributors.

►

Provides, in the appendix, a completely updated

Incorporates a range of new evidence with respect

comprehensive example demonstrating the application of financial statement analysis

to the extent to which markets are efficient.

techniques in practice. XXXIII

H O W TO USE THIS B O O K L e arn in g objectives list the information you will learn by studying the chapter. They are restated in the margins in appropriate locations and so become useful revision tools.

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

understand how assets are valued under conditions of certainty

m

2

use the tools of financial mathematics to value equity securities

3

explain the main differences between the valuation of ordinary shares based on dividends and on earnings

4

use the tools of financial mathematics to value debt securities

5

explain the nature of interest rate risk

6

understand the theories that are used to explain the term structure of interest rates

7

understand the effect of default risk on interest rates

8

apply the concept of duration to immunise a bond investment.

LEARNING OBJECTIVE 1 Understand how assets are valued under conditions of certainty

C h ap fe r introductions give you an overview of the chapter's most important points and contextualise the topics to the wide area of business finance.

Introduction I n C h a p t e r 1 w e d is c u s s e d b r ie f ly t h e im p o r t a n t c o n c e p t o f t h e t im e v a lu e o f m o n e y . I n C h a p te r 3 w e p r e s e n te d s o m e m a t h e m a t ic a l to o ls u s e f u l i n a n a ly s in g p ro b le m s in v o lv in g t h e t im e v a lu e o f m o n e y . I n p a r t i c u la r , w e s h o w e d h o w p ro m is e d s tre a m s o f f u t u r e ca sh flo w s c a n b e v a lu e d , p r o v id e d t h a t th e r e q u ir e d r a te o f r e t u r n is k n o w n . I n t h i s c h a p te r w e a p p ly th e s e to o ls t o t h e v a lu a t io n o f d e b t a n d e q u it y s e c u r itie s . I n i t i a l l y w e a s s u m e t h a t t h e s e c u r it y s f u t u r e c a s h flo w s a re k n o w n w i t h c e r ta in ty . L a t e r in t h e c h a p te r w e in tr o d u c e u n c e r t a in t y , b u t o n ly i n a lim it e d w a y . A m o re f o r m a l a n d d e ta ile d t r e a t m e n t o f u n c e r t a in t y is g iv e n in C h a p te r 6 .

K e y term s are defined in the margins beside the term's first appearance in the text. These terms are then listed in the glossary at the end of the book. T h e le a s t c o m p lic a te d m e a s u re o f t h e t e r m

s tr u c tu r e o f in t e r e s t ra te s is t h e m a r k e t y ie ld o n a

g o v e r n m e n t b o n d t h a t p a y s n o in t e r e s t d u r in g it s lif e , b u t p a y s a fix e d s u m a t m a t u r it y . S u c h a b o n d is ZERO-COUPON BONDS (ze r o s )

bonds that pay only one cash flow, the payment at maturity

k n o w n as a z e r o - c o u p o n b o n d ( o f te n a b b r e v ia te d ju s t t o a z e r o ) . T h e p ric e o f a z e ro w i t h a fa c e v a lu e o f F d o lla r s a n d a t e r m o f n y e a rs is s im p ly :

P〇 = (l+z„)n

Example 4. Rankine Ltd is currently paying a dividend of 90 cents per share. If investors expect this dividend to be maintained and require a rate of return of 15 per cent on the investment, what is the value of Rankine’s shares?

SOLUTION The value of Rankine's shares is calculated as follows: 0

歷0 .1 5 = $ 6.00

xxxiv

E x a m p le s are provided throughout the text to illustrate the practical application of the theory and working providing guidance for students.

How

TO USE THIS BOOK

Finance in action F,NANCE

ON GUARD AGAINST A BOND FALL

IN ACTION

----------------------------- ------------ ------- ---- ----------------- ---------------------- ------------------- -----------In an artide published in 2013, financial journalist Christopher Joye reminds readers of interest rate risk, which flows from the connection between interest rates and bond prices. Bond traders have been making out like bandits since the global financial crisis. A portfolio of Australian government bonds with maturities longer than 10 years has delivered annual total returns of over 12 per cent since December 2007. Yet the preconditions for the mother-of-all bond market reckonings are sliding into place. This contingency, which AM P^ Shane O liver believes is a 'significant risk', could result in wiping more than $60 billion off Aussie bond values, with steep capital losses. To properly understand these risks, one needs to appreciate how extraordinary current circumstances are. W hen doing so, it helps to keep in mind a key principle: bonds that pay fixed, a$ opposed to variable, rates hove prices that are inversely related to external interest rates. If you invested in a bond paying an annual fixed coupon of, say, 3 per cent, and market interest rates surge to 5 per cent, that bond would be worth substantially less than when you bought it. The converse is also true: if market rates decline ... it would be worth more. This is why Australian government bond prices have soared since 2007: market yields have fallen sharply as global central banks have floored policy rates close to zero and printed unprecedented amounts of money to fund public and private debt.

is a feature containing interesting items from the business media that relate the theory to real-world practice.

Source: 'O n guard against a bond fall', Christopher Joye, Australian Financial Review, 5 January 2013, p. 39.

S u m m a rie s give students a checklist of the topics covered in the chapter and

SUMMARY •

Financial assets such as bonds and shares can be valued by discounting their future cash flows to present values and summing these present values. The discount rate used is the required rate of return or opportunity cost of capital. • If the future cash flows from an asset are certain, the required rate of return will reflect only the effect of time on the value of money. • If the future cash flows are uncertain, investors will also require compensation for risk and the rate will be increased by the inclusion o f a risk premium.

serve as a useful revision tool when preparing for exams.

•

•

and a price-earnings ratio. The value of this ratio depends mainly on risk and expected growth in earnings. Debt securities (bonds) are priced by discounting their future coupon interest payments and face value. For any company, the interest rate required by lenders will be less than the required rate of return on the company's ordinary shares. The price of a debf security is inversely related to the interest rate required by investors. Interest rates at any given time will usually be different for different terms to maturity. This pattern is known

Self-test p ro b le m s

f jt

at the end of selected

SELF-TEST PROBLEMS

1 Richards Ltd pays annual dividends on its ordinary shares. The latest dividend was 75 cents per share and was paid yesterday. Dividends are expected to grow at 8 per cent per annum for the next 2 years, after which a growth rate of 4 per cent per annum will be maintained indefinitely. Estimate the value of one share if the required rate of return is 14 per cent per annum. 2 A government bond with a face value of $100 and a coupon interest rate of 11 per cent per annum matures in 3 years, time. Inferest payments occur twice each year and a payment has just been made. If the current market yield on the bond is 13 per cent per annum, what is the current price of the bond? 3 The current interest rates (yields) on zero-coupon government bxinds are as follows:

1

13.90

2

11.70

3

10.50

chapters cover all the topics within the chapter for thorough exam preparation.

Assume that the term structure can be explained purely by expectations of future interest rates, and therefore there is no liquidity (or risk) premium. Calculate the expected 1-year rates for the next 2 years. Solutions to self-test p r o b lem s a r e a v a ila b le in A p p e n d ix B.

Additional e n d -of-ch ap te r q u e stio n s a n d p ro b le m s provide further practice and

cA

Valuation under certainly [LO 1] A promise to pay $10000 in 4 years, time is certain to be kept. If the risk-free rate for a 4-year term is 5.5 per cent per annum, what is the value of this promise today? Do we know what the value will be in a year's time? Why or why not?

2

Valuation of shares [LO 2] Assume that today is the last day of 2014. Rednip Ltd is expected to pay annual dividends of 64 cents in 2015 (Year 1). Assume that this dividend is expected to grow at an annual rate of 10 per cent and investors require a rate of return of 20 per cent per annum,

develop deeper understanding of the topics covered. They are linked back to the learning objectives for each chapter.

PROBLEMS

1

a) Estimate Rednip Ltd's share price today.

XXXV

CHAPTER CONTENTS m

Finance as an area of study

2

m

The company's financial objective

m

Financial decisions

2

KB

Fundamental concepts in finance

KQ

Busi门 ess structures

3

IB

Outline of the book

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

describe the structure of finance as an area of study

2

identify the major decisions made by financial managers and investors

3 identify the major types of business entities 4 specify the objective of the company 5 identify and explain the fundamental concepts in finance.

B usiness finance

Finance as an area of study LEARNING OBJECTIVE 1 Describe the structure of finance as an area of study

This book introduces the reader to the area o f study know n as finance. Although financial issues have been studied fo r centuries, i t is only relatively recently— in the last 50 years or so— th a t finance has emerged as an area o f study in its own rig ht, w ith a well-established body o f theory and evidence. In the chapters th a t follow, we w ill introduce you to the m ajor issues in finance. Finance can be described as having tw o m ain components, which are:1 • •

corporate finance investments.

Corporate finance takes the view point o f the company. The m ain issues involved are the choice o f assets, the financing decision and the dividend decision. Imagine th a t a group o f investors has set up a new company. The investors are the shareholders (that is, the owners) o f the company. The company must decide2 w hat assets i t w ill buy and how i t w ill fund the purchase o f these assets. The company may use its own m oney— th a t is, the money contributed by the shareholders— to fund the purchase, or i t may borrow the money. O r it may use b oth shareholders* funds and borrowed funds. When the company has been operating fo r a tim e, it may have made a p ro fit. I f so, it may decide to d istribute some or all o f the p ro fit to the shareholders. Such a d istrib u tio n is called a dividend. I f the dividend paid is less than the p ro fit, then some o f the p ro fit is retained w ith in the company, and w ill be used to fu nd asset acquisitions and/or debt repayment. Corporate finance is also concerned w ith corporate governance issues. For example, should the Board o f Directors include some outsiders*? Should senior managers be granted shares to encourage them to make decisions th a t are in the best interests o f the shareholders? Investments takes the view point o f the investor rather than the company. Investors are concerned about the re tu rn they w ill earn on an investm ent — the more the better. But unless investors are w illin g to take a risk, they cannot expect to earn a high return. A ll investors dream o f fin d in g an investm ent th a t produces high returns at low risk— b u t m ost w ill never fin d one. So, investors m ust make a trade­ o ff between retu rn and risk. In investm ents, this balancing o f risk and re tu rn is a m ajor issue. A large p art o f the solution is fo r investors to choose a diversified set o f assets in w hich to invest. Investments is also about the pricing o f securities such as shares and bonds. These securities are traded in financial markets, many o f which are very active, w ith transactions ru n n in g in to the m illions o f dollars every day. How does the risk o f a security affect the price at which i t w ill trade in these financial markets? W hat factors, other than risk, m ig ht also be im portant? And how m ig h t the price be expected to change in the future?

Financial decisions LEARNING OBJECTIVE 2

In this book we focus on financial decisions made by companies and investors. Some o f these decisions are: Corporate (or company) decisions:

Identify fhe major decisions made by financial managers and investors

Asset management: W hat new assets should the company acquire? How much should i t pay fo r these assets? W orking capital management: How much cash should the company hold? How much inventory? Capital structure: How much should the company borrow? Payout policy: How much should the company pay out to its shareholders? Mergers and acquisitions: Should the company take over another company? 1

2

A third component, financial markets and institutions, overlaps to some extent with corporate finance and investments. The focus o f this component is on the markets for various securities and the design of financial instruments. It also considers the financial issues faced by banks and other financial institutions. Strictly speaking, a company is just a legal structure, and hence cannot have any personal qualities, such as the ability to make decisions. Company decisions are in fact made by people such as the company s directors. However, for ease of exposition, we attribute personal qualities to companies.

C hapter o ne Introduction

Investor decisions: • •

Portfolio theory: How can an investor achieve a better trade-off between risk and return? Asset pricing: How much is a particular security w orth? W hat is the relationship between long-term interest rates and short-term interest rates?

Busi门ess structures When a business is being established, one o f the firs t decisions th a t has to be made concerns the type o f business structure th a t is to be used. In Australia, although many small businesses are sole proprietorships or partnerships, nearly all large businesses, and many thousands o f small businesses, are companies. Hence, in this book, our focus is on companies. But to place the corporate (company) form in context, we firs t discuss the advantages and disadvantages o f sole proprietorships and partnerships.

LEARNING OBJECTIVE 3 Identify the major types of business entities

1.3.1 I Sole proprietorship A sole proprietorship is a business owned by one person. M any small service businesses, retail stores and professional practices are operated as sole proprietorships.

SOLE PROPRIETORSHIP

business owned by one person

Advantages The advantages o f a sole proprietorship structure include: • • •

Control o f the business rests w ith the owner, so it is relatively easy to make decisions and there is no scope fo r disagreements between owners. I t is easy and inexpensive to form , and to dissolve. It is n o t treated as a separate e n tity fo r tax purposes. Therefore, any business p rofits belong to the owner and are taxed only once as p art o f the owner s assessable income.

Disadvantages The disadvantages o f a sole proprietorship structure include: • •

•

It is n o t a separate legal e n tity and therefore the owner has unlim ite d lia b ility fo r debts incurred by the business. In other words, all obligations o f the business are personal obligations o f the owner. The size o f the business is lim ite d by the wealth o f the owner and by the am ount th a t can be borrowed. I t can be d ifficu lt to raise funds fo r expansion because lenders are usually reluctant to lend large amounts to individuals. Ownership o f a sole proprietorship can be transferred only by selling the business to a new owner. I f a sole proprietorship is n o t sold, then i t w ill cease to exist when the owner retires or dies.

1 .3.2! Partnership A partn ersh ip is a business owned by tw o or more people acting as partners. M any small service

PARTNERSHIP

businesses, retail stores and professional practices are operated as partnerships.

business owned by two or more people acting as partners

Advantages The advantages o f a partnership structure include: •

•

I t is easy and inexpensive to fo rm because there are no legal requirements th a t need to be met. A ll th a t is necessary is an agreement, preferably in w ritin g to avoid future disagreements, by those form ing the partnership. A partnership can combine the wealth and talents o f several individuals, and employees can be offered the prospect o f becoming partners (owners) in the future.

B usiness finance

Disadvantages There are also im p o rta n t disadvantages o f a partnership structure, including: • •

•

Partnerships are n o t separate legal entities and the partners are therefore personally liable for obligations (including debts) entered in to by the partnership. It can be d ifficu lt fo r partners to w ithdraw th e ir investm ent because the partnership w ill term inate i f a p artne rs interest in the partnership is sold or a partner dies. In either case, a new partnership w ill have to be formed. Disputes between partners or form er partners can be very damaging.

.3 .3 1Company COMPANY

separate legal entity formed under the Corporations Act 2001; shareholders are the owners of a company

A com pany is a separate legal e n tity form ed under the Corporations A ct 2001. The owners o f a company are called shareholders because th e ir ownership interests are represented by shares in the company s capital. Companies vary greatly in size. They range from large companies listed on a stock exchange w ith many thousands o f shareholders to small fam ily companies carrying on a relatively small-scale business. In a large company, the shareholders and the managers are usually separate groups. The shareholders elect the Board o f Directors, which appoints managers to run the company on behalf o f the shareholders.

Advantages Companies have several advantages, including: • LIMITED LIABILITY

legal concept that protects shareholders whose liability to meet a company’s debts is limited to any amount unpaid on the shares they hold

• •

A company is a legal e n tity d istin ct from the owners, which enables it to conduct its operations in its own name. A company can buy, own and sell property; it can sue or be sued in its own name; and i t can enter into contracts w ith other entities. The shareholders o f m ost companies have lim ited liability. This means th a t i f the company fails and i t is unable to pay its debts, the owners o f fu lly paid shares are n o t obliged to contribute fu rth e r funds to meet the company s debts. However, if shares are p a rtly paid, then shareholders can be obliged to contribute any unpaid amount. A company has an indefinite life, which means that, unlike a sole proprietorship or partnership, its existence and operations are unaffected by the death or retirem ent o f its owners. The Corporations Act 2001 distinguishes between public companies, which may in vite members o f the public to invest in them, and proprietary companies, which have no such power. Public companies may be listed on a stock exchange, which facilitates trading in the company s shares. Ownership o f shares in a listed public company can be transferred very easily w ith o u t any effect on the company s operations, which are conducted by employees. Stock exchange lis tin g also makes it relatively easy fo r public companies to raise capital by issuing additional shares th a t are sold to existing shareholders or to new investors.

Disadvantages The corporate form o f ownership also has some disadvantages, which include: • •

•

•

•

A company is more expensive to establish than a sole proprietorship or a partnership. A company is subject to more onerous regulation. For example, there are extensive reporting requirements, p articularly fo r listed public companies. Capital raising by companies is also highly regulated. For example, shares and other securities can be issued only i f investors are provided w ith info rm a tio n to make inform ed decisions about whether to invest in those securities. It can be d ifficu lt to m otivate managers and staff who are employees o f a company. In comparison, sole proprietorships and partnerships are managed by people who are also owners o f the business and who w ill see a direct lin k between th e ir efforts and the rewards they receive. Because a company is owned by one group (the shareholders) b ut may be run by a d ifferent group (the managers), there can be conflicts o f interest between those who own the company and those who make decisions on th e ir behalf. These conflicts result in agency costs1which are discussed fu rth e r in Section 1.5.8. The taxation treatm ent o f companies can be a disadvantage. Company profits are subject to income tax and shareholders may also be taxed when they receive dividends paid o ut o f the profits.

C hapter o ne Introduction

Therefore, the use o f a company structure can involve double taxation. However, the extent o f this problem depends on the type o f taxation system imposed by the government. Under Australian tax law, many shareholders are n ot subject to double taxation. Much o f this book concerns listed public companies. However, m ost o f the concepts in this book are also relevant to other form s o f business entity. There w ill, o f course, be differences in the details, depending on the e n tity s size and the nature o f its business. In addition, many o f the ideas considered in this book can be applied to n o t-fo r-p ro fit entities, including public sector entities.

Rational solutions to investm ent and financing problems can only be achieved i f the company s objective is clearly specified. The objective assumed in m ost o f this book is th a t management seeks to maximise the m arket value o f the company s ordinary shares. Because an alternative term fo r shares is equityt this objective is often expressed as the m axim isation o f the m arket value o f shareholdersJequity. I t is consistent w ith the economists assumption th a t companies seek to maximise economic p ro fit. I f the m arket value o f a company s ordinary shares is maximised, then the opportunities open to the shareholders are also maximised— greater wealth implies more choices. For example, i f a shareholder wishes to sell his or her shares in order to finance greater consumption, the higher the share price, the greater are his or her consumption opportunities.

In Section 1.4 we stated th a t we assume th a t management seeks to maximise the m arket value o f shareholders’ equity. To achieve this objective, the financial manager m ust understand how financial markets work. To finance a company s investments, securities, such as shares and debt securities, w ill need to be issued— th a t is, these securities w ill need to be sold to investors. Subsequently, investors may choose to sell th e ir securities to other investors in financial markets. The actions o f buyers and sellers in financial markets w ill determ ine the prices o f the securities and therefore the m arket value o f the company. The m arket value, V, o f a company may be expressed as:

LEARNING OBJECTIVE 4 Specify the objective of the company

LEARNING OBJECTIVE 5 Identify and explain the fundamental concepts in finance

V= D+ E where

D = the m arket value o f the company s debt E = the m arket value o f the company s equity (shares) The value th a t the financial markets place on a company s debt and equity securities w ill depend on the risk and expected return on investments in those securities. In tu rn , the risk and retu rn o f the securities w ill depend on the risk and return th a t the company achieves on the investments it makes in its assets. In finance, the success o f an investm ent is judged by its a b ility to generate more cash than originally outlaid on the investment. This w ill enable the company to make interest payments to lenders and repay the amount borrowed, and to make payouts, such as dividends, to shareholders.

The tim e value o f money principle is based on the proposition th a t an individual w ill always prefer to receive a dollar today rather than receive a dollar at any later date. Even i f the individual does n ot want to spend the dollar today, he or she would rather receive the dollar today and then invest it, rather than receive the dollar at a later date. Therefore, a dollar is w o rth more Qess), the sooner (later) i t is to be received, all other things being equal.This principle is discussed and applied in Chapter 3. Some fu rth e r applications are considered in Chapter 4.

TIME VALUE OF M ONEY

principle that a dollar is worth more (less), the sooner (later) it is to be received, all other things being equal

B usiness finance

1 .5 .3 1 Risk aversion

RISK-AVERSE INVESTOR

an investor who dislikes risk and who will only choose a risky investment if the expected return is high enough to compensate for bearing the risk

In finance, i t is usually assumed th a t investors display risk aversion, which means th a t they do not like risk. Given a choice between tw o investments th a t have the same expected return, b u t one has lower risk, a risk-averse investor w ill choose the one w ith the lower risk. Risk aversion does n o t im ply that an investor w ill reject all risky investments. Rather, it implies th a t an investor w ill choose a risky investment only i f the expected retu rn on the investm ent is high enough to compensate the investor fo r bearing the risk. Because investors are risk averse, we expect th a t in the long term , the average re tu rn on high-risk investments w ill exceed the average retu rn on low -risk investm ents— i f this were n o t so, no-one would invest in the high-risk investments. For example, in the long term , shares produce higher returns than bank deposits because shares are riskier than bank deposits. The relationship between ris k and expected return is discussed in Chapter 7.

The purchasing power o f money changes as a result o f price increases (inflation) and price decreases (deflation). D uring a period o f in fla tio n there is an increase in the general level o f prices, w ith a consequent decrease in the purchasing power o f money. In contrast, during a period o f deflation there is a decrease in the general level o f prices, w ith a consequent increase in the purchasing power o f money. I t is necessary, therefore, to distinguish between the nominal or face value o f money and the real or inflation-adjusted value o f money. For example, i f the annual rate o f in fla tio n is 3 per cent, the real value o f a dollar is decreasing annually by 3 per cent— th a t is, relative to the purchasing power o f a dollar today, a dollar next year w ill be w orth only 97 cents in real term s.3 Returns on investments may be measured in either nom inal or real terms. In m ost financial markets, trading is conducted in nom inal terms. Similarly, m ost financial contracts are w ritte n in nom inal terms. For example, the interest rate agreed to in a loan m ust be paid whatever the future in fla tio n rate turns out to be. Such an interest rate is called a nominal interest rate. An interest rate may also be expressed in real terms, w hich is equal to the nom inal interest rate after taking out the effect o f infla tion . I f the nom inal rate o f retu rn on an investm ent exceeds the in fla tio n rate, then the real rate o f return is positive— th a t is, the investm ent w ill increase the investors purchasing power.

An efficient financial market is one composed o f numerous w ell-inform ed individuals whose trading activities cause prices to adjust instantaneously and w ith o u t bias in response to new inform ation. Price changes are therefore caused by new inform a tion becoming available. The concept o f m arket efficiency means th a t we should expect securities and other assets to be fa irly priced, given th e ir risk and expected return. In Section 1.5.3 we explained that, because investors are risk averse, higher-risk investments w ill need to offer investors higher expected returns— th a t is, in the long term , risk and expected return w ill be positively related. But w hat are the details o f this relationship? The capital asset pricing model (CAPM) provides one answer to this question. According to the CAPM, risk can be a ttributed to tw o sources: a

b

market-wide factors, such as changes in interest rates and foreign exchange rates— this is called systematic risk (also referred to as non-diversiftable or market risk) factors th a t are specific to a p articular company, such as the possible discovery o f a new m ineral deposit by a m ining company— this is called unsystematic risk (also referred to as diversifiable or unique risk).

W hile unsystematic risk can be largely elim inated by the investor holding a well-diversified portfolio, systematic risk cannot be eliminated. A nother model th a t has been developed to measure the riskiness o f an investm ent and to establish the trade-off between risk and expected retu rn is the Fama-French model. According to the CAPM and 3

This result is an approximation. With a rate of inflation of 3 per cent per annum, $1 today is equivalent to $1.03 next year and it follows that a dollar next year is worth $1/1.03 = $0.970874 today. This issue is discussed further in Chapter 3.

C hapter one Introduction

the Fama-French model, risk-averse investors can diversify th e ir investments to elim inate unsystematic risk. Consequently, the m arket w ill only reward investors by offering a higher expected retu rn fo r bearing systematic or m arket risk. Both models are discussed in Chapter 7. M arket efficiency is considered in detail in Chapter 16.

Derivative securities include forward contracts, futures contracts, options and swaps. In each case, the value o f the derivative security depends on the value o f some underlying security. For example, the value o f an option to buy a share in Wesfarmers Ltd depends heavily on the m arket value o f a Wesfarmers share. In this case, the option is the derivative, while the Wesfarmers share is the prim ary security, or underlying asset. Real assets, like a coal m ine or an idea fo r a new product, may also have features that resemble derivatives. For example, the owner o f a coal m ine has the option to close the m ine and reopen it later. Derivative securities are considered in Chapters 17 and 18.

Arbitrage plays a central role in finance. I f two identical assets were to trade in the same market at different

ARBITRAGE

prices, and i f there were no transaction costs, then an arbitrage opp ortu nity would exist. A risk-free p ro fit could be made by traders simultaneously purchasing at the lower price and selling at the higher price. This situation could n ot persist because competition among traders would force up the price o f the lowerpriced asset and/or force down the price o f the higher-priced asset u n til the prices o f the two assets were the same. Arbitrage therefore precludes perfect substitutes from selling at different prices in the same market. I t follows th a t the financial prices we observe m ust be set by the financial markets in such a way th a t arbitrage is n ot possible. This idea is simple yet remarkably powerful. It has applications throughout finance in such diverse areas as the capital structure decision (how much should a company borrow?), payout policy, interna tion al finance, option pricing and the term structure o f interest rates.

simultaneous transactions in different markets that result in an immediate risk-free profit

In Section 1.3.3 we m entioned th a t one o f the disadvantages o f the corporate structure is the p ossibility th a t managers may pursue th e ir own objectives rather than the interests o f the shareholders. For example, a company th a t operates in a mature ind ustry where there are few grow th opportunities may have surplus cash th a t cannot be invested p rofitably in its usual fields o f operation. The company s shareholders would benefit i f the surplus were paid to them as a dividend or used to buy back shares. But the managers may decide instead to use the cash to acquire another company th a t operates in a different industry. This investm ent may benefit managers by giving them greater opportunities fo r prom otion and higher pay justified by the increase in company size. However, the acquisition may n o t increase shareholders* wealth. There can therefore be a conflict o f interest between shareholders and managers. M aking an unprofitable takeover is only one way in which managers may pursue th e ir own interests at the expense o f the shareholders. O ther examples include managers w orking less energetically than they could and managers directly diverting the company s resources to th e ir own benefit, such as by acquiring expensive company cars, taking unnecessary business trips to exotic locations, and so on. The relationship between shareholders and managers is an example o f an agency relationship. In an agency relationship, one party, the principal, delegates decision-making a u th o rity to another party, the agent. In a company run by managers, the managers are the agents and the shareholders are the principals. Shareholders are aware o f the possibility th a t managers may pursue th e ir own objectives and w ill try to lim it this behaviour by monitoring the behaviour o f managers and by in s titu tin g contracts designed to align the interests o f managers and shareholders. For example, a Board o f Directors th a t includes a significant number o f non-executive directors can be effective in m on itoring managers on behalf o f shareholders. In addition, many companies employ management remuneration schemes designed to give managers an incentive to maximise shareholders* wealth. For example, these schemes often provide senior executives, particularly the chief executive, w ith options to purchase shares in the company at an attractive price. Finally, i f agency costs are high, the company w ill probably be poorly run and, in

B usiness finance

consequence, its share price w ill be low and it may become a target fo r takeover. Existing managers generally fare badly when such a change o f control occurs, so the desire to avoid being taken over can also lim it the self-interested behaviour o f managers. Agency theory has been used to examine various corporate financial decisions including capital structure, dividend and share repurchase decisions, and leasing decisions. The application o f agency theory to these decisions is discussed in Chapters 1 1 ,1 2 ,1 3 and 15.

O utline of the book The ideas introduced in this chapter are developed in the remainder o f the book. • • • • • • •

In Chapters 2 to 7, fundam ental concepts underlying finance theory are developed. Chapters 8, 9 and 10 consider sources o f finance fo r companies, and the in s titu tio n a l framework in which financing decisions are made. In Chapters 1 1,12 and 13, payout decisions and financing decisions are discussed. Chapter 14 then considers the measurement o f the cost o f capital to be used in project evaluation, while Chapter 15 provides an analysis o f leases. Chapter 16 reviews the literature on m arket efficiency, while Chapters 17 and 18 consider futures contracts and options respectively. Chapter 19 reviews the theory and evidence on takeovers. In Chapters 20 and 21 the principles outlined earlier in the book are applied to short-term asset management, including inventory, cash and accounts receivable.

awldvHu M3IA3W 3M〇

SUMMARY In this chapter, we have introduced the key themes to be addressed in the book. • The two main components of finance are corporate finance and investments. This book focuses on financial decisions made by companies (corporate decisions), w hich include asset and w orking capital management decisions, capital structure and borrow ing decisions, payout policy and merger and acquisition decisions; and financial decisions made by investors (investor decisions), including portfolio and risk decisions and asset pricing decisions.

KEY TERMS arbitrage 7 company 4 limited liability 4 partnership 3

8

The objective assumed in most of this book is that management seeks to maximise the market value of the company's ordinary shares (shareholders' equity). To do this, the financial manager must understand how financial markets work. The fundamental concepts in finance include value, the time value of money, risk aversion, nominal versus real values, market efficiency and asset pricing, derivative securities, arbitrage and agency relationships. The market value (V) of a company can be expressed as the market value of the company's debt (D) plus the market value of the company's equity (£).

risk-averse investor 6 sole proprietorship 3 time value of money 5

C hapter o ne Introduction

QUESTIONS

1

[LO 2】Distinguish between investment decisions and financing decisions.

2

[LO 3] Explain the following: a) a sole proprietorship b) a partnership c) a company.

3

[LO 3] Outline the advantages and disadvantages of a sole proprietorship.

4

[LO 3] Outline the advantages and disadvantages of a partnership.

5

[LO 3] W hat advantages does a company have over a sole proprietorship and a partnership?

6

[LO 3] W hich types o f investors have limited liability? Explain your answer.

7

[LO 5] W h y do people usually prefer to receive $1 today instead of in a year's time?

8

[LO 5 】 Comment on this statement: A company should borrow during times o f high inflation because it con repay the loan in cheaper dollars.

9

[LO 5] W h a t is the relationship between diversifiable and non-diversifiable risk? How does this distinction affect the reward that investors receive for bearing risk?

CHAPTER O N E REVIEW

itu

10 [L0 5]

W h a t is meant by the term 'efficient market'? How does competition between traders promote efficiency?

11

[LO 5] W h a t is meant by the term 'arbitrage7?

12

[L0 5] W h a t is meant by the term 'agency relationships'?

9

CHAPTER TWO Consumption, investment and the capital market

CHAPTER CONTENTS HI

Introduction Fisher’s Separation Theorem: a sim plified exam ple

11

ii

BS

m

Fisher's Separation Theorem: a form al a pproach

14

Investors' reactions to m anagers' decisions

24

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain how a com pany's m anagers can, in principle, make financial decisions that w ill be supported by all shareholders

2

explain how the existence o f a capital m arket makes it possible for the com pany to make decisions acceptable to all shareholders

3

命

identify a com pany's optim al investm ent/dividend p olicy under conditions o f certainty.

C hapter t w o C o n s u m p t io n ,

investment a n d the capital market

^ ^ J ~ ln t r o d u c t io n In this chapter we present a theoretical fram ework, know n as ‘Fisher’s Separation Theorem’，th a t shows im p orta nt relationships between companies, th e ir shareholders and the capital m arket. We use this fram ework to make some observations on investm ent decisions, financing decisions and dividend policy. Although the fram ework we present is simple and rather abstract, it provides im p o rta n t insights into some fundam ental issues in finance. To introduce the framework, we present in Section 2.2 a sim plified numerical example th a t captures many o f the m ain lessons o f the theorem. Readers who do n o t wish to develop a detailed technical understanding o f the theorem may wish to read only Section 2.2.

Fishers Separation Theorem can be traced to the w ork o f Irv in g Fisher1 2 and is widely regarded as laying a foundation fo r many fundam ental results o f finance theory. The theorem considers the follow ing situation. Suppose th a t a company has to decide how much it should pay to its shareholders in dividends and how much it should retain fo r investm ent in the company. The more the company pays out in dividends, the less there is available fo r investm ent; the more the company invests, the less there is available to pay out as dividends. M ig h t some shareholders want high dividends (and therefore low investment), while other shareholders w ant ju s t the opposite? I f so, w ill the company be forced to make a decision that w ill disappoint some o f its shareholders? Fishers answers are, yes, there may be this type o f disagreement among the shareholders b ut, no, i f there is a capital m arket then there is a way to please all shareholders. In this section, we outline a sim plified example o f Fishers Separation Theorem th a t preserves much o f its flavour b u t is based on in tu itio n rather than a rigorous, technical approach.

Assume th a t a company is operating under conditions o f certainty, th a t there are tw o tim e dates (‘now, and ‘later’）and th a t there are tw o equal shareholders (‘A ’ and ‘B’). The company m ust decide3 how much o f its current resources i t should invest and how much it should pay out as a current dividend. An investm ent now generates a retu rn later, and the company then pays out all its resources as a final dividend. Shareholders can use th e ir dividends to finance consumption. In itially, there is no capital m arket b ut at a later stage in the analysis i t is assumed th a t transactions in a capital m arket are possible. The existence o f the capital m arket enables individuals (including the shareholders A and B) to borrow and lend fo r one period at a fixed interest rate. It is fu rth e r assumed th a t the company has $8000 in resources and has identified tw o possible investm ent projects called ‘Project Small’ and ‘Project Upgrade’. • •

Project Small requires an in itia l outlay o f $5000 now and w ill produce a cash inflow o f $5700 later. Project Upgrade requires a further outlay o f $2000 now and w ill produce a further cash inflo w o f $2200 later.

I t is also assumed th a t it is impossible to invest only in Project Upgrade. Together, projects Small and Upgrade constitute P roject Large*. Clearly, Project Large requires an outlay o f $5000 + $2000 = $7000 now and w ill produce a cash inflo w o f $5700 + $2200 = $7900 later. I f the company invests only in Project

1 2 3

This section is drawn from Brown (1996). Fisher (1930). See also Hirshleifer (1970). In fact, decisions are made by managers rather than by an inanimate company* but for ease of expression we frequently refer to a company making a decision. We have assumed that managers will seek to maximise the interests of the shareholders.

LEARNING OBJECTIVE 1 Explain how a company's managers can, in principle, make financial decisions that will be supported by all shareholders

B usiness finance

Small, it can pay a dividend o f $8000 - $5000 = $3000 now b u t i f it invests in Project Large, i t can pay a dividend o f only $8000 - $7000 = $1000 now. This situation is summarised in Table 2.1.

TABLE 2.1 Investment/dividend opportunities facing the company Project

Investment outlay now ($)

Dividend now (equals $8000 minus outlay) ($)

Dividend later ($)

Small

5000

3000

5700

Upgrade

2000

n.a.(a)

2200

Large

7000

1000

7900

Not applicable because Project Upgrade is not a stand-alone project.

2 .2 .3 1 The shareholders' consumption opportunities and preferences Recalling th a t Shareholders A and B hold equal shares, the consumption opportunities each faces are equal to h a lf the to ta l dividends paid by the company as shown in Table 2.1. For sim plicity, i t is also assumed th a t a dividend paid now cannot be stored in order to finance consumption later.4 The consumption o pportunities facing each shareholder are shown in Table 2.2.

TABLE 2.2 Consumption opportunities facing each shareholder Project selected by the company

Consumption per shareholder now ($)

Consumption per shareholder later ($)

Small

1500

2850

Large

500

3950

Suppose th a t Shareholder A wishes to consume $1500 now, w hile Shareholder B wishes to consume only $500 now. Thus, Shareholder A wants a relatively high dividend now and therefore wants the company to invest in Project Small. Shareholder B, o f course, is in the opposite position. Desiring only a low level o f consumption now, Shareholder B wants the company to adopt a high level o f investm ent and thus wants the company to invest in Project Large. Clearly, the company cannot make a decision that w ill satisfy b oth shareholders simultaneously and therefore i t is n o t possible to say which investm ent is optim al. The company w ill be forced to make a decision th a t w ill be opposed by one o f its tw o shareholders.

2 .2 .4 1 Solution: introduce a capital market

LEARNING OBJECTIVE 2 Explain how the existence of a capital market makes it possible for the company to make decisions acceptable to all shareholders

命

A solution can be found i f there is a capital m arket in which the shareholders can borrow and lend on th e ir personal accounts. In this example, it is assumed th a t the interest rate in the capital m arket is 12 per cent per period. I t is now possible to state th a t there is an optim al decision th a t w ill be supported by b oth shareholders. This decision is th a t the company should invest in Project Small and should reject the o pp o rtu n ity to invest in the upgrade th a t w ill convert Project Small to Project Large. In other words, allowing Shareholder B access to the capital m arket has caused B to change his or her support from w anting the company to invest in Project Large to w anting the company to invest in Project Small. 4

This assumption simplifies the analysis but is not necessary. It is a simple matter to permit resources to be carried from one period to the next. In the absence of a capital market, resources can be carried forward in time at an interest rate of zero. However, any consumption opportunities opened up by allowing resources to be carried forward at an interest rate of zero will be more restricted than the opportunities that become available when a capital market is introduced and interest rates are positive.

C hapter t w o C o n s u m p t io n ,

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How do we know Shareholder B w ill react in this way? The answer is th a t the capital m arket allows Shareholder B to make financial arrangements that, from Bs view point, provide an even better outcome than is possible i f the company invests in Project Large. This result can be proved as follows. When the company invests in Project Small, Shareholder B w ill receive a current dividend o f $1500. This w ill finance Bs desired current consum ption o f $500, w ith $1000 le ft over. This sum o f $1000 can be le n t in the capital m arket fo r one period at an interest rate o f 12 per cent, thus producing a later cash in flo w to B o f $1000 x 1.12 = $1120. This sum can then be added to the future dividend o f $2850. Therefore, on the later date, Shareholder B can consume resources to the value o f $1120 + $2850 = $3970. If, instead, Project Large were undertaken, Shareholder B could consume only $3950 on the later date (see Table 2.2). Therefore, provided there is a capital market, the shareholders w ill be unanimous and the company can make investm ent and dividend decisions confident th a t these decisions are optim al from the view point o f all shareholders.

2 .2 .5 1 An analysis using rates of return The analysis can be recast in terms o f rates o f return. The rates o f retu rn on the projects are: Project Small:

$5700-5000

Project Upgrade:

$5000 $2 2 0 0 -2 0 0 0 $2000

14%

= 10%

Comparing these rates o f retu rn w ith the interest rate o f 12 per cent, the optim al decision is to accept Project Small (because 14 per cent exceeds 12 per cent) and to reject Project Upgrade (because 10 per cent is less than 12 per cent). In effect, the cost o f investing is the o pp o rtu n ity cost o f forgoing the capital m arket return o f 12 per cent. For Project Small, the benefit (14 per cent) exceeds the o pp o rtu n ity cost (12 per cent), while fo r Project Upgrade the benefit (10 per cent) is lower than the o pp o rtu n ity cost (12 per cent). Note also th a t while the apparent rate o f retu rn on Project Large is ($7900 - $7000)/$7000 = 12.86 per cent, this rate o f retu rn is in fact a weighted average o f the rates o f retu rn on the component projects Small and Upgrade. I t is not valid to suggest th a t the company should invest in Project Large merely because 12.86 per cent exceeds 12 per cent.

2.2.61 A solution requiring borrowing In Section 2.2.4, the interest rate (12 per cent) fell between the rates o f retu rn on Project Small (14 per cent) and Project Upgrade (10 per cent). Therefore, Project Small was accepted and, in tu rn , this decision required Shareholder B to lend in the capital m arket. I f the interest rate had been lower than the rate o f return on both projects— say i t had been 9 per cent— then the optim al decision would have been to invest in both projects. In other words, Project Large would have been accepted. Therefore, the current dividend would have been only $500 per shareholder. W hile this decision would clearly have won the support o f Shareholder B, who wishes to consume only $500 now, a current dividend o f $500 per shareholder w ill be insufficient fo r Shareholder A to finance his or her desired current consumption o f $1500. In this case, Shareholder A m ust borrow $1000 from the capital m arket. A t an interest rate o f 9 per cent per period, the required repayment later is $1000 x 1.09 = $1090. This am ount is paid out o f the later dividend o f $3950, thus leaving Shareholder A w ith $3950 - $1090 = $2860 to finance later consumption. This level exceeds the $2850 o f later consum ption th a t would have been available to Shareholder A i f the company had invested in only Project Small. Therefore, Shareholder A w ill also support the decision to invest in Project Large and there is again a unanimous decision.

2 .2 .7 1 Fisher's Separation Theorem and net present value The problem facing the company s manager can also be solved by calculating a measure know n as a projects *net present value* (NPV). This measure is extremely im p o rta n t and is referred to in a num ber o f later chapters. It is discussed in detail in Chapter 5. A t this p o in t we provide only a very b rie f introduction.

LEARNING OBJECTIVE 3 Identify a company's optimal investment/ dividend policy under conditions of certainty

B usiness finance

To calculate a projects net present value, we firs t use the projects required rate o f retu rn to convert future cash flows to th e ir equivalent values today. We then subtract the in itia l outlay required. I f the result is a positive number, then the project is an acceptable investm ent; i f the result is a negative number, then the project is n o t acceptable. In the in itia l example o f Project Small and Project Upgrade presented in Section 2.2.4, the interest rate in the capital m arket is 12 per cent. In this example, it is also the required rate o f retu rn on the project. The net present value calculations are: iV W o f Project Small = ---------- $5000 = $89.29 > 0

1.12

N P V o f Project Upgrade =

1.12

- $2000 = -$35.71 < 0

Project Small is an acceptable investm ent because its NPV is positive, while Project Upgrade is not an acceptable investm ent because its NPV is negative. Thus, use o f the NPV rule has led to the same investm ent decision as we discussed earlier in Section 2.2.4. N ot only does an optim al decision exist, it can also be found by applying the NPV rule.

2 .2 .8 | Fisher’s Separation Theorem: summary LEARNING OBJECTIVE 1 Explain how a company’s managers can, in principle, make financial decisions that will be supported by all shareholders

In the absence o f a capital market, the shareholders disagreed on what decisions the company should make on th e ir behalf. This problem could be solved* only by imposing a solution to the detrim ent o f one o f the shareholders. But i f there is a capital m arket, the shareholders are sure to reach a unanimous decision. Thus, there is an optim al investm ent/dividend decision. This resolution is possible because the existence o f the capital m arket enables one o f the shareholders to achieve a result th a t fo r h im or her was indisputably b etter than the result th a t the company alone could provide, given the investm ent o pportunities available. An o ptim al decision exists, and can be identified by the company s managers i f they use the net present value (NPV) rule to analyse investm ent proposals.

2.3

Fisher’s Separation Theorem: a formal approach

The conclusions th a t we reached largely by in tu itio n in Section 2.2 are reached in a more rigorous fashion in this section.

2.3.1 | Assumptions The assumed objective o f a company is to maximise the m arket value o f its ordinary shares. A company s managers, therefore, have to make investment, financing and dividend decisions consistent w ith that objective. The managers* job would be easier i f there were a consistent set o f decision rules th a t could be employed in m aking investm ent, financing and dividend decisions. The w ork o f Irv in g Fisher provides a fram ework in which such rules can be developed. In itia lly these decision rules are developed in a very sim plified setting. However, the decision rules are applicable even when more realistic assumptions are made. The assumptions in Fishers analysis are: a b C d e

命

There are only two points in tim e: the present (Time 1) and a later tim e (Time 2). There is no uncertainty, and hence the outcome o f all decisions is know n now to everybody. There are no imperfections in the capital market, A ll decision makers are rational. The company s managers wish to use the company s resources according to the wishes o f the shareholders.

C hapter t w o C o n s u m p t io n ,

investment a n d the capital market

2 .3 .2 |T h e company The company is endowed w ith a fixed am ount o f resources at Time 1 and the managers have to decide how much o f these resources should be invested and how much should be paid out as dividends. Any resources not paid out at Time 1 are invested, and the level o f this investm ent determines the resources available to pay dividends at Time 2. The opportunities available to the company are summarised in a production p o ssib ilities curve (PPC) as illustrated in Figure 2.1.

Figure 2.1 Production possibilities curve

PRODUCTION POSSIBILITIES CURVE

curve that displays the investment opportunities and outcomes available to the company; its shape therefore determines the combinations of current dividends, investments and future dividends that a company can achieve

l^l s8Jno 0s EJ 9J

(N

l—

The horizontal axis measures resources available to the company at Time 1. Assume th a t the company has 200 units o f resources available to it. It could pay this am ount as a dividend at Time 1. In this case, investm ent would be zero and dividends at Time 2 w ould also be zero. The p oint (200, 0) represents this extreme decision. A t the other extreme, the company could pay no dividend at Time 1 and invest the whole o f the company s resources. This decision would result in 250 units being available fo r d is trib u tio n as a dividend at Time 2 and is represented by the p o in t (0, 250). Point Q is an interm ediate case in which a dividend o f 150 units is paid at Time 1, leaving 50 units to be invested. The PPC shows th a t an investm ent o f 50 units at Time 1 can be transform ed in to 160 units o f resources at Time 2. Therefore the dividend at Time 2 is 160 units. INDIFFERENCE CURVE

2 .3 .3 |T h e shareholders Shareholders forgo current consumption by investing in the company at Time 1 in order to receive a retu rn th a t then increases th e ir consum ption o pportunities at Time 2. A persons preference fo r consumption at Time 1 (Cj) or at Time 2 (C2) is represented by indifference curves as depicted in Figure 2.2. The term indifference indicates th a t the person derives equal u tility from the bundles o f C and C2 represented

curve showing a set of combinations such that an individual derives equal utility from (and thus is indifferent between) any combinations in the set

A

B usiness finance

by all points on a single curve; fo r example, equal u tility is derived from points X and Y in Figure 2.2. However, any p o in t on a higher indifference curve is preferred to all points on lower curves; fo r example, Z is preferred to X and Y. The slope o f an indifference curve at any p o in t shows the consumer s willingness to trade o ff Cx fo r C2. I t can be seen from Figure 2.2 th a t the indifference curves are convex; they approach the horizontal as the level o f C1 increases and approach the vertical as the level o f C2 increases. The im plication is th a t a consumers desire to increase consumption fu rth e r at a given tim e decreases as the level o f consumption at th a t tim e increases.

:igure 2.2 Indifference curves of a representative shareholder

2 .3 .4 1 The company’s decision We now b ring together the company and the shareholders in an attem pt to id e n tify the decision the company should make. We assume th a t there are two shareholders, and (B\ In Figure 2.3, indifference curves fo r Shareholder A are labelled A v A 2 and A 3 and indifference curves fo r Shareholder B are labelled Bv B2 and B3. I f the company chooses p o in t A — th a t is, a current dividend o f 90 and investm ent o f 110, yielding a dividend o f 228 at Time 2— then shareholder As u tility is maximised. However, Shareholder Bs u tility is n o t maximised at this point; i t is maximised only i f the company chooses p o in t B. This requires a current dividend o f 160 and investm ent o f 40, yielding a dividend o f 144 at Time 2. In short, the company is unable to reach a decision th a t w ill lead simultaneously to m axim um u tility fo r both shareholders. This situation poses a severe dilemma fo r the company because i t means th a t the company m ust consider the preferences o f each o f its shareholders when m aking investm ent decisions. In other words, there is no simple decision rule th a t w ill satisfy all shareholders. Such a rule does exist, however, i f there is a capital market.

LEARNING OBJECTIVE 2 Explain how the existence of a capital market makes it possible for the company to make decisions acceptable to all shareholders

命

2.3^5| Soluti on: introduce a capital market In this simple model, the capital m arket can be thought o f as a place where current resources may be transform ed into future resources and vice versa. The rate at which these transform ations may be made is in effect an interest rate. We assume th a t the capital m arket is frictionless, and therefore the interest rate fo r borrowers is equal to the interest rate fo r lenders. For example, i f the interest rate is 10 per cent

C hapter t w o C o n s u m p t io n ,

90

160

investment a n d the capital market

200*2 0 5

Time 1 resources ( q i

per period, and 100 u nits o f current resources are placed w ith the capital m arket fo r one period, then 100 x 1.1 = 110 units o f resources become available at Time 2. In effect, this is lending to the capital market. Similarly, i f a person has a claim to receive 110 units o f resources at Time 2, the capital m arket may be used to transform this claim in to 110/1.1 = 100 units o f resources at Time 1. This transaction corresponds to a person borrow ing 100 units at Time 1 and repaying the loan w ith a payment o f 110 u nits at Time 2. Suppose th a t a person has claims on resources in both periods. For example, a person may have an income o f 100 units at Time 1 and an income o f 165 units at Time 2. W hat consumption opportunities are available i f the interest rate is 10 per cent per period? A t one extreme, the person may choose to consume only at Time 2. In this case, consumption at Time 1 is zero and consumption at Time 2 is 165 + 100 x 1.1 = 275 units. A t the other extreme, the person may choose to consume only at Time 1. In this case, consum ption at Time 2 is zero and consum ption at Time 1 is (165/1.1) + 100 = 250 units. Therefore, this persons claim on current resources is 250 units. In short, this persons wealth at Time 1 is 250 units. Figure 2.4 illustrates this case. The line join in g these tw o extreme positions is shown in Figure 2.4 and may be called a m arket opportunity line as i t defines all combinations o f consumption possibilities at the tw o Times, consistent w ith an in itia l wealth level o f 250 units. I f a person can reach any one p o in t on this line, then by borrow ing or lending, all other points on the line are also available to the person. For example, i f a person can reach point A (100 units at Time 1 and 165 units at Time 2), then the person can also reach p o in t (140 units at Time 1 and 121 units at Time 2), by borrow ing 40 units today and repaying 44 units at Time 2. The equation o f a m arket o pp o rtu n ity line can be derived as follows. I f a persons income at Time 1 is Cx and at Time 2 is C2, and the interest rate is i per period, then the persons wealth W1 at Time 1 is: …

^

C2

MARKET OPPORTUNITY LINE

line that shows the combinations of current and future consumption that an individual can achieve from a given wealth level, using capital market transactions

B usiness finance

Figure 2.4 Market opportunity line

Equivalently, this equation can be w ritte n as: W \(l + /) = C“ 1 + /) + C2 or C2 = - ( l + i)C 1 + Wl ( l + i) This is a linear equation w ith slope -(1 + 〇 and intercept ^ ( 1 + i). W ith a current wealth level o f 250 and an interest rate o f 10 per cent per period the equation is: C2 = - ( 1 + 0.1)C1 + 250(1.1) and therefore C2 = - l . l C 1 + 275 To illustrate fu rth e r the interpretatio n o f m arket o pp o rtu n ity lines, suppose th a t the person is offered a choice o f two income streams, A or B. Stream A consists o f 100 units at Time 1 and 165 units at Time 2, w hile Stream B consists o f 120 units at Time 1 and 55 units at Time 2. I t has already been shown that i f the interest rate is 10 per cent, Stream A corresponds to a wealth level o f 250 units at Time 1 and the equation o f the m arket o pp o rtu n ity line is C2 = -1.1C 1 + 275. The wealth level corresponding to Stream B is 120 + 55/1.1 = 170 units. The equation o f the m arket o pp o rtu n ity line fo r Stream B is C2 = -1.1C1 + 187. These lines, together w ith the persons indifference curves, are shown in Figure 2.5. Figure 2.5 shows th a t this person w ill maximise u tility by accepting income Stream A and then use a capital m arket transaction to convert Stream A to Stream A \ As we have seen, Stream A provides an income o f 100 units at Time 1 and 165 units at Time 2, and a wealth level o f 250 units. The person then enters the capital m arket and borrows 40 units at Time 1, achieving a consumption level o f 140 units at Time 1. In return, the persons claim on Time 2 resources is reduced by 44 units (fro m 165 units to 121 units). The loan repayment required at Time 2 is, o f course, 44 units (since 40 x 1.1 = 44).

命

C hapter t w o C o n s u m p tio n ,

investment a n d the capital market

Figure 2.5 Consumption opportunities offered by two wealth levels

Had Stream B been accepted, the optim al p o in t would have been B \ which could have been achieved by lending 120 - 80 = 40 units at Time 1 and consuming 55 + (40)(1.1) = 99 units at Time 2. However, p o in t is on a lower indifference curve than p o in t A / and therefore yields lower u tility . To summarise: Stream A should be chosen because i t corresponds to a higher wealth level, which, in tu rn , ensures th a t higher u tility can be achieved, given access to a capital market.

2 .3 .6 1 Proving there is an optimal policy Fishers Separation Theorem provides the optim al solution and involves all three elements: the company, the shareholders and the capital market. Suppose th a t the company has E units o f resources and is considering three investm ent/dividend policies, shown in Figure 2.6 as points Pv P2 and P. A m arket o pp ortu nity line w ith slope -(1 + z) has been drawn through each o f the three points. The line through P1 shows th a t i f policy P1 were adopted, the shareholders* wealth would increase from E to Wv Similarly, i f policy P2 were adopted, the shareholders* wealth would increase to W2i and i f policy P were adopted, the shareholders’ wealth would be PV. Because the u tility o f shareholders depends directly on th eir wealth, they w ill unanim ously prefer policy P because the resulting wealth level W is the maximum achievable. Relative to policy P, i t is clear th a t represents too little investm ent by the company, whereas P2 represents too much investm ent by the company. Policy P, which occurs at the p o in t o f tangency between the PPC and the m arket o p p o rtu n ity line, is the optim al policy fo r the company and w ill receive the support o f all shareholders. This result may be shown more form ally by superimposing representative indifference curves fo r shareholders A and B on Figure 2.6. This is shown in Figure 2.7. The company chooses policy P; th a t is, i t invests (E - C p and pays dividends o f C* at Time 1 and C*2 at Time 2. Shareholder A enters the capital m arket and lends resources so th a t this shareholders personal optim al p oint PA is reached. Shareholder B borrows from the capital m arket in order to reach PB, which

B usiness finance

Figure 2.6 Effect of company policy on shareholder wealth

Figure 2.7 Fisher’s Separation Theorem: two shareholders with access to a capital market

is Bs personal optim al p oint. A ny policy other than P w ill result in lower u tility fo r both shareholders. For example, i f the company were to choose policy Pv then Shareholder As m axim um u tility would occur at p o in t P^, which is on a lower indifference curve than p o in t PA, w hile Shareholder Bs m axim um u tility would occur at p o in t P^, which is on a lower indifference curve than p o in t PB. The same conclusion holds i f the company were to choose policy P2. There is, therefore, just one policy P th a t w ill maximise the u tility o f all shareholders simultaneously. Regardless o f differences in th e ir u tility functions (preferences), all shareholders w ill support the company s decision to choose policy P. In this sense, the company and its shareholders are separate. The company does not need to consult each shareholder before it makes its decision because it knows in

C hapter t w o C o n s u m p tio n ,

investment

advance th a t all shareholders, regardless o f differences in th e ir personal preferences, w ill support the choice o f policy P. Since policy P does n o t require knowledge o f any shareholders u tility function, it follows th a t P m ig ht be identifiable using data directly available to the company. That this is in fact the case is proved in the follow ing section.

2 .3 .7 | Identifying the optimal policy Suppose th a t a company is endowed w ith E units o f current resources and is considering a num ber o f small investm ent projects, each requiring an outlay o f A units o f resources. I t has compiled a lis t o f these projects, ranked from the highest rate o f return to the lowest. The project w ith the highest rate o f retu rn w ill return C2 units at Tim e 2. The company proposes the follow ing decision rule: accept the project i f and only if: R e tu m a tT im e 2 _ A > 〇

This is illustrated in Figure 2.8.

Figure 2.8

I t is clear from Figure 2.8 th a t C; > △ (1 + f) and therefore:

Under the proposed rule, the project is accepted. Fishers Separation Theorem also recommends acceptance since policy P has n ot yet been achieved. Now consider the second project, w hich also requires an outlay o f A and which returns Cf， 2 at Time 2. Reading from Figure 2.8, it is found that: C2 + C2 〉 C*2 + △(!■ + /) and therefore

Both Fishers Separation Theorem and the decision rule recommend acceptance o f this second project. Projects w ill continue to be accepted u n til policy P is reached. Beyond th a t point, both the theorem and the rule recommend rejection o f all fu rth e r projects on the list. This is shown in Figure 2.9.

B usiness finance

Reading from Figure 2.9 it is found that: C2 " + A(1 + i) > C2 " + C2 " and therefore -△ < 0 Therefore, both the proposed rule and the theorem recommend rejection o f this project. The proposed rule and the theorem are completely consistent. A ll projects th a t are acceptable according to the theorem are also acceptable according to the rule. A ll projects rejected by the theorem are also rejected by the rule. Therefore, a company th a t always applies this rule to its investm ent decisions w ill be able to locate the optim al investm ent/dividend policy and w ill maximise the wealth o f its shareholders. In tu rn , the shareholders can use the capital m arket to achieve th e ir preferred consum ption patterns and thereby maximise u tility. The name given to this rule is the net present value rule. The retu rn next period is divided by the factor (1 + z) to convert the future retu rn in to a present value. The investm ent outlay is then subtracted from the present value to give the net present value (iVPV). I f the iVPVis positive, the project w ill increase the wealth o f the shareholders and should therefore be accepted. I f the NPV is negative, the project w ill decrease the wealth o f the shareholders and should therefore be rejected. The NPV rule is frequently used in practice and is considered fu rth e r in Chapter 5.

2 .3 .8 1 Implications for financial decision making A num ber o f im plications fo r investm ent, financing and dividend decisions can be drawn from Fishers analysis. These im plications w ill hold where there are perfect markets fo r both capital and inform ation. However, Fishers analysis is unaffected by the intro du ction o f uncertainty, provided it is assumed that all participants have the same expectations.5 Further, although the presentation o f Fishers analysis has

5

Fama and Miller (1972, pp. 301-4).

C hapter t w o C o n s u m p t io n ,

investment a n d the capital market

been confined to a case involving only tw o periods, its im plications are unaffected by extension to the m ultiperiod case.6

The investment decision Fishers Separation Theorem means th a t a company can make investm ent decisions in the interests o f every shareholder，regardless o f differences between shareholders’ preferences— th a t is, a company can make an investm ent decision w ith which every shareholder w ill agree. Moreover, there is a rule th a t w ill ide ntify th a t decision: a company should invest up to the p o in t where the net present value o f the marginal u n it o f investm ent is zero. In this simple model, an equivalent rule is to invest up to the p o in t where the rate o f retu rn on the m arginal u n it o f investm ent equals the m arket interest rate. These tw o rules and other commonly implem ented investm ent evaluation techniques are considered in Chapter 5 in the context o f certainty. This discussion is extended in Chapter 6 to investm ent evaluation where there is uncertainty.

The financing decision In Fishers analysis there is a single m arket interest rate. In effect, there is no d istinction between debt and equity securities, and the cost to the company o f acquiring funds is independent o f the type o f security issued. I t follows th a t the value o f the company and the wealth o f its shareholders are independent o f the company’s capital structure. As a result, the financing decision can be described as ‘irrelevant’. When the financing decision is discussed in Chapter 12 this result is confirm ed in a less restrictive framework.

The dividend decision In Fishers analysis, all resources n ot invested at Time 1 are distributed to shareholders as dividends, and all returns at Time 2 are also distributed as dividends_ th a t is, it is assumed th a t the company does not borrow or lend in the capital market, although its shareholders may do so. Suppose, however, that the company is perm itted to borrow o r lend in the capital market. In th a t case, the company has greater choice in its dividend policy, while m aintaining the same level o f investm ent. For example, the company could pay a higher dividend at Time 1 and borrow the resources needed to m aintain investm ent at the optim al level given by the p o in t o f tangency between the PPC and the m arket o p p o rtu n ity line. This is illustrated in Figure 2.10.

ure 2.10

6

ibid” pp. 64-7.

B usiness finance

Compared w ith the basic Fisher analysis (Fig. 2.7), the company in Figure 2.10 pays a larger dividend at Time 1 (C**> C^) and a smaller dividend at Time 2 (C^* < C*2). To m aintain the company s investment level at E - C*, the company borrows C** - C\ from the capital m arket. A t Time 2 the company s gross retu rn is b u t the loan repayment reduces the net retu rn at Time 2 to C^. In short, the company、 investm ent decision is unchanged b ut its dividend decision is different. The im p o rta n t p o in t to note is th a t the new policy Pr lies on the same m arket o pp o rtu n ity line as the original *Fisher policy* P and therefore the wealth o f shareholders is unchanged. The ability o f shareholders to maximise th e ir u tility is also unchanged. As explained previously, i f any one p o in t on a m arket o p p o rtu n ity line is attainable, then, by borrow ing or lending, all other points on the line are also attainable. From the shareholders’ p o in t o f view, therefore, p o in t Pr is no b etter or worse than p o in t P. In summary, provided th a t the company does n o t alter its investm ent decision, the dividend decision does n o t affect shareholders* wealth. In this sense dividend policy is irrelevant. This proposition is discussed fu rth e r in Chapter 11.

2.4

Investors' reactions to managers/ decisions

The lin k between decisions made by a company s managers and the resultant actions by investors is illustrated in Figure 2.11.

Figure 2.11 supplies funds to

transact in

A company s managers may, on behalf o f the company, make an investm ent decision, a financing decision o r a dividend decision. In fo rm atio n about this decision is transm itted to investors. On the basis o f this inform ation, investors may adjust th e ir expectations o f future returns from an investm ent in the company, and revise th e ir valuation o f the company s shares. Investors w ill then compare the current m arket price o f the company s shares w ith th e ir revised valuation and either buy or sell shares in the company. Investors* actions in the share m arket w ill determ ine the new m arket price o f the company s shares.

令

C hapter t w o C o n s u m p t io n ,

investment a n d the capital market

Pursuing a goal o f m axim ising the m arket value o f a company s shares is easy when there are no m arket imperfections and no uncertainty. Managers know w ith certainty an investm ents cash flows and its net present value. Therefore, they w ill know whether acceptance o f the investm ent w ill increase the m arket value o f the company s shares. As all investors also know the investm ents net present value, there w ill be an immediate increase in the price o f the company s shares to reflect the resulting increase in the wealth o f the company. Further, managers and investors know th a t financing and dividend decisions are irrelevant and therefore these decisions w ill have no effect on the m arket value o f the comp any s shares.

In practice there is uncertainty. W hat effect w ill the acceptance o f an investm ent proposal have on the m arket value o f a company s shares? As is illustrated in Figure 2.11, any change in the company s share price w ill depend on the reaction o f investors to the decisions made by the managers. Obviously there can be no reaction unless investors obtain inform a tion about th a t decision. When there is uncertainty, the effect on the share price o f decisions made by managers is no longer perfectly predictable. A sim plification is to assume that everyone agrees about the probability d istrib u tio n o f the outcomes o f all decisions. This means th a t although there is uncertainty, the exact nature o f th a t uncertainty is agreed on by all. In this case, when investors obtain inform ation, the share price w ill adjust im m ediately to reflect the new best estimate o f the ‘tru e ’ value o f the company. Sufficient conditions fo r this to arise are: *... a m arket in which (i) there are no transaction costs in trading securities, (ii) all available inform a tion is costlessly available to all m arket participants and (iii) all agree on the im plications o f current inform a tion fo r the current price and d istrib u tio n o f future prices o f each security’.7 As these conditions are n o t satisfied in existing capital markets, it is fortunate th a t they are sufficient b ut not necessary conditions.8 For example, managers* decisions may s till have an impact on share prices even though there are transaction costs and/or there are only a lim ite d number o f investors who have access to inform a tion about these decisions. I t is true th a t departures from the sufficient conditions give rise to the problem th a t managers are unable to predict w ith certainty the impact th a t a particular decision w ill have on a company s share price. Fortunately there is a great deal o f empirical evidence on the reaction o f share prices to the release o f inform ation. This evidence is reviewed in Chapter 16. A t this p o in t we sim ply note th a t there is evidence in well-developed capital markets (such as the Australian capital market) th a t there are investors who react quickly to the receipt o f new inform ation, w ith the result th a t this in fo rm a tio n w ill be reflected in security prices. In general, therefore, managers should n o t depart from a course th a t they expect w ill increase the value o f the company’s shares.

7 8

Fama (1970, p. 387). ibid” pp. 387-8.

B usiness finance

SUMMARY •

•

•

A company's shareholders are likely to be a diverse group, with different preferences regarding current and future consumption. Therefore, it might be thought that when making decisions on investments and dividends, a company’s managers would find it impossible to meet the wishes of all shareholders. Fisher showed that, provided there is a capital market through which shareholders can borrow and lend, a company can make decisions that w ill be supported by all shareholders. The company should invest up to the point where the return on the marginal investment equals the

•

interest rate in the capital market. Therefore, the optimal decisions can be identified using net present value (NPV) analysis. These decisions will maximise the wealth of the shareholders. In this sense, the company and its shareholders are 'separate7; the company's managers can make optimal decisions without having to discover the preferences of individual shareholders. Although the w orld of business is considerably more complicated than Fisher's simple model, the central messages of his theorem remain a useful guide for company managers.

KEY TERMS indifference curve 15 market opportunity line

tu

production possibilities curve

15

17

QUESTIONS

1

[LO 2] Outline the roles played by companies, shareholders and the capital market in Fisher's analysis.

2

[LO 3] Fisher's Separation Theorem ties together many o f the basic notions that underlie much o f modern finance theory: wealth maximisation, utility maximisation and net present value. Discuss.

3

[LO 3] W h a t is Fisher's Separation Theorem? W h a t are its major implications for financial decision making?

4

[LO 3] Financial decision making is a trivial task in a w orld o f certainty. Discuss.

5

[LO 3 】W hat are the implications for financial decision making when the interest rate on borrowing is greater than the interest rate on lending?

PROBLEMS 1

Calculating consumption possibilities with and without a capital market [LO 2] Assume a three-date model in which a rational person has an endowment of $ 2 0 0 0 now, $ 1 0 0 0 in Year 1 and $50 0 in Year 2. If the person wishes to consume $40 0 now and $ 12 00 in Year 2, what could she consume in Year 1 if: a) there is no capital market b) there is a capital market in which the interest rate is 5 per cent per year?

2

Investment decisions: applying Fisher's Separation Theorem [LO 3] A company faces a similar situation to the one described in Section 2.2. It has two equal shareholders (A and B)x is operating under conditions of certainty in a two-period framework ('now7 and later') and is considering an investment in Project Small, which can be upgraded to Project Large. Project Small requires an outlay of $1 1 0 0 0 0 today and will return $121 0 0 0 later. Project Upgrade requires an outlay of $ 6 0 0 0 0 today and will return $ 6 5 0 0 0 later. The company has $ 2 0 0 0 0 0 in resources. There is a capital market in which the interest rate for both borrowing and lending is 5 per cent per period. a)

26

Using the net present value rule, show that the company should invest in Project Large (that is, it should invest in both Project Small and Project Upgrade).

C hapter t w o C o n s u m p t io n ,

investment a n d the capital market

c) Suppose that Shareholder A wishes to consume $ 4 0 0 0 0 today. What does she do? How much will she be able to consume later? Show that this outcome is better for Shareholder A than if the company had invested only in Project Small. d) Suppose instead that Shareholder A wishes to consume equal amounts now and later, and the company invests in Project Large. What does she do? Show that this action will deliver the desired outcome for Shareholder A. Investment decisions: applying FisheKs Separation Theorem [LO 3]

Consider exactly the same situation as in Problem 2, except that the interest rate is 9 per cent per period. a) Using the net present value rule, show that the company should invest only in Project Small. b) How much will the company pay each shareholder in dividends today, and how much will it pay each shareholder in dividends later? c) Suppose that Shareholder A wishes to consume $ 4 0 0 0 0 today. What does she do? How much will she be able to consume later? d) Compare Shareholder A's consumption in Problem 2(c) with her consumption in Problem 3(c). Investment planning [LO 3]

CHAPTER T w o REVIEW

b) How much will the company pay each shareholder in dividends today, and how much will it pay each shareholder in dividends later?

Consider the following situation: • A company starts with $12 million in cash. • The interest rate is 15 per cent. • The optimal policy for the company is to invest $6 million in assets. • The net present value of this investment is $2 million. Answer the following questions: a) In 1 year’s time, how much will the company receive from the investment? b) Draw, to scale, the Fisher diagram that represents this case. c) What are the marginal and average rates of return on the investment? d) What is the total wealth of the company's shareholders immediately after the investment plan is announced? Effect of an interest rate decrease [LO 3] Redraw your diagram for Problem 4 to show the effect of an interest rate decrease on the company's investment plan. Show the net present value of the revised investment plan. Would all investors be made better off by the decrease in interest rates and the consequential revision in the investment plan? Give reasons for youranswer. Effect of higher investment [LO 3]

Return to the diagram you have drawn for Problem 4. Suppose that the company decides to invest $7.5 million— that is, $1.5 million more than before. Redraw the market opportunity line consistent with this new level of investment. What effect has the increased level of investment had on the company's shareholders?

REFERENCES Brown, R.L., 'Fisher’s Separation Theorem: an alternative approach^ Accounting Research Journal, 1996, vol. 9, no. 1, pp. 7 8 -8 1 . Fama, E., 'Efficient capital markets: a review o f theory and empirical w ork', Journal of Finance, M a y 1970, pp. 3 8 3 -4 1 7 .

Fama, E. & Miller, M .; The Theory of Finance, Holt, Rinehart & Winston, N ew York, 1972. Fisher, I., The Theory of Interest, M acm illan Company, N e w York, 1930. Hirshleifer, J.; Investment, Interest a n d Capital, Prentice-Hall, Englewood Cliffs, N e w Jersey, 1970.

27

CHAPTER CONTENTS ED HH

Introduction

29

H3

Valuation of contracts with multiple cash flows

46

Annuities

50

Fundamental concepts of financial mathematics

29

HH

Simple interest

31

田

Principal-and-interest loan contracts

58

m

Compound interest

33

BH

General annuities

63

LEARNING OBJECTIVES

Z

After studying this chapter you should be able to: 1

understand and solve problems involving simple interest and compound interest, including accumulating, discounting and making comparisons using the effective interest rate

2

value, as at any date, contracts involving multiple cash flows

3

distinguish between different types of annuity and calculate their present value and future value

4 apply your knowledge of annuities to solve a range of problems, including problems involving principal-and-interest loan contracts 5

distinguish between simple and general annuities and make basic calculations involving general annuities.

C hapter THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL /sAATHEMATICS

Financial mathematics provides the finance specialist w ith some extremely useful tools w ith which to solve financial problems. In this chapter, we present the m ajor tools o f financial mathematics and indicate some o f th e ir im p o rta n t applications. You w ill fin d th a t a thorough understanding o f these tools, and how they may be used, w ill be very valuable when you study later chapters. Although you w ill fin d a large number o f formulae in this chapter, you w ill n ot master financial mathematics i f you sim ply try to memorise the formulae. I f you fu lly understand the approach and the logic th a t are embodied in the formulae, you w ill n o t need to memorise them.

3.2

Fundamental concepts of financial mathematics

In this section, we explain four fundam ental concepts used in financial mathematics: cash flows, rate o f return, interest rate and tim e value o f money.

3 .2 .1 1 Cash flows Financial mathematics concerns the analysis o f cash flows between parties to a financial con tract.1 For example, when money is borrowed there is an in itia l flow o f cash from the lender to the borrower, and subsequently one (or more) cash (re)payment(s) from the borrower to the lender. In financial mathematics, as in finance generally, we are concerned w ith the cash flow consequences o f a decision or a contract. How much cash w ill flow between the parties? When w ill these cash flows occur? These are the basic questions th a t m ust firs t be answered when analysing a financial contract using the tools o f financial mathematics. We are n o t concerned w ith the possible non-cash consequences o f a contract, such as effects on reported p ro fit; nor are we concerned w ith effects on parties outside the contract.

CASH FLOW

payment (cash outflow) or receipt (cash inflow) of money FINAN C IAL CONTRACT

arrangement, agreement or investment that produces cash flows

3 .2 .2 ! Rate of return Financial decision makers usually fin d it convenient to relate the cash inflows th a t result from a contract to the cash outflows th a t the contract requires. Typically, this inform a tion is presented as a rate of return. Where there are only tw o cash flows in a financial contract— one at the sta rt o f the contract and another at the end— the rate o f retu rn is usually measured by:2 Ci - C

〇

C〇 where C1 = cash in flo w at Time 1 C〇= cash outflow at Time 0 r = rate o f retu rn per period The value o f C1 - C〇measures the dollar return to the investor. D ividing the dollar return by C〇 , which is the investm ent outlay, measures the rate o f return. Example 3.1 illustrates the calculation o f a rate o f return. Note th a t a rate o f retu rn is always measured over a tim e period. In Example 3.1 the tim e period is 1 year. It is meaningless to state th a t an investm ent has returned, say, 20 per cent w ith o u t also specifying the tim e period involved. 1 2

We use the term contract* broadly. For example, we include depositing money in a bank as an act carried out as part of the contract between the depositor and the bank. There are other measures. For example, under some circumstances it is convenient to measure the rate of return by EnCCj/Cg) [natural logarithm]. This measure is discussed further in Section 3.4.4.

RATE OF RETURN

calculation that expresses the ratio of net cash inflows to cash outflows

B usiness finance

Example 3.1

bB

On 1 January 2014, Paul buys an antique clock for $ 2 00 00. On 1 January 2015, the clock is sold for $2 4 0 0 0 . What rate of return has been achieved?

SOLUTION Using Equation 3.1, the rate of return is: r= Ci ~ C 〇 C〇 _ $24 0 0 0 -$ 2 0 0 0 0

$20000 $4000

_ $20000 4 = 20% per annum

3 2 3 | Interest rate INTEREST RATE

rate of return on debt DEBT

financial contract in which the receiver of the initial cash (the borrower) promises a particular cash flow, usually calculated using an interest rate, to the provider of funds (the lender) TIME VALUE OF MONEY

principle that a dollar is worth more (less), the sooner (later) it is to be received, all other things being equal

The term in te r e st ra te 1 is an im p o rta n t special case o f the more general term 4rate o f return* and is used when the financial contract is in the fo rm o f debt. A lthough a precise defin itio n o f debt is difficult, the general principle involved is th a t one party (the borrower) provides a specific promise regarding the future cash flow(s) payable to the other party (the lender). Debt may be contrasted w ith agreements where no particular promise is made regarding the future cash flows. For example, when Paul purchased the antique clock in Example 3.1 he was n ot promised any particular future cash inflow. Similarly, where an investm ent is made in ordinary shares, the shareholder is n o t promised any p articular cash inflow(s) from the investment.

3 .2 .4 |T im e value of money One o f the m ost im p o rta n t principles o f finance is th a t money has a tim e value. This principle means th a t a given sum o f money (say, a cash flow o f $100) should be valued differently, depending on when the cash flow is to occur. Suppose you have the choice o f receiving $100 either today or in 1 years tim e. As a rational person you w ill choose to take the money today. Even i f you do n ot plan to spend the money u n til 1 year later, you w ill s till choose to take the money today rather than in 1 years tim e because you w ill be able to earn interest on the money during the coming year. Because o f the interest you w ill earn, you w ill have more than $100 in 1 year’s tim e. Obviously, from your p o in t o f view this is better than receiving only $100 in 1 year’s time. By choosing to take the $100 today, rather than $100 in 1 years tim e, you are in effect saying th a t $100 received today is more valuable to you than the promise o f $100 to be received in 1 years tim e. To p ut this another way, you have im plied th a t $100 to be received in 1 years tim e is w o rth less than $100 today. You have recognised th a t money has a tim e value.3 An im p o rta n t consequence o f the fact th a t money has a tim e value is th a t we cannot validly add cash flows th a t w ill occur on different dates. Suppose you are offered $100 today and a fu rth e r $100 in 1 years time. How much is this offer w o rth to you? A t this stage we cannot answer this question, except to say th a t the value today is less than $200. The value today o f the cash flow o f $100 in 1 years tim e is less than 3

Other reasons for taking the money today, rather than later, are risk (you are not certain that the future cash flow will be paid) and e x p ected in flation (you fear that in a years time the purchasing power of $100 will be lower than it is today). While these reasons are valid, note that money has a time value, even in the absence of these reasons—that is, even if the risk is zero (you are certain that the future cash flow will be paid) and you expect that the inflation rate next year will be zero or negative (purchasing power either will not change or will increase), you will s till take the $100 today, in preference to $100 later, simply because interest rates are positive.

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time value of m o n e y : a n introduction t o financial mathematics

$100, so the to ta l value today o f the tw o cash flows m ust be less than $200. In financial mathematics it is extremely im p o rta n t never to attem pt to add cash flows th a t w ill occur on different dates.

3.3

Simple interest

3.3.1 | The basic idea of simple interest Many financial contracts specify the interest rate to be paid, rather than specifying explicitly the cash payment(s) required. Suppose, fo r example, th a t you borrow $1000, and agree to repay the loan by making a lum p sum payment in 1 years tim e at an interest rate o f 12 per cent per annum. Then: Interest owed = 0.12 x $1000 = $120 Lump sum payment = $1000 + $120 = $1120 This example is, o f course, very straightforw ard. O nly one tim e period is involved— in this case it happens to be 1 year— and the interest rate is quoted on a m atching (annual) basis. There is little scope fo r confusion in this case. But suppose the contract had specified a lum p sum repayment after 2 years, but the interest rate was quoted as 12 per cent per annum. How do we apply an annual rate to a period that is n ot equal to 1 year? To answer this question we need a rule or convention to enable us to apply an annual interest rate to a period o f 2 years. There are several ways in which this can be done, one o f which is sim ple in terest. A distinguishing feature o f simple interest is that, during the entire term o f the loan, interest is computed on the original sum borrowed. For example, suppose th a t a loan o f $100 m ust be repaid in a lum p sum after 2 years. Simple interest is to be charged at the rate o f 12 per cent per annum. Because simple interest is being used, interest in both years is charged on the sum o f $100. The interest in each year is thus $12, so the lum p sum repayment is $124. Therefore, the interest rate payable at the m a tu rity (term ination) o f the loan w ill in fact be 2 x 12 per cent = 24 per cent. Similarly, i f payment was instead due after h a lf a year, a simple interest rate o f 12 per cent per annum means that, in fact, interest w ill be paid at the rate o f V2 x 12 per cent = 6 per cent per half-year. Example 3.2 illustrates simple interest.

LEARNING OBJECTIVE 1 Understand and solve problems involving simple interest and compound interest, including accumulating, discounting and making comparisons using the effective interest rate

SIMPLE INTEREST

method of calculating interest in which, during the entire term of the loan, interest is computed on the original sum borrowed

Example 3.2 Molly's Bakeries Ltd borrows $ 1 0 0 0 0 and agrees to repay the loan by a lump sum payment in 6 months7 time. The interest rate is 8 per cent per annum (simple). Calculate the lump sum payment.

6

SOLUTION Interest rate per half-year = - x 8%

2 =4%

Interest payable = $10000 x 0.04

=$400 Lump sum payable = $ 1 0 0 0 0 + $400

= $10400

3 .3 .2 | Formula development: future sum Suppose an am ount P— also know n as the principal — is borrowed and w ill be repaid in a lum p sum. The interest rate is r per period (for example, per annum) and repayment is required after t periods. Using simple interest, the interest payable is based on the original principal, so the interest owing after one

PRINCIPAL

amount borrowed at the outset of a loan

B usiness finance

FUTURE SUM

amount to which a present sum, such as a principal, will grow (accumulate) at a future date, through the operation of interest

period is P x r. A fte r t periods the interest payable is sim ply P x r x t. Therefore, the required future sum 5, th a t w ill repay the am ount borrowed, is given by: S = principal and interest = P + P rt S = P (l + rt)

I

3.2

Example 3.3 illustrates the use o f Equation 3.2 to calculate a future sum using simple interest.

Example 3.3 a) Use Equation 3.2 to calculate Molly’s repayment of a loan of $ 1 0 0 0 0 after 6 months if simple interest is used and the interest rate is 8 per cent per annum. b) W hat would be the repayment if the lump sum repayment were instead required after 15 months?

SOLUTION a) S = P(1 + rt) =

$10000 $10000

1+0.08 X

6

、

,T2,

1.04

$10400

b) S = P(1 + rt) =$10000 =

$10000 1+0.08 $ 10000x

'1 5 、 .T2,

1.10

$11000

3 .3 .3 1 Formula development: present value PRESENT VALUE

amount that corresponds to today's value of a promised future sum

In many practical cases, we know the future repayment S, the interest rate r and the tim e period t, and our problem is to fin d the principal P (or presen t value) th a t is implied. In this case we simply rearrange Equation 3.2 to find:

1 + rr

3.3

The present value P is the sum o f money th a t corresponds to today s value o f the future sum promised. The fact th a t P is n ot equal to S follows from the fact th a t money has a tim e value. Im portantly, P in Equation 3.3 can also be thought o f as a price. I f a prospective borrower promises to pay a sum S in t years* time, then given the interest rate r, we can calculate the price (value) o f the borrowers promised future payment o f S. In other words, i f we view the loan from the lenders perspective, the principal represents the price (or present value) paid by the lender, to secure from the borrower, the promise to pay the future cash flow required by the contract. Looked at from the borrow ers view point, the promised future cash flow has been sold by the borrower to the lender fo r its present value, which is the loan principal.

3.3.4 | Applications of simple interest There are many commercial applications o f simple interest. For example, simple interest is used for Treasury notes, bills o f exchange and many bank deposits. Because large sums o f money are often

C hapter three T he

time value of m o n e y : a n introduction t o financial mathematics

involved, there m ust be clear rules or conventions used in applying simple interest. These conventions can differ between countries. Using bills o f exchange as an example, the Australian conventions are:

a b C

d

Interest rates are quoted on an annual basis. The tim e period t is calculated as the exact num ber o f days divided by 365. In a leap year, 29 February is included in the num ber o f days, b ut the year is s till assumed to consist o f 365 days. Calculations are made to the nearest cent.

Bills o f exchange are discussed in detail in Section 10.5.3. The conventions used in Australia are illustrated in Examples 3.4 and 3.5.

Example 3.4 Stars Ltd borrows $ 1 0 0 0 0 0 on 20 January 201 2, to be repaid in a lump sum on 2 March 2012. The interest rate is 8.75 per cent per annum. Calculate the lump sum repayment.

SOLUTION The time period involved is 42 days, consisting of 1 1 days in January, 29 days in February and 2 days in March; note that we do not count both 20 January and 2 March but we d o count 29 February because 2012 is a leap year. Using Equation 3.2 and the conventions explained in this section the lump sum repayment is: S = P(1 +rf) =$10 00 0 0 1 + (0 .0 8 7 5 )( 盖

)

=$10 00 0 0 x 1.010068493 $101 006.85

Example 3.5 Moon Ltd promises to pay $ 5 0 0 0 0 0 in 6 0 days’ time. For a company with M oon’s credit standing the market interest rate for a loan period of 6 0 days is 14.4 per cent per annum. How much can Moon borrow?

SOLUTION Using Equation 3.3 and the conventions explained in this section, Moon can borrow the sum of: P=丄

1 + rt $500000

= 1 + ( 0 .144)(盛

）

$500000 _ 1.023 671 232 =$488 438.07

3.4

Com pound interest COM PO U N D INTEREST

3 .4 .1 1 The basic idea of compound interest When interest is received by a lender, the interest can then be le n t to another borrower and, in due course, w ill earn fu rth e r interest. The basic idea o f com p ou n d in te r e st is th a t interest is periodically

interest calculated each period on the principal amount and on any interest earned on the investment up to that point

B usiness finance

added to the principal. Thus interest generates fu rth e r interest, which then generates s till more interest, and so on. This process is illustrated in Example 3.6.

Example 3.6

i s

On 31 December 2013, Kee Saw deposited $ 1 0 0 0 0 0 in a bank account that paid interest at the rate of 5 per cent per annum. How much was in the account after 4 years?

SOLUTION The history of Kee Saw ’s account is as follows: Balance 31 December 2013

Account opened

$100000.00

31 December 2014

Interest 0.05 x $100000.00 = $5000.00

$105000.00

Interest 0.05 x $105000.00 = $5250.00

$110250.00

Interest 0.05 x $110250.00 = $5512.50

$115762.50

Interest 0.05 x $115762.50 = $5788.13

$121550.63

31 December 2015

31 December 2016

31 December 2017

As the growth in Kee Saw 's account balance makes clear, with compound interest, the amount of interest each year increases. For example, in the first year the interest received was $ 5 0 0 0 .0 0 but in the fourth year the interest received was $5788.13. After 4 years, Kee Saw ’s account balance is $ 1 2 1 5 5 0 .6 3 but had the account been paid interest at the fixed amount of $ 5 0 0 0 per annum — that is, if Kee Saw had not been able to reinvest interest to earn further interest— the balance would have been only $ 1 2 0 0 0 0 . Therefore, in 4 years, Kee Saw earned $1 55 0 .6 3 of 'interest on interest'.

3 .4 .2 1 Formula development: future sum and present value

ACCUMULATION

process by which, through the operation of interest, a present sum becomes a greater sum in the future

Assume th a t a principal o f P dollars is deposited— th a t is, lent to a bank o r o ther financial in s titu tio n — fo r a term o f n periods, w ith interest paid at the rate i per period at the end o f each period. O ur task is to develop a form ula fo r the future sum 5 th a t w ill be accum ulated after m periods, allowing fo r compound interest. A fte r one period the interest earned is iP, so the account balance at the end o f the firs t period is P + iP = P(1 + 〇. In fact the balance (or accumulated sum) at the end o f any given period is simply the balance a t the sta rt o f th a t period m ultiplie d by (1 + 〇. D uring the second period interest w ill be earned on the am ount P(1 + 〇. So: Balance at end o f Period 2 = = = =

命

(balance at start o f Period 2) x (1 + /) (balance at end o f Period 1) x (1 + /) P(1 4- i) x (1 + i) P(1 + 〇2

CHAPTER THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

Similarly: Balance at end o f Period 3 = (balance at start o f Period 3) x (1 -h /) = (balance at end o f Period 2) x (1 + /) = P(1 + i)2 x (1 + i) = P(1 + 〇3 Generalising from this discussion, the sum accumulated after n periods is given by P(1 + i)nf so the form ula fo r the future sum S is:

3.4

S = P ( l + i) n The corresponding form ula to find the present value P o f a future sum S is: ^

S

3.5 where

5 = future sum a fter n periods P = principal (or price or present value) i = interest rate per period n = num ber o f periods To illustrate Equation 3.4 we use the inform a tion in Example 3.6. The value o f Kee Saws deposit after selected terms is shown in Table 3.1.

TABLE 3.1 Accumulated value (future sum) of $100000 at 5 per cent per annum Date

Number of years completed

31 December 2014

1

$100000 (1.05)

105000.00

31 December 2015

2

$100000(1.05)2

110250.00

31 December 2016

3

$100000 (1.05)3

115 762.50

31 December 2017

4

$100000(1.05)4

121550.63

31 December 2018

5

$100000 (1.05)5

127628.16

31 December 2023

10

$100000 (1.05)10

162889.46

31 December 2033

20

$100000 (1.05)20

265 329.77

31 December 2063

50

$100000 (1.05)50

1146739.98

Calculation

Accumulated value ($)

The effect o f compound interest becomes more pronounced as the number o f periods becomes large. For example, after 50 years, the value o f Kee Saws account is nearly $1.15 m illion, or more than 10 times the amount w ith which he opened the account.

£ 6000 DEBT GREW TO £116 000_____________________________ If you don't repay a loan, and a lot of time passes, the debt can grow to unmanageable proportions, as happened to an unfortunate borrower in Manchester in the United Kingdom. A grandmother has been forced to put her house up for sale after she ended up owing a massive £1 16 0 0 0 — on a £ 6 0 0 0 loan. Esther 〇sei, 57, borrowed the money in 1 9 8 8 to pay for her father's funeral and to buy a new cooker for her Clayton home. continued

Finance in ACTION

B usiness finance

continued

But she could not meet the cost of the loan and 1 8 years later, the amount she owed had grown to £1 16 0 0 0 . .. Esther said: 1 borrowed the money when I was grieving for my father. I just signed the papers/ W h en the lender applied to take possession of her home, Esther sought help by going to the North Manchester Law Centre. Lawyers negotiated a deal at Manchester County Court . . . A law centre spokesperson said Esther should never have entered into the loan agreement. 'It was a very high rate of interest/ / 5 、 l/n Autnors7 note: Equation 3.4 can be rearranged to: /= f - J - 1. Substituting S = £1 16 000,

P = £ 6 0 0 0 and n = 1 8 years into this equation, gives / = 17.89 per cent per annum. However, this may not have been the contract interest rate because the final debt may have included unpaid fees. Source: '£ 6 0 0 0 debt grew to £116 0 0 0 7, Jo Rostron, Manchester M etro News, 21 July 2006.

To illustrate Equation 3.5, which gives the present value o f a future sum promised, suppose th a t an individual is offered the sum o f $100 000 to be received after 5 years. I f the relevant interest rate is 5 per cent per annum, compounded annually, the present value o f this promised sum is: (1 + /广

_ $100 000 一

（1.05)5

$100 000 _ 1.276281563 =$78352.62

DISCOUNTING

process by which, through the operation of interest, a future sum is converted to its equivalent present value

That is, looking ahead 5 years to the receipt o f this promised sum o f $100000, it is w orth, in todays terms, only $78 352.62. The logic underlying this result is th a t i f one wished to set aside money today to accumulate a sum o f $100000 in 5 years* tim e, the am ount needed to be set aside today is $78352.62. A fte r 5 years, this sum w ill accumulate to $78 352.62 x (1.05)5 = $100 000. Clearly, all o ther things being equal, the longer the w aiting period— th a t is, the later the promised sum is to be received— the lower is the value today. The process by which a future sum is converted to its equivalent present value is called discounting. This process is illustrated in Table 3.2, which shows the present value o f $100 000 to be received at selected future dates, discounted using an interest rate o f 5 per cent per annum. Again, the effect o f compound interest becomes more pronounced when the num ber o f periods is large. A promise to be paid $100000 in 50 years* tim e is w o rth only $8720.37 in todays terms i f the discount rate is 5 per cent per annum.

TABLE 3.2 Present value of $100000 at 5 per cent per annum Number of years to wait

Calculation

Present value ($)

1

$100000/1.05

95 238.10

2

$100000/(1.05)2

90702.95

3

$100000/(1.05)3

86383.76

4

$100000/(1.05)4

82270.25

C hapter three T he

time value of m o n e y : a n introduction to financial mathematics

Table 3.2 continued

Number of years to wait

Calculation

Present value ($)

5

$100000/(1.05)5

78352.62

10

$100000/(1.05)10

61391.33

20

$100000/(1.05)2°

37688.95

50

$100000/(1.05)so

8720.37

3 .4 .3 1 Nominal and effective interest rates Many financial contracts specify th a t a loan shall be repaid by a series o f payments made on various future dates, rather than by a lum p sum at the end o f a single tim e period. For example, a so-called interestonly loan requires payments o f interest at regular intervals followed by the repayment o f the principal in a lum p sum on the loan’s m a tu rity date. In m ost loans, the interest rate specified is a nom inal in terest rate, which is an interest rate where interest is charged more frequently than the tim e period specified in the interest rate. To sim plify matters, we assume th a t interest is charged (and therefore compounded) on the same dates as payments are required.4 Examples o f nom inal interest rates are: 15 per cent per annum w ith quarterly payments, and 1.5 per cent per quarter w ith m on thly payments. Where a nom inal interest rate is used in a loan contract, a convention is needed to decide how an interest rate quoted fo r one tim e period w ill be applied to a different tim e period. The convention adopted is to take a simple ratio. So, fo r example, *15 per cent per annum payable quarterly* means th a t interest w ill be charged each quarter at the rate o f 3.75 per cent per quarter— th a t is, the annual rate o f 15 per cent is simply scaled down to one-quarter o f this rate because there are fo ur quarters in a year. Similarly, *1.5 per cent per quarter payable m o n th ly * means th a t interest w ill be charged each m on th at 0.5 per cent per m onth because a m on th is one-third o f a quarter and one-third o f 1.5 is 0.5. Conversely, an effective in terest rate is one where the frequency o f charging (payment) does match the tim e period specified by the interest rate. Examples o f effective interest rates are: 15 per cent per annum w ith annual payments and 0.5 per cent per m onth w ith m on thly payments. W hile few financial contracts specify an effective interest rate, i t is an im p o rta n t concept because it provides a consistent basis on which to compare interest rates. This use is illustrated later in Example 3.8. From the lender s view point i t is preferable to have interest paid more frequently, all other things being equal. To illustrate th is fact, suppose th a t a bank is w illin g to lend $100 000 fo r 1 year at 15 per cent per annum on an in te re s t only, basis b u t has the choice o f receiving either annual or quarterly interest payments. Thus, the bank faces a choice between the cash inflows shown in Table 3.3.

INTEREST-ONLY LOAN

loan in which the borrower is required to make regular payments to cover interest accrued but is not required to make payments to reduce the principal. On the maturity date of the loan, the principal is repaid in a lump sum N O M IN A L INTEREST RATE

quoted interest rate where interest is charged more frequently than the basis on which the interest rate is quoted. The interest rate actually used to calculate the interest charge is taken as a proportion of the quoted nominal rate. Note: The term 'nominal interest rate7 also has another meaning (see Section

3.4.4)

TABLE 3.3 Cash inflows at 15 per cent per annum

EFFECTIVE INTEREST RATE

Cash inflow at Hme t At f = 1 quarter Annual interest Quarterly interest

4

A t t = 2 quarters

A " = 3 quarters

At f = 4 quarters

$0

$0

$0

$115000

$3750

$3750

$3750

$103750

This assumption is relaxed in Section 3.8.

interest rate where interest is charged at the same frequency as the interest rate is quoted

I f we sim ply add up the two streams o f cash flows shown in Table 3.3 we would, o f course, find that both to ta l $115000 but, as we explained earlier, this procedure is n o t valid because i t involves adding cash flows th a t occur on different dates. Because earlier cash inflows are preferred to later cash inflows, the quarterly interest stream is w o rth more to the bank. I t is w o rth more because the early* cash inflows o f $3750 can be re-lent to earn fu rth e r interest later in the year. Exactly how much more valuable the quarterly stream w ill prove to be w ill depend on the level o f interest rates during the year, b u t because interest rates are always positive, the bank cannot lose by accepting the quarterly payments rather than the annual payment. An im p o rta n t special case can be developed by assuming th a t during the coming year the bank can continue to lend money at 3.75 per cent per quarter. Thus the firs t quarterly inflow o f $3750 can be re-lent fo r the rem aining three quarters, generating fu rth e r quarterly interest payments o f 0.0375 x $3750 = $140.63, together w ith the repayment o f $3750 at the end o f the fo u rth quarter. A quarterby-quarter analysis is shown in Figure 3.1. As shown in Figure 3.1, taking in to account the future opportunities fo r re-lending, the bank can secure a to ta l cash inflow, at the end o f the fo u rth quarter, o f $115 865.06, which fo r the bank is clearly preferable to a cash in flo w (on the same date) o f only $115 000. In effect, w ith interest paid quarterly, the bank has earned at an annual rate o f retu rn given by: $115 865.06 - $100 000

$100 000 » 15.865%

Cash flows re-lent at 3.75 per cent per quarter 0

1

2

$3 750.00

1—

3

4

$3 750.00

$3 750.00

$103 750.00

,► $ 140.63

$ 140.63

$

3 890.63

$ 145.90

$

4 036.53

$

4 187.90

Quarters

$3 890.63 1----------- ►

$4 036.53

$115 865.06 W ith only an annual interest payment, the bank would have had to specify an interest rate o f 15.865 per cent per annum to equal this rate o f return. Therefore, this example has established that there is a sense in which the nom inal interest rate o f 15 per cent per annum, which is payable quarterly, is equivalent to an effective interest rate o f 15.865 per cent per annum, payable annually. But the sum o f $115865 is simply the future sum that would result from lending $100000 to earn compound interest at the rate o f 3.75 per cent per quarter for four quarters. This is easily seen by noting that: $100000 x (1.0375)4 = $100000 x 1.158 65 = $115865 Generalising from this example, i f a lender advances a principal o f P and specifies a nom inal interest rate o f; per period, w ith interest payments required every subperiod, and there are m subperiods in every period, then the future sum at the end o f one period is given by:

The effective interest rate i per period is: . S -P i = -----P

p { x+ i ) P

~p

C hapter THREE T he TIME VALUE OF MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

therefore

Equation 3.6 is the form ula fo r calculating the effective interest rate zper period fo r a nom inal interest rate;, compounding m times per period. The use o f this form ula is illustrated in Examples 3.7 and 3.8.

Example 3.7 Calculate the effective annual interest rates corresponding to 12 per cent per annum, compounding: a) semi-annually

6

b) quarterly c) monthly d) daily.

SOLUTION Using Equation 3.6, the calculations are shown in Table 3.4.

TABLE 3.4 Compounding frequency

Calculation

Effective annual interest rate (%)

(a) Semi-annually

(1.06)2- 1

12.3600

(b) Quarterly

(1.03)4 - 1

12.5509

(c) M onthly

( l. 〇l ) 12- l

12.6825

(d) Daily

(1.000 328 767)365- l

12.7475

These calculations illustrate the fact that, all other things being equal, more frequent compounding produces a higher effective interest rate.

Example 3.8 Lake Developments Ltd wishes to borrow money and is offered its choice of the following nominal interest rates: a) 15.00 per cent per annum, payable annually b) 14.50 per cent per annum, payable semi-annually c) 14.00 per cent per annum, payable quarterly d) 13.92 per cent per annum, payable monthly. Which of these nominal interest rates provides the lowest cost of finance in terms of the corresponding effective annual interest rate?

SOLUTION Using Equation 3.6, the effective annual interest rates are: a) /= 15 per cent per annum b) / = (1.0725)2 - 1 = 1 5 . 0 2 6 per cent per annum c) / = (1.035)4 - 1 = 14.752 per cent per annum d) / = (1.01 16)12 - 1 = 14.843 per cent per annum. Thus option (c), which is a nominal interest rate of 14.00 per cent per annum with quarterly compounding, provides the lowest effective annual interest rate.

6

In some problems it is necessary to fin d out w hat nom inal interest r a te ,m u s t be charged in order to achieve a target effective interest rate, z. Answering a problem o f this type requires th a t Equation 3.6 be rearranged so th a t; appears on the left-hand side o f the equation. This is shown below. Equation 3.6 is: 1

+

丄

m

Adding 1 to b oth sides, and raising to the power 1/m: ( l + /)1/m = l + 丄 m Subtracting 1 from b oth sides, and m u ltip lyin g by m: 7 = /7?[(l + /)1/m- l ]

3.7

The use o f this form ula is illustrated in Example 3.9.

Example 3.9 A financial institution raises funds from several different types of deposits but all its loans to borrowers require monthly repayments. The effective annual interest rate that it pays depositors is 7.5 per cent per annum. To cover its other costs and make a profit, the institution adds a margin of 3 per cent per annum. Therefore, its target effective interest rate is 10.5 per cent per annum. W hat nominal annual interest rate must it charge borrowers?

6

SOLUTION Using Equation 3.7, the nominal annual interest rate is: / = m[(l + i)]^m- 1] = 12W.10511/ 12- 1] = 1 2 x 0.008355155 = 1 0% per annum

The financial institution would need to charge a nominal annual interest rate of 10 per cent on the loans it makes.

3.4.41 Compound interest: two special cases and a generalisation In this section we discuss real interest rates, continuous interest rates and geometric rates o f return. To understand the remainder o f the chapter, knowledge o f these issues is not required, so some readers may wish to o m it this section.

Special case no. 1: the real interest rate REAL INTEREST RATE

interest rate after taking out the effects of inflation N O M IN A L INTEREST RATE

interest rate before taking out the effects of inflation. Note: the term 'nominal interest rate' also has another meaning (see Section 3.4.3)

A real in te re st rate is an interest rate after taking out the effects o f infla tion . Hence, the word Veal1 in this context is used in the same sense as i t is used in phrases such as ‘real GDP’ and ‘real wages’. An interest rate before taking out the effects o f in fla tio n is usually referred to as a nom inal in terest rate. The phrase ‘nom inal interest rate’ in this context should n o t be confused w ith its use in Section 3.4.3. In th a t section, the phrase N om inal interest rate* referred to an interest rate where the frequency o f payment o r compounding did n ot match the basis on which the interest rate was quoted. Suppose th a t a representative basket o f goods th a t a consumer m ig ht buy costs $500 today. I f the in fla tio n rate in the coming year is expected to be 20 per cent per annum, the price o f the basket at the end o f the year is expected to be $500 x 1.2 = $600. Suppose also th a t a lender currently has $2000 th a t w ill be lent at a nom inal interest rate fo r 1 year. By lending this sum the lender forgoes the consumption now o f four representative baskets o f goods. I f a real interest rate o f 5 per cent per annum is to be achieved,

C hapter three T he

time value of m o n e y : a n introduction to financial mathematics

then the lender requires th a t at the end o f the year the sum generated w ill be sufficient to purchase 4 x 1.05 = 4.2 baskets o f goods— th a t is, the sum required in 1 year is: 4.2

baskets x $600 per basket = $2520

Therefore, the nom inal annual interest rate required is: $2520 - $2000 $2000

=26% Generalising from this example, let: B = the price today o f a representative basket o f goods P = principal p = expected in fla tio n rate z* = required real interest rate z = nom inal interest rate ^ ^ Thus the lender forgoes consumption o f — baskets today, to be able to consume ~ ^ +

baskets in

a years tim e. The expected price o f one basket in a years tim e is B(1 + p ). Therefore, the sum required in p 1 years tim e is —(1 + i*) x B(1 + p). Therefore, the nom inal interest rate required is:

i = ^ ------------------------------P On sim plifying, this gives:

3.8

/ = (1 + i*) (1 + / ? ) - l

Equation 3.8 shows the lin k w ith the idea o f compounding: the nom inal interest rate i is n o t sim ply the sum o f the real interest rate i* and the expected in fla tio n rate p t b u t rather is in the form o f the real interest rate compounded, by the expected in fla tio n rate. Rearranging Equation 3.8 gives:

3.9

l + P

Equation 3.9 gives the real interest rate corresponding to a nom inal interest rate z i f the expected infla tion rate is p. Expansion o f Equation 3.9 gives the result: •氺 . •幸 i = i- p - p i 士

i- v

That is, the real interest rate i* is not simply the difference between the nom inal interest rate i and the expected infla tion rate p. However, where the rates are ^m a ir, pi* w ill also be small and the approximation i* ^ i - p w ill be close. The calculation o f a real interest rate is illustrated in Example 3.10.

E xample 3.10 If the inflation rate is expected to be 2 0 per cent per annum and the nominal interest rate is 30 per cent per annum, calculate the corresponding real interest rate.

SOLUTION Using Equation 3.9: r = 上^ - 1 1 +P

1.30

= ---------l 1.20

.

=8.33% per annum

6

Special case no. 2: continuous interest rates

CONTINUOUS INTEREST

method of calculating interest in which interest is charged so frequently that the time period between each charge approaches zero

As we showed in Section 3.4.3, the more frequently compounding occurs, the higher is the effective interest rate, other things being equal. In the lim itin g case, compounding becomes so frequent th a t the tim e period between each interest charge approaches zero. This is know n as continuous in terest and it can be shown th a t continuous interest is an example o f exponential growth. Using continuous interest, the fu tu re sum S is S

where

3.10

= P eJn

S = future sum P = principal

j = continuously compounding interest rate per period n = number o f periods e = 2.71828182846 The calculation o f a future sum using continuous interest is illustrated in Example 3.11.

E xample 3.11 If the interest rate is 12 per cent per annum, compounding continuously, how much will a principal of $ 1 0 0 0 0 0 be worth after 1 year? After 2 years?

SOLUTION Using Equation 3.10, the future sum after 1 year is: S = Pein

=$100000

x e (012) ( 1)

=$100000

X

1.127496852

=$112 749.69 Again using Equation 3.10, the future sum after 2 years is: S = Pein

x e (012)( 2) =$100000 x e 0-24 =$100000

=$127124.92

The effective interest rate th a t results from continuous compounding is found by setting n equal to 1 period and solving: . S -P i = -----P _ Pef - P —

i h where

P

Kill

i = effective interest rate per period j = continuously compounding interest rate per period e = 2.71828182846 The calculation o f an effective annual interest rate th a t is equivalent to a continuously compounding interest rate is illustrated in Example 3.12.

命

C hapter three T he

time value of m o n e y : a n introduction to finan c ial mathematics

E xample 3.1! W hat is the effective annual interest rate corresponding to a nominal interest rate of 12 per cent per annum, compounding continuously?

SOLUTION Using Equation 3.11, the effective annual interest rate / is given by: /=

- 1

= e°-,2 - l = 1 2 .7 4 9 6 9 % per annum

Of course, this is the interest rate implicit in Example 3.1 1.

Although continuous compounding is rarely used in loan contracts, i t is frequently used in other contexts. In particular, academic studies o f security prices often assume th a t returns compound continuously between the dates on which the prices are observed. Consider the security prices P〇, Px and P2 observed on dates 0 ,1 and 2 respectively. These dates are assumed to be equally spaced. For example, the prices may be observed at weekly intervals. Assuming th a t returns accrue continuously through time, we can apply Equation 3.10 to assert th a t in the firs t week: P i = P〇eri and in the second week: P2 = P\eri where r1 is the continuously compounding weekly rate o f retu rn in the firs t week and r2 is the continuously compounding weekly rate o f retu rn in the second week. Solving fo r r1 and r2 gives: n = in (P i/P 〇 ) and r2 = in {P2/P l ) where in means logarithm to the base e (usually referred to as the natural logarithm ). More generally, we can w rite th a t the rate o f retu rn in period t is: rt = £n {P t/P t-i) An expression o f the fo rm £n (P t/P t-i) is called a lo g p ric e re la tiv e and, when calculated this way, r t is called a logarithm ic rate o f retu rn or a continuous rate o f return. There are two reasons fo r choosing to measure rates o f retu rn in this way. First, the correct way to compound logarithm ic rates o f return is sim ply to add them. Thus, fo r example:

LOG PRICE RELATIVE

That is:

natural logarithm of the ratio of successive security prices. Implicitly, it is assumed that prices have grown (or decayed) in a continuous fashion between the two dates on which the prices are observed. Also known as a logarithmic rate of return and a

P2 = P0eri+r2

continuous rate of return

P2 = P\er2 But P\ = P〇 eri Substituting, we find: P2 = P〇 en er2

The last equation shows that, using logarithm ic rates o f return, the to ta l rate o f retu rn over the two tim e periods is sim ply the sum o f the rates o f retu rn in each o f the tw o constituent periods. Thus calculations such as finding an average rate o f retu rn are simpler when using logarithm ic rates o f return.

命

B usiness finance

As discussed in Section 3.4.5, i t is not valid to add rates o f retu rn i f they are measured using the simple a rith m e tic1d efin itio n that:

The second reason fo r using logarithm ic rates o f retu rn is a statistical one. The greatest loss an investor can suffer is when the security price falls to zero. Using the simple arithm etic definition, the rate o f return associated w ith this event is - 1 — th a t is, the rate o f retu rn is -1 0 0 per cent. Using logarithm ic rates o f return, the same event w ill register as a rate o f retu rn o f - 〇〇. Given th a t there is no upper lim it to the rate o f retu rn th a t m ight be achieved, i t follows th a t while arithm etic rates o f retu rn fa ll in the range -1 to +〇〇, logarithm ic rates o f retu rn fa ll in the range - 〇〇to +〇〇. Thus, w hile the statistical d istribution th a t describes logarithm ic rates o f retu rn might have the convenient property o f symmetry, and thus might fo llo w the norm al d istribution, arithm etic rates o f retu rn w ill not be sym metric and thus cannot be norm ally distributed.

A generalisation: geometric rates of return GEOMETRIC RATE OF RETURN

average of a sequence of arithmetic rates of return, found by a process that resembles compounding

Compound interest is a special case o f a geom etric rate o f return. In the case o f compound interest, the interest rate is the same in each period. In the more general case o f geometric rates o f return, the rate o f retu rn can be different in each period. W hile the sum invested is s till subject to the compounding process, the rate at which compounding occurs w ill differ from period to period. Suppose th a t $1000 is invested fo r 4 years and each year the investm ent earns a different rate o f return, as follows: • • • •

In In In In

Year 1: 10 per cent per annum Year 2: 5 per cent per annum Year 3: 8 per cent per annum Year 4 :1 5 per cent per annum.

The value o f this investm ent therefore grows as follows: 1 A t the 2 A t the 3 A t the 4 A t the

end o f Year 1: $1000.00 end o f Year 2: $1100.00 end o f Year 3: $1155.00 end o f Year 4: $1247.40

x 1.10 = $1100.00 x 1.05 = $1155.00 x 1.08 = $1247.40 x 1.15 = $1434.51.

O f course, this result could have been found more quickly and conveniently by calculating, in one step: $1000 x 1.10 x 1.05 x 1.08 x 1.15 = $1434.51 W ritin g the calculation in this way emphasises the sim ilarity between compound interest and the more general case o f geometric rates o f return. I t is natural to ask: w hat annual compound interest rate would have produced the same result? In other words, w hat single rate o f retu rn zper year would need to be earned in each o f the 4 years, to produce the same future sum? To answer this question we need to solve: $1000 x 1.10 x 1.05 x 1.08 x 1.15 = $1000(1 + 〇 4 th a t is, i = [(1.10)(1.05)(1.08)(1.15)]1/4_ i =(1.434 S l) 1^ - ! =9.440% per annum In fact, i in this calculation is the mean (or average) geometric rate o f return. I t is the rate o f return which, i f earned in every period, and allowing fo r the effects o f compounding, would produce the same outcome as th a t actually observed. In the general case, the mean geometric rate o f retu rn is: i = [ ( l + r i ) ( l + r2) . . . ( l + 〇 ] V " - l where

命

rk = the rate o f retu rn in period k /c = 1, 2, n n = the num ber o f completed periods

K1H

CHAPTER THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

I f the rate o f retu rn is calculated each period from security prices P〇, Pl

t

then:

Pk ~ Pk-\

Pk-l Pk

Pk-l Substituting in Equation 3.13 gives:

3.14 It is im p o rta n t to understand th a t the mean rate o f retu rn is not (rx + r2 + ... + rn)/ri— th a t is, i t is not correct simply to sum the rates o f retu rn and divide by the number o f periods. This fact is illustrated in Example 3.13.

E xample 3.1 An investment of $ 1 0 0 0 0 0 produces rates of return as follows: In Year In Year In Year In Year

1: 2: 3: 4:

a a a a

gain of 10 per cent loss of 5 per cent loss of 8 per cent gain of 3 per cent

Calculate the value of the investment at the end of the fourth year and calculate the mean annual rate of return.

SOLUTION The value of the investment at the end of the fourth year is: $ 1 0 0 0 0 0 x 1.10 x 0.95 x 0.92 x 1.03 = $ 9 9 0 2 4 .2 0 Using Equation 3.14, the mean annual rate of return is:

_ /$ 9 9 0 2 4 .2 0 \1/4

—V $100000

)

1 一

= -0.002 448 = -0.2 448%

This small negative mean rate of return is consistent with the outcome that the final value ($99024.20) is less than the sum invested ($ 1 0 0 0 0 0 )— that is, the investment has produced a loss after 4 years. Note that the incorrect calculation of the mean as: 10% - 5 % - 8 % + 3 % 4 =0%

clearly gives a nonsensical answer because in this example the mean rate of return must be negative.5

5

Note that we are discussing here the correct measurement of p a s t returns. We are not discussing the forecasting of fu tu re returns.

B usiness finance

3.5 LEARNING OBJECTIVE 2 Value, as at any date, contracts involving multiple cash flows

Valuation of contracts with multiple cash flows

3.5.1 | Introduction Many loan contracts stipulate th a t more than one cash flow is required to repay the loan. For example, a housing loan may require m on thly repayments over a period o f 20 years— a to ta l o f 240 repayments. In this section we consider the valuation o f contracts th a t involve m ultiple cash flows. We do n o t assume th a t the am ount or tim in g o f the cash flows follows any particular pattern. Some im p o rta n t special cases involving equal amounts at equally spaced tim e intervals are considered in Section 3.6.

3.5_2| Value additivity W hile i t is not valid to add cash flows th a t occur at different times, i t is valid to add cash flows th a t occur at the same tim e. Therefore, i f a contract requires cash payments to be made on, say, 1 A p ril and 1 May, we should n o t sim ply add these cash flows. However, i f we firs t value the 1 A p ril cash flow as i f i t were to occur on 1 May, we could then add the two cash flows, since one is actually a May cash flow and the other has, so to speak, been converted to the equivalent o f a May cash flow. Alternatively, we could firs t value the 1 May cash flow as i f it were to occur on 1 A p ril; sum m ation o f these tw o cash flows then provides the to ta l value o f the tw o cash flows as at 1 A pril. For th a t m atter we could choose any date at all, value the two cash flows as i f they were to occur on that date, and thus produce a valuation as at th a t date. To im plem ent this approach we need to decide how we can value, as at any given date, a cash flow that occurs on some earlier or later date. For example, we need to decide how a 1 A p ril cash flow can be valued as at 1 May. The answer is provided by the interest rate. Using our knowledge o f compound interest we can use Equation 3.4 to carry forw ard in tim e (‘accumulate’）the value o f any cash flow, provided we know the interest rate to use. Similarly, we can use Equation 3.5 to carry backward in tim e (‘discount’) the value o f any cash flow i f we know the interest rate to use. The process o f valuation as at any given date is illustrated in Example 3.14.

Example 3.14 On 1 February 2 0 1 4 you sign a contract that entitles you to receive two future cash flows, as follows: On 1 February 2016: $ 1 0 0 0 0 On 1 August 2017: $6 00 0 Assuming that the relevant interest rate is 5 per cent per annum (effective), value this contract as at: a) 1 February 2 0 14 b) 1 February 2 0 16 and c) 1 August 2017. The following time line shows the timing of the cash flows in this problem.

t= 0 years I 1 1 February 2014

t= 2 years I 1 1 February 2016 $10000

t= 3.5 years I 1 1 August 2017 $6000

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time value of m o n e y : a n introduction to finan c ial mathematics

SOLUTION a) Valuation as at 1 February 2 0 14 Both cash flows must be discounted to 1 February 2014. This requires that the $ 1 0 0 0 0 to be received on 1 February 2016 be discounted for 2 years and the $6 0 0 0 to be received on 1 August 20 1 7 be discounted for 3.5 years. The equation we need to use in each case is Equation 3.5. The valuation as at 1 February 2 0 1 4 is: $10000 °

$6000

(1.05)2 + (1.05)3.5 = $9070.2948+ $5058.1151 = $ 1 4 128.41

Because this valuation is made as at the start of the contract, Va is called the present value of the contract. b) Valuation as at 1 February 20 1 6 The cash flow of $ 6 0 0 0 on 1 August 2 0 1 7 must be discounted for 1.5 years to calculate an equivalent amount as at 1 February 2016. Therefore, the valuation as at 1 February 2 0 1 6 is: $6000

Vb = $10000 +

PRESENT VALUE OF A CONTRACT

the value today that is equivalent to the stream of cash flows promised in a financial contract

(1 .0 5 )15 = $ 1 0 0 0 0 + $5576.57 $15 576.57

c) Valuation as at 1 August 2 0 1 7 The cash flow of $ 1 0 0 0 0 on 1 February 2 0 16 must be accumulated for 1.5 years to calculate an equivalent amount as at 1 August 2017. The equation we need to use is Equation 3.4. Therefore, the valuation as at 1 August 2 0 1 7 is: ^ = $1 〇〇〇〇(1.〇5)15 + $6000 =$10759.30 +$6000 = $16759.30

Because 1 August 2 0 1 7 is the date of the final cash flow of the contract, Vc is called the terminal value of the contract.

In Example 3.14, the three valuations VQf Vb and Vc are all valuations o f the same financial contract. They d iffer because the date o f valuation differs. There should, therefore, be logical connections between the three valuations. For example, the contracts present value (Vai the valuation as at 1 February 2014) should be the same as taking the contracts term inal value (Vct the valuation as at 1 August 2017) and discounting fo r 3.5 years. In fact, the mathematics underlying the valuation process guarantees this result, as the follow ing calculation confirms: Vc

(1.05)3*5

$16759.30 (1.05)3*5

=$14128.41 =Va In effect, the valuation process consists o f using compound interest to discount and accumulate cash flows to calculate value equivalents at a common date. The valuation as at th a t date is then found sim ply by adding the value equivalents fo r th a t date.

TERMINAL VALUE OF A CONTRACT

the value, as at the date of the final cash flow promised in a financial contract, that is equivalent to the stream of promised cash flows

3 .5 .3 1 Formula development: valuation as at any date Where a cash flow o f C dollars occurs on a date t, the value o f th a t cash flow as at a valuation date t* is given by:

V r = Ct( l + I f date t* occurs after date t, then t* is greater than t and, in Equation 3.15, the power (t* - t) is positive, and the equation correctly indicates th a t an accumulation o f Ct is required. Conversely, i f date t* occurs before date t, then t* is less than t and, in Equation 3.15, the power (t* - t) is negative, and the equation correctly indicates th a t a discounting o f Ct is required. Where there is more than one cash flow to be valued, the to ta l value o f the contract is the sum o f the values o f each cash flow. The calculation o f a contracts value at various dates is illustrated in Example 3.15.

E xample 3.15 Confirm that Equation 3.15 is correct by using it to recalculate the valuations made in Example 3.14. In each case, / = 5 per cent per annum, C 2 = $ 1 0 0 0 0 and C3 5 = $6000. The valuation date t * , however, differs in each case.

SOLUTION a)

Valuation as at 1 February 20 1 4 In this case, t* = 0. Using Equation 3.15: V〇= $ 10 0 0 0 (1,05)°-2 + $ 6 0 0 0 (1.05)°-3-5 = $ 10 0 0 0 11.05 厂2 + $ 6 0 0 0 (1 _05 广3 5 = $10000

$6000

(1.05)2

(1.05)3"5

= $ 9 0 7 0 . 2 9 4 8 + $5058.1151 = $ 1 4 1 2 8 .4 1 = Va as calculated in Worked example 3.14 b)

Valuation as at 1 February 2016 In this case, t* = 2. Using Equation 3.15: V2 = $ 10 0 0 0 (1.05)2-2 + $6 0 0 0 (1,05)2-3-5 = $ 10 0 0 0 (1.05)0 + $ 6 0 0 0 (1.05 广1 5 = $10000+ ^ 〇

(1.05)1-5 = $ 1 0 0 0 0 + $5 576.57 = $ 1 5 576.57 = c)

as calculated in Worked example 3.14

Valuation as at 1 August 2 0 17 In this case, t* = 3.5. Using Equation 3.15: V3 5 = $10 0 0 0 (1,05)3-5- 2 + $ 6 0 0 0 (1.05)3-5- 3-5 = $ 10 0 0 0 (1.05)1 5 + $6 0 0 0 (1.05)° = ($ 10 0 0 0 x 1.075 92 9 83) + $6 00 0 = $ 1 6 7 5 9 .3 0 = Vc as calculated in Worked example 3.14

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time value of m o n e y : a n introduction to finan c ial mathematics

3 .5 .4 1 Measuring the rate of return When there are m ultiple cash flows in an investm ent, there are also m ultiple tim e periods. Inevitably the question arises: For a given set o f cash flows extending over tw o or more tim e periods, how can we measure the rate o f retu rn per period? There are a num ber o f d ifferent answers to this question, b ut the answer most frequently offered is to employ a measure know n as the internal rate o f return. In this section we outline this method. I t is discussed in greater detail in Section 5.4.2. First, however, we review the measurement o f the rate o f retu rn over a single period. Consider a oneperiod investm ent th a t costs $1000 and promises a cash inflo w o f $1120 a year later. Such an investm ent would usually be described sim ply as a 1-year loan o f $1000 at an interest rate o f 12 per cent per annum. We would infer th a t the interest rate is 12 per cent per annum by observing th a t the interest component o f the cash flow after 1 year is $120, so the interest rate is $120/$1000 = 12 per cent. This is, o f course, the result given by the simple defin itio n o f *rate o f return* in Equation 3.1. Equally, we could have said that the rate o f return is the value o f r th a t solves the follow ing equation: $1120

-$1000 = 0

The calculation $1120/(1 + r) is the present value o f $1120 using a discount rate o f r. On solving this equation we would, o f course, fin d th a t r = 0.12, or 12 per cent. The advantage o f th in kin g about the rate o f retu rn in this way is th a t we can readily see how to extend this approach to the case o f many cash flows and tim e periods. Consider the follow ing investm ent. An in itia l investm ent o f $1000 is made and, as before, a cash flow o f $1120 is to be received after 1 year but, in addition, a fu rth e r cash flow o f $25 is to be received 2 years after making the in itia l investm ent. In tabular form , the cash flows o f this investm ent are shown in Table 3.5.

TABLE 3.5 Year

Cash flow ($)

0

-1 0 0 0

1

+ 1120

2

+ 25

Obviously this investm ent promises a rate o f retu rn o f more than 12 per cent per annum, since the firs t cash inflo w alone is sufficient to produce a rate o f retu rn o f 12 per cent per annum. As an investor, however, we would prefer the $25 inflo w to have been promised fo r Year 1 rather than Year 2. Had this occurred, the cash inflow after 1 year would be $1145, representing a rate o f retu rn o f 14.5 per cent per annum. P utting these observations together, the investm ent s annual rate o f retu rn m ust be more than 12 per cent, b u t less than 14.5 per cent. The internal rate o f return measure proposes th a t the rate o f retu rn in this case is the value o f r th a t satisfies the follow ing equation:

$1120

$25

1+ r

(1 + r)2

-$1000 = 0

The term $25/(1 + r)2 can be thought o f as the present value o f $25, discounted fo r 2 years at the rate r per annum. Solving this equation, we find r = 14.19 per cent per annum.6 We can confirm this result by noting that:

$1120 1.1419

$25 -$1000 (1.1419)2

= $980.821438 + $19.172 725 - $1000 = -$ 0 .0 0 5 8 3 6 «$0 6

In this particular case, r can be found by solving the resulting quadratic equation. In more general cases, numerical methods are usually required.

B usiness finance

The figure o f 14.19 per cent falls w ith in the range o f 12 per cent to 14.5 per cent, as suggested earlier by our in tu itiv e reasoning. Where there are n cash inflow s Ct (where t = 1, n), follow ing an in itia l cash outflow o f C〇, the internal rate o f return is th a t value (or values) o f r th a t solves the equation:7 c.

,

c2 r\

1+ r

(1 + r)2

I ••• l

Cn (1 + r)1

or X：

Ct t

3.6 LEARNING OBJECTIVE 3 Distinguish between different types of a 门nuity and calculate their present value and future value AN N U ITY

series of cash flows, usually of equal amount, equally spaced in time

Co = 0

3.16

A n n u itie s

3.6.1 I Definition and types of annuity In Section 3.5 we explained how to analyse contracts th a t require more than one cash flow to be paid. We considered a general case th a t can be used to deal w ith a wide range o f contracts. There is, however, a special case th a t is found in a large num ber o f financial contracts and hence requires fu rth e r discussion. This is the case o f the annuity. An annuity is a series o f cash flows, usually o f equal amount, equally spaced in tim e. Thus, fo r example, $500 paid each m onth fo r a year is an annuity. Similarly, $600 per week fo r 12 weeks is an annuity; so is $20 000 per annum fo r 10 years. Annuities are involved in many personal loans and commercial loans, and in certain kinds o f financial instrum ents such as bonds. In itia lly we consider fo ur types o f annuity: ordinary annuity, annuity-due, deferred annuity and ordinary perpetuity.

The o rd in a ry annuity ORDINARY ANNUITY

annuity in which the time period from the date of valuation to the date of the first cash flow is equal to the time period between each subsequent cash flow

Like many annuities, the cash flow pattern o f the ordinary annuity consists o f equal amounts, equally spaced in tim e. The distinguishing characteristic o f the ordinary annuity is that the tim e period fro m the date o f valuation to the date o f the firs t cash flow is equal to the tim e period between each subsequent cash flow. Diagrammatically, the cash flow pattern o f the ordinary annuity, using six cash flows as an example, is: 0

1

2

3

4

5

6

$C

$C

$C

$C

$C

$C

AN NUITY-DUE

annuity in which the first cash flow is to occur 'immediately' (i.e. on the valuation date)

The annuity-due The distinguishing feature o f the annuity-due is th a t the firs t cash flow occurs on the valuation date 一 th a t is, immediately. Diagrammatically, the cash flow pattern o f the annuity-due, using six cash flows as an example, is:

DEFERRED AN N U ITY

annuity in which the first cash flow is to occur after a time period that exceeds the time period between each subsequent cash flow

0

1

2

3

4

5

$C

$C

$C

$C

$C

$C

The deferred annuity The distinguishing feature o f the deferred annuity is th a t the firs t cash flow is to occur after a tim e period th a t exceeds the tim e period between each subsequent cash flow. 7

If the cash flows are produced by a bond, it is conventional to call the internal rate of return the bonds y ie ld -to -m a tu rity (or 'yield1for short). For further discussion, see Sections 4.4 and 4.7. The Microsoft Excel* function IRR uses numerical methods to calculate the internal rate of return for a given initial outlay and set of cash flows.

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time value of m o n e y : a n introduction to finan c ial mathematics

Diagrammatically, the cash flow pattern o f the deferred annuity, using as an example six cash flows, the firs t to occur after three tim e periods, is: 0

1

2

3

4

$C

5

$C

6 $C

7 $C

8 $C

$C

The ordinary perpetuity The ordinary perpetu ity is an ordinary annuity w ith the special feature th a t the cash flows are to continue forever.8 Diagrammatically, the cash flow pattern o f the ordinary perpetuity is: 0

1

2

3

4_____________

$C

$C

$C

$C ----------------- >

where the arrows indicate continuing forever.

3 .6 .2 1 Formula development: present value of an ordinary annuity The form ula fo r the present value o f an ordinary annuity is one th a t we w ill use frequently. This form ula can then be adapted to apply to the other types o f annuity. The cash flow pattern o f an ordinary a nnuity o f n cash flows o f C dollars each is shown below: 0

1 2 $C

3 $C

$C

n -1

n

$C

$C

The present value P o f this stream o f cash flows is given by the sum o f the present values o f the individual cash flows: C

P-

+ i

C

C

C

C

( i + iy

( i + iy

( l + i) " - 1

( l + i) n

K IH

where z = the interest rate per period. M u ltip lyin g both sides o f Equation 3.17 by (1 + 〇 gives: n/1 .x ^ P(1 + z) = C +

C + /

C

C

C

( l + i)2

( l + 〇n_2

( l + i) n~l

B f lU

Subtracting Equation 3.17 from Equation 3.18, we fin d th a t all terms on the right-hand side cancel out, except the last term o f Equation 3.17 and the firs t term o f Equation 3.18, giving: P (l + / ) - P = C -

C (1 + 0 "

C

Pi = C-

(1 + i)n which, on rearrangement gives: P.

C

1 (1 + ^

I t is often convenient to consider an annuity o f $1 per period— th a t is, we set C = 1 and Equation 3.19 becomes: P = A(n, i)

(i + 0n Equation 3.20 is the form ula fo r the present value o f an ordinary a nnuity consisting o f n cash flows, each o f $1 per period. The functional notation A{ny i) is sim ply a shorthand way o f referring to

8

We could, of course, also consider the categories p e rp e tu ity -d u e and d eferred p e rp e tu ity but have not done so because the purpose at this stage is simply to introduce the idea of a perpetuity, as distinct from an annuity of finite life.

ORDINARY PERPETUITY

ordinary annuity with the special feature that the cash flows are to continue forever

this equation.9 Values o f A(n, 〇 fo r different values o f n and i are provided in Table 4 o f Appendix A. The valuation o f ordinary annuities is illustrated in Example 3.16.

Example 3. Find the present value of an ordinary annuity of $ 5 0 0 0 per annum for 4 years if the interest rate is 8 per cent per annum by: a) using a calculator to discount each individual cash flow b) using a calculator to evaluate the formula given in Equation 3.19 c) using the Microsoft Excel® function PV (rate, nper, pmt) d) using Table 4 of Appendix A to evaluate the formula given in Equation 3.20.

SOLUTION a)

Discounting each individual cash flow: P= —

+

C

+

i + ； (i =$5000 1.08

C

+

+/)2

C

(i +/]3

$5000

$5000

$5000

(1.08)2

(1.08)3

(1.08)4

(i +/)4

=$4629.6296 + $4286.6941 + $3969.1612 + $3675.1493 = $16560.63

b)

Using Equation 3.19:

$5000 0.08

(1.08)4

$ 5 0 0 0 x3 .3 1 2 122 684 $16560.63

c) Using the Microsoft Excel® function PV (rate, nper, pmt): The Microsoft Excel® function PV returns -1 x the present value of an ordinary annuity. The required inputs are the interest rate (as a decimal), the number of periods and the amount of each cash flow. Using a Microsoft Excel® spreadsheet, we find that-PV(0.08, A, 5000) = $16560.63. d) Using Table 4 of Appendix A: P= CA[n, i) =$5000 x 3.3121 =$16560.50

Except for the relatively small rounding error when using Table 4 of Appendix A, the four answers are identical.

3.6.31 Formula development: present values of annuities-due, deferred annuities and o rdinary perpetuities Present value of an annuity-due The cash flow pattern o f an annuity-due w ith n cash flows o f C dollars each is shown below: 0 $C 9

1 $C

2

3 $C

n -2 $C

$C

n -1 $C

The notation sometimes read as 'A angle n at rate i \ is also used to indicate this equation. There is no special significance in this notation: it is simply a different convention. Mathematically, the functional notation A {n ,i) serves equally well.

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time value of m o n e y : a n introduction to

It is im p o rta n t to be aware th a t in an annuity-due consisting o f n cash flows, there are only {n - 1) tim e periods involved.10 Inspecting the annuity-due diagram, i t is clear th a t an annuity-due o f n cash flows is sim ply an immediate cash flow plus an ordinary a nnuity o f (n - 1) cash flows. The present value o f an annuity-due is therefore: P = C + -4 i 1

^

13.21

( l + £•广 1

or

13.22

P = C[1 + y 4 ( n - l, 〇l where

P = present value C = cash flow per period z = interest rate per period n = num ber o f cash flows The valuation o f annuities-due is illustrated in Example 3.17.

E xample 3.17 Kathy's rich uncle promises her an allowance of $ 1 0 0 0 0 per month, starting today, with a final payment to be made 6 months from today. If the interest rate is 0.5 per cent per month, what is the present value of the promised allowance?

SOLUTION Kathy has been promised seven payments of $ 1 0 0 0 0 with the first being due immediately. Thus, she has been promised $ 1 0 0 0 0 today, plus an o rd in a ry annuity of six payments. This is the logic embodied in Equation 3.21. Using this equation with n set equal to 7, gives:

p= c + ^ [ i - - L _ ]

= $10000+ i M ° ° [ l 0.005

= $ 1 0 0 0 0 + $ 10000 0.005

(1.005)7-1 1 (1.005)6

= $ 1 0 0 0 0 + $58 963.84 =$ 68 963.84

Present value of a deferred annuity The cash flow pattern o f a deferred annuity is as follows: 0

1 2

k -1

k

k+1

k + n -2

k + n -1

$C

$C

$C

$C

In this case, there are n cash flows and the firs t cash flow occurs on date k. To find the present value o f this series o f cash flows, imagine th a t the valuation was to be made as at date (k - 1) instead o f date zero. Looking ahead from date ( k - 1 ) , the cash flow pattern is th a t o f an ordinary a nnuity o f n cash flows. Thus, at date (/c - 1), the present value is given by the present value o f an ordinary annuity:

10 This is frequently a source of confusion. For an ordinary annuity, it makes no difference whether n is defined as the number of cash flows or the number of time periods, since these are equal. For an annuity-due, we must choose whether to use n to represent the number of cash flows or the number of time periods. We have chosen to develop the formula with n representing the number of cash flows.

c

Pk-l

1

3.23

(1 + i) n

where _ 丄= the present value at date (/c - 1) To s h ift the valuation date back from date (k - 1) to date zero, we sim ply discount the value given by Equation 3.23 fo r (k - 1) periods. Thus the required form ula is: 」 ____C

P=

(1 + 〇fc_1 i

3.24

(1 + i) n

or C

P=

A{n, i)

3.25

(1 + 〇fc_1 where

C = cash flow per period z = interest rate per period n = num ber o f cash flows k = num ber o f tim e periods u n til the firs t cash flow

Alternatively, the present value o f a deferred a nnuity can be found by firs t im agining th a t cash flows are to occur on all (k + n - 1 ) dates. The present value o f such a stream is, o f course, given by the present value o f an ordinary annuity consisting o i (k + n - 1) cash flows. The effect o f the deferral period is accounted fo r by subtracting the present value o f the firs t (k - 1) h is s in g 1cash flows, because these cash flows w ill n o t occur. That is: present value o f an p =

present value o f an

ordinary annuity of

less

(k-\- n - l ) cash flows

ordinary annuity o f (A: - 1) cash flows

That is: C !_ 1 i ( l + i) k+n- \

c 1

1

i

3.26

= C[A(k+ n - l J ) - A ( k - l , i ) ] The valuation o f deferred annuities is illustrated in Example 3.18.

Example 3. Jason will be starting a 6-month live-in training course in 4 months, time. His father, Sam, has promised him a living allowance of $ 2 0 0 0 per month to help support him during this time. If the simple interest rate is 9 per cent per annum, payable monthly, how much money will Sam need to set aside today to finance Jason's allowance?

SOLUTION Sam needs to set aside the present value of the promised allowance. The allowance is an annuity of six payments, the first payment to be made 4 months from today. Diagrammatically, the cash flows are: 0

1

2

3

4

$2000

5

6

$2000

7

$2000

8

$2000

9

$2000

$2000

Using the logic developed in this section, we can approach this problem in two stages. First, w hen v ie w e d from the s ta n d p o in t o f d ate 3, the cash flows form an ordinary annuity of six payments. W e therefore value this stream, as at date 3, using Equation 3.19, which gives the present value of an ordinary annuity. Second, we find the value as at date zero by discounting for three periods. The calculations are shown below. Note that the interest rate is 0.09/1 2 = 0.75 per cent per month.

G h APTER THREE T he TIME VALUE OF MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

As at date 3 the value is:

$2000 0.0075

(1.0075)°

$11 691.195 260

As at date zero, the value is thus: p _ $11 691.195 260 (1.0075)3 =$11 432.04

This is, of course, the logic embodied in Equation 3.24, as we now show. In this case, n = 6, k = 4 and /' = 0.09/1 2 = 0.75 per cent per month. Using Equation 3.24:

n

1 (1+/)

C k-]

(1 $2000

1

0.0075 (1.0075)°. (1.0075) r 1 x $ 2 0 0 0 x5 .8 4 5 59763 1.022 669172 =$11 691.195260 ~

1.022 669172

= $11432.04

Alternatively, using Equation 3.26, and again using n = 6 , k = 4 and / = 0.75 per cent per month, the required sum is: c

! i L

1 ( i+ ^ ' J

$2000 i 0.0075 L

C

,

1

i

i (1.0075)9 J

$2000 , 0.0075 L

1 ( i. 〇〇75)3 J

=($2000 x 8.671 5 76 42 3)-($ 20 00 x 2.955 556 237) = $ 17343.1 5 2 9 -$ 5 9 1 1 .1125 = $11432.04

Present value of an ord ina ry perpetuity The cash flow pattern o f an ordinary perpetuity o f C dollars per period is shown below: 0 1 2 3 4 5 ---------------------------------------------------------------► $C $C $C $C $ C --------------------► The ordinary p erpe tu ity is an ordinary annuity where the num ber o f cash flows n becomes in d e fin ite ly large. Therefore, to fin d its present value, we need to consider the form ula fo r the present value o f an ordinary annuity and allow n to become indefinitely large. Thus the problem is to value: P = lim — (1 + i) n Because the interest rate z is positive, (1 + i)n becomes ind efin itely large as n becomes ind efin itely 1 large. This means th a t (丄 + becomes very small because the denom inator o f this fraction becomes

very large. In the lim it, the value o f this fraction approaches zero and thus the present value o f an ordinary p erpetuity is:11 C

3.27 where

C = cash flow per period i = interest rate per period The valuation o f ordinary perpetuities is illustrated in Example 3.19.

E xample 3.19 A government security promises to pay $3 per annum forever. If the interest rate is 8 per cent per annum and a payment of $3 has just been made, how much is the security worth?

SOLUTION Using Equation 3.27:

$3 0.08 =$37.50

The value of the security is $37.50.

3 .6 .4 ! Future value of annuities I t is frequently necessary to calculate the value o f an annuity as at the date o f the final cash flow. Such a calculation is required if, fo r example, regular savings are being made towards a target fu tu re sum. To derive the form ula fo r the future value o f an ordinary annuity, we use a two-stage process. First, the present value o f the annuity is calculated. Second, the future value is calculated by accumulating the present value fo r the n periods from the valuation date to the date o f the final cash flow. In effect we use the compound interest form ula S = P(1 + i)n where, in this case, P is given by the present value o f an ordinary annuity. That is: 1 (1 + i) n

(1 + i) n

= f [ ( i + On - i ]

3.28

I f C = $1, Equation 3.28 may be w ritte n as:12 S(n, i) = (1 + 〇 n-1 i

3.29

Values o f S(«, z) fo r different values o f n and i are given in Table 3 o f Appendix A. Alternatively, the M icrosoft Excel4 fu nctio n - FV(rate, nper, pm t) m aybe used. The FV fu nctio n returns the value o f- 1 x the future value o f an ordinary annuity, where 'rate* means the interest rate as a decimal, 'nper* means the number o f periods and pint* means the am ount o f each periodic cash flow. The calculation o f the future value o f an annuity is illustrated in Example 3.20.

11

• _

. . .

c

Similarly, it is a simple matter to show that the present value of a perpetuity-due is C + —, and the present value of a deferred 1 C i perpetuity, where the first cash flow occurs after k periods, i s ------- -- x (1 + i)K 12 The notation can also be used.

CHAPTER THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

Example 3.20 Starting with his next monthly salary payment, Harold intends to save $ 2 00 each month. If the interest rate is 8.4 per cent per annum, payable monthly, how much will Harold have saved after 2 years?

SOLUTION The monthly interest rate is 8.4/12 = 0.7 per cent. Using Equation 3.28, Harold's savings will amount to: s = y [ii+ - r - i] = ^ ° ° f(1.007)24- l l 0.007 L' J = $ 2 0 0 x2 6 .0 3 4 9 2 5 07 =$5206.99

Alternatively, using Microsoft Excel®, we find that - FV(0.007, 24, 200) = $5206.99.

We could use this two-stage approach to derive formulae fo r the future values o f annuities-due and deferred annuities. In practice, however, i t is usually ju s t as easy to apply this approach using the numbers o f the particular problem. As we said at the sta rt o f this chapter, rather than learning a lis t o f formulae, i t is preferable to learn the approach and then apply th is approach to the particular problem. This is illustrated in Example 3.21.

Example 3.21 Harold's sister Janice can also save $ 2 0 0 per month, but whereas Harold takes 1 month to save his first $200, Janice will start by setting aside $ 2 0 0 immediately. With an interest rate of 0.7 per cent per month, how much will she have in 2 years' time? Reconcile this amount with the savings achieved by Harold in the previous example.

SOLUTION This problem requires the future value of an annuity-due. W e first calculate the present value, then accumulate this amount for 24 months: Step 1 n

^

C

1 (1 + /)

$200.

$200 0.007

(1.007)24

$4604.321 714

Step 2 S=P(1 +/)n =$4604.321 714(1.007)24 =$5443.43

Janice is thus able to save $5443.43 after 2 years, compared with Harold's savings of $5206.99. That is, Janice will save $236.44 more than Harold. Logically, this amount should equal the future value of the initial $ 2 0 0 Janice set aside at the start, accumulated for 24 months at 0.7 per cent per month. This is in fact the case, because $ 2 00 x (1.007)24 = $236.44.

6

B usiness finance

3.7 LEARNING OBJECTIVE 4 Apply your knowledge of annuities to solve a range of problems, including problems involving principaland-interest loan contracts

Principal-and-interest loan contracts Basic features of the contract

An im p o rta n t application o f annuities is to loan contracts, where the principal is gradually reduced by a series o f equal repayments. This type o f loan is often called a prin cipal-an d-in terest loan or a credit foncier loan. M any commercial loans, consumer loans and housing loans are in this category. The promised repayments form an annuity and the present value o f the repayments is equal to the loan principal. Therefore, i f the promised future repayments are made on tim e the debt should reduce gradually during the loan term , so th a t when the final promised repayment is made the debt should be extinguished. This pattern is illustrated in Example 3.22.

Example 3.22 On 31 December 2014, Pennant Ltd borrows $ 1 0 0 0 0 0 from Z N A Bank. Annual repayments are required over 5 years at a fixed interest rate of 11.5 per cent per annum. How much is each annual repayment? Show the year-by-year record of the loan account for the 5 years ended 31 December 2019.

SOLUTION PRIN CIPAL-AND INTEREST LOAN

loan repaid by a sequence of equal cash flows, each of which is sufficient to cover the interest accrued since the previous payment and to reduce the current balance owing. Therefore, the debt is extinguished when the sequence of cash flows is completed. Also known as a credit fonder loan

The annual repayments of C dollars form an ordinary annuity with a present value of $ 100000. Using Equation 3.19: $100000

C =

0.115

(1.115 广

C x 3.649 877 84

So c= $100000 _ 3.649 877 847 =$27398.18

The annual repayment required is $27398.1 8. Alternatively, we could use the Microsoft Excel® function PMTjrate, nper, pv). Using the spreadsheet, we find that -PM T(0.115,5, 100000) returns $27398.1 8. The year-by-year record o f the loan account is shown in Table 3.6.

TABLE 3.6 Entry

Date 31 December 2014 31 December 2015

31 December 2016

31 December 2017

Principal borrowed interest 0.115 x $100000.00 = $11500.00

Balance owing $100000.00 $111500.00

Less repayment $27398.18

$84101.82

Arfrf interest 0.115 x $84101.82 = $9671.71

$93 773.53

Less repayment $27398.18

$66375.35

AcW interest 0.115 x $66375.35 = $7633.17

$74008.52

Less repayment $27398.18

$46610.34

C hapter three T he

time value of m o n e y : a n introduction to finan c ial mathematics

Table 3.6 continued Date

Entry

31 December 2018

31 December 2019

Balance owing

interest 0.115 x $46610.34 = $5360.19

$51970.53

Less repayment $27398.18

$24572.35

^ i n t e r e s t 0.115 x $24572.35 = $2825.83

$27398.18

Less repayment $27398.18

$0.00

The year-by-year record shows th a t annual repayments o f $27398.18 are just sufficient to repay the loan over the 5-year term .

3 .7 .2 1 Principal and interest components As shown by the loan account in Example 3.22, the required repayments are ju s t sufficient to extinguish the debt at the required date. This is achieved by a series o f repayments, each o f which is sufficient to cover interest accrued since the previous repayment and to reduce the principal. As the principal decreases, so also does the interest accruing and thus, as tim e passes, a larger p roportion o f each repayment goes to reducing the principal. The principal and interest components o f the repayments in Example 3.22 are shown in Table 3.7.

TABLE 3.7 Year ended 31 December

Interest component ($)

Principal component ($)

Repayment ($)

2015

11500.00

15898.18

27398.18

2016

9671.71

17726.47

27398.18

2017

7633.17

19765.01

27398.18

2018

5 360.19

22037.99

27398.18

2019

2825.83

24572.35

27398.18

This pattern is more marked where the num ber o f repayments to be made is large. This is shown in Example 3.23.

Example 3.23 Phantom Ltd borrows $1 0 0 0 0 0 at an interest rate of 1 1.5 per cent per annum, repayable by equal monthly instalments over 2 0 years. Calculate the principal and interest components of the first and last repayments.

SOLUTION In this example, the monthly interest rate is 0 .1 1 5 /1 2 = 0 .0 0 9 5 8 3 3 3 3 and the loan term is 20 x 12 = 2 40 months. W e use Equation 3 .19 to calculate the monthly repayment: $ 1 0 0 0 0 0 = --------- ---------0.009583 333

1-

________ 1________ (1.009583 333)240

= C x 93.77084022 continued

continued

So c=

$100000

~ 93.770 840 22 = $1066.43

The interest accrued during the first month of the loan is 0 .0 0 9 5 8 3 333 x $ 1 0 0 0 0 0 = $958.33. Therefore, when the first monthly repayment of $ 1066.43 is made, $958.33 (or nearly 90 per cent of the repayment) is required to meet the interest accrued during the first month and only $108.10 (just over 10 per cent of the repayment) is available to reduce the principal. At the end of the loan term this pattern is reversed. Only a small amount of interest will accrue during the last month, so almost the whole of the final monthly repayment will be available to reduce the principal. The component of principal in the final repayment is $ 1 0 6 6 .4 3 / 1 .0 0 9 5 8 3 333 = $1056.31; therefore, the interest component is only $10.1 2. One aspect of this pattern is that the balance owing decreases slowly in the early stages of repayment, but decreases rapidly as the maturity date is approached. This pattern is considered in more detail in the next section.

3 .7 .3 ] Balance owing at any given date The balance owing at any given date is the present value o f the then rem aining repayments. We explained earlier how the principal is the present value o f all promised repayments. O f course, the principal is sim ply the balance owing at the tim e the loan is made. Similarly, the balance owing at any given date is the present value o f the repayments s till to be made as at th a t date. The calculation o f the balance owing on a loan is illustrated in Example 3.24.

E xample 3.24 Consider again Phantom Ltd's loan of $ 1 0 0 0 0 0 at an interest rate of 1 1.5 per cent per annum, repayable by equal monthly instalments over 20 years. As shown in Example 3.23, the required monthly repayment is $1066.43. W hat is the balance owing when: a) one-third of the loan term has expired? b) two-thirds of the loan term has expired?

SOLUTION a) The loan term is 2 4 0 months. Therefore, when one-third (or 80 months) of this term has expired, 160 monthly repayments are still to be made. The balance owing at the end of month 80 is the present value of the then remaining 16 0 repayments: $1066.43 0.009583 333

(1.009583 333)*160.

= $87087.85

b) When two-thirds (or 160 months) of the loan term has expired, 80 monthly repayments still have to be made. Therefore, the balance owing at the end of month 160 is: $1066.43

________1________ ■

0.009583 333

(1.009583 333)80.

=$59394.64

C hapter three T he

time value of m o n e y : a n introduction t o financial mathematics

In the previous section we explained that, in these types of loans, the balance owing reduces slowly at first and more rapidly towards the end of the loan term. This pattern is clearly evident in this example. When one-third of the loan term has expired, the balance owing is still more than $ 8 7 0 0 0 out of an original loan of $ 1 0 0 0 0 0 . That is, the passing of one-third of the loan term has seen the principal fall by less than 13 per cent. When two-thirds of the loan term has expired, only about 4 0 per cent of the debt has been repaid. A more detailed presentation of this pattern is provided in Figure 3.2.

Figure 3.2 Balance owing as a loan is repaid o o o o o o o o

0 9 8 7 6 5 4 3

o o o - $ lM O

cr) .E

9UUDID

CQ

10 220 200

180

160

140

120 100

80

60

40

20

Months remaining

3 .7 .4 1 Loan term required In some applications it is necessary to solve fo r the required loan term n given the principal, interest rate and periodic repayment. For example, in order to plan future expenditure, a borrow er may wish to know when an existing loan w ill be repaid. Solving fo r the loan term requires us to rearrange Equation 3.19 so th a t n appears on the left-hand side: C (i + 0"

c

(1 + i) n ( i + O77

c C -P i

and therefore: n = log[C/(C-P/)] i 〇g (i + 〇

_

_

E E 3

Logarithms to any base (such as base 10 or base e) w ill give the correct answer. The calculation o f a required loan term is illustrated in Example 3.25.

A

B usiness finance

E xample 3.25 One year ago, Canberra Fruit Ltd borrowed $ 7 5 0 0 0 0 at an interest rate of 12 per cent per annum. The loan is being repaid by monthly instalments of $ 1 6 6 8 3 .3 4 over 5 years. As a result of making the promised repayments over the past year, the balance owing is now $ 6 33 532 .48 . The company can now afford repayments of $ 2 0 0 0 0 per month and the company manager wishes to know when the loan will be repaid if repayments are increased to that level. The manager also wishes to know the amount of the final repayment.

SOLUTION Using Equation 3.30: n _ log [C /(C -P i] lo g (l + /) _ log { $ 2 0 0 0 0 / [ $ 2 0 0 0 0 - ($633 5 3 2.481(0.011]}

=

log(l.Ol)

_ lo g ( $ 2 0 0 0 0 / $ l3 6 6 4 .6 7 5 2 )

=

l〇g(i. 〇 i)

_ log (1 .4 6 3 6 2 7 9 1 )

=

log(l.Ol)

Using 'common' logarithms (logarithms to the base 10):13 = 0 .1 6 5 4 3 0 6 8 2 0 .0 0 4 321 373 = 3 8 .2 8 2

months

The loan will be repaid after a further 39 months; for the first 38 months the repayment will be $ 2 0 0 0 0 per month, while the last (39th) repayment will be a smaller amount. The amount of the last repayment must be such that the present value of all 39 repayments equals the balance owing of $633 532.48. Using R to represent the amount of the last repayment, we therefore require that: $ 6 3 3 5 3 2 .4 8 =

$20000 0.01

R

(1.01)38

(1.01)39

= $ 6 2 9 69 3 .2 6 6 1 + —

(1.01)39 $ 3 8 3 9 .2 1 3 9 =

R

(1.01)39

which gives R = $5659.47. The amount of the last (39th) repayment is $5659.47.

3 .7 .5 1 Changing the interest rate VARIABLE INTEREST RATE LOAN

loan where the lender can change the interest rate charged, usually in line with movements in the general level of interest rates in the economy

In some loan contracts, usually called variable in terest rate loans, the interest rate can be changed at any tim e by the lender, although, in practice, changes are norm ally made only when there has been a change in the general level o f interest rates in the economy. Such a change may be signalled or caused by the Reserve Bank o f Australia changing the cash rate. In Australia, many housing loans, and many commercial loans, are in this category. Typically, the parties to the contract w ill at the outset agree on a notio na l loan term — say, 15 years fo r a housing loan— and the lender w ill then require a regular repayment th a t is calculated as i f the current interest rate is fixed fo r 15 years. If, as is always the case, the general level o f interest rates subsequently changes, the interest rate charged on the loan w ill then be changed. The lender w ill then set the new required repayment, which w ill be calculated as i f the new interest rate is fixed fo r the remaining

13

令

Use of natural logarithms (logarithms to the base e) must give the same answer. In this case the calculation is n = 0.380918223/0.00995033 = 38.282.

C hapter THREE T he TIME VALUE OF MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

loan term. Alternatively, the lender may allow the borrower to continue m aking the same repayment and, instead, alter the loan term to reflect the new interest rate.14 O f course, a com bination o f b oth responses is also a possibility. These choices are illustrated in Example 3.26.

E xample 3.26 Three years ago Andrew and Jane borrowed $ 8 0 0 0 0 , repayable by equal monthly instalments over 15 years. At the time they borrowed the money, the interest rate was 9.6 per cent per annum calculated monthly. Following standard procedures, the lender correctly calculated the required monthly payment to be $840.21. Andrew and Jane have made all repayments on time and the balance owing is now $71 685.05. The general level of interest rates has been rising and the lender has now decided to increase the interest rate to 10.8 per cent per annum calculated monthly. What will be the new monthly repayment if the loan term is to remain unchanged? If, instead, the monthly repayment is left at $840.21, by how many months will the loan term increase?

SOLUTION The new monthly repayment C must be set so that the present value, calculated using the ne w interest rate, of the remaining 144 repayments equals the balance outstanding of $71 685.05. The new interest rate is 10.8 per cent per annum or 0.9 per cent per month. Therefore, using Equation 3.19: $ 7 1 6 8 5 .0 5 = — ^ 1 --------- — 0.009 L (1.009)144. = 80.531 669 39 C C = $890.15

The new repayment is $890.15 per month. Alternatively, if the loan term is extended, and the monthly repayment is left at $840.21, the new loan term may be found using Equation 3.30: n

log [C /(C -P f)] log(l + /) log {$8 40.21/[$840.21 -($71 685.05)(0.009)]} log( 1.009) _ log(4.307785 068) =

log( 1.009)

=162.998 months w 163 months

The remaining loan term is now 163 months, which is 19 months longer than the 144 'expected7 at the time of the interest rate increase.

LEARNING OBJECTIVE 5 Distinguish between simple and general annuities and make basic calculations involving general annuities SIMPLE A N N U IT Y

3.8

G eneral annuities

In our discussion o f annuities, the frequency o f compounding has coincided w ith the frequency o f the cash flows. An a nnuity w ith this feature is called a sim ple annuity. For example, we have considered cases where interest is calculated and charged annually, and the borrow er is required to make annual repayments. In practice, however, this is n ot always the case. Situations arise where loan repayments are required more frequently, o r less frequently, than interest is charged (compounded). An a nnuity w ith this feature is called a general annuity. 14 Note, however, that if the interest rate is increased to a level where the monthly repayment is less than the monthly interest accruing (that is, C < P i), then the loan term becomes infinite. In these circumstances lenders will usually require a higher monthly repayment.

annuity in which the frequency of charging interest matches the frequency of payment GENERAL A N N U IT Y

annuity in which the frequency of charging interest does not match the frequency of payment; thus, repayments may be made either more frequently or less frequently than interest is charged

In a general annuity, the frequency o f compounding does n o t match the frequency o f repayment. There are thus two cases to consider:

a

b

The frequency o f compounding is greater than the frequency o f repayment. For example, a loan contract may specify an interest rate o f 8 per cent per annum, compounding quarterly, b u t repayments are made annually. The frequency o f compounding is less than the frequency o f repayment. For example, a loan contract may specify an interest rate o f 8 per cent per annum, compounding quarterly, b u t repayments are made m onthly.

In b oth cases, to solve the problem we need firs t to adjust the specified interest rate to an interest rate where the compounding frequency matches the repayment frequency.15 This adjustm ent is made using the concept o f the effective interest rate th a t we discussed in Section 3.4.3. This concept was summarised in Equation 3.6, which we reproduce below: /

. \

m

/=(1 +m) where

_1

i = the effective interest rate per period j = the nom inal interest rate, compounding m times per period

Note th a t in this equation the tim e dimension o f z is fo r a longer period than the tim e dimension o f m ight be an interest rate per quarter. I t is convenient to restate Equation 3.6 in terms o f an interest rate zs, fo r the shorter tim e period, and an interest rate zL, fo r the longer tim e period. That is, Equation 3.6 is rew ritten as:

j/m . For example, z m ig ht be an interest rate per annum while

3.31 where m = the num ber o f ‘short’ periods in one ‘long’ period. The use o f Equation 3.31 is illustrated in Examples 3.27 and 3.28.

E xample 3.27 Use Equation 3.31 to express 8 per cent per annum, compounding quarterly, as: a) an effective annual interest rate b) an effective monthly interest rate.

SOLUTION a) In this case, interest is compounding quarterly and we wish to calculate an equivalent interest rate in which compounding occurs annually. Thus we are required to calculate iL, where is = 0.08/4 = 0.02, and m = 4. Using Equation 3.31: 彳=(1 + 'S )m _ 1 = (1.02)4 -1 = 0 .0 8 2 4 3 2 16 « 8 .2 4 3 % perannum

b) In this case, interest is compounding quarterly and we wish to calculate an equivalent interest rate in which compounding occurs monthly. Thus we are required to calculate is, where iL = 0.08/4 = 0.02 and m = 3. Using Equation 3.31:

0.02 = (1 + /s)3 - l /s = (1 .0 2 )1/ 3 _ l = 0 .0 0 6 6 2 2 71 « 0 .6 6 2 % per month

15 Alternatively, an adjustment can be made to the repayment amount. However, when using a calculator it is generally easier to adjust the interest rate.

C hapter three T he

time value of m o n e y : a n introduction to finan c ial mathematics

Example 3.28 A loan is currently being repaid by repayments of $ 5 5 0 0 0 at the end of each quarter. The interest rate is 8 per cent per annum. The borrower wishes to change to a monthly repayment schedule that will pay oft the loan by the same maturity date. Calculate the amount of each monthly repayment.

SOLUTION The repayment schedule for a typical quarter is shown in Figure 3.3.

:igure 3.3 Monthly and quarterly repayments i

:l

3 me)nths

$c

$C

$55 000 $C

As shown in Figure 3.3, it is proposed to replace each end-of-quarter cash flow of $ 5 5 0 0 0 with three end-of-month cash flows of C dollars each. Interest is charged quarterly at a nominal rate of 8 per cent per annum— that is, the effective qfuarter/y interest rate is 2 per cent per quarter. As shown in Example 3.27 (b), the equivalent effective m onthly interest rate is 0.662 271 per cent per month. Equating the present values of the quarterly and monthly cash-flow streams gives: $55 000 = 1.02

C (1.006622 71 )3

1.006622 71

Note, however, that although we have included the calculation of (1.006622 71 )3 in this expression, this calculation should by definition equal 1.02 (see the calculation in Example 3.27 (b) for clarification). Therefore, we need to solve: $55 000 = 1.02 which gives

C

L _

0.006622 71 L

1 ' 1.02.

C = $ 1 8 2 1 2 .4 5

Therefore, monthly repayments of $1 8 2 1 2 .4 5 will pay the loan off at the same maturity date as quarterly repayments of $ 5 5 0 0 0 . Note that 3 x $18 212.45 = $5 46 37.3 5, which is slightly less than the quarterly repayment of $5 5 0 0 0 . This difference reflects the present-value effect of making monthly repayments earlier than the quarterly repayments they replace.

B usiness finance

SUMMARY • Financial managers frequently make decisions that involve the time value of money. This chapter covered the major tools of financial mathematics needed to support these decisions. These tools include calculating rates of return, present values and future values, and defining and applying interest rates, including simple interest and compound interest. • The definition and valuation of various streams of cash flows were considered in detail, with the present value of an ordinary annuity being used as the basis

for dealing with several related problems. Annuity applications, including interest-only loans and principal-and-interest loans, were also discussed. • A wider class of problems, in which interest is charged either more frequently or less frequently than cash flows occur, was also discussed. • Throughout the chapter, emphasis was placed on developing a sound understanding to support the use of the various formulae that were derived.

KEY TERMS accumulation 34 annuity 50 annuity-due 50 cash flow 29 compound interest 33 continuous interest 42 debt 30 deferred annuity 50 discounting 36 effective interest rate 37 financial contract 29 future sum 32 general annuity 63 geometric rate of return 44 interes卜 only loan 37 interest rate 30

log price relative 43 nominal interest rate 3 7 , 40 ordinary annuity 50 ordinary perpetuity 51 present value 32 present value of a contract 47 principal 31 principal-and-interest loan 58 rate of return 29 real interest rate 40 simple annuity 63 simple interest 31 terminal value of a contract 47 time value of money 30 variable interest rate loan 62

SELF-TEST PROBLEMS 1 Andrew borrowed $ 6 0 0 0 and repaid the loan 60 days later by a single payment of $6250. What is the implied annual simple interest rate? 2 Angela deposits $ 5 0 0 0 today in a bank account that pays interest annually at the rate of 8 per cent. She then makes 10 more deposits of $ 1 0 0 0 each at annual intervals. a) How much does she have when she has made the last deposit? b) If Angela wished to accumulate the same sum by making a single deposit now, what amount would she need to deposit? 3

Geoff and Gail wish to borrow $ 7 5 0 0 0 to be repaid by equal monthly instalments over 25 years. The nominal annual interest rate is 9.9 per cent. a) What is the effective annual interest rate? b) What is the amount of the monthly repayment? Solutions to self-test problem s ore a v a ila b le in A p p e n d ix B.

INTERNATIONAL ARTICLES International articles related to this topic are available on the Online Learning Centre at www.mhhe.com / au /peirso n!2 e

66

C hapter three T he

time value of m o n e y : a n introduction to finan c ial mathematics

1

[LO 1] Explain the difference(s) between an interest rate and a rate of return.

2

[LO 1] Distinguish between simple interest and compound interest.

3

[LO 1] In financial mathematics, the symbol P can stand for 'present value', 'price' or 'prin cipa l’，but all three terms really hove the some meaning. Discuss.

4

[ L O llT h e term 'nominal interest rate' has two different meanings. Explain these two meanings, distinguishing carefully between them.

5

[LO 1] Rotes o f return should be multiplied, not added. Is this true? Why, or why not?

6

[LO 2] Given a required rote o f return, a set o f cash inflows can be valued os at any date, and the later is the valuation date the higher the value. Is this true? Why, or why not?

7

[LO 3] Distinguish between an annuity-due and a deferred annuity.

8

[LO 4] In any variable interest rote loon, it is possible that the interest rate con be increased to a level where the loan term becomes infinite unless the periodic repayment is increased. Explain how this can occur, and relate your answer to the characteristics of Equation 3.30.

9

[LO 5] Distinguish between a simple annuity and a general annuity.

CHAPTER THUEE REVIEW

QUESTIONS

PROBLEMS 1

Simple interest earned [LO 1] Nicholas deposits $2 0 0 0 in a bank fixed deposit for 6 months at an interest rate of 13.25 per cent per annum. How much interest will he earn?

2

Simple interest earned [LO 1] If Nicholas reinvests the $2000, plus the interest earned (see Problem 1), for a further 6 months, again at 13.25 per cent per annum, how much interest will he earn in this second 6-month period?

3

Implied simple interest rate [LO 1] Jane borrowed $ 1 0 0 0 0 and repaid the loan 30 days later by a single payment of $10400. What is the implied annual simple interest rate?

4

Calculating the loan term [LO 1] Mary borrowed $7250 at an annual simple interest rate of 15.50 per cent. She repaid the loan by paying a lump sum of $7394.70. What was the loan term?

5

Calculating the lump sum repayment [LO 1] On 2 April 2014, Paradise Pencils Ltd borrows $2 00 000 , repaying in a lump sum on 16 M ay 2014. The interest rate is 9.55 per cent per annum. How much is the lump sum repayment?

6

Simple interest earned (harder) [LO 1] On 5 February 2014, Financial Solutions Ltd deposits $ 3 0 0 0 0 0 with Second Street Bank at a simple interest rate of 4.4 per cent per annum. The maturity date of the deposit is 5 M ay 2014. Calculate the amount of interest the deposit will earn.

7

Present value [LO 1] Jupiter Mining Ltd promises to pay $ 5 0 0 0 0 0 in 90 days' time. Taking into account the company’s credit standing, the market interest rate for a loan period of 90 days is 10.65 per cent per annum. How much can Jupiter Mining borrow?

8

Simple and compound interest [LO 1] a) What will be the accumulated value, at the end of 10 years, of $1000 invested in a savings account that pays 8 per cent per annum? Assume that no withdrawals are made from the savings account until the end of the tenth year. What is the interest component of the accumulated value? b) Assume that interest is withdrawn every year. What will be the total interest earnings at the end of the tenth year? W hy does this amount differ from the interest earned in Problem 8 (a)?

67

Compound interest earned [LO 1] If you invest $ 6 5 0 0 0 for 3 years at 14.7 per cent per annum (interest payable annually), how much will you have at the end of the 3 years? Compound interest earned [LO 1] If you invest $ 8 7 0 0 0 at 7.35 per cent per annum (interest paid annually), how much will you have: a) at the end of 3 years? b) at the end of 6 years? Compound interest earned (harder) [LO 1] Frank has invested $ 1 0 0 0 0 for 10 years at 12.4 per cent per annum. He has to pay tax on the interest income each year. a)

Calculate the value of the investment at the end of the tenth year if his tax rate is: i) 45 per cent per annum ii) 30 per cent per annum iii) 15 per cent per annum iv) zero per annum.

b)

Rework your answer to (a)(i) if, instead of having to pay tax each year, Frank must pay in tax 45 per cent of the accumulated interest at the end of the tenth year. Which tax system is better for him? W h y?

Compound interest earned [LO 1】 Philip invests $ 1 7 2 0 0 at an interest rate of 2.5 per cent per quarter. How much is the investment worth after 2 years? Compound interest earned [LO 1】 Rhiannyn invests $ 2 5 0 0 0 at an interest rate of 0.6 per cent per month. How much is the investment worth after 3 years? Present value [LO 1] Calculate the following present values: a) $1 00 0 payable in 5 years if the interest rate is 12 per cent per annum b) $ 1000 payable in 10 years if the interest rate is 12 per cent per annum c) $1000 payable in 5 years if the interest rate is 6 per cent per annum d) $ 1 6 2 0 5 payable in 1 year if the interest rate is 1.5 per cent per month e) $1 million payable in 4 0 years if the interest rate is 15 per cent per annum f)

$1 million payable in 100 years if the interest rate is 15 per cent per annum.

Compound interest [LO 1] Neeta Stoves Ltd borrows $8 00 0 repayable in a lump sum after 1 year. The interest rate agreed to is described as ' 15.0 per cent per annum, calculated monthly’. How much is the repayment? Implied compound interest rate [LO 1] What is the annual interest rate (compound) implied by each of the following future values (FV), present values (PV) and terms (/): a) FV = $9 20 00; PV = $8 20 00; f = 2 years b) FV = $1 6 0 4 6 0 0 ; PV = $1 50 0 0 0 0 ; f= 4 years c) FV = $ 2 0 0 0 0 0 0 ; PV = $ 1 3 0 7 6 0 0 ; t = 3 years d) FV = $ 1 0 0 0 0 0 0 0 ; PV = $ 6 0 0 0 0 0 0 ; t = 6 years e) FV = $ 1 0 0 0 0 0 0 0 ; PV = $ 6 0 0 0 0 0 0 ; f = 5.5 years? Effective annual interest rate [LO 1] What is the effective annual interest rate corresponding to each of the following nominal interest rates: a) 18 per cent per annum, payable half-yearly b) 18 per cent per annum, payable monthly c) 18 per cent per annum, payable fortnightly d) 1 8 per cent per annum, payable daily e) 18 per cent per annum, payable continuously?

C hapter THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

Effective annual interest rate [LO 1]

What is the effective annual interest rate corresponding to each of the following nominal interest rates: a) 7.5 per cent per annum, payable half-yearly b) 7.5 per cent per annum, payable monthly c) 7.5 per cent per annum, payable fortnightly d) 7.5 per cent per annum, payable daily e) 7.5 per cent per annum, payable continuously? 19

Effective annual interest rate [LO 1]

Jerm Ltd buys a bank bill for $91 107 and sells it 5 4 days later for $93 323. What annual effective interest rate did Jerm Ltd earn? 20

Simple interest and effective annual interest rate [LO 1]

Liana Ltd bought a bank bill on 7 January 2012 for $976 751 and sold it on 3 March 2012 for $98761 8. a) What simple interest rate did Liana Ltd earn? b) What annual effective interest rate did Liana Ltd earn? 21

Calculating the effective annual interest rate [LO 1]

On 16 January 201 2, an investor lent a sum of money to be repaid, with interest, on 1 1 March 2012. The interest rate was 6.15 per cent and was quoted on a simple interest basis. What effective annual interest rate did the investor earn? 22

CHAPTER THUEE REVIEW

18

Effective annual interest rate (harder) [LO 1]

Rock Solid Ltd sells, on credit, goods to the value of $8465.95 to University Garden Supplies Ltd. Rock Solid offers a discount of half of 1 per cent for payment within 7 days; otherwise, payment must be made on or before the thirtieth day. What is the effective annual interest rate implicit in the discount being offered? State any assumptions you make. 23

Effective annual interest rate (harder) [LO 1] Since 1 August 201 2, W ing Yin's investment policy has been to lodge fixed (term) deposits at her local bank.

The bank pays interest on the maturity date of a deposit and the interest rate is expressed as an annual simple interest rate. When a deposit matures, W ing Yin's policy is to re-lodge the whole sum (principal and interest) immediately for a further period. She chooses the term of each deposit according to her assessment of the interest rates available at that time. W ing Yin's decisions to date are as follows: Date

Decision

1 August 2012

8-month deposit at 9.15 per cent per annum

1 April 2013

6-month deposit at 8.45 per cent per annum

1 October 2013

10-month deposit at 8.16 per cent per annum

Calculate, as at 1 August 2014, the effective annual interest rate W ing Yin has earned since she began this policy. (Assume that all months are of equal length.) Briefly explain each step. 24

Nominal interest rate [LO 1]

A retail chain operates its own credit provision system for customers. Company policy is to set a nominal annual interest rate, and to charge interest monthly. To cover its costs and make a return on capital, the company has a target effective interest rate of 19.5 per cent per annum. What nominal annual interest rate should it set? 25

Nominal interest rate [LO 1]

If the real interest rate is 10 per cent per annum, and the expected inflation rate is 25 per cent per annum, what should be the nominal interest rate? 26

Nominal interest rate (harder) [LO 1]

George is intending to lend money to his nephew to help him set up a new business. The loan will be made now, and is to be repaid in a lump sum after 3 years. George wishes to earn a real interest rate of 3.5 per cent per annum. He expects the inflation rate in the coming year to be 10 per cent but believes that it will fall steadily thereafter to 6 per cent in the following year and to 4 per cent in the third year. What annual interest rate should George set on the loan?

69

27

Nominal interest rate (harder) [LO 1]

Grose Paterson Bank Ltd is intending to lend money to a client. The loan is to be repaid in a lump sum after 7 years. The bank's required real rate of return is 3 per cent per annum. The bank expects the inflation rate in the coming year to be 8 per cent per annum, falling to 5 per cent per annum the following year and 4 per cent per annum thereafter. What annual interest rate should the bank set? 28

Real annual rate of return [LO 1]

In Xanadu, the consumer price index (CPI) stood at 147.6 on 1 January 2010. O n that date, SBF Ltd invested $ 5 0 0 0 0 for 4 years at an interest rate of 11.4 per cent per annum (compound). On 1 January 2 0 14 the CPI stood at 193.8. What real annual rate of return has SBF earned? 29

Log price relative [LO 1]

An investor purchases 1000 shares at $5.50 per share on 31 M ay 2014. Over the next 6 months the investor notes down the price of the share at the end of each month. The result is shown below: End o f June

$5.85

End of July

$6.12

End o f August

$5.75

End o f September

$5.75

End o f October

$6.44

End of November

$6.60

There were no dividends paid in this period. Calculate, for each month, the log price relative, using natural (base e) logarithms. What does the sum of the log price relatives represent? Compare this sum to ^n($6.60/$5.50). Explain. 30

Average annual rate of return [LO 1]

Matthew bought an apartment for $3 64 000 . After 4 years he estimates that its value has changed as follows: In Year 1: an increase of 7 per cent In Year 2: an increase of 2 7 per cent In Year 3: a decrease of 5 per cent In Year 4: an increase of 1 1 per cent. How much is it worth now? What is the average annual rate of return? 31

Present value [LO 1]

What is the present value (at 7 per cent per annum) of a contract that provides for the following three payments to be made: After 6 months: $7601 After 2.5 years: $9900 After 7 years: $1 8 5 2 2 ? 32

Present and future values [LO 1]

A company is entitled to receive a cash inflow of $8 00 0 in 2 years7 time and a further cash inflow of $ 1 4 0 0 0 in 5 years' time. If the interest rate is 8.5 per cent per annum, how much is this stream of cash inflows worth: a) today b) in 5 years7 time. 33

Internal rate of return [LO 1]

An investment costs $ 5 0 0 0 0 and generates cash inflows of $ 4 0 0 0 0 after 1 year and $ 3 0 0 0 0 after 2 years. Show that the internal rate of return on this investment is approximately 27.2 per cent per annum. 34

Valuation of cash flows at any date [LO 2]

A contract will produce cash inflows on 4 different dates. These cash inflows are: $1 0 0 0 after 1 year, $8000 after 3 years, $ 1 2 0 0 0 after 7 years and $ 1 0 0 0 0 after 10 years. The required rate of return is 8.5 per cent per annum. a) Calculate the present value. b) Calculate the value as at the start of Year 1.

C hapter three T he

time value of m o n e y : a n introduction to finan c ial mathematics

d) Calculate the value as at the start of Year 7. e) Calculate the terminal value. f) What is the relationship between these successive valuations? 35

Valuing different types of annuity [LO 3]

Consider an annuity of 6 cash flows of $5 00 0 payable annually. If the interest rate is 7 per cent per annum, what is the value of this annuity today if the first cash flow is to be paid: a) immediately b) in 1 year’s time c) in 4 years' time? 36

Annuities [LO 3]

Today is Stanley's 55th birthday. He plans to retire on his 65th birthday and wants to put aside the same sum of money every birthday (starting today) up to and including his 65th birthday. He then wants to be able to withdraw $ 1 0 0 0 0 every birthday (starting with his 66th) up to and including his 85th birthday. He believes that an interest rate of 10 per cent per annum is a reasonable estimate. How much does he need to put aside each birthday? 37

O rdinary perpetuities [LO 3]

How much money would be needed to establish a permanent scholarship paying $1 00 0 at the end of each year, if money can be invested at 8 per cent per annum? 38

CHAPTER THREE REVIEW

c) Calculate the value as at the start of Year 3.

O rdinary perpetuities (harder) [LO 3]

Kevin Oldfellow attended Unicorn High School in the 1960s. After leaving school, Kevin established an advertising agency that proved to be highly successful. Kevin is now very wealthy and wishes to establish a fund that will provide a perpetual scholarship scheme to support students at Unicorn High. At the initiation of the scheme Kevin will award six scholarships— one each to students currently in Years 7 to 12 inclusive. These students keep these scholarships until they leave the school. In subsequent years, one scholarship will be awarded every year to a student entering the school at Year 7 and that student keeps the scholarship through to Year 12. Kevin has sought advice from the school and has been told that it costs about $6 00 0 to keep a student at Unicorn High for 1 year. The current long-term nominal interest rate is 6 per cent per annum. The long-term real interest rate is estimated to be 2.5 per cent per annum. Kevin has been advised that it will cost him $ 6 3 6 0 0 0 to set up the scheme. However, Kevin is not convinced, arguing that, 'The current inflation rate is about 3.5 per cent per annum. If this continues then it won't be long before the real value of a scholarship will not be enough to keep a student at the school for a year. Surely this has to be factored into the calculation somehow'. Kevin has approached you for advice. a) What is the logic behind the advice that a fund of $ 6 3 6 0 0 0 would be sufficient? Show your calculations. b) Suppose that for the next 5 years the annual inflation rate continues to be 3.5 per cent and the annual interest rate continues to be 6 per cent. What will be the real value of an annual scholarship payment after 5 years? c) What amount would you advise Kevin to put into the scholarship fund? Explain. d) Assuming that the forecasts in (b) are correct, show how the amount in the fund and the amount of each scholarship would evolve over the first 2 years. 39

Deferred perpetuities [LO 3]

A pine plantation returns nothing to its owner in the first 2 years. In the following 2 years, the returns are $ 1 0 0 0 0 0 and $1 50 000 , respectively, and after that the return is $ 2 0 0 0 0 0 per year in perpetuity. All returns are in cash and occur at year end. a) What is the present value of the constant return stream at the beginning of the fifth year if the returns can be invested at 8 per cent per annum? b) What is the current present value of the whole return stream at the same required rate of return? 40

Deferred perpetuities [LO 3]

What is the present value of a perpetual cash inflow of $1 00 0 received at the end of each year, the first inflow occurring 2 years from now, if the interest rate is 5 per cent per annum? This cash flow can be produced by investing $ 1 0 0 0 0 in a business this year and $6 00 0 next year. What is the present value of the investment? Is it profitable?

71

B usiness finance

41

Calculating principal and interest repayments [LO 4]

Luke borrows $ 8 0 0 0 0 0 from a bank to set up a medical practice. He agrees to pay a fixed interest rate of 10.2 per cent per annum (calculated monthly) and to repay by equal monthly instalments over 10 years. Calculate the monthly repayment. By how much does Luke's first repayment reduce the principal? If the loan is paid off as planned, by how much will the lost repayment reduce the principal? 42

Calculating principal outstanding [LO 4]

After making 21 monthly repayments, Luke (see Problem 41) inherits a large sum of money and decides to repay the (remaining) loan. When the twenty-second repayment is due he asks for the payout figure. How much should it be? 43

Calculating the loan term [LO 4]

John decides that he desperately needs a new Italian suit priced at $1999. He borrows the money and agrees to pay $71.07 each month at an interest rate of 16.8 per cent per annum, payable monthly. For how long will he be making repayments? 44

Annual rate of return [LO 4]

What is the approximate annual rate of return on an investment with an initial cash outlay of $ 1 0 0 0 0 and net cash inflows of $2 77 0 per year for 5 years? 45

Nom inal interest rate and effective interest rate [LO 4 】

Warren Cameron buys a boat for $30000, paying $5 00 0 deposit. The remainder is borrowed from the Goodfriend Loan Co. to be repaid by 15 monthly payments of $2027.50 each. What is the monthly interest rate being charged? What is the nominal annual interest rate? What is the effective annual interest rate? 46

Calculating the loan term [LO 4 】

Anne Hopewell has just borrowed $ 7 0 0 0 0 to be repaid by monthly repayments over 20 years at an interest rate of 18 per cent per annum. Based on this information, the monthly repayment is approximately $1 08 0 but Anne intends to make higher monthly repayments. She asks you how long it will take to repay the loan if the amount she pays per month is: a) $1100 b) $1200 c) $1500. 47

Annuities [LO 4]

Layla borrows $5 00 00, repayable in monthly instalments over 10 years. The nominal interest rate is 12 per cent per annum. What is the monthly repayment? After 3 years have passed, the lender increases the interest rate to 13.5 per cent per annum and Layla is given the choice of either increasing the monthly repayment or extending the term of the loan. What would be the new monthly repayment? What would be the new loan term? 48

Annuities [LO 4]

Exactly a year ago, Stephen and Lan Kuan borrowed $ 1 5 0 0 0 0 from a bank, to be repaid in equal monthly instalments over 25 years at an interest rate of 7.8 per cent per annum. Today, the bank told them that it was introducing a monthly fee of $10 but they could continue to repay the loan by making their current monthly payments. However, Stephen and Lan Kuan are worried because if they do this, the loan will take longer to repay. They have asked you to calculate how much longer it will take to repay the loan. 49

Effective annual interest rate, repayments and loan terms [LO 4 】

Don and Jenny wish to borrow $180000, to be repaid over a period of 20 years by monthly instalments. The interest rate (nominal) is 7.8 per cent per annum. The first payment is due at the end of the first month. a) Calculate the effective annual interest rate. b) Calculate the amount of the monthly repayment if the same amount is to be repaid every month for the period of the loan. c) Suppose, instead, that the lender agrees that Don and Jenny will repay $1 10 0 per month for the first 12 months, then $ 1 2 5 0 per month for 出e 12 months after that, then $X per month thereafter. Assuming that the term is to stay at 20 years, how much is $X? d) Alternatively, suppose that Don and Jenny decide to repay $2 50 0 per month from the time the money is borrowed until it is repaid. How long would it take to repay the loan? What would be the amount of the final payment?

72

C hapter THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS

Repayments and loan terms [LO 4 】

Peter borrowed $ 8 0 0 0 0 0 to refit his fishing trawler. The loan requires monthly repayments over 15 years. When he borrowed the money the interest rate was 13.5 per cent per annum, but 18 months later the bank increased the interest rate to 15.0 per cent per annum, in line with market rates. The bank tells Peter he can increase his monthly repayment (so as to pay off the loan by the originally agreed date) or he can extend the term of the loan (and keep making the same monthly repayment). Calculate: a) the new monthly repayment if Peter accepts the first option b) the extra period added to the loan term if Peter accepts the second option. 51

Calculating repayments [LO 4]

Wahroonga Furniture Ltd (WFL) is planning a large sale of its stock of lounge suites and dining tables. As part of its marketing, WFL will offer customers loans of up to $1 00 00, with no repayment required during the first 6 months. The customer then makes equal monthly repayments. The total loan term (including the first 6 months) is 2 years. The effective interest rate that WFL requires on the loans is 12 per cent per annum. What monthly repayment must WFL charge on a loan of $ 1 0 0 0 0 ? 52

Simple and general annuities [LO 5]

A simple annuity of $ 3 00 per quarter is to be replaced by annual payments (the payments to be made at the end of each year). What will be the annual payments if the nominal interest rate is 6 per cent per annum?

CHAPTER THREE REVIEW

50

REFERENCES Crapp, H. & Marshall, J., Money Market Maths, Allen & Unwin, Sydney, 1986.

M artin, P. & Burrow, M ., Applied Financial Mathematics, Prentice-Hall, Sydney, 1991.

Knox, DM., Zima, P. & Brown, R.L., Mathematics of Finance, 2nd edn, M cG raw-H ill, Sydney, 1999.

73

CHAPTER FOUR Applying the time value of money . to security . valuation

CHAPTER CONTENTS ED

Introduction

75

Financial asset valuation under certainty

75

Valuation of shares

76

HH

Valuation of debt securities

80

BH

Interest rate risk

81

m m

The term structure of interest rates

82

EB

The default-risk structure of interest rates

89

BE1

Other factors affecting interest rate structures

91

Appendix 4.1 Duration and immunisation

97

LEARNING OBJECTIVES After studying this chapter you should be able to:

命

1

understand how assets are valued under conditions of certainty

2

use the tools of financial mathematics to value equity securities

3

explain the main differences between the valuation of ordinary shares based on dividends and on Gamings

4

use the tools of financial mathematics to value debt securities

5

explain the nature of interest rate risk

6

understand the theories that are used to explain the term structure of interest rates

7

understand the effect of default risk on interest rates

8

apply the concept of duration to immunise a bond investment.

C hapter four A pplying

the time value of m o n e y to security valuation

In Chapter 1 we discussed b riefly the im p o rta n t concept o f the tim e value o f money. In Chapter 3 we presented some mathematical tools useful in analysing problems involving the tim e value o f money. In particular, we showed how promised streams o f future cash flows can be valued, provided th a t the required rate o f retu rn is known. In this chapter we apply these tools to the valuation o f debt and equity securities. In itia lly we assume th a t the security s fu tu re cash flows are know n w ith certainty. Later in the chapter we introduce uncertainty, b ut only in a lim ite d way. A more form al and detailed treatm ent o f u ncertainty is given in Chapter 6.

4.2

Financial asset valuation under certainty 1

The benefits o f owning an asset are the present and future consumption opportunities attributable to it. For a financial asset, these benefits are in the form o f cash. For example, an investor who holds a government bond u n til m a tu rity receives cash in the form o f interest payments during the bonds life and, at m aturity, in the fo rm o f the payment o f the face value. In the case o f shares, the investor receives cash in the form o f dividends and, on sale o f the shares, in the form o f the price obtained fo r the shares. A decision to buy an asset implies a simultaneous decision to forgo current consumption. It is assumed that, at any time, investors prefer more consumption to less consumption, other things being equal. Application o f this principle between tw o points in tim e implies that, other things being equal, earlier cash inflows are preferred to later cash inflows. As explained in Chapter 3, these observations may be summarised by the phrase ‘money has a tim e value’. To review this principle, suppose th a t a person is given the choice o f receiving $100 now or $100 in 1 years time. A rational person w ill always choose to receive the cash immediately, even i f there is no desire to consume immediately. The reason, o f course, is th a t the earlier cash flow can be invested. This w ill enable even greater consum ption later. I f the interest rate is 12 per cent per annum, the investor (consumer) in this example can invest fo r 1 year the immediate cash flow o f $100, and at the end o f the year have $112 available fo r consumption. Clearly $112 o f consum ption is preferable to $100 o f consumption. In this example the cash flows were, in effect, a g ift. Suppose, however, th a t the investor is offered the chance to buy the rig h t to receive $100 in 1 years tim e. W hat is the m axim um price the investor should offer fo r th is right? We have just seen th a t $100 is ‘w o rth ’ $100 x 1.12 = $112 in 1 year’s time. The rig h t to receive $100 in 1 years tim e is therefore w o rth at present: =

LEARNING OBJECTIVE 1 Understand how assets are valued under conditions of certainty

$100

1.12 $89.29

The am ount $89.29 is referred to as the present value o f $100 to be received in 1 years tim e i f the discount rate is 12 per cent per annum. Therefore, the interest rate has tw o functions: it is the rate at which present sums can be converted to equivalent future sums, and i t is also the rate at which promised future sums can be converted to equivalent present values. Therefore the value o f a financial asset is not simply the sum o f the cash th a t it generates in future periods. For example, a financial asset that generates returns o f $100 at the end o f each o f the next 5 years is n o t w o rth $500 today. I t is n o t valid to add together cash flows th a t occur at different times. However, adding together present values is valid because each value relates to the same tim e, the present. Where there are many cash flows from the same asset, the present value o f the asset is the sum o f the present values o f every future cash flow. The present value o f the asset is calculated using the relevant interest rate. I f the cash flows are certain to occur, as we assume here, then the relevant interest rate is the risk-free interest rate, Tr. Thus: P〇 =

1

1+

7 + —(l +^ rf—2)2 + . . . +

—

^

(1 + rf)n

In this section we review some of the results explained in Chapter 3. Readers familiar with this material may safely omit this section.

令

A

B usiness finance

or

p〇 = t ^

ED

y

where

P〇 = present value o f the asset Ct = dollar return (cash flow) at tim e t n = term o f the investm ent = risk-free interest rate per tim e period t = 1, 2, n Suppose th a t an asset returns $100 per annum fo r 5 years and th a t an investor requires an annual interest rate o f 3.6 per cent as compensation fo r forgoing current consumption. Substituting in Equation 4.1 we find that: $100

$100

$100

$100

$100

1 + 0.036

(1 + 0 .0 3 6 ) 2

(1 + 0.036”

（1 + 0 .0 36)4

(1 -f 0 .0 3 6 )5

n

= $ 9 6 ,5 2 5 + $93,171 + $89,933 + $86,808 + $83,792 = $ 4 5 0 ,2 2 9

Therefore, this investor would be prepared to pay $450.23 fo r the asset. In summary, a financial asset is valued in a w orld o f certainty by discounting the known future cash flows at the risk-free interest rate, thus compensating investors fo r th e ir preference fo r current consumption.

4.3 LEARNING OBJECTIVE 2 Use the tools of financial mathematics to value equity securities

4.3.1 [V aluation of shares assuming certainty I f future cash flows are known w ith certainty, Equation 4.1 can be used to value shares.2 The periodic cash flows from an investm ent in shares are called dividends. Unless liqu id atio n o f the company is contemplated, the dividends are assumed to continue indefinitely. Therefore, Equation 4.1 may be rew ritten as:

DIVIDENDS

periodic distributions, usually in cash, by a company to its shareholders

Valuation of shares

D, p 〇

= J2

4.2

(1 + rf Y

where D t = dividend per share in period t The appropriate discount rate remains the risk-free interest rate, because under conditions o f certainty investors require the same rate o f return on all assets. I t m ig h t appear th a t Equation 4.2 ignores a second potential source o f retu rn from an investm ent in shares— th a t is, the capital gain from selling the shares at a price greater than the price at which they were purchased. This impression is incorrect. Suppose th a t an individual purchases shares w ith the inte n tio n o f selling them in 5 years* time. Equation 4.2 may be expanded as follows: Dt

p〇 = E r=l (1 + rf )[

Ps

(1 + r /)5

4.3

where P5 = share price at the end o f the fifth year The capital gain (or loss) is the difference between P5 and P〇 . The price o f the shares when they are sold is the discounted value o f all future dividends from Year 6: 〇〇

作 2

令

= Z

Dt

t=6 (1 + r/ 广 5

4.4

The discussion that follows is directed towards the valuation of ordinary shares. Preference shares are another form of equity capital. The valuation of preference shares is discussed in Chapter 14 and the distinction between ordinary shares and preference shares is discussed in detail in Section 10.7.2.

C hapter four A

pplying the time value of m o n e y to security valuation

+

I I -

E 5 3E W

x

Substituting Equation 4.4 in to Equation 4.3:

5

(

D/ -f/

+/

which is Equation 4.2. Therefore, where a company is assumed to have an in fin ite life, the current m arket price o f its shares can be expressed as the present value o f an in fin ite stream o f dividends. Even in a m arket where investors are seeking capital gains, the valuation form ula remains the same.

4 .3 .2 1 Valuation of shares under uncertainty Valuing a security under uncertainty is d iffic u lt and, in general, few ( if any) people can consistently expect to reach a better valuation than that given by the current m arket price. This statement is discussed fu lly in Chapter 16. However, the statement is unhelpful i f the company is n ot traded on a stock exchange, because there is then no current m arket price to observe. Moreover, to say th a t the best estimate o f a shares ^true* value is its current m arket price provides no insight in to the factors th a t give a share its value. In this section, some o f the fundam ental factors determ ining a share s value are considered. Where there is uncertainty, investors require compensation in the form o f a higher promised rate of return. Equation 4.2 becomes:

p 〇= H

g (D ')

(i +

where E(Dt ) = expected dividend per share in period t ke = required rate o f return on the shares The appropriate value o f ke is determ ined using the concept o f the o p p o rtu n ity cost o f capital. The ‘true ’ or economic cost o f investing in a particular security is the retu rn forgone on the next best alternative. For a risky security, this return is greater than the return on the risk-free security (r^). In short, ke > r,. The am ount by which ke exceeds r^is often referred to as the security s risk premium. Further, the riskier the security being considered, the higher the risk premium w ill be and the higher ke w ill be. D eterm ination o f exactly how much higher ke should be requires a measurement o f risk* and a theory lin kin g th a t measure to required rates o f return. These theories are developed in Chapter 7. A t this p o in t we assume th a t all investors reach the same assessment o f risk, and therefore apply the same o p p ortu nity cost o f capital (discount rate) to the same expected dividend stream, therefore a rriving at the same price fo r the company s shares. It may seem unrealistic to assume th a t everyone has the same expectations. However, at the tim e o f making a financial decision, it may be reasonable fo r the company s management to assume th a t its assessment o f the likely impact o f th a t decision on the company s share price w ill prove to be correct. I f this is so, then management should act as i f it is realistic to assume that everyone has the same expectations. The simplest assumption to make when estim ating a share s value is th a t the company w ill m aintain in perpetuity the current dividend per share, D 〇 . In this case the estimate is:3 P〇

A) ke

The use o f Equation 4.6 is shown in Example 4.1.

3

This formula treats the dividends as an ordinary perpetuity. For further details, see Section 3.6.

♦

B usiness finance

Example 4.1 Rankine Ltd is currently paying a dividend of 90 cents per share. If investors expect this dividend to be maintained and require a rate of return of 15 per cent on the investment, what is the value of Rankine's shares?

SOLUTION The value of Rankine's shares is calculated as follows: $0.90 0.15

$ 6.00

G rowth in dividends I t is usually more realistic to assume th a t a company s dividend per share w ill change. For example, it may be assumed th a t the dividend per share w ill grow at a constant rate. In this case, the estimated value is:

p 〇

= J2

Q〇( l + g ) f (1 + ke)1

where g = expected grow th rate in dividend per share Where k e is greater thang and the grow th in dividends is assumed to continue indefinitely, Equation 4.7 can be w ritte n as:4 A ) ( l+ g )

P〇

k e -g

One approach to estim ating g is to calculate the past grow th rate in dividend per share and use this as the estimate o f the expected grow th rate. This is shown in Example 4.2.

Example 4 .： Assume that for the past 10 years the growth rate in Rankine Ltd's dividend per share has been 10 per cent per annum. Assume further that this growth rate is expected to be maintained indefinitely. The latest dividend per share was 90 cents and was paid yesterday. What is the value of Rankine's shares?

SOLUTION Using Equation 4.8, the value of Rankine’s shares is: D〇 (l+ g )

P〇 -

k e -g $0.90 x 1.1 0 .1 5 -0 .1 0 $19.80

4

The terms in Equation 4.7 form an infinite geometric series, with a common factor (or ratio) between each term of, -8 . Provided that - 1 < + 8 • there will be a limiting sum equal to the first term of the series, divided by

1 ke

\

ke

(1 - the common ratio). That is: P

〇 \ ke

、

1 K}

D〇(l + g )

k e-g

1 + kt> A)(l +g) ke-g

■+ ke

If ke < g , the model breaks down. Under these circumstances: -

命

■ke

>

1 and there is no limiting sum (P0

).

〇〇

C hapter four A pplying

the time value of m o n e y to security valuation

A second approach to estim ating g is to assume th a t the grow th in dividend per share is related to the company s retained earnings and to the rate o f retu rn on those earnings. I f the company retains a constant p roportion b o f its earnings each year and reinvests those earnings at a constant rate r, then g = hr, and Equation 4.8 can be rew ritten:

If Rankine Ltd retains 4 0 per cent of its earnings each year (jb = 0.4), and these earnings are reinvested to earn a 25 per cent rate of return (r = 0.25), what is the value of Rankine's shares?

SOLUTION The value of Rankine’s shares, using Equation 4.9, is as follows: p _ $0.90 x [1 + (0.4 x 0.25)] 0

一 ^ 0 . 1 5 - ( 0 . 4 x 0.25)^

=$19.80 The assumption th a t the past grow th rate is expected to be m aintained indefinitely is unlikely to be realistic, particularly where the company has been experiencing a relatively high growth rate. We m ight therefore assume th a t the current grow th rate w ill be m aintained fo r several years before falling to a level expected to be sustained indefinitely. This is shown in Example 4.4.

Example 4.4 Assume that the growth rate will remain at its current level of 10 per cent per annum (gf^ for only a further 3 years, and is then expected to fall to 6 per cent per annum (g) and remain at that level indefinitely. W hat is the share price today?

SOLUTION This complication is easily handled by first using Equation 4.8 to estimate the value of the shares as at the end of the third year. The value of the shares today is given by the present value of this estimate, plus the present value of the dividends to be paid in the first 3 years. The value of Rankine's shares is calculated as follows: p

0

D〇 l i + g ,) , P〇 (i ^ g ') 2 , Poll + g ,)3 , (i + M

(i + M

_ $ 0 .9 0 X 1.10 1.15

2

(l + M

$ 0 .9 0 X (1.10)2 +

(1.15)2

+

3

1 _ :: P 〇 ( i + g 'l 3(i+ g l (l + M

3

(b-gl

$ 0 .9 0 x (1.10 )3

1

$ 0 .9 0 x (1.10)3 x (1.06)

(1.15 )3

+ (1.15)3 X

(0 .1 5 -0 .0 6 )

= $ 1 1 .7 5

Comparing the previous tw o examples, the reduction in the expected dividend grow th rate after Year 3 has resulted in a reduction in the value o f the shares from $19.80 to $11.75. This highlights the sensitivity o f the share value to estimates o f the future grow th rate in dividend per share. The formulae used to estimate a share value may also be used to estimate the required rate o f retu rn on a company s shares, given th e ir current m arket price. This application is discussed fu rth e r in Chapter 14.

4 .3 .3 | Share valuation and the price-earnings ratio The ratio o f a company s share price to its earnings per share— th a t is, its price-earnings ratio _ is often used by security analysts to estimate the value o f the company s shares.5 To illustrate this m ethod o f 5

m

LEARNING OBJECTIVE 3 Explain the main differences between the valuation of ordinary shares based on dividends and on earnings

A discussion of the use of the price-earnings ratio to value shares is contained in most texts on investments. See, for example, Brailsford, Heaney and Bilson (2011, pp. 386-93) and Bodie, Kane and Marcus (2011, pp. 601-9).

命

B usiness finance

valuation, we again use the example o f Rankine Ltd, and assume th a t Rankines current earnings per share is $2.25. Assume also th a t an analyst estimates th a t the appropriate price-earnings ratio fo r the company is 9.0. Therefore, the value o f each share is estimated at $20.25— th a t is, $2.25 x 9.0. This estimate would then be compared w ith the current market price to determine whether the shares are overvalued or undervalued. However, this leaves unanswered the question: How does an analyst estimate the appropriate priceearnings ratio? In m ost cases where analysts use this m ethod o f valuation, the appropriate price-earnings ratio is determ ined in a way th a t can best be described as judgm ental— th a t is, no form al model is used b ut the analyst tries to take into account the factors considered to be relevant. Two im p o rta n t factors are risk and grow th opportunities. The riskier the analyst believes the investm ent to be, the lower the appropriate price-earnings ratio. To see this, imagine th a t an analyst is try in g to value two companies th a t are equivalent in all respects, including th e ir current and expected earnings, except th a t one company is riskier than the other. Because investors dislike risk, other things being equal, the company th a t is riskier w ill be less attractive to investors and w ill thus have a lower value. Since both companies have the same earnings, the ratio o f price to earnings w ill be lower fo r the riskier company. The other im p o rta n t factor is grow th opportunities. I f an analyst believes a company has substantial opportunities fo r growth, a high price-earnings ratio w ill be assigned. In this case the current earnings level is likely to be surpassed in the future, thereby ju stifyin g a price today th a t appears ‘h igh’ relative to current earnings. O ther factors likely to be considered include the price-earnings ratios o f companies in the same industry, and prospects fo r the ind ustry and the economy as a whole.

4.4 LEARNING OBJECTIVE 4 Use the tools of financial mathematics to value debt securities

As we saw in Section 4.3, the returns on an investm ent in shares are dividends and capital gains. In the case o f an investm ent in debt securities (frequently called bonds or debentures), the returns are usually in the fo rm o f interest payments and the repayment o f the face value or principal on the m a tu rity date. As has been explained fo r shares, i f all securities offer certain returns, each security s o p p o rtu n ity cost o f capital is the risk-free interest rate (or yield) r^. Therefore, i f future cash flows are know n w ith certainty, rf \s the appropriate discount rate to apply. Equation 4.1 is rew ritten fo r bonds as follows: n

deben tu res)

d e b t s e c u ritie s issued w ith a m e d iu m o r lo n g te rm to m a tu rity

COUPONS fix e d in te re s t p a y m e n ts m ade on bonds a nd d e b e n tu re s

Valuation of debt securities

F

Q

P〇 == E t=\ (1 + rf y

(1 + rf )n

interest payment (often called coupon payment or just coupon) at tim e i F = face value (principal repayment) at m aturity, which is date n n = num ber o f periods to m a tu rity risk-free interest rate (yield) rf = The use o

where

Example 4.5 Suppose that Rankine Ltd borrows by issuing 3-year bonds with a face value of $100, and a coupon interest rate of 10 per cent. The cash flows to a bond holder will be interest (/coupon,) payments of $ 1 0 per year for 3 years, followed by payment of $ 1 0 0 at the end of the third year. If the required rate of return is also 10 per cent per year, what is the value of Rankine’s bonds?

SOLUTION The value of the bonds is given by Equation 4.10: D 0

$10

$10

$10

$100

1.1

( l. l) 2

( l. l) 3

( l. l) 3

=$9.091 +$8.26 4+ $7.513+ $75.131 = $

100.00

C hapter four A

pplying the time value of m o n e y to security valuation

Once a bond has been issued— th a t is, sold by the borrower to the lender— its promised future cash flows are fixed. Ownership o f the bond entitles the owner to receive from the issuer a fixed schedule o f future cash flows. I f the m arket interest rate changes, it w ill affect the attractiveness o f the bond to potential investors. I f m arket interest rates decrease, the bond w ill become more attractive; i f m arket interest rates increase, the bond w ill become less attractive. O f course, this w ill cause bond prices to change. A decrease (increase) in m arket interest rates w ill cause an increase (decrease) in the prices of existing bonds. This is illustrated in Example 4.6.

Example 4.6 Suppose that immediately after Rankine's debt contract is agreed, conditions in the debt market change and the required rate of return falls to 8 per cent per annum. Rankine must still make interest payments of $1 0 each year, but investors now require a return of 8 per cent per annum. W hat is the value of Rankine’s bonds now?

SOLUTION Again applying Equation 4.10, the security is now valued more highly, as follows:6 $10

$10

^

$10

(

$100

0 = h O S + (1.08 )2 + (1 .0 8 )3 + (1.08)3 = $ 1 0 5 ,1 5 4

Similarly, if the required rate of return had risen from 10 per cent to 12 per cent, the price would have fallen as follows: $10

$10

$10

$100

TTTi + (i.i2)2 + (1.12)3 + (i.i2)3 $ 9 5 .1 9 6

4.5

Interest rate risk

Example 4.6 shows th a t when interest rates change, so do bond prices. The possibility o f unforeseen price changes means th a t a bond is risky— its future value is uncertain. Thus, even i f a bond is risk-free in the sense th a t the borrower is certain to make the promised cash payments, it is risky in the sense th a t the bond holder (lender) can suffer unforeseen losses i f interest rates increase. When interest rates increase, bond prices fall. For the investor in bonds this is a capital loss, and therefore in this respect the increase in interest rates is undesirable. A benefit m ust be set against that loss: the interest receipts can be reinvested at the new, higher rate o f interest. The opposite occurs when interest rates fall. Investors make capital gains b ut interest receipts can be reinvested only at the new lower rate. These effects are know n as the price effect and the reinvestment effect and are always o f opposite sign fo r a given change in m arket interest rate. The price effect and the reinvestm ent effect are both sources o f interest rate risk. The net effect fo r the investor depends on the size o f the interest rate change and on the period fo r which the bond is held. Appendix 4.1 outlines a m ethod th a t an investor may use to obtain some protection against interest rate risk. A t any given tim e, the m arket-determ ined interest rate (or yield) on a bond w ill depend on the features o f that bond. Two features th a t are usually particularly im p o rta n t to m arket participants are the term o f the security and the risk o f the borrower defaulting on the promised payments. The connection between

By convention, bonds in Australia are assumed to have a face value of $100, but in practice bond face values are much higher—often in the millions o f dollars. Therefore, bond prices per $100 of face value are usually taken to more than two decimal places. We follow the Australian convention and use three decimal places.

m

LEARNING OBJECTIVE 5 Explain the nature of interest rate risk

B usiness finance

Finance in

ACTION

O N GUARD AGAINST A BOND FALL__________________________ In an article published in 2013, financial journalist Christopher Joye reminds readers of interest rate risk, which flows from the connection between interest rates and bond prices.

TERM STRUCTURE OF INTEREST RATES

relationship between interest rates and term to maturity for debt securities in the same risk class

Bond traders have been making out like bandits since the global financial crisis. A portfolio of Australian government bonds with maturities longer than 10 years has delivered annual total returns of over 12 per cent since December 20 07 . Yet the preconditions for the mother-of-all bond market reckonings are sliding into place. This contingency, which A M P ’s Shane Oliver believes is a 'significant risk’， could result in wiping more than $ 6 0 billion off Aussie bond values, with steep capital losses. To properly understand these risks, one needs to appreciate how extraordinary current circumstances are. W hen doing so, it helps to keep in mind a key principle: bonds that pay fixed, as opposed to variable, rates have prices that are inversely related to external interest rates. If you invested in a bond paying an annual fixed coupon of, say, 3 per cent, and market interest rates surge to 5 per cent, that bond would be worth substantially less than when you bought it. The converse is also true: if market rates decline ... it would be worth more. This is why Australian government bond prices have soared since 20 07 : market yields have fallen sharply as global central banks have floored policy rates close to zero and printed unprecedented amounts of money to fund public and private debt. Source: 7On guard against a bond fall', Christopher Joye, The Australian Financial Review, 5 January 2013, p. 39.

DEFAULT-RISK STRUCTURE OF INTEREST RATES

relationship between default risk and interest rates

term and interest rates is called the term stru ctu re o f in te re st rates, while the connection between default risk and interest rates is called the d efau lt-risk stru ctu re of in te re st rates. These are now considered.

4.6 LEARNING OBJECTIVE 6 Understand the theories that are used to explain the term structure of interest rates

ZERO-COUPON BONDS (zero s)

bonds that pay only one cash flow, the payment at maturity

The term structure of interest rates

4.6.1 | W h a t is the term structure? To consider the effect o f a bonds term on its interest rate, all other factors need to be held constant. Thus, to elim inate the effect o f differences in default risk, the term structure o f interest rates is usually studied by focusing on government bonds since all such bonds have the same risk o f default (assumed to be zero). The least complicated measure o f the term structure o f interest rates is the m arket yield on a government bond th a t pays no interest during its life, b ut pays a fixed sum at m aturity. Such a bond is known as a zero-coupon bond (often abbreviated just to a zero). The price o f a zero w ith a face value o f F dollars and a term o f n years is simply:

P〇= ( T ^ f where zn is the yield on the zero, often known as the zero rate fo r a term o f n. The term structure o f interest rates is the set o f zero rates zv z2, ... zn. In practice, except fo r terms o f 6 m onths or less, zerocoupon bonds are relatively rare. However, there are coupon-paying bonds and it is possible to estimate the underlying zero rates from the prices o f coupon-paying bonds. The Reserve Bank o f Australia has made such estimates fo r the Australian m arket. Four examples are shown in Figure 4.1. As shown in Figure 4.1, the shape and level o f the term structure can vary w idely over tim e. For example, i t may be steeply upward sloping, as i t was on 27 June 1994, or almost flat, as i t was on 19 July 2006, or gently downward sloping, as i t was on 27 November 2007.

G h APTER FOUR A

ure 4.1 The term structure

pplying

THE TIME VAUJE OF MONEY TO SECURITY VALUATION

Australia: various dates

12 . 00 % —

10. 00 % d

--------- 19-Jul-06

d

8 .00 %

oJ

a>

OJOZ

6 .00 %

P 0 ! D 如SE

4.00%

— 27-Jun-94

——— 27-Nov-07

一 广

......

7-Jan-09

LU

2 .00 %

0.00% 0.00

2.00

4.00

6.00

8.00

10.00

12.00

Term to maturity (years)

Source: Based on estimates available from the Reserve Bank of Australia website.

4 .6 .2 1 Using the term structure to price a bond I f we know — or have estimated— the current term structure o f zero rates, in principle it is easy to calculate the price o f any coupon-paying bond. This process is illustrated in Example 4.7. When we have the prices, we can then calculate the corresponding yields. These calculations are shown in Example 4.8.

Example 4.7 Suppose that the face value of every bond is $ 100 and the current zero rates for terms of 1 ,2 and 3 years are 7 .0 , 8.0 and 8.5 per cent per annum respectively. W hat are the prices of: a 1-year bond paying annual coupons of 5 per cent, a 2-year bond paying annual coupons of 9 per cent and a 3-year bond paying annual coupons of 7.5 per cent per annum?

SOLUTION In a year's time, the 1-year bond will make a single payment of $105, consisting of $ 1 0 0 face value and $5 of coupon interest. The required rate of return on a 1-year investment is 7.0 per cent per annum. The price of the bond is therefore D

$105

r = ------1.07 =$98.131

The 2-year bond will pay $9 after 1 year and $1 09 after 2 years. In effect, this coupon-paying bond can be decomposed into two zero-coupon bonds. The first is a 1-year zero which pays $9 and the second is a 2-year zero that pays $109. Because we know the 1-year and 2-year zero rates, we know how to price these constituent zero-coupon bonds. The price of the 2-year bond is the sum of the two constituents. D

$9

$109

1.07

(1.0812

p = ------- +

*

=$101.861

Extending the same logic to the 3-year bond, its price is P:

$ 7 .5 0

_______ $7.5 〇 + $ 1 〇7.5 〇

1.07 + (1.08)2 $97.602

(1.085)J

B usiness finance

Given the price o f a coupon-paying bond, its in te rn a l rate o f return, know n as the bonds yield, can be calculated. For fu rth e r details, see Sections 3.5.4 and 5.4.2.

Example 4.8 What are the yields on the three bonds described in Example 4.7?

SOLUTION For the 1-year bond, the yield is the value of r which solves the following equation: $98,131 = $ 1 0 5 0 0 1+r

We know from the previous example that the solution to this equation is r = 7.0 per cent per annum. For the 2-year bond, yield is the value of r which solves the following equation: $101,861

l^

+ $10900 n + r|2

This equation is solved when r is approximately 7.957 per cent per annum. For the 3-year bond, yield is the value of r which solves the following equation: $ 9 7 ,6 0 2

$ 7 .5 0

$ 7 .5 0

$ 1 0 7 .5 0

1 + r + (1 + r ) 2 +

(1 + r)3

This equation is solved when r is approximately 8.438 per cent per annum. Note that the 2-year and 3-year yields are close to, but not equal to, the corresponding zero rates.

YIELD CURVE

graph of yield to maturity against bond term at a given point in time

The pattern o f yield against term is called the yield curve. Data fo r the Australian yield curve at 10 different dates are given in Table 4.1.

TABLE 4.1 Australian yield curve data Term to maturity Date of yield curve

3 months

6 months

2 years

5 years

10 years

June 1998

4.93

4.98

5.18

5.38

5.58

June 2000

5.87

5.96

5.89

6.05

6.16

June 2002

5.21

5.32

5.44

5.78

5.99

June 2004

5.61

5.65

5.34

5.67

5.87

June 2006

6.09

6.16

5.78

5.78

5.79

June 2008

7.81

8.04

6.97

6.69

6.59

June 2009

3.25

3.30

3.90

5.10

5.56

June 2010

4.89

5.01

4.57

4.97

5.33

June 2011

4.99

5.10

4.75

4.89

5.16

June 2012

3.49

3.41

2.40

2.49

3.00

Source: Compiled from Reserve Bank of Australia data (www.rba.gov.au). See tables Interest Rates and Yields— Money Market and Capital Market Yields— Government Bonds. For 1998 and 2000 yields for 3(6) months are issue yields for 13-(26)-week Treasury notes. From 2002 to 201 2 these yields are yields for 90-(l 80)-day bank accepted bills. Yields for 2, 5 and 10 years are bond yields.

Like the closely related concept o f the term structure, yield curves can have a wide range o f shapes. For example, the yield curve in Australia was upward sloping in June 2002 and June 2009 b ut m ostly downward sloping in June 2012. Typical yield curve shapes are illustrated in Figure 4.2.

C hapter four A pplying

the time value of m o n e y to security valuation

Figure 4.2 Alternative yield curves

4 .6 .3 1 Term structure theories: expectations and liquidity (risk) premium Obviously the term structure at any given tim e is no accident. Presumably, participants in the debt markets do n ot set the interest rate for, say, a term o f 2 years7 w ith o u t in some way considering the 1-year and 3-year interest rates. In other words, the interest rate fo r a particular term w ill be determ ined by the m arket in the context o f interest rates fo r other terms. The exact id e n tity o f the factors th a t explain the term structure is controversial, w ith different theories proposing different mechanisms. There is, however, broad agreement th a t expectations o f the future course o f interest rates are central to explaining the term structure. The core o f the e x p e c ta tio n s th e o ry o f the term structure is th a t interest rates are set such that investors can expect, on average, to achieve the same retu rn over any future period, regardless o f the term o f the zero-coupon bond in which they invest. For example, suppose th a t in the current term structure the interest rate fo r a 2-year term to m a tu rity is 8 per cent per annum, while the interest rate fo r a 3-year term to m a tu rity is 9 per cent per annum. Suppose, fu rthe r, th a t $1000 is invested fo r 3 years. A fte r 3 years, the investor w ill have $1000 x (1.09)3 = $1295.03. Alternatively, suppose the same investor invests $1000 fo r 2 years. A fte r 2 years, the investor w ill have $1000 x (1.08)2 = $1166.40. I f the investor can re-lend this sum fo r the th ird year at an interest rate o f 11.028 per cent per annum, then at the end o f the th ird year the investor w ill have $1166.40 x 1.11028 = $1295.03, which is the same as the retu rn from the 3-year investm ent. This is shown in Figure 4.3.

Figure 4.3 Return from the 3-year investment 0

1

2

3 years

<<--------------------------------------------- 9% p . a . --------------------------------------------- > < --------------8% p.a. -----------------------------1.028% p .a .----------------------------->

As shown in Figure 4.3, the current term structure is 8 per cent per annum fo r a term o f 2 years and 9 per cent per annum fo r a term o f 3 years. According to expectations theory, the factor th a t explains the 7

For ease of exposition, in this section we use the term interest rate for a term of n years* to mean the yield per annum on a zero-coupon bond with a term o f n years.

EXPECTATIONS THEORY

of the term structure is that interest rates are set such that investors in bonds or other debt securities can expect, on average, to achieve the same return over any future period, regardless of the security in which they invest

B usiness finance

current term structure is the m arkets expectation th a t the 1-year interest rate on the day 2 years from now w ill be 11.028 per cent per annum. In th a t case investors w ill earn 9 per cent per annum over the coming three years, regardless o f whether they invest fo r three years, by: a b

buying the 3-year bond today; or buying the 2-year bond today and buying a 1-year bond in 2 years* time.

Therefore, the expectation o f the future interest rate determines today s term structure. This process is extended in Figure 4.4. Suppose th a t today s 1-year interest rate is 6.5 per cent per annum. Then the m arket m ust expect next years 1-year interest rate to be 9.521 per cent per annum, because (1.08)2 = 1.065 x 1.095 21 = 1.1664. The economic interpretatio n is th a t the same return is expected over the next 2 years, regardless o f whether an investor: a b

buys a 1-year bond today and buys a fu rth e r 1-year bond in 1 years tim e; or buys the 2-year bond today.

Figure 4.4 Return from the 3-year investment (extended) years - 9% p.a. 8% p.a. -6.5% p .a .-

-> < r

-11.028% p.a. 9.521% p.a.-

-11.028% p.a.

As a final illu stratio n o f the expectations mechanism, consider again the in fo rm a tio n shown in Figure 4.4 and imagine th a t there is an investor who intends to lend $1000 fo r a 2-year period. Consider the follow ing three ways in which such an investm ent could be made: a b

c

Buy the 2-year bond now and hold i t u n til i t matures. A t the end o f the 2-year period, this investm ent w ill have accumulated to $1000 x (1.08)2 = $1166.40. Buy a 1-year bond now and, after 1 year, reinvest in a fu rth e r 1-year bond, which is then held u n til m aturity. A t the end o f the 2-year period, this investm ent is expected to have accumulated to $1000 x 1.065 x 1.095 21 = $1166.40. Buy the 3-year bond now and sell i t after 2 years. A t the end o f the 2-year period, th is investm ent is expected to be w o rth $1000 x (1.09)3/1 .1 10 28 = $1166.40.

As these calculations show, the expected outcome is the same, regardless o f the investm ent strategy. The m arket has set today s term structure in such a way th a t it reflects the m arkets expectations o f the future course o f interest rates. To formalise our discussion o f expectations theory, we w ill use the notation zt t+k to mean the interest rate per annum fo r a period beginning on date t and ending on date t + k. For example, z3 4 means the interest rate fo r the year starting 3 years from now and ending 4 years from now. We make the follow ing assumptions: a b

fu tu re 1-year interest rates (zx 2, z2 3, and so on) are known w ith certainty8 there are no transaction costs.

Given these assumptions, com petition in the bond m arket w ill result in a term structure th a t ensures th a t the sum to which a dollar accumulates over n years i f invested at today s long-term interest rate z 〇n m ust equal the sum to which it accumulates over n years when invested in the sequence o f present and future 1-year interest rates z12, z2 3, . . . , zn_^ n. As a consequence, an investor who wants to invest for, say, 10 years is indifferent between investing in a 10-year bond and investing in a sequence o f 1-year bonds over the next 10 years. Hence, today s 2-year interest rate, z〇2, is determ ined from today s 1-year interest rate and the 1-year interest rate in a years time. That is,

(1 + z 〇 ,2)2 = (1 + 2〇 .i)(l +<2l ，2)

命

8

Alternatively, we could assume that investors are risk neutral. The concept of risk neutrality is explained in Section 7.3.

C hapter four A

pplying the time value of m o n e y to security valuation

Similarly, today s 3-year interest rate, z 〇3, is determ ined from today s 1-year interest rate, the 1-year interest rate in a years tim e and the 1-year interest rate in the year after that. That is, (1 + 2 〇,3)3 = (1 + z 〇，i ) ( l + 2 1?2)(1 + 之 2,3)

Generalising, fo r any given term o f t years, today s t-year interest rate z〇t is set by the m arket such that:

(1 + 20，f ) ’ = (1 + 20，1)(1 + 21，2)(1 +

Q j

) . . . (1 + 2 f- l ，f )

Rearranging this equation, today’s t-year interest rate z 〇t is given by: z〇 ,t = [(1 + 2〇a ) x (1 + z i, 2) x (1 + z 2,3) x ... x (1 + z M .f) ]1/r- l

E U I

Thus, in our earlier discussion, using Equation 4.11 gives the 2-year interest rate as: z 〇,2 = (1.065 x 1.095 21)1/2- 1 = 8% oer annum and the 3-year interest rate is: z〇,3 = (1.065 x 1.095 21 x 1.11028)1/3 - 1 = 9% per annum The essence o f expectations theory is th a t the term structure is determ ined by investors’ expectations o f short-term rates w ith in the m a tu rity o f the competing long-term security.9 Expectations theory can help to reconcile the existence o f the differing shapes o f the term structures shown in Figure 4.1 and the yield curves shown in Figure 4.2. In general, an upward-sloping term structure implies th a t investors expect future short-term interest rates to increase.10 In th a t case, investors are n ot prepared to invest in long-term securities unless the yield is greater than th a t on short-term securities, because otherwise the investors would be better o ff investing in short-term securities and reinvesting the proceeds at m aturity. In general, a downward-sloping term structure implies th a t investors expect future short-term interest rates to decrease— th a t is, investors are prepared to purchase long-term securities yielding less than short-term securities because they expect th e ir retu rn to be no larger i f they adopted an investm ent strategy requiring continual reinvestm ent in short-term securities. In short, i f expectations about the level o f future short-term rates change, then actual long-term yields on existing securities w ill tend to adjust in the same direction. A fla t term structure means th a t investors expect future short-term interest rates to be the same as the current short-term rate. Consequently, the long-term rates w ill equal the short-term rates.11 Commentators on the expectations theory o f the term structure have suggested th a t interest rates are not formed solely on the basis o f expectations. For example, the liquidity prem ium (risk prem ium ) theory suggests th a t although expectations are a foundation fo r the term structure, there is in addition a premium due to uncertainty about the future level o f interest rates. Suppose, fo r example, th a t an investor has an investm ent target o f $10000 to be achieved in 2 years* tim e — th a t is, the investm ent horizon is 2 years. The easiest and safest way to achieve this target is to invest today the present value o f $10000, where the present value is calculated using todays 2-year zero rate. Alternatively, the investor could invest the same sum today fo r 1 year at today s 1-year interest rate and, when this investm ent matures in 1 years tim e, reinvest the proceeds fo r a fu rth e r year. O f course, this reinvestm ent is made at next years 1-year interest rate, which today is n ot known. Hence, the outcome o f this alternative is risky, whereas the previous approach is risk-free.12 This fact is illustrated in Example 4.9.

LIQUIDITY PREMIUM ( r is k p r e m i u m ) THEORY

of the term structure is that although future interest rates are determined by investors' expectations, investors require some reward (liquidity premium) to bear the increased risk of investing long term INVESTMENT HORIZO N

the particular future date on which an investor intends to liquidate (sell) their investment

It is convenient to think of short-term rates as determining long-term rates, but in fact the market determines all rates simultaneously. 10 That this is not always the case may be seen from the following example. If the current term structure is: 1 year: 6 per cent;

9

2 years: 10 per cent; and 3 years: 11 per cent, then the 1-year interest rate, 1 year hence, is expected to b e :--------- 1 = 14.15%

( l. ll) 3 (I.IO)2

while the 1-year interest rate, 2 years hence, is expected to be: —------ - 1 = 13.03%.

l 〇6

11 This result holds even if there is a large difference in the number of bonds outstanding with different maturities. One of the implications of the expectations theory is that interest rates are independent of the relative supply of bonds across the range of maturities. 12 A third possibility would be to buy today a 3-year bond and sell it after 2 years, at which time it has become a 1-year bond. The price obtained at the end of 2 years will depend on the 1-year interest rate at the time of the sale. Because this interest rate is not known today, the price that will be achieved is also unknown today—that is, the investment is risky.

令

Example 4 .9 Freya wishes to have $ 1 0 0 0 0 in 2 years7 time. The current interest rate on a 2-year zero-coupon bond is 7.5 per cent per annum and Freya decides to invest in this bond. a) How much should Freya invest today? How much will she have after 2 years have passed? b) The current interest rate on a 1-year zero-coupon bond is 6.5 per cent per annum. It turns out that during the coming year interest rates fall steeply and at the end of the year the interest rate on a 1-year zero-coupon bond is only 4.2 per cent per annum. If Freya had chosen to invest the same amount in 2 sequential 1-year investments, how much would she have after 2 years have passed? c) The current interest rate on a 3-year zero-coupon bond is 8 per cent per annum. It turns out that the 1-year interest rate at the end of 2 years is 9.5 per cent per annum. If Freya had chosen to invest the same amount in a 3-year bond and then sell that bond after 2 years, how much would she have after 2 years have passed?

SOLUTION a) Freya should invest today the present value of $ 1 0 0 0 0 at today's 2-year interest rate. The amount to invest is therefore $ 1 0 0 0 0 / (1 .075)2, which equals $8653.33. • That is, Freya will today pay $8653.33 for a 2-year zero-coupon bond with a face value of $10000.

• This investment is guaranteed to produce $ 1 0 0 0 0 after 2 years because on the bond's maturity in 2 years7 time, the face value of $ 1 0 0 0 0 will be paid to Freya. b) After 1 year, Freya will have $8653.33 x 1.065, which is equal to $9215.80. Reinvesting this amount for a further year at 4.2 per cent per annum produces a final amount of $9 215.80 x 1.042, which is equal to $9602.86. Freya therefore does not achieve her target of $1 00 00. c) The face value of the 3-year zero-coupon bond must be $8653.33 x (1.08)3, which is equal to $1 09 00.7 0. At the end of the second year, the bond has become a 1-year bond and the interest rate at that time is 9.5 per cent per annum. Therefore, the price of the bond when it is sold is $1 0900.70/1.095, which equals $9954.98. Freya therefore does not achieve her target of $10000. As Example 4.9(a) illustrates, an investor who buys a zero-coupon bond w ith a term to m a tu rity that matches the investm ent horizon is guaranteed to achieve th e ir target. As Examples 4.9(b) and 4.9(c) illustrate, a different choice may lead to the target n ot being achieved. In other cases, the target could be exceeded. For example, in p a rt (c), i f the 1-year interest rate at the end o f the second year had been anything lower than 9.007 per cent Freya would have ended up w ith more than $10 000 at the end o f the th ird year.13 In other words, any choice other than investing in the m aturity-m atching bond involves risk: the target m ig ht be exceeded or i t m ight n o t be achieved. To induce an investor to depart from investing in the m aturity-m atching bond w ill require a higher interest rate— th a t is, a risk prem ium . In Freyas case, she w ould require a higher interest rate on either the 1-year or the 3-year bonds. However, proponents o f the liq u id ity (risk) prem ium theory believe that, in general, the investm ent horizons o f bond investors (lenders) are shorter than the investm ent horizons o f bond issuers (borrowers).14 Therefore, on balance, the prem ium tends to be higher, the longer the term o f the bond, causing an upward bias in the term structure. Such a bias w ill tend to cause yield curves to be upward sloping. This means th a t compared w ith the yield curves th a t would be observed i f only expectations mattered, an upward-sloping yield curve w ill become steeper, a downward-sloping yield curve w ill become less steep (or perhaps even fla t o r upward-sloping) and a fia t yield curve w ill become upward sloping.15

4 .6 .4 | Empirical evidence The empirical evidence on the theories we have discussed presents a rather complex picture. In the US, Fama (1984), McCulloch (1987) and Richardson, Richardson and Sm ith (1992) found evidence 13 Because $10 900.70/1.09007 is equal to $10 000. 14 Proponents could, for example, point to the fact that investors rarely lodge fixed deposits at a bank with a term exceeding 5 years. But banks often offer mortgage loans with terms of 20 or 30 years. 15 In June 2009 the yield curve was steeply upward sloping. This yield curve is consistent with short-term interest rates having been reduced by central banks to stimulate growth in response to the global financial crisis. Higher yields for longer term securities are consistent with expectations of increasing future short-term interest rates and an increase in the risk premium.

C hapter four A pplying

the time value of m o n e y to security valuation

supporting the existence o f a premium. But Longstaff (2000) found no evidence o f a prem ium at the very short end o f the yield curve. The evidence in Australia is also mixed. In a test at the short end o f the term structure (90-day interest rates, compared w ith 180-day interest rates), Tease (1988) found that the data quite strongly supported the expectations theory in various forms. Similarly, studies by Robinson (1998), and Young and Fowler (1990) found support fo r the expectations theory using 90-day and 10-year interest rates. However, studies by Alles (1995) and Heaney (1994), in both cases using more thorough statistical analyses, found little support fo r the expectations theory. In a study o f 14 countries, Beechey, Hjalmarsson and Osterholm (2009) found that, consistent w ith the expectations hypothesis, in 10 countries (including Australia) the m arket appeared to set short-term interest rates and long-term interest rates simultaneously. However, fo r all 10 o f these countries there appeared to be risk premiums, suggesting th a t expectations alone do n o t determine the term structure.

4 .6 .5 1 Inflation and the term structure One issue yet to be considered is the relationship between the in fla tio n rate and the term structure o f interest rates. In general, we w ould expect lenders to require the nom inal interest rate to compensate them fo r expected in fla tio n .16 Therefore, the higher the expected in fla tio n rate, the higher w ill be the observed nom inal interest rate. As a consequence, i f the in fla tio n rate is expected to increase over tim e, the nom inal interest rate on sh ort-term bonds w ill also be expected to increase over tim e. According to the expectations th eo ry we w ill therefore see an upward-sloping yield curve. In addition, unexpected changes in the in fla tio n rate are also like ly to have an im pact on the term structure. Such unexpected changes w ill cause a change in the level o f interest rates. As explained earlier, the p ossibility o f such changes gives rise to interest rate risk, and the liq u id ity prem ium th eo ry suggests th a t this in tu rn w ill give rise to the tendency fo r interest rates on long-term bonds to be higher than those on short-term bonds.

4.7

The default-risk structure of interest rates

As explained in Section 4.3.2, the presence o f uncertainty causes the o p p o rtu n ity cost o f capital to exceed the risk-free interest rate. For debt o f a given term , the higher the m arkets assessment o f the p robability o f default, the higher w ill be kdi the required rate o f return (or expected yield) on the debt. However, because debtholders rank ahead o f shareholders, it is expected th a t the required rate o f retu rn on a company s debt w ill be less than the required rate o f return on its shares. In short, fo r any given company, rf
16 See Equation 3.7 and the discussion in Section 3.4.4. 17 Standard & Poors rates issuers o f long-term debt on a 23-point scale ranging from AAA (extremely strong capacity to pay interest and repay principal) to D (the borrower is expected to fail to pay all or substantially all of its obligations as they come due). Fitch uses a 21-point scale, ranging from AAA (exceptionally strong capacity for payment of financial commitments) to D (has entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure, or which has otherwise ceased business). All three companies also rate short-term debt. Both Fitch and Standard & Poors use an 8-point scale, while Moody’s uses a 4-point scale.

LEARNING OBJECTIVE 7 Understand the effect of default risk on interest rates

|www j

Example 4 . 1 0 Bonds issued by the Red Vines Company mature in 1 year's time with a maturity value of $110. There is no cash flow during the year. Investors believe that there is a 90 per cent chance that the full payment of $ 1 10 will be made and a 10 per cent chance that no payment will be made. Calculate: a) the price of Red Vines' bonds b) the yield to maturity of the bonds.

SOLUTION a)

The expected payment at the end of the year is 0.90 x $ 1 1 0 + 0 . 1 0 x $ 0 = $99. Assuming that the market requires an expected rate of return, kd, of 10 per cent on these bonds, they will have a price of:

=$90

b)

The yield, r, is therefore found by solving: $ 9 0 = ili

〇

1+ r

Therefore, the yield to maturity is: $110 , r = ----------1 $90 =

22 . 22 %

That is, an investor who purchases the bonds for $9 0 and holds them to maturity will earn a rate of return of 22.22 per cent per annum if Red Vines does not default.

TABLE 4.2 Moody's ratings for long-term
Aa Aal

Of the highest quality; minimal credit risk Government o f Australia

New South Wales Treasury Corporation

Treasury Corporation o f Victoria

Western Australian Treasury Corporation

High quality; subject to very low credit risk Queensland Treasury Corporation

South Australian Government Financing Authority

Tasmanian Public Finance Corporation Aa2

Australia and New Zealand Banking Group Ltd

Australian Rail Track Corporation Ltd

Commonwealth Bank of Australia

Macquarie University

Rabobank Australia Ltd

National Australia Bank Ltd

University o f Newcastle (Australia)

Westpac Banking Corporation

Aa3

Toyota Finance Australia Ltd

A

Upper-premium grade; subject to low credit risk

A1

BHP Billiton Ltd

HSBC Bank Australia Ltd

SPI Electricity Pty Ltd

Suncorp-Metway Ltd

A2

AMP Group Finance Services Ltd

Bendigo and Adelaide Bank Ltd

Macquarie Bank Ltd

Telstra Corporation Ltd

Westfield Group A3

Baa Baal

Coca-Cola Am atil Ltd

Heritage Bank Ltd

Jemena Ltd

Members Equity Bank Pty Ltd

Rio Tinto Ltd

Volkswagen Financial Services Australia Ltd

Wesfarmers Ltd

Woolworths Ltd

Subject to moderate credit risk; medium grade; may possess certain speculative characteristics Bank of Queensland Ltd Brambles Ltd

C hapter four A pplying

the time value of m o n e y to security valuation

Table 4.2 continued

Baa2

Baa3

Dexus Property Group Victoria Teachers Mutual Bank Alcoa of Australia Ltd Brisbane A irport Corporation Pty Ltd Goodman Group Origin Energy Ltd Ansell Ltd Lend Lease Group Premier Finance Trust Australia

Transurban Finance Company Pty Ltd Woodside Petroleum Ltd Amcor Ltd Envestra Ltd Leighton Holdings Ltd Sydney A irport Finance Company Pty Ltd Boral Ltd Newcrest M ining Ltd Qantas Airways Ltd

Ba

Speculative elements; subject to substantial credit risk

Bal Ba2 Ba3

Aus drill Ltd Fortescue Metals Group Ltd

B

Speculative; subject to high credit risk

B1 B2 B3

Barminco Holdings Pty Ltd Atlas Iron Ltd Cristal Mining Australia Ltd

Caa

Of poor standing; subject to very high credit risk

Investec Bank (Australia) Ltd Nufarm Ltd Genesee & Wyoming Australia Pty Ltd

Caal Caa2 Caa3

Ca C

Highly speculative; in or very near default; some prospect of recovery of principal and interest Typically in default; little prospect for recovery of principal or interest

Source: www.moodys.com, accessed 9 September 2013.

4.8

O ther factors affecting interest rate structures

Yield differentials on securities may also result from differences in m arketability— th a t is, the investors ability to convert the securities in to cash w ith o u t a price penalty. O ther things being equal, an investor w ill buy a security o f low m arketability only i f the yield is greater than th a t on a security o f high m arketability. For example, a life insurance company would usually require a higher interest rate to lend mortgage funds to a company than to lend the same am ount by purchasing the company s debt securities th a t are traded in an active m arket. Similarly, it is conceivable th a t tax effects w ill give rise to differences in yields on bonds. Finally, we refer briefly to the relationship between the yield on bonds and the required rate o f retu rn on ordinary shares. In Section 4.3, we suggested th a t the required rate o f return on ordinary shares may be expressed as the rate o f discount th a t equates the present value o f the expected future dividends w ith the current m arket price o f the shares. Clearly, i f dividends are expected to grow over tim e, the required rate o f return on an investm ent in ordinary shares w ill be greater than the current dividend yield (D 〇/P 〇). Therefore, it is n ot valid to directly compare the yields on debt securities w ith the dividend yields on ordinary shares. N ot surprisingly, the evidence suggests th a t the required returns on ordinary shares exceed those on debt securities.18 This evidence is consistent w ith the idea th a t investors require a higher expected rate o f return to invest in ordinary shares than to invest in, say, debentures because ordinary shareholders are exposed to greater risk. Their risk exposure is greater because ordinary shareholders are the residual claimants on the cash flows o f the company. Therefore, th e ir returns are the firs t to be affected by a dow nturn in the company s prospects and, in the event o f the company being wound up, ordinary shareholders have the last claim on its assets. 18 For international evidence, see Dimson, Marsh and Staunton (2003) and for Australian evidence, see Brailsford, Handley and Maheswaran (2008) and Brailsford, Handley and Maheswaran (2012).

命

B usiness finance

SUMMARY • Financial assets such as bonds and shares can be valued by discounting their future cash flows to present values and summing these present values. The discount rate used is the required rate of return or opportunity cost of capital. • If the future cash flows from an asset are certain, the required rate of return will reflect only the effect of time on the value of money. • If the future cash flows are uncertain, investors will also require compensation for risk and the rate will be increased by the inclusion of a risk premium. • The value of an ordinary share is the present value of a dividend stream that can, in principle, continue forever. The calculation of a share’s value can be simplified by assuming that dividends are constant or grow at a constant rate over time. Shares can also be valued using the company’s current earnings

and a price-earnings ratio. The value of this ratio depends mainly on risk and expected growth in namings. • Debt securities (bonds) are priced by discounting their future coupon interest payments and face value. For any company, the interest rate required by lenders will be less than the required rate of return on the company’s ordinary shares. The price of a debt security is inversely related to the interest rate required by investors. • Interest rates at any given time will usually be different for different terms to maturity. This pattern is known as the term structure of interest rates. Expectations of future interest rates, together with a risk premium have been suggested as explanations of the shape of the term structure. • The interest rate or yield on debt also depends on the probability that the borrower will default.

KEY TERMS bonds (or debentures) 80 coupons 80 default-risk structure of interest rates dividends 76 duration 98 expectations theory 85

82

immunisation 97 investment horizon 87 liquidity premium (risk premium) theory term structure of interest rates 82 yield curve 84 zero-coupon bonds 82

87

SELF-TEST PROBLEMS 1 Richards Ltd pays annual dividends on its ordinary shares. The latest dividend was 75 cents per share and was paid yesterday. Dividends are expected to grow at 8 per cent per annum for the next 2 years, after which a growth rate of 4 per cent per annum will be maintained indefinitely. Estimate the value of one share if the required rate of return is 14 per cent per annum. 2 A government bond with a face value of $ 1 00 and a coupon interest rate of 1 1 per cent per annum matures in 3 years7 time. Interest payments occur twice each year and a payment has just been made. If the current market yield on the bond is 13 per cent per annum, what is the current price of the bond? 3 The current interest rates (yields) on zero-coupon government bonds are as follows: Interest rate [% 13.90 11.70 10.50

Assume that the term structure can be explained purely by expectations of future interest rates, and therefore there is no liquidity (or risk) premium. Calculate the expected 1-year rates for the next 2 years. Solutions to self-test problems are available in Appendix B.

92

C hapter

four

A pplying

the time value of m o n e y to security valuation

1

[LO 1] Assuming certainty, the rates o f return on a ll financial assets w ill be identical. Outline why this statement is correct and indicate the factors on which this market rate of return depends.

2

[LO 2] The valuation o f a share using the dividend growth model is very sensitive to the forecast o f the dividend growth rate. This feature is a serious limitation on its usefulness to a share analyst. Discuss.

3

[LO 3] A company's share price reflects the discounted value o f either its future dividends or its future earnings. Discuss.

4

[LO 4] W h y are bond prices and yields inversely related? Doesn't a higher yield make a bond more attractive to investors and hence make it worth more, not less?

5

[LO 5] Government bonds are not riskless. Do you agree with this statement? W h y?

6

[LO 6] Differences between the current yields on different bonds con be explained by their relative riskiness

7

[LO 6] What is the term structure of interest rates? Discuss the various theories that try to explain the term structure of interest rates.

8

[LO 6 】Given an upward-sloping term structure, it is preferable for a company to raise debt by issuing shortterm debt securities. Discuss.

9

[LO 6 】 If the term structure is downward sloping, does this mean that liquidity preferences are not having any influence on interest rates?

10

[L0 7] How can both the Government of Australia and the Treasury Corporation of Victoria have a credit rating of A a a? Wouldn't the Treasury Corporation of Victoria have a higher credit risk than the Australian government?

11

[LO 8] What is 'immunisation7? (See Appendix 4.1, Introduction.) How may duration matching help? What are the problems of duration matching?

and different terms to maturity. Discuss.

cA

PROBLEMS

1

Valuation under certainty [LO 1] A promise to pay $ 1 0 0 0 0 in 4 years' time is certain to be kept. If the risk-free rate for a 4-year term is 5 .5 per cent per annum, what is the value of this promise today? Do we know what the value will be in a year's time? W hy or why not?

2

Valuation of shares [LO 2] Assume that today is the last day of 2014. Rednip Ltd is expected to pay annual dividends of 64 cents in 2015 (Year 1). Assume that this dividend is expected to grow at an annual rate of 10 per cent and investors require a rate of return of 20 per cent per annum. a) Estimate Rednip Ltd's share price today. b) What is Rednip Ltd's share price expected to be at the end of 2 0 1 5 ?

3

Valuation of shares [LO 2] The required rate of return on the shares in the companies identified in (a) to (c) below is 15 per cent per annum. Calculate the current share price in each case. a) The current earnings per share of Zero Ltd are $1.50. The company does not reinvest any of its earnings, which are expected to remain constant. b) Speedy Ltd's current dividend per share is 80 cents. This dividend is expected to grow at 5 per cent per annum. c) Reduction Ltd's current dividend per share is 60 cents. The dividend of the company has been grow­ ing at 12 per cent per annum in recent years, a rate expected to be maintained for a further 3 years. It is envisaged that the growth rate will then decline to 5 per cent per annum and remain at that level indefinitely.

CHAPTER F O U R REVIEW

QUESTIONS

4

Required rate of return on a bond [LO 4] A 10 per cent $ 1 00 government bond that pays interest annually, and currently is 5 years from maturity, is selling for $103.29. What is the required rate of return (yield) on this bond? What is the implied real interest rate if the expected inflation rate is 5 per cent per annum?

5

Valuation of bonds [LO 4] A 12 per cent $ 1 00 government bond pays coupon interest twice yearly and matures in 5 years7 time. The current market yield on the bond is 10 per cent per annum. If a coupon payment has just been made, what is the current price of the bond?

6

Bond prices and interest rate changes [LO 5] Consider two 1 2 per cent $100 government bonds that differ only in that one matures in 2 years7 time and the other in 5 years7 time. Both bonds are currently selling for $1 00 and pay coupon interest annually. a) What will be the price of each bond, given an immediate fall in the required yield to 10 per cent per annum? b) What will be the price of each bond, given an immediate increase in the required yield to 14 per cent per annum? c) Explain the relative price movements in response to interest rate changes as evidenced by parts (a) and (b).

7

Bond prices and interest rate changes [LO 5] Welshpool Investments Ltd has a portfolio of 5 bonds (A, B, C, D and E). Their terms to maturity are 2, 3, 5, 10 and 25 years respectively. Each of the bonds has a coupon interest rate of 8 per cent per annum and a yield of 6 per cent per annum and each has just made a coupon payment. All 5 bonds pay annual coupons. a) Calculate the price of each bond. b) Re-calculate the price of each bond if the required yield on each bond increases to 7 per cent per annum. c) Comparing your answers to (a) and (b), what patterns are evident? Explain.

8

Using the term structure to price a bond [LO 6] The government currently has on issue zero-coupon bonds with terms of 1, 2 and 3 years. Their yields are, respectively, 6, 9 and 10 per cent per annum. The government proposes to issue a 3-year bond paying annual coupons and wishes to issue the bond at a price close to its face value of $100. To two decimal places, what coupon interest rate should the government choose?

9

Expectations theory of the term structure [LO 6] The current risk-free zero-coupon interest rates are as follows:

1

6.00

2

6.50

3

6.90

4

7.20

5

7.40

a) Assume that the term structure can be explained purely by expectations of future interest rates, and there­ fore there is no liquidity or risk premium. Calculate the expected 1-year interest rates for the next 4 years. b) Explain why it is not possible in this market for the 6-year zero-coupon interest rate to be 6 per cent per annum. 10

Liquidity premium theory of the term structure [LO 6 】 The current zero-coupon interest rates for terms of 4 and 5 years are 8.4 and 8.5 per cent per annum respectively. Jane Chan wishes to invest today and has an investment horizon of 4 years. Specifically, her target is to have $ 1 0 0 0 0 0 in 4 years' time. She is considering two investment strategies: (i) buying the 4-year bond and (ii) investing the amount calculated for the first strategy but instead buying the 5-year bond and selling the bond after 4 years have passed.

CHAPTER FOUR APPLYING THE TIME VALUE 〇F MONEY TO SECURITY VALUATION

b) Suppose Jane decides to implement strategy (ii). What 1-year interest rate on the horizon date will see Jane exceed her target? c) How would proponents of the expectations hypothesis interpret this result? How would proponents of the liquidity premium hypothesis interpret this result? 11

Pricing with default risk [LO 7]

Waverton Foundry Ltd has just issued a 1-year zero-coupon bond with a face value of $ 1 0 0 0 0 0 0 0 . It is known that there is a 3 per cent chance that the company will default on this payment and that, if it does, investors in the bond will receive nothing. The market requires an expected rate of return of 8.6 per cent per annum. a) How much is the bond issue worth today? What is the implied promised yield? b) Suppose instead that, in the event of default, there is a 2 per cent chance that investors would receive $ 7 0 0 0 0 0 0 and a 1 per cent chance that they would receive nothing. How much is the bond issue worth today? What is the implied promised yield? Compare this with your answer to (a) and comment. 12

Duration and interest rate elasticity [LO 8]

Consider the following four bonds: Bond

Term to maturity (years)

Coupon rate [% p.a.)

A

2

10

B

3

12

C

3

10

D

3

8

芝 C H A P T EF R oan HEVIE

a) How much will Jane need to invest today if she implements strategy (i)?

Each bond has a face value of $100 and the current yield is 9 per cent per annum. All bonds pay annual coupons. a) Calculate the current price of each bond. b) Calculate the duration of each bond. (See Appendix 4.1.) c) Calculate what the price of each bond would be if the market interest rate increased to 11 per cent per annum. d) What would be the percentage capital loss on each bond? 13

Duration and immunisation [LO 8]

An investor is considering the purchase of a 10-year bond that pays a single annual interest payment at the rate of 10 per cent. The bond's face value is $1 00 0 and its current price is $1 134.19. Determine whether the investor can ensure a particular rate of return over a 7-year time horizon. (See Appendix 4.1 14

Duration and immunisation [LO 8]

If you wish to 'lock in’ the current yield of 8.5 per cent per annum for 3 years, which of the following bonds should you invest in? Coupon rate (% p.a.) 1

Bond

Term to maturity (years)

A

2.0

10

B

3.0

10

C

3.5

10

D

4.0

10

E

4.0

18

Each bond has a face value of $100. Assume that coupon payments are made at the end of each year.

95

B usiness finance

REFERENCES Alles, L, 'Time varying risk premium and the predictive power of the Australian term structure of interest rates ’， /Accounf/ng one/ F/'nance, November 1995, pp. 7 7 —96. Beechey, M w Hjalmarsson, E. & Osterholm, P., Testing the expectations hypothesis when interest rates are near integrated', Journal of Banking and Finance, M ay 2009, pp. 9 3 4 -4 3 . Bodie, Z., Kane, A. & Marcus, A.J., Investments, 9th edn; M cG raw-H ill, N ew York, 20 1 1 . Brailsford, Tw Heaney, R. & Bilson, C., Investments, 4th edn, Cengage, M elbourne, 20 11 . Brailsford, T., Handley, J.C. & Maheswaran, K., 'Re-examination of the historical equity risk premium in Australia7, Accounting and Finance, M arch 20 08 , pp. 7 3 -9 7 .

96

Fama, E.F., 'Term premiums in bond returns', Journal of Financial Economics, December 1984, pp. 5 2 9 -4 6 . Heaney, R., 'Predictive power of the term structure in Australia in the late 1980s: a note', Accounting and Finance, M a y 1994, pp. 3 7 -4 6 . Longstaff, F.A., The term structure of very short-term rates: new evidence for the expectations hypothesis', Journal of Financial Economics, December 20 00 , pp. 3 9 7 -4 1 5 . Macaulay, Fw Some Theoretical Problems Suggested by the

Movements of Interest Rates, Bond Yields and Stock Prices in the US Since 1856, N ational Bureau o f Economic Research, N ew York, 1938. McCulloch, J., 'The monotonicity o f the term structure: a closer look', Journal of Financial Economics, M arch 1987, pp. 1 8 5 -9 2 .

Brailsford, T.; Handley, J.C. & Maheswaran, K., 'The historical equity risk premium in Australia: post-GFC and 128 years o f da ta', Accounting and Finance, M arch 20 12 , pp. 2 3 7 -4 7 .

Richardson, M ., Richardson, P. & Smith, T., 'The monotonicity of the term structure: another look', Journal of Financial Economics, M arch 1992, pp. 9 7 -1 0 5 .

Cox, J.C., Ingersoll, J.E. & Ross, S.A., 'Duration and the measurement o f basis risk', Journal of Business, January 1979, pp. 5 1 -6 1 .

Robinson, E.S., 'The term structure of Australian interest rates: tests of the expectations hypothesis', Applied Economics Letters, July 1998, pp. 4 6 3 -6 7 .

Dimson, E., Marsh, P.R. & Staunton, M ., 'G loba l evidence on the equity risk premium', Journal of Applied Corporate Finance, Fall 2 0 0 3 , pp. 2 7 -3 8 .

Tease, W.J., The expectations theory of the term structure of interest rates in Australia7, The Economic Record, June 1988, pp. 1 2 0 -7 .

Elton, EJ. & Gruber, M J ., Modern Portfolio Theory and Investment Analysis, 5th edn, John W ile y and Sons, N ew York, 1995.

Young, I. & Fowler, D., 'Some evidence on the term structure of interest rates: how to find a black cat when it's not there', Accounf/’ng one/ F/nance, M a y 1990, pp. 2 1 -6 .

A ppendix 4 .1

A p p e n d ix

命

D uration

a n d im m u n isatio n

Duration and immunisation

Introduction In S ection 4.5 it w as sh ow n that h old ers o f b o n d s are su bject to in terest rate risk. A change in th e level o f interest rates affects b o th the m arket price o f an existing b o n d an d th e in terest rate at w hich in terest receipts can be reinvested. For exam ple, an increase in in terest rates m eans an im m ed ia te capital loss to holders o f b o n d s becau se th e price o f th eir secu rities w ill fall. H ow ever, th ere is th en th e o p p o r tu n ity to reinvest in terest receipts at th e h igh er in terest rate. The reverse applies i f in terest rates fall. The possib ility o f ch a n g in g in terest rates p resen ts difficulties fo r in vestors. Su ppose, fo r exam ple, that an in vestor w ishes to h ave a target su m o f m o n e y in 3 years* tim e. The challenge is to c h o o s e a b o n d

LEARNING OBJECTIVE 8 Apply the concept of duration to immunise a bond investment

in vestm en t that w ill achieve th is target, regardless o f in terest rate changes du ring the 3 years. A strategy to achieve such an ob jectiv e is called

im m unisation.

If p ossib le, the in vestor sh ou ld bu y a 3-year b o n d

that m akes n o in terest p a ym en ts (k n ow n as c o u p o n s) du ring its life. Such secu rities are usually called z e r o -co u p o n b o n d s .19 The in v e s to r k n ow s w ith certain ty the price o f the b o n d at th e en d o f th e 3 years because th e b o n d w ill th en b e w o rth exactly its face value, as it m atu res at th at tim e. Since there are n o cou p on in terest paym en ts, th e in vestor also has n o d ou b ts arising fr o m u n certain ty a b ou t the in terest rate that w ill b e earn ed o n rein vested cou p on s. Th erefore, the in vestor k n ow s p recisely w hat th e in vestm en t

IM M U N IS A TIO N

strategy designed to achieve a target sum of money at a future point in time, regardless of interest rate changes

w ill b e w orth at the en d o f th e 3 years, an d thus ach ievem en t o f the target is guaranteed. The p rob lem is that alth ough z e r o -c o u p o n b o n d s exist, c o u p o n b o n d s are m u ch m ore co m m o n . Im m u n isation u sing cou p on -p a y in g b o n d s is m ore difficu lt to achieve. A tech n iqu e certain to im m u n ise an in v estm en t in c ou p on -p a y in g b o n d s against all p ossib le changes in in terest rates has n ever b e e n achieved. H ow ever, there is a tech n iq u e th at w ill im m u n ise a b o n d in vestm ent in a relatively sim ple en v iro n m e n t in w hich the yield curve is fiat, b u t m a y m ake a single parallel sh ift up o r d o w n .20 This tech n iq u e is b a sed o n th e co n c e p t o f b o n d d u ra tion an d its origin s can be traced to research u n derta k en b y M acaulay (1 9 3 8 ).

Bond duration M acaulay realised th at a b o n d payin g a lo w c o u p o n rate is in a sen se a lon ger* in v estm en t th an a h igh er c o u p o n b o n d w ith the sam e term to m aturity. For exam ple, con sid er tw o 5-y ear b o n d s , b o th o f w h ich have a face value o f $ 1 0 0 0 , pay in terest annually an d are cu rren tly p riced to yield 10 p er cen t p er annum . They differ, h ow ever, in that o n e has a c o u p o n rate o f 5 p e r cen t per an n u m and the o th e r a c o u p o n rate o f 15 p er cen t p er annum . The cash flow s and th eir p resen t values are sh ow n in Table A 4.1.

Table A 4 .1 5% coupon cash flow

Present value

15% coupon cash flow

Present value

($)

t$)

($)

($)

1

50

45.45

150

136.36

2

50

41.32

150

123.97

3

50

37.57

150

112.70

50

34.15

150

102.45

5

50

31.05

150

93.14

5

1000

620.92

1000

620.92

Year

4

Total

8 1 0 .4 6

1189.54

19 With zero-coupon bonds, an investor receives no regular interest payments during the bonds life. A zero-coupon bond is purchased at a discount from its face value and it is either held to maturity, when the investor receives the face value, or sold before maturity at a price determined in the market. 20 For a discussion of techniques appropriate to several, more complex, environments, see Elton and Gruber (1995).

令

T h erefore, th e price o f the 5 per cen t c o u p o n b o n d is $ 8 1 0 .4 6 and th e price o f th e 15 p er cen t cou p on b o n d is $ 1 1 8 9 .5 4 . For th e lo w -c o u p o n b o n d , th e face value p a ym en t ($ 1 0 0 0 ) represents a b ou t 77 per cent o f its p rice (becau se $ 6 2 0 .9 2 /$ 8 1 0 .4 6 = 0 .7 7 ). For the h ig h -c o u p o n b o n d , th e face value represents on ly a b o u t 52 p er cen t o f its p rice ($ 6 2 0 .9 2 / $ l 1 8 9 .5 4 ~ 0 .5 2 ). Conversely, the first in terest paym en t con trib u tes on ly a b ou t 5.6 p er cen t to the value o f th e lo w -c o u p o n b o n d ($ 4 5 .4 5 /$ 8 1 0 .4 6 = 0 .0 5 6 ) bu t c on trib u tes nearly 11 .5 p er cen t to the value o f th e h ig h -c o u p o n b o n d ($ 1 3 6 .3 6 /$ 1 1 8 9 .5 4 = 0 .1 1 5 ). It is clear th a t the lo w -c o u p o n b o n d brin gs returns to th e in vestor later in its life, relative to the h ig h -co u p o n b on d . In this sense, the lo w -c o u p o n b o n d is longer*. DURATION

M acaulay p r o p o s e d that this tim in g feature cou ld be in co rp o ra te d in to a d u r a t io n m easure by

measure of the time period of an investment in a bond or debenture that incorporates cash flows that are made prior to maturity

w eigh tin g th e n u m ber o f p eriod s that w ill elapse b e fo r e a cash flo w is received b y th e fraction o f the b o n d s p rice th at the p resen t value o f th at cash flo w represents. In this w ay th e tim e p e r io d is w eigh ted by th e ‘relative im p o rta n ce ’ o f the cash flo w that w ill occu r at th at tim e. Table A 4 .2 sh ow s th e calculation o f d u ra tion fo r the tw o b o n d s discu ssed above.

T able A 4 . 2

鲁

~ 'f

Time

5% coupon weight

Weight x time

15% coupon weight

Weight x time

1

4 5 .4 5 /8 1 0 .4 6 = 0 .0 5 6 0 8

0.056 08

1 3 6 .3 6 /1 1 8 9 .5 4 = 0 .1 1 4 6 3

0.1 14 63

2

4 1 .3 2 /8 1 0 .4 6 = 0 .0 5 0 9 8

0.101 96

1 2 3 .9 7 /1 1 8 9 .5 4 = 0 .1 0 4 2 2

0.208 44

3

3 7 .5 7 /8 1 0 .4 6 = 0 .0 4 6 3 6

0.139 08

1 1 2 .7 0 /1 1 8 9 .5 4 = 0 .0 9 4 7 4

0.2 84 22

4

3 4 .1 5 /8 1 0 .4 6 = 0 .0 4 2 1 4

0.168 56

1 0 2 .4 5 /1 1 8 9 .5 4 = 0 .0 8 6 1 3

0.344 52

5

3 1 .0 5 /8 1 0 .4 6 = 0 .0 3 8 3 1

0.191 55

9 3 .1 4 /1 1 8 9 .5 4 = 0 .0 7 8 3 0

0.391 50

5

6 2 0 .9 2 /8 1 0 .4 6 = 0 .7 6 6 1 3

3.830 65

6 2 0 .9 2 /1 1 8 9 .5 4 = 0 .5 2 1 9 8

2.609 90

T otal = d u ra tion

4 .4 8 7 88

3.9 5 3 21

As su ggested earlier, the du ration o f the lo w -c o u p o n b o n d (4 .4 8 8 years) is lon g er th an the du ration o f th e h ig h -c o u p o n b o n d (3 .9 5 3 years). D u ration an d term to m a tu rity are equal on ly fo r a z e r o -co u p o n b on d . The du ration o f a co u p o n -p a y in g b o n d is always less th an its term to m aturity. The steps u sed to calculate d u ra tion

D are

su m m arised in th e form u la:

rm 〇) if

D = f

A4.1

台 卜 。J w here

Ct = cash flo w (c o u p o n in terest o r p rin cip al) at tim e

PV(Ct) = p resen t value

t

o f Ct

Q

~ (i + 0 f N ow

P

〇

= price o f the b o n d

_ y -

Q

,

" t t (i + 0 f w here

Pn (1 +

Ct = c o u p o n in terest at tim e t Pn = face value pa ym en t at m atu rity z = required yield p er p e rio d

n = n u m ber

o f p eriod s to m atu rity

E qu ation A 4 .1 can be rew ritten in its m ore usual form :

y ' Ct x t D：

f t i (1 + 〇r f Q r t i (1 + iY

A4.2

A ppendix 4 .1

D uration

Example A4.2 includes a duration calculation th a t follows Equation A4.2. First, however, we provide a b rie f mathematical analysis to h ig hligh t the importance o f the duration measure. Readers who are n ot interested in this analysis can o m it this section.

Duration and interest elasticity As explained in Section 4.4, i f interest rates increase (decrease), then bond prices decrease (increase). When there is a change in interest rates, all bond prices respond in the opposite direction, b u t they do not all respond to the same extent. In other words, different bonds have different interest elasticities. It is im p orta nt fo r a bond investor to know the interest elasticity o f the bond because this w ill be a good indicator o f the interest rate risk being borne. The n otio n o f elasticity is prom inent in economics. Perhaps the best known example is the price elasticity o f demand fo r a particular good. This is expressed as follows:

QdP where

rj = price elasticity o f demand P = price o f the good Q = q uantity o f the good demanded ^

= derivative o f q ua ntity demanded w ith respect to price

Price elasticity indicates the response o f the q ua ntity demanded to a change in price. W hat m atters fo r a bond investor is the interest elasticity o f the bond price; in other words, what matters is the response o f the bond price to a change in the interest rate. The elasticity E is given by: i dP〇

E:

A4.3

P〇 d i The form ula fo r bond price is: Ci

P〇

Pn

Cn

C2

(1 +

(i + v

i) n

(1 + /广

and therefore: Q

2C2

(1 + 0 2

(1 + i f

dP〇 di

~

(-1

'

f

2 〇2

nCn

(1 + 〇2

(1 + i) n

C\

\\-\- i ) \ l + i

nPn

nCn

(l + i) ^ 1 (l + O^ .

1 nPn

( l + i) n

Substituting in to Equation A4.3:

E

^ i \ f

l

\ f

C{

2C2

nCn

nPn

(1 + i y

(1 -f i) n

(1 + i) n

：

P〇 I \ l + i )

D

.1 + /

\ l + i

A4.4

where duration, D, is as defined in Equation A4.2. Equation A4.4 shows th a t the interest elasticity o f a bonds price is proportional to its duration. The longer the duration, the greater (in the sense o f being more negative) is the interest elasticity. For example, i f the interest rate is 10 per cent per annum and the duration is 4.5 years, the interest elasticity is: 3.10

( 1r 10 ,

.

：-0.409

(4.5) ,

a n d im m unisation

I f the duration is 9 years, the interest elasticity is: /0.10、

E

V I . 10,

⑼

- 0 .8 1 8

Duration and bond price changes Given th a t duration is related to interest elasticity, it follows th a t i t is possible to use duration to work out the approximate percentage price change th a t w ill occur fo r a given change in interest rate. Using Equations A4.3 and A4.4: i dP〇 = _ f P〇 d i

~

D

VI

I t follows that: dP〇 _

f

\

P〇" ~ ~ V l T /

Ddi

Therefore, fo r 'small* discrete changes in interest rates and bond prices we have the follow ing approxim ation: AP〇

(it

DAi

A4.5

An application o f Equation A4.5 is shown in Example A4.1.

Example A 4 .1 Consider the 5-year 15 per cent coupon bond priced to yield 10 per cent per annum. As shown in Tables A4.1 and A4.2, the price of this bond is $1 189.54 (per $1 0 0 0 face value) and its duration is 3.953 years. What is the percentage price change if the interest rate falls to 9.5 per cent per annum?

SOLUTION In this case the interest rate change is -0.5 per cent = -0.005. Equation A4.5 gives the approximate answer as: 1 V I . 10 0.01797

(3.953)(-0.005)

In other words, the result will be a capital gain of approximately 1.797 per cent. (The exact answer is close to 1.819 per cent.)

Duration and immunisation Suppose th a t the yield curve is flat, b ut i t may make a parallel s h ift up or down. If, at the tim e o f a parallel sh ift, an investor is holding a bond whose duration matches the rem aining investm ent period, the investm ent is im m unised against the s h ift— th a t is, the investm ent w ill achieve at least the target yield, notw ithstanding the yield shift. This can be seen in Example A4.2. Managing risk by matching Macaulay s duration to the investm ent horizon is an im p o rta n t idea but the procedure we have described has a num ber o f lim ita tion s. In particular, it is im p o rta n t to investigate w hat happens i f there is more than one yield s h ift during the investm ent period. Consider again Example A4.2 and suppose th a t the yield had shifted down to 8 per cent imm ediately after date 0.0, but then shifted up to 12 per cent just before date 3.0 (the end o f the investm ent period). In th a t case, the investor w ill hold 1.229 37 bonds after 3 years have passed, b ut the price w ill be only $1022.578 per bond, which gives a value o f 1.229 37 x $1022.578 = $1257.127. This falls short o f the target o f having at least $1275.312.

A ppendix 4 .1

D uration

Example A4.2 Suppose that there is a flat yield curve at an interest rate of 10 per cent per annum. An investor wishes to lock in7 this yield for a 3-year investment period. Bond A has a term of 3.4 years, a face value of $1000, a coupon rate of 7 per cent and pays interest annually. Table A4.3 shows the calculation of Bond A 7s duration using Equation A4.2. n

$2877.402

Duration = —---------------

$958,161

=3.003 years

Table A4.3 Bond A Time (years)

Cash flow ($)

Present value of cash flow ($)

Time

x present value ($)

0.4

70

67.382

26.953

1.4

70

61.256

85.758

2.4

70

55.687

133.649

3.4

1070

773.836

2631.042

958.161

2877.402

Total

According to the immunisation strategy, Bond A should provide an immunised investment because its duration matches the investment period— that is, an investment of $958,161 in Bond A will be worth at least $958,161 x ( l. l) 3 = $127 5.31 2 in 3 years7 time, regardless of an interest rate shift. To demonstrate this, it is assumed that: a) immediately after buying Bond A, the yield curve makes a parallel shift from 10 per cent to 8 per cent, and remains at that level for the next 3 years b) as each coupon interest payment is received, the investor reinvests in— that is, buys more of— the same bond c) bonds and dollars are infinitely divisible, thereby allowing the investor to purchase or sell any fraction of Bond A. After 0.4 years have passed, the investor receives a coupon payment of $70. The bond is now a 3-year bond. The yield curve has shifted down to 8 per cent, so the price of one bond is then: $70

$70

$1070

hOS + (1.08)2 + (1.08)3 =$974,229

Therefore, the investor can purchase the fraction 70.00 /97 4.2 29 of one bond. This fraction is 0.071 852, so the investor now holds 1.071 852 bonds. After 1.4 years, the investor receives a further coupon payment of $70 per bond; therefore the cash received is $70 x 1.071 852 = $75.0296. The bond is now a 2-year bond and its price is: $70

$1070

L08 + (1.08)2 =$982,167

The investor can now purchase a further 75 .02 9 6 / 9 8 2 .1 6 7 = 0 .0 7 6 3 9 of a bond. This type of cycle is repeated after 2.4 years and the investment in bonds is then sold after 3 years. Table A4.4 summarises the progress of the investment. continued

a n d im m unisation

continued

Table A4.4 Date = investment period expired (years) Item 0.0

0.4

M

2.4

3.0

3.40000

3.00000

2.00000

1.00000

0.40000

70.00000

75.02960

80.37700

958.16100

974.22900

982.16700

990.74100

Bonds purchased (no.)

1.00000

0.07185

0.07639

0.08113

N il

No. of bonds held

1.00000

1.07185

1.14824

1.229 37

1.22937

958.16100

1044.22700

1127.76400

1217.98700

1275.54900

Bond term remaining (years) Coupon interest received ($) Price o f one bond ($)(fl)

Value o f bonds held ($)

N il

Nil 1037.56300

(°) Present value of remaining cash flows per $ 1000 face value. Yield used is 10 per cent per annum for the price at date zero. Yield used is 8 per cent per annum for prices calculated after date zero.

As can be seen in the bottom right-hand corner of the table, the sum received from the sale after 3 years is $1275.549. This amount exceeds the target sum after 3 years of $ 1 27 5.31 2 and the investment has therefore achieved the target rate of return of at least 10 per cent per annum. What if the interest rate had risen to 12 per cent (instead of falling to 8 per cent)? In that case, the progress of the investment would be as shown in Table A4.5.

Table A4.5 Date = investment period expired (years) Item 0.0 Bond term remaining (years) Coupon interest received ($)

3.40000 Nil

0.4 3.00000

1.4 2.000 00

2.4 1.00000

3.0 0.40000

70.00000

75.56880

81.34680

958.16100

879.90800

915.49700

955.35700

Bonds purchased (no.)

1.00000

0.07955

0.08255

0.08515

No. of bonds held

1.00000

1.07955

1.16210

1.24725

1.24725

958.16100

949.905 00

1063.89700

1191.56500

1275.40600

Price o f one bond ($)(a)

Value o f bonds held ($)

N il 1022.57800 N il

Present value of remaining cash flows per $ 1000 face value. Yield used is 10 per cent per annum for the price at date zero. Yield used is 12 per cent per annum for prices calculated after date zero.

Again, therefore, the investment has achieved the target yield of 10 per cent per annum, notwithstanding the shift in yield after the investment was made.

In principle, this problem can be solved easily. W hen the yield changes, so too does the duration o f the bond held. W hen the yield shifts on the firs t occasion, the investor should change the bond holding so that, once again, duration matches the investm ent period. The investor is then imm unised against the next yield shift. This is simple in principle b ut in practice there are difficulties because it implies that a rebalancing o f the investm ent— buying and selling bonds— is needed every tim e the duration o f the investm ent changes. Because duration is a function o f the current yield and future coupon payments, this means th a t a bond transaction is needed every tim e the yield shifts, and every tim e a coupon payment is received. This can be costly and cumbersome. Only a fla t yield curve subject to parallel shifts has been considered. It may be shown th a t i f a sloped yield curve shifts in parallel fashion the investor s till matches duration and investm ent period, b ut the duration form ula is slightly more complex. I f a sloped yield curve shifts in some non-parallel way then the im m unisation strategy w ill depend on the type o f non-parallel s h ift assumed to occur. For an example, see the article by Cox, Ingersoll and Ross (1979).

▼ CHAPTER CONTENTS ED

Introduction

104

m

The discounted cash flow methods compared

108

m

The capital-expenditure process

104

EB

Other methods of project evaluation

118

BH

Methods of project evaluation

104

Project evaluation and real options analysis

123

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain the importance of each of the steps in the capital-expenditure process

2

outline the decision rules for each of the main methods of project evaluation

3

explain the advantages and disadvantages of the main project evaluation methods

4 explain why the net present value method is preferred to all other methods 5

understand the relationship between economic value added (EVA) and net present value (NPV)

6

understand the relationship between real options, managerial flexibility and firm value.

B usiness finance

Introduction In Chapter 1 we described the p rim ary financial functions o f a financial manager as raising funds and allocating them to investm ent projects so as to maximise shareholders’ wealth. In this chapter, we consider how such projects should be selected to ensure the m axim isation o f shareholders’ wealth. The term investment project is interpreted very broadly to include any proposal to outlay cash in the expectation th a t future cash inflow s w ill result. There is, therefore, a wide range o f such projects. These include proposals fo r the replacement o f plant and equipment, a new advertising campaign, research and development activities, and proposals to take over competing firm s. In th is book, investm ent and financing decisions are discussed in the order in which they are usually considered in practice. In general, management w ill firs t examine the alternative investm ent projects available to it. A fte r the acceptability o f these projects has been determined, management w ill, i f necessary, set about raising the funds to im plem ent them. It is logical, therefore, to discuss the evaluation and selection o f proposed investm ent projects before discussing the methods o f financing them. In this chapter, we examine the principles and methods o f project evaluation. In Chapter 6, the application o f these principles and methods is discussed. The evaluation and selection o f investm ent projects is only one element o f the capital-expenditure process. Before discussing the methods o f project evaluation, therefore, we outline the capital-expenditure process.

5.2 LEARNING OBJECTIVE 1 Explain the importance of each of the steps in the capital-expenditure process

* LEARNING OBJECTIVE 2 Outline the decision rules for each of the main methods of project evaluation

^0^

The capital-expenditure process

Capital-expenditure management involves the planning and control o f expenditures incurred in the expectation o f deriving future economic benefits in the fo rm o f cash inflows. Consider the follow ing possible proposals: a m anufacturer is considering b uilding a new plant; an airline is considering the replacement o f several o f its aircraft; a pharmaceutical company is considering a new research and development program. Each proposal involves m aking current outlays in the expectation o f future cash inflows and, therefore, each can be analysed as a capital-expenditure proposal. This is the case even though, fo r example, the costs o f research and development are usually recognised fo r accounting purposes as expenses in the period in which they are incurred. Capital expenditures are very im p o rta n t fo r a company because freq ue n tly the am ounts o f m oney involved are large and th e ir effects extend w ell in to the fu tu re . A fte r capital expenditures have been made, i t is lik e ly th a t th e ir effects w ill continue fo r some tim e as m any projects are n o t easily m odified. I f there is e ithe r no second-hand m arket or, at best, o nly a
5.3

Methods of project evaluation

In th is section we consider the evaluation and selection o f investm ent projects. F irst, we consider the net present value and the in te rn a l rate o f re tu rn m ethods, w hich were explained in a one-period se ttin g in Chapters 2 and 3. We then consider o the r m ethods th a t have been employed in project evaluation.

C hapter five Project

evaluation : principles a n d methods

TABLE 5.1 Tasks and outcomes of the capital expenditure process | Tasks

Outcomes

Stage 1 Generation of investment proposals

Systematic processes are established to ensure members of the organisation may contribute ideas to enhance firm value Incentives may be provided to reward employees who contribute ideas

Investment proposals are forwarded to management - employees dealing in production processes w ill typically contribute ideas relating to eliminating operating inefficiencies - proposals by upper-level managers w ill mostly relate to wider issues such as product development or expansionary opportunities

Stage 2 Evaluation and selection of investment proposals

Data about each investment proposal are • collected. Data include: 一 a description of the proposal - the reasons for its adoption - estimates of amount and tim ing of cash inflows and outflows - an estimate o f the time u ntil the proposal w ill come into operation and the economic life o f the proposal once it is adopted All proposals are then evaluated using standard uniform procedures to ensure that assessments are conducted objectively The economic evaluation of the projects is conducted using a variety o f techniques (discussed in Section 5.3) that take into account the risk of the net cash flows that are expected to be delivered by the project

A list o f recommended projects is prepared by responsible management

Stage 3 Approval and control of capital expenditures

A capital expenditure budget is prepared that • details the estimated capital expenditure requirements on new and existing projects over the next few years: - a short-term budget is prepared that relates to a period ranging from, say, 6 months to 2 years - a longer-term budget is also prepared that provides forecasts of cash requirements over the next 2 to 5 years Processes are established to ensure that the project is properly managed and monitored. These processes typically include: - the appointment of a project manager responsible for the implementation of the project and the preparation of regular progress reports 一 the establishment of a realistic timetable for implementation of the project - the establishment of a separate account for each project to ensure that expenditures are readily observed

Systematic processes are established that enable the firm to effectively manage and m onitor the implementation o f new projects

continued

B usiness finance

Table 5.1 continued Tasks Stage 4 Post­ completion audit of investment projects

•

•

Outcomes

Projects are regularly re-evaluated via a postcompletion audit to ensure that each project is meeting the expectations o f the firm The audit w ill identify where cash flows are significantly different from budget forecasts and possible reasons for such differences

•

•

In itial investment decisions may be improved as those responsible for investment proposals are aware that they w ill be audited Improvements in the operating perform 芑nee of projects facilitated as new inform ation is regularly provided to managers Unsuccessful projects are identified at the earliest possible time— leading to their abandonment and subsequent savings to the firm

M any methods are used to evaluate and compare investm ent projects. The methods outlined in this section are those th a t surveys o f business practice suggest are used most frequently. They are o f two basic types: a

b

the discounted cash flow methods, such as the internal rate o f return and net present value methods, which discount a projects estimated cash flows to allow fo r the magnitude and tim in g o f the cash flows the non-discounted cash flow methods, such as the accounting rate o f retu rn and payback period methods.

Figure 5.1 shows some results from different surveys o f chief financial officers in the US, Australia and Canada. In all three countries, net present value and internal rate o f retu rn are easily the m ost popular, followed by payback period.

Figure 5.1 Selected project evaluation methods used by surveyed chief financial officers!0) 80.00% 70.00%

< - ui 60.00% 、 !/>

50.00% 40.00% 30.00%

f i

20 .00 %

s< ^0 o 10.00 % 0.00%

Internal rate of return

Net present value

Payback period

Accounting rate Real options of return analysis

(a) The aggregated percentage exceeds 100 per cent because most respondents use more than one method of project evaluation Sources: Graham, J.R. & Harvey, C.R., 'The theory and practice of corporate finance: Evidence from the field7, Journal of Financial Economics, May 2001, pp. 187-243; Coleman, L., Maheswaran, K. & Pinder, S.; 'Narratives in managers' corporate finance decisions', Accounting & Finance, September 2010, pp. 6 0 5 -3 3 ; Baker, H., Dutta, S. & Saadi, S., 'Management views on real options in capital budgeting', Journal of Applied Finance, February 2011, pp. 18-29.

C hapter five Project

evaluation : principles a n d methods

In this chapter i t is assumed in itia lly th a t investm ent projects are independent. Two projects are said to be independent i f the acceptance o f one project does n o t preclude the acceptance o f the other project. Two conditions are necessary fo r two or more projects to be classified as independent: • •

It m ust be technically feasible to undertake one o f the projects, irrespective o f the decision made about the other project(s). The net cash flows from each project m ust be unaffected by the acceptance or rejection o f the other project(s).

An example o f independent investm ent projects is where an e n tity is considering whether to purchase new machinery fo r its factory and whether to commission a new advertising campaign. As these investments are independent, management can make an accept/reject decision on each investm ent w itho ut considering its relationship to other investments. Problems caused by the existence o f projects that are n ot independent are considered in Section 5.4.3.

INDEPENDENT PROJECT

a project that may be accepted or rejected without affecting the acceptability of another project

DISCOUNTED CASH FLOW (DCF) METHODS

5.3.1 I Discounted cash flow methods It can be seen from Figure 5.1 th a t the two m ost frequently employed discounted cash flow (DCF) m ethods are the net present value and internal rate o f retu rn methods.The net presen t value (NPV) o f a project is equal to the difference between the present value o f its net cash flows and its in itia l cash outlay.1 Assuming a cash outlay at the beginning o f the projects life, and a series o f net cash flows in the following periods, the net present value o f the project is calculated as follows:

which can be w ritte n more conveniently as: npv

=

y

^

c, ?- c 〇 (1 + k)(

+ — ^

(1 + r)

(1 + r)2

+

+

(1 + r)n

5.3

This can be w ritte n more conveniently as: n Ct

Q = E

t=\ (1 + r )'

5.4

where C〇= the in itia l cash outlay on the project Ct = net cash flow generated by the project at tim e t n = the life o f the project r - the internal rate o f return 1

2

NET PRESENT VALUE (N P V )

the difference between the present value of the net cash flows from an investment discounted at the required rate of return, and the initial cash outlay on the investment

5.2

where C〇= the in itia l cash outlay on the project Ct = net cash flow generated by the project at tim e t n = the life o f the project k = required rate o f retu rn The in tern al rate of retu rn (IRR) o f a project is the rate o f return th a t equates the present value o f its net cash flows w ith its in itia l cash outlay.2 Assuming a cash outlay at the beginning o f the projects life and a series o f net cash flows in the follow ing periods, the internal rate o f retu rn is found by solving fo r r in the follow ing equation: C〇 = - ^ -

methods which involve the process of discounting a series of future net cash flows to their present values

The cash flows could be discounted and/or compounded to equivalent values at any point in time. It is usual to discount the cash flows to the present; hence the use of the term n e t p r e se n t value. An alternative would be to calculate a n et terminal value. This is equal to the difference between the accumulated value of the net cash flows generated by a project, and the accumulated value of the initial cash outlay. Use of the net terminal value method gives the same decision as for the net present value method. Other terms used to describe the same concept include ‘the DCF return on investment’，‘yield’ and ‘the marginal efficiency of capital’.

INTERNAL RATE OF RETURN (IRR)

the discount rate that equates the present value of an investment’s net cash flows with its initial cash outlay; it is the discount rate at which the net present value is equal to zero

5.4

The discounted cash flo w methods com pared

The assumed objective o f a company is to maximise shareholders* wealth. Consistent w ith this objective, projects should be accepted only i f they are expected to result in an increase in shareholders’ wealth. Therefore, the m ethod o f project evaluation m ust be consistent w ith m axim ising shareholders* wealth. O ther things being equal, this w ill occur where a project generates more cash, rather than less cash, and generates cash sooner, rather than later. The ability o f the net present value and interna l rate o f return methods to result in decisions th a t are consistent w ith this objective is considered in the follow ing sections.

5.4.1 | Net present value The net present value o f a project is found by discounting the projects future net cash flows at the required rate o f return and deducting from the resulting present value the in itia l cash outlay on the project. Therefore: n

npv

=J2 t= l

Ct (1 + 吖

-C o

5.5

Where the investment outlays occur over more than one period, C〇in Equation 5.5 refers only to the in itia l cash outlay. A ll subsequent outlays are included in the calculation o f the net cash flows o f future periods. O f course, this may result in subsequent negative net cash flows in addition to the in itia l cash outiay. Management should select projects w ith a positive net present value and reject projects w ith a negative net present value. The am ount o f any positive net present value represents the imm ediate increase in the company s wealth th a t w ill result from accepting the project— th a t is, a positive net present value means th a t the projects benefits are greater than its cost, w ith the result th a t its im plem entation w ill increase shareholders1wealth. Conversely, projects th a t have a negative net present value would reduce shareholders’ wealth. The m agnitude o f a projects net present value depends on the projects cash flows and the rate used to discount those cash flows. I t follows th a t the estim ation o f a projects future cash flows is an im p o rta n t step in project evaluation. This involves deciding w hat cash flow data are relevant fo r project evaluation and then estim ating those data. W hile both aspects are im p orta nt, the mechanics o f estim ation, which is the job o f engineers, m arket research analysts and others, is beyond the scope o f this book. We focus on the firs t aspect— th a t is, the principles involved in defining and measuring project cash flows. There are essentially tw o approaches to measuring a projects net cash flows. The most popular m ethod is to forecast the expected net p ro fit from the project and adjust i t fo r non-cash flow items, such as depreciation. The second method, and the approach used in this book, is to estimate net cash flows directly. The cash inflow s w ill comprise receipts from the sale o f goods and services, receipts from the sale o f physical assets, and other cash flows. Cash outflows include expenditures on materials, labour, indirect expenses fo r m anufacturing, selling and adm inistration, inventory and taxes. W hile the measurement o f a projects net cash flows may seem to be straightforw ard, there are some aspects th a t w arrant fu rth e r consideration. These are discussed in Chapter 6. In addition to estim ating a projects future cash flows, i t is also necessary to estimate the life o f the project and determine the required rate o f retu rn to be used in discounting the cash flows. The correct discount rate to apply is the o p p o rtu n ity cost o f capital.3 This is the rate o f retu rn required on the next

3

Estimation of the required rate of return, or discount rate, is discussed in Chapter 14. It is sufficient at this stage to point out that the required rate of return is simply the rate of return that a project must generate in order to justify raising funds to undertake it. Where there is perfect certainty about the outcome of an investment, the risk-free rate, such as the current yield on government securities of the same maturity as the investment, is the appropriate discount rate. However, where there is uncertainty about the outcome of the investment, a risk-adjusted required rate of return must be used. Throughout the remainder of the book we will use the term req u ired rate o f retu rn to indicate the discount rate used in discounted cash flow calculations.

C hapter five Project

evaluation : principles a n d methods

best— th a t is, forgone— alternative investment. I f the net cash flows have been estimated on an after-tax basis, then, to be consistent, the appropriate required rate o f retu rn is the after-tax rate. The measurement o f the required rate o f retu rn is considered in Chapter 14. Example 5.1 illustrates the application o f the net present value method.

Example 5.1 Bruce Barry is considering an investment of $ 9 0 0 0 0 0 in a project that will return net cash flows of $5 09 000 , $ 4 5 0 0 0 0 and $ 4 0 0 0 0 0 at the end of Years 1, 2 and 3, respectively. Assuming a required rate of return of 10 per cent per annum, what is the net present value of the project?

SOLUTION The net present value may be calculated as shown in Table 5.2.

TABLE 5.2 Calculating a project’s net present value (NPV) Year

Net cash flows ($ ) !

0

(900 000 )⑷

Discount factor at 10%

Present value ($) (900000)

1

509000

0.909 09

462 727 (扮

2

450000

0.826 45

371901^)

3

400000

0.751 31

300 526 (幻 235154

NPV ($) ^T h e amount in brackets represents the initial cash outlay.

^T he sum of $ 4 6 2 7 2 7 + $371 901 + $ 3 0 0 5 2 6 = $1 135 154 is the maximum amount the company would be prepared to pay for the project if the required rate of return is 10 per cent per annum.

A t a discount rate o f 10 per cent per annum, the project has a positive NPV o f $235154 and is therefore acceptable. This m ethod is consistent w ith the company’s objective o f m axim ising shareholders’ wealth. I f a company implements a project th a t has a positive net present value, the company w ill be more valuable than before it undertook the project, and therefore, other things being equal, the to ta l m arket value o f the company s shares should increase im m ediately by the same am ount as the net present value o f the new project. In other words, the company is undertaking a project th a t has a net present value in excess o f th a t necessary to leave its share price unchanged. This was shown form ally in Chapter 2 using Fishers Separation Theorem. In summary, the decision rule fo r the net present value m ethod is as follows: Accept a project i f its net presen t value is positive when the p ro je cts net cash flows are discounted a t the required rate o f return.

5 .4 .2 1 Internal rate of return The internal rate o f return fo r a project is the rate o f return th a t equates the present value o f the projects net cash flows w ith its in itia l cash outlay. This means th a t Equation 5.4 can be rew ritten as follows: Ct

c〇 = 0

From Equation 5.6, the internal rate o f retu rn is the discount rate th a t results in a zero net present value. However, the interna l rate o f retu rn is n o t only the discount rate th a t causes the net present value o f the projects cash flows to be zero. It also represents:

... the highest rate o f interest an investor could afford to pay, w ithout losing money, i f a ll the funds to finance the investm ent were borrowed, an d the loan (principal an d accrued in terest) w as repaid by using the cash proceeds from the investm ent a s they were earn ed.4

Even i f the investm ent outlays occur in more than one period, C〇in Equation 5.6 refers only to the in itia l cash outlay. Any subsequent investm ent outlays are subtracted from the cash flows o f future periods, which suggests th a t some o f the net cash flows in Equation 5.6 m aybe negative. The effect on the interna l rate o f retu rn o f negative net cash flows in subsequent periods is discussed later in this section. If, as is usual in practice, the projects net cash flows in each period are n o t equal, the internal rate o f retu rn can be found only by tria l and error— th a t is, by varying the discount rate u n til the present value o f the cash flows is equal to the investm ent outlay. I f this process shows th a t the present value o f the net cash flows is greater than the in itia l cash outlay, then some higher discount rate should make them equal, and vice versa. A fte r the interna l rate o f return has been measured, the acceptability o f an investm ent project is determ ined by comparing the internal rate o f return r w ith the required rate o f retu rn k. Any project w ith r > k should be accepted and any project w ith r < k should be rejected. Example 5.2 illustrates the application o f the internal rate o f retu rn method.

Example 5.2 If we take the cash flows of Example 5.1, the project's internal rate of return may be calculated using Equation 5.3 as follows: Cn =

C l

〇

d - )

_

+

C2

d

+ r

+

)2

C3

( l + r

)3

Thus: $900 0 0 0 - $509000 + $450000 + $_400000

By trial and error, r = 25 per cent.5 If the required rate of return is, say, 15 per cent, the project’s internal rate of return of 25 per cent exceeds the required rate of return and the project is acceptable. The use o f this method, therefore, appears to be consistent w ith the company s objective o f m aximising shareholders* wealth. I f the required rate o f retu rn is the m inim um return th a t investors demand on investments then, other things being equal, accepting a project w ith an internal rate o f return greater than the required rate should result in an increase in the price o f the company s shares.

M ultiple and indeterminate internal rates of return In Example 5.2 the investm ents cash flows consisted o f an in itia l cash outlay, followed by a series o f positive net cash flows. In such cases a unique positive internal rate o f retu rn w ill usually exist. In certain circumstances, however, it is possible fo r the present value o f the future net cash flows to be equal to the in itia l cash outlay at more than one discount rate— th a t is, a project may have more than one internal rate o f return. A necessary condition fo r m ultiple internal rates o f retu rn is th a t one or more o f the net cash flows in the later years o f a projects life m ust be negative. The presence o f negative net cash flows in the later years o f a projects life is n o t a sufficient condition fo r m ultiple interna l rates o f return. In many cases, negative cash flows in the later years o f a projects life are consistent w ith there being only one internal rate o f re tu rn .6

4 5 6

See Bierman and Smidt (1993). In practice, a financial calculator may be used to calculate the internal rate of return and eliminate the time-consuming computations involved in the trial-and-error process. Alternatively, the ^RR1function in Microsoft Excel® might also be used. Descartes* rule of signs states that there can be as many positive roots for 1 + r as there are changes in the sign of the cash flows. Therefore, if, after the initial cash outlay, the net cash flows are always positive, there will be at most one positive root for l + r, and consequendy only one for r itself. However, two sign changes in the cash flow can result in two positive values for 1 + r, so there may also be two positive values for r. For example, if the two positive values for 1 + r are +1.1 and +1.3, there will be two positive values for r: 10 per cent and 30 per cent. In the remainder of this section we use the term in tern al rate o f retu rn to mean p o sitiv e in te rn al r a te o f retu rn .

C hapter five Project

evaluation : principles a n d methods

While, in practice, there is little likelihood o f the occurrence o f m ultiple internal rates o f return, i t is im p orta nt to recognise th a t there are circumstances where m ultiple internal rates do occur. Such a set o f circumstances is illustrated in Example 5.3.

E xample 5.3 Consider an investment project with the cash flows shown in Table 5.3.

TABLE 5.3 Project cash flows Year

Cash flow

0

-14545 620

1

34182 000

2

-20000 000

An example of where such a cash flow pattern may occur is where a mining company is obliged, after completion of its mining operations, to restore the mine site to its original condition. If we solve for the internal rate of return of this project, then we find that its net present value is zero at both 10 per cent and 25 per cent— that is, the project has two internal rates of return. The project's net present value profile, which plots the project's net present value as a function of the required rate of return, is shown in Figure 5.2.

Figure 5.2 Net present value profile showing two internal rates of return

The number o f internal rates o f retu rn is lim ite d to the number o f sign reversals in the cash flow stream. In this case there are tw o sign reversals, which is a necessary, b u t n o t sufficient, condition fo r two internal rates o f return. Three sign reversals is a necessary condition fo r three rates, and so on. Hence, the number o f cash flow sign reversals corresponds to the maximum, b ut n ot necessarily the actual, number o f internal rates o f return. It may be argued th a t m ultiple rates are not a problem because the project may be abandoned at the beginning o f the second year, thereby avoiding the subsequent negative cash flow, and also the m ultiple internal rate o f return problem. I f the project is term inable and has a positive residual value, a unique internal rate o f return may be calculated. However, in some cases, abandonment o f the project may n ot be feasible because it may involve substantial abandonment costs in the early years o f operation, or there may be a legal obligation to continue the project fo r a num ber o f years. In addition to the problem o f m ultiple internal rates o f return, it is possible fo r an investm ent project to have no internal rate o f return. For example, a project w ith the follow ing pattern o f cash flows: -$80 000, +$100 000, -$5 0 000, has no internal rate o f return.

6

^

B usiness finance

Projects w ith a cash flow stream th a t results in either m ultiple internal rates o f return, or no internal rate o f return, are likely to be rare in practice, b ut the possibility o f such occurrences does exist. In what follows, it is assumed th a t a projects cash flow pattern results in a unique internal rate o f return. In summary, the decision rule fo r the internal rate o f retu rn m ethod is: Accept a project i f it h as a unique in ternal rate o f return th at is g reater than the required rate o f return.

5 .4 .3 1 Choosing between the discounted cash flow methods Independent investments LEARNING OBJECTIVE 3 Explain the advantages and disadvantages of the main project evaluation methods

For independent investments, both the IRR and NPV methods o f investm ent evaluation lead to the same accept/reject decision, except fo r those investments where the cash flow patterns result in either m ultiple interna l rates o f retu rn or no internal rate o f return. In other words, i f a project has an internal rate o f retu rn greater than the required rate o f return, the project w ill also have a positive net present value when its cash flows are discounted at the required rate o f retu rn — th a t is, NPV > 0 when r > k, NPV < 0 when r < k, and NPV = 0 when r = k. This is always true, provided th a t the projects cash flows consist o f one or more periods o f cash outlay followed only by positive net cash flows. Such a project is referred to as a conventional project and the net present value profile o f such a project is illustrated in Figure 5.3. Figure 5.3 shows th a t the higher the discount rate, the lower is the net present value. The intercept o f the net present value profile w ith the horizontal axis occurs at the p o in t where k = r, which is the interna l rate o f return because i t is the discount rate at which the net present value is zero.

Figure 5.3 Net present value profile for a conventional project

Figure 5.3 shows th a t at a required rate o f retu rn o f k1} the net present value is positive and r > k1} while at a required rate o f retu rn o f k2 the net present value is negative and r < /c2. I f management

has to decide whether to accept or reject an independent investm ent project, then b o th the internal rate o f retu rn m ethod and the net present value m ethod w ill give results consistent w ith m axim ising shareholders’ wealth.

M utually exclusive investments So far it has been assumed th a t investm ent projects are independent, which means th a t management can make an accept/reject decision about each project w ith o u t considering its relationship w ith other

C hapter five Project

evaluation : principles a n d methods

projects. In this section, we allow fo r the fact th a t investm ent projects may be interdependent. In this case, the expected benefits fro m one project are affected by a decision to accept or reject another project. In the extreme case, where the expected cash flows from a project w ill completely disappear i f another project is accepted, or i t is technically impossible to undertake the proposed project i f another project is accepted, the projects are said to be m utually exclusive. For example, i f a company owns land on which it can build either a factory o r a warehouse, then these tw o projects are m utually exclusive. I f a decision is made to b uild the factory, the company is unable to build the warehouse. A nother example o f m utually exclusive projects is i f different types o f equipment can be used to manufacture the same product. The choice o f one type o f equipm ent autom atically leads to the rejection o f the other.In the remainder o f this section the discounted cash flow methods w ill be evaluated, assuming th a t investm ent projects are m utually exclusive. Where management has to select from m utually exclusive projects it is necessary to rank the projects in order o f acceptability. This means th a t i t is necessary to determ ine w hether it makes any difference to project selection i f projects are ranked according to th e ir internal rates o f retu rn or th eir net present values. First, we consider in Example 5.4 whether the interna l rate o f retu rn or net present value methods should be used to evaluate m utually exclusive investments.

E xample 5.4 Consider the mutually exclusive investments, A and B, in Table 5.4.

TABLE 5.4 Project 1 Cash outlay ($)

Net cash flow 1 year after the year of outlay ($)

IRR (%)

N P V @ 10%($)

A

-1

+10

900

8.09

B

-100000

+200000

100

81818.18

The internal rate o f retu rn m ethod ranks a 900 per cent retu rn on $1 ahead o f a 100 per cent return on $100000. A t a required rate o f retu rn o f 10 per cent, both investments are w o rth undertaking, but if a choice has to be made between the tw o investments, then investm ent B w ith the larger net present value is to be preferred. This is because B adds more to the company s value than A. The net present value method w ill ensure th a t the value o f the company is maximised, whereas the use o f the internal rate o f return m ethod w ill n o t ensure th a t result. I t is apparent, therefore, th a t the internal rate o f return and net present value methods can rank m utually exclusive investm ent projects differently. This is now explained.

Ranking mutually exclusive investments Although both projects in Example 5.4 had the same life, the in itia l cash outlays were different. However, even if the in itia l cash outlays and the projects* lives had been the same, i t is s till possible th a t the internal rate o f return and net present value methods would rank m utually exclusive investments differently. This is illustrated by Example 5.5. In Example 5.5, the difference in ranking is caused by differences in the magnitude o f the net cash flows. In addition to differences in ranking caused by differences in the cash flow streams, the interna l rate o f retu rn and net present value methods may give a different ranking where the investm ent projects have unequal lives. It may be concluded, therefore, that: … any difference in the m agnitude or tim ing o f the cash flows m ay cause a difference in the ranking o f investm ent projects using the internal rate o f return an d net presen t value methods.

MUTUALLY EXCLUSIVE PROJECTS

alternative investment projects, only one of which can be accepted

Example 5.5 Two projects, C and D, have the same initial cash outlays and the same lives but different net cash flows, as shown in Table 5.5.

What are the internal rates of return and net present values for projects C and D?

SOLUTION Table 5.6 shows the internal rates of return and the net present values at a required rate of return of 10 per cent for projects C and D.

TABLE 5 .6 Internal rate of return (%) Net present value ($)

Project C

40

119008

D

50

105 785

Both projects have a positive net present value and an internal rate of return greater than the required rate of return and are therefore acceptable in their own right. In other words, if the projects are independent, both should be implemented. However, if the projects are mutually exclusive and therefore must be ranked, the two methods give different rankings. In this case using the net present value method, C is preferred to D, while using the internal rate of return method, D is preferred to C. This is illustrated in Figure 5.4, which shows the net present value profiles fo r tw o projects, E and F. Assume, as in Example 5.5, th a t the tw o projects have the same cash outlay and lives, and that the pattern o f net cash flows results in the net present value profiles shown in Figure 5.4. In this case, the net present value profiles o f the two projects intersect. A t a discount rate o f rv or at any other discount rate less than r2, the net present value o f E is greater than the net present value o f F, w hile at a discount rate o f r3, or at any other discount rate greater than r2, the net present value o f F is greater than the net present value o f E.7 On the other hand, it has already been shown th a t the interna l rate o f retu rn is found where the net present value is zero and, using this rule, Project F is ranked ahead o f Project E because its internal rate o f return, r5, is greater than r4, which is the internal rate o f retu rn o f E.8 In this case, the tw o methods can provide management w ith different rankings o f projects E and F. 7

For projects such as those in Table 5.5 with the same initial cash outlay, r2 is found by equating the present values of projects E and F as follows:

PVe = Y 7.

8

Ce, (1 + r2) f

c,：t

-E ； ,= 1 (1 +

厂2 )

In this instance, r2 = 18.89 per cent. This means that if the required rate of return is less than 18.89 per cent, the internal rate of return and net present value methods result in conflicting rankings. Remember that discounting of the net cash flows at the internal rate of return will result in a net present value of zero. Therefore: n

〇= E

Q ( l + r)f

-C 〇

C hapter five Project

evaluation : principles a n d methods

Figure 5.4 Net present value profiles for projects E and F

Like Example 5.5, Figure 5.4 shows th a t even where tw o m utually exclusive projects have the same in itia l outlays and the same lives, a difference in the projects* rankings may s till occur as a result o f the projects’ different tim e patterns o f net cash flows. Therefore, fo r m utually exclusive investm ent projects, the net present value m ethod is superior to the internal rate o f retu rn method, because it always gives a wealth-maximising decision.

Figure 5.5 Net present value profiles for projects G and

Even where the projects are m utually exclusive, the tw o methods could 5deld consistent rankings i f the patterns o f the projects* net cash flows result in net present value profiles th a t do n o t intersect. This is illustrated in Figure 5.5. In this case, the net present value o f Project G at a discount rate o f is greater

than the n et present value o f Project H. This is consistent w ith the internal rate o f retu rn m ethod as r3, the interna l rate o f retu rn o f Project G, is greater than r2, the internal rate o f retu rn o f Project H. However, because o f the possibility th a t the internal rate o f retu rn m ethod may give an incorrect ranking o f m utually exclusive investm ent projects, the net present value m ethod is preferred.

The incremental internal rate of return approach to ranking mutually exclusive investments The internal rate o f return m ethod can be adapted so th a t i t provides a correct ranking o f m utually exclusive projects. This is shown in Example 5.6.

Example 5.6 The cash flows for two projects, I and J, are shown in Table 5.7. Are projects I and J acceptable?

TABLE 5.7

"

Cash flows ($) Project

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

I

-45 000

13 500

13500

13500

13500

13 500

J

-30000

9150

9150

9150

9150

9150

SOLUTION If the required rate of return is 8 per cent per annum, both projects are acceptable using either the net present value or the internal rate of return method, as shown in Table 5.8.

TABLE 5.8 Project

Internal rate of return (%)

Net present value ($)

I

15.2

8902

J

15.9

6533

If the two projects are mutually exclusive, then, using the net present value method, Project I is preferred to Project J, while using the internal rate of return method, Project J is preferred to Project I. The incremental cash flows from choosing Project I (the project with the lower internal rate of return) rather than Project J (the project with the higher internal rate of return) are presented in Table 5.9. These cash flows may be assigned to the notional project 1 minus J’.

TABLE 5.9 Cash flows for notional project Year 1 minus } ' ($) 0

-15000

1

4350

2

4350

3

4350

4

4350

5

4350

C hapter five Project

evaluation : principles a n d methods

The internal rate of return of this notional project is 13.8 per cent. As this internal rate of return is greater than the required rate of return of 8 per cent, the notional project should be accepted. Accepting the notional project 7I minus J7 is equivalent to accepting Project I in preference to Project J. This is the ranking given by the net present value method.

The possibility o f conflict between the interna l rate o f retu rn and net present value methods may therefore be avoided by the use o f this ‘increm ental internal rate o f retu rn ’ approach. It results in a ranking o f m utually exclusive projects th a t is consistent w ith the net present value method. However, the net present value m ethod is simpler and is more obviously consistent w ith the objective o f wealth maximisation, which is expressed in absolute dollar term s rather than in percentage terms.

5 .4 .4 1 Benefit-cost ratio (profitability index) Research shows th a t some chief financial officers use the p ro fita b ility index m ethod o f project evaluation. In this m ethod, instead o f showing the net present value as an absolute am ount, the present value o f the n et cash flows is divided by the in itia l cash outlay to give a b e n e fit-c o st ra tio or p ro fita b ility index.A b e n e fit-co st ratio fo r the project in Table 5.2 is calculated as follows: Benefit-cost ratio =

present value o f net cash flows

5.7

initia l cash outlay

_ $1 135154 $900 000

m LEARNING OBJECTIVE 4 Explain why the net present value method is preferred to all other methods BENEFIT-COST RATIO

index calculated by dividing the present value of the future net cash flows by the initial cash outlay (also known as a profitability index)

= 1 .2 6 Using the benefit-cost ratio, the decision rule is to accept projects w ith a benefit-cost ratio greater than 1, and to reject projects w ith a benefit-cost ratio less than 1. Clearly, projects w ith benefit-cost ratios greater than 1 w ill have positive net present values, and those w ith benefit-cost ratios less than 1 w ill have negative net present values. In the above example, the net present value is $235154 and the benefit-cost ratio is 1.26. Both methods therefore indicate th a t the project is acceptable and, in general, b oth methods w ill give the same accept/reject decision fo r independent projects. However, the benefit-cost ratio provides no info rm a tio n additional to th a t already provided by the NPV method. Thus, there is little p o in t in using this method. In addition, the benefit-cost ratio can result in a ranking o f m utually exclusive projects th a t differs from the ranking th a t would result from using the NPV method. This is shown in Example 5.7.

LEARNING OBJECTIVE 2 Outline the decision rules for each of the main methods of project evaluation

Example 5.7 Consider the mutually exclusive investments projects in Table 5.10.

TABLE 5.10 Ranking projects using the benefit-cost ratio Project K

Project L

Present value of net cash flows ($)

260000

100000

Initial cash outlay ($)

180000

50000

80000

50000

260 000

100 000

180 000 1.44

50 000 2.00

Net present value Benefit-cost ratio =

In this case, although the net present value of Project L is less than the net present value of Project K, the benefit-cost ratio of L is greater than that of K.

命

B usiness finance

Therefore, i f the b e n e fit-co st ra tio is used i t may result in management p re fe rrin g projects w ith low er net present values. The b e n e fit-co st ra tio m ust therefore be rejected as a ranking technique because i t can provide incorrect rankings o f m u tu a lly exclusive projects. Research indicates th a t the p o p u la rity o f the p ro fita b ility index to managers relative to o the r p roject evaluation techniques is low. Further, survey evidence9 suggests th a t the technique tends to be used by managers who face a shortage o f funds available to invest in w ealth-enhancing projects. Faced w ith such constraints, managers have to decide on the m ix o f acceptable projects th a t should be funded in order to m axim ise the w ealth created fo r the firm . This process, know n as capital rationing, is discussed in Section 6.8.

5.5

O ther methods of project evaluation

In Figure 5.1, there were two m ajor non-discounted cash flow methods employed by the companies surveyed. They are the accounting rate o f retu rn and the payback methods. These methods are frequently employed in conjunction w ith the discounted cash flow methods o f project evaluation.

The accounting rate of return ACCOUNTING RATE OF RETURN

earnings from an investment expressed as a percentage of the investment outlay

There are many ways to calculate the accounting rate o f return or retu rn on investm ent. The most popular methods are those th a t express a projects average annual earnings as a percentage o f either the in itia l investm ent or the average investm ent in the project. That is: average annual earnings Va =

100

------------------------------------------------------------ X ------- %

initia l investment in a project average annual earnings

1

100

ra = --------------------------------------------------- x ----- %

average investment in a project

1

5.8

■ 5.9

PAYBACK PERIOD

the time it takes for the progressive accumulated net cash flows generated by an investment to equal the initial cash outlay

Payback period The payback period is the tim e it takes fo r an e n tity to recover a projects in itia l cash outlay. For example, the payback period o f a machine th a t costs $300000 and has net cash flows o f $100000 per annum is 3 years. Sections 5.5.1 and 5.5.2 show th a t the accounting rate o f retu rn and payback methods are in fe rio r to the net present value method.

5.5.1 | Accounting rate of return LEARNING OBJECTIVE 2 Outline the decision rules for each of the main methods of project evaluation

Essentially, the accounting rate o f retu rn is the earnings from a project, usually after deducting both depreciation and income tax, expressed as a percentage o f the investm ent outlay. I t is compared w ith a required rate o f retu rn or cut-off rate to determine the project s acceptability. I f the accounting rate o f return is greater than the required rate o f return, the project is acceptable; i f i t is less than the required rate o f return, the project is unacceptable. The accounting rate o f retu rn has many variants. We w ill calculate only three o f these. To calculate these variants o f the accounting rate o f return, management m ust firs t estimate: a

b 9

the average annual earnings to be generated by a project. This is calculated by d ivid in g the to ta l net p ro fit from the project by the num ber o f years d urin g w hich the p ro fit is expected to be received. the investm ent outlay on the project. This is equal to either its in itia l investm ent outlay, including additional and permanent w orking capital requirements, or the average capital employed in the For surveys of capital budgeting practices, see Burns and Walker (2009).

C hapter five Project

evaluation : principles a n d methods

project. The average capital employed on a project is calculated either as the average book value o f the investment, or more frequently as the average o f the capital invested in the project at the beginning and the end o f its life. The methods o f calculating the accounting rate o f retu rn are illustrated in Example 5.8.

E xample 5.8 Assume that a company is considering an investment project that costs $ 1 0 0 0 0 0 0 0 and generates returns in Years 1 ,2 and 3 as shown in Table 5.11.

6

TABLE 5.11 Data for calculating the accounting rate of return Item___________ I

Year 2

Year 3

2000000

3000000

4000000

10000000

7000000

4900000

31 December

7000000

4900000

3430000

Average

8500000

5 950000

4165 000

Earnings (after depreciation and income tax) ($)

Year 1_____

|

Average 3000000

Book value ($)(a) 1 January

6205 000

^Assuming that depreciation is calculated at 30 per cent on the reducing balance.

Using these data, the following accounting rates of return may be calculated: a) Accounting rate of return based on the initial investment is: $3000000 =3〇% $10000000

b) Accounting rate of return based on the average book value is:

$3 000000 = 48% $6205000

c)

Accounting rate of return based on average investment as measured by the average of the capital invested at the beginning and the end of the project's life is: $3 000000 =44.68% $ 10 000000+ $3 430000

Each variant yields a different rate of return. For example, if the rate of return is calculated by dividing average annual earnings by the a verage investment outlay, then the project's rate of return would be much higher than if it had been calculated by dividing average annual earnings by the in itia l investment outlay.

There are two fundam ental problems w ith using the accounting rate o f return, irrespective o f the way it is defined. First, it is arbitrary. This is because i t is based on accounting earnings rather than cash flows. As a result, factors such as the depreciation m ethod employed and the m ethod o f valuing inventories w ill have a substantial bearing on the measurement o f earnings and therefore on the accounting rate o f return. Second, i t ignores the tim in g o f the earnings stream. Equal weight is given to the earnings in each year o f the projects life. This problem is illustrated in Example 5.9.

LEARNING OBJECTIVE 3 Explain the advantages and disadvantages of the main project evaluation methods

E xample 5.9 A company is considering two projects, M and N. Both projects cost $ 1 000 00 at the beginning of the first year and have a life of 5 years. The residual value of each project at the end of the fifth year is zero. The earnings for each project are shown in Table 5.12.

TABLE 5.12 Annual earnings ($) Project

Outlay ($1

Year 1

Year 2

Year 3

Year 4

Year 5

Total

M

100000

2500

5000

10000

15000

17500

50000

N

100000

17500

15000

10000

5000

2500

50000

The average rate of return for each project is: $50 00 0/5

$10000

$ 10 00 00 /2

$50000

100%

0^ 0/

1

Project M has increasing earnings while Project N has decreasing earnings. However, both result in the same total earnings, and therefore the same average annual earnings. Consequently, both projects are regarded as equally acceptable if the accounting rate of return method is used. However, the two projects are not equally acceptable because the earnings from Project N are received earlier than the earnings from Project M. Intuition would suggest, therefore, that Project N is preferable to Project M.

The accounting rate o f retu rn fails to reflect the advantages th a t earlier returns have over later returns. As a result, this m ethod ranks projects w ith the same in itia l outlay, life and to ta l earnings equally, even though the projects1patterns o f earnings may be different. In addition, i f projects w ith the same in itia l outlay and to ta l earnings have different lives, the accounting rate o f retu rn m ethod w ill automatically favour projects w ith short lives. However, there is no reason w hy such projects should necessarily prove to be the m ost profitable projects. Because o f its significant shortcomings, the accounting rate o f retu rn m ethod should n o t be used to evaluate investm ent projects. However, as we observed earlier, in practice the accounting rate o f return is often used in conjunction w ith the discounted cash flow methods. Because external financial analysts use earnings (profit) to assess a company s performance, management may wish to ensure th a t projects are acceptable according to both accounting and discounted cash flow criteria.

5 .5 .2 1 Payback period The payback period is the tim e it takes fo r the in itia l cash outlay on a project to be recovered from the projects net cash flows. I t is calculated by summing the net cash flows from a project in successive years u n til the to ta l is equal to the in itia l cash outlay. This is illustrated in Table 5.13.

TABLE 5.13 Calculation of payback period Project Q Year

Initial cash outlay ($)

0

100000

Project R

Net cash flow ($)

Initial cash outlay ($)

Net cash flow ($)

100000

1

20000

20000

2

30000

40000

C hapter five Project

evaluation : principles a n d methods

Table 5.1 3 continued

Project Q Year

Initial cash outlay ($)

Project R

Net cash flow ($)

Initial cash outlay ($)

Net cash flow ($)

3

30000

40000

4

20000

10000

5

70000

10000

Total

170000

120000

Payback period

4 years

3 years

To decide whether a project is acceptable, its payback period is compared w ith some maximum acceptable payback period. A project w ith a payback period less than the m axim um w ill be accepted, while a project w ith a payback period greater than the m axim um w ill be rejected. An im p o rta n t question is: W hat length o f tim e represents the correct, payback period as a standard against which to measure the acceptability o f a particular project? In practice a m axim um payback period is set, which is inevitably arbitrary, and may be from , say, 2 to 5 years. A ll projects w ith a payback period greater than this m axim um are rejected. Calculation o f the payback period takes in to account only the net cash flows up to the p o in t where they equal the investm ent outlay. The calculation o f the payback period ignores any net cash flows after that point. As a result, the payback m ethod o f evaluation discriminates against projects w ith long gestation periods and large cash flows late in th e ir lives. The payback period is n o t a measure o f a project s pro fitab ility. I f the m ost profitable projects were always those th a t recovered the investm ent outlay in the shortest period o f tim e, then current assets such as inventory and accounts receivable would yield higher returns than non-current assets, and noncurrent assets w ith short lives would yield higher returns than non-current assets w ith long lives. Mere recovery o f the outlay on a project yields no p ro fit at all. I f there is a p ro fit on the project i t m ust be due to additional cash flows after the investm ent outlay has been recovered. Therefore, the m ajor weakness o f the payback m ethod is its failure to take account o f the magnitude and tim in g o f all o f a projects cash inflows and outflows. Why then is payback popular as a m ethod o f investm ent evaluation? As was shown in Figure 5.1, many companies around the w orld use payback in conjunction w ith other methods. One reason fo r its popularity is th a t i t provides in fo rm a tio n on how long funds are likely to be com m itted to a project. Managers who prefer projects w ith short payback periods are interested in how soon the funds invested in a project w ill be recouped and hence this m ethod provides managers w ith inform a tion th a t w ill facilitate th eir preparation o f cash flow budgets, thereby enabling them to better manage the liq u id ity o f the firm . Another reason is th a t the near-term cash flows considered in calculating the payback period are regarded as more certain than later cash flows. As a result, insistence on a short payback period is a simple b u t imprecise way o f controlling fo r risk.

5 .5 .3 1 Economic value added (EVA) In Section 5.5.1, i t was noted th a t the accounting rate o f retu rn m ethod is often used in addition to the discounted cash flow methods because financial analysts generally use accounting inform a tion to assess performance year by year. To overcome the problems o f measuring the accounting rate o f return discussed in Section 5.5.1, the economic value added (EVA) approach to measuring performance was introduced by consulting firm s in the US.10

10 Economic value added (EVA) is the term used by the US consulting firm Stern-Stewart. This firm has been instrumental in popularising this measure of performance.

LEARNING OBJECTIVE 2 Outline the decision rules for each of the main methods of project evaluation

m

LEARNING OBJECTIVE 5 Understand the relationship between economic value added (EVA) and net present value (NPV)

B usiness finance

Accounting p ro fit is calculated as the difference between revenues and expenses fo r a reporting period. One o f the costs incurred by a company th a t is n o t deducted in calculating p ro fit is the company s required rate o f return. To calculate the EVA o f an investm ent, i t is sim ply a m atter o f deducting from accounting earnings the p ro fit required from the investm ent, calculated as the required rate o f return m ultiplie d by the capital invested in the project. Thus, using Example 5.9, i f the required rate o f return is 10 per cent, then the returns generated in Years 1, 2 and 3 would be as shown in Table 5.14.

TABLE 5.14 Year 1

Year 2

Year 3

2000

3000

4000

700

490

$2300

$3510

Earnings (after depreciation and income tax) ($) Capital charge: Am ount invested x 10% ($)

1000(fl)

Economic value added (EVA)

$1000

In Year 1, the amount invested in the project is $10000, therefore the capital charge is $10000 x 10% = $1000. The EVA in Table 5.14 shows the addition to the company s wealth created by the investment. If the accounting rate o f retu rn were equal to the required rate o f return, then EVA would be zero. EVA, therefore, provides management w ith a simple rule: invest only i f the increase in earnings is sufficient to cover the required rate o f return. EVA makes the required rate o f retu rn an im p o rta n t element in measuring the performance o f an investm ent. The manager o f a plant can improve EVA either by increasing earnings or by reducing the capital employed. Therefore, there is an incentive fo r managers to id e n tify underperform ing assets and dispose o f them. Note th a t this approach to measuring EVA does n ot measure present value. However, it can be shown th a t the present value o f a stream o f future EVAs fo r an investm ent is equal to the net present value of the investm ent. The EVA in each period is equal to the net cash flow plus or m inus the change in the value o f the investm ent less the required rate o f return. Thus:

5.10

E V A ^ C ^ il-I^ -k l^ where Ct = net cash flow in Year t I t = value o f the investm ent at the end o f Year t = value o f the investm ent at the end o f Yeart k = required rate o f return However, there are tw o special cases: a

b

In Year 0, EVA0 = C〇+ J〇because there is no capital charge u n til Year 1. A t the end o f the project, the investm ent in the project (Jt) is zero because the investm ent is liquidated and therefore EVAt = Ct - (1 + k) 1 ^ . Therefore, the present value o f a stream o f EVAs is: EVA〇

EVAi

EVA2

1+ k

(1 + k ) 2

EVAT. y

EVAt

{ l + k )T~l ( l + k )T

BB1

where EVA0 = C〇+ J〇 EVA1 = C1 + I 1 - ( l + k) I 0 EVA2 = C2 + 12 - (1 + /c) £ \^ 4 了_1 = C t_i + 1"了_1 (1 + /c) 1了_2

EVAj = CT - (1 + /c) I T-1 W hen these values are substituted in to Equation 5.11, we fin d th a t all the I terms cancel out, leaving: C〇 ^ - g j - + — ^

1 + fc

(1 + k f

+ .,,+

£ r-i (l + k f - 1

_C

t

(1 + k ) T

= NPV

That is, the discounted stream o f EVAs is the same as the NPV o f the investment.

C hapter five Project

5.6

evaluation : principles a n d methods

Project evaluation and real options analysis

A key message o f this chapter has been th a t discounted cash flow techniques, such as NPV and IRR, provide the m ost accurate, and m ost popular, approach to project evaluation. However, we know th a t these techniques are answering a very specific question about the lin k between a project and wealth creation th a t may n o t be the question we should be m ost interested in. For example, NPV analysis provides us w ith an estimate o f the wealth created fo r the firm now zfthe firm were to imm ediately invest in the project. That is, the approach treats projects as now-or-never prospects— whereas we know th a t in reality managers often have significant fle xib ility in how they manage a project (including when to begin it). In addition, NPV is lim ite d to a yes-or-no analysis; fo r example, i t im p lic itly gives no recognition to the fact that, after a project has begun, managers may intervene in the project as circumstances develop. Obviously, this significantly understates the role o f managers. These lim ita tion s o f NPV analysis can, in principle, be dealt w ith using an approach known as real options analysis. The follow ing section explains how real options analysis differs from standard discounted cash flow techniques and describes some o f the evidence th a t suggests that, despite its apparent usefulness, it is used by relatively few financial managers.11

5 .6 .1 1 Real options analysis Consider the follow ing scenario: substantial o il reserves have just been discovered in Sydney Harbour and the government has called fo r bids fo r the rig h t to extract the oil. Comprehensive geological reports estimate th a t there are 40 m illio n barrels o f o il th a t could be extracted. Owing to the unique environm ent in which the o il is located, and the need to ensure that any disturbance to the environm ent fro m the invasive extraction process is remedied, the present value o f the expected cost o f extraction is relatively high, at $80 per barrel. The long-run expected sales price o f the o il is estimated to be $70 per barrel in present value terms. How much would an investor bid fo r the rig h t to extract oil? Standard NPV analysis would suggest that no rational investor would bid a positive amount fo r the extraction rig h t as the project has a negative NPV w ith each barrel o f o il extracted decreasing wealth by $10. W hat is wrong w ith this analysis? I t ignores the fact th a t the successful bidder fo r the project obtains the right, b u t n o t the obligation, to commence operations. That is, the successful bidder has the option to extract the oil. Based upon current expectations o f available technology, cost structures and revenues i t is at present unprofitable to extract the o il and the option would n o t be imm ediately taken up. However, it is n ot d ifficu lt to th in k o f circumstances th a t may result in the project having a positive NPV. For example, new technology may be developed to substantially reduce the cost o f extraction or the long-run expected sales price o f o il m ig ht increase. Either way, the successful bidder has purchased the rig h t to exploit any advantageous change in circumstances. Throughout this chapter it has been im p lic itly assumed th a t the problem facing management is lim ited to accepting or rejecting a project fo r immediate im plem entation. In reality o f course, th is is rarely the case. Managers can often choose when to im plem ent a project and can influence the way an ongoing project is managed. These choices* faced by management are often referred to as real option s and problems may arise when the value o f options created (or destroyed) by management decisions is not accounted fo r during the project evaluation stage. Some common examples o f real options include: •

O ption to delay investm ent— this option is linked to the a b ility o f the firm to ‘w ait and see’ and collect more inform a tion about the project th a t may alter the final decision. This option is especially valuable to a firm where the level o f uncertainty surrounding a project is high. W hen a firm finally commits to a project, it is giving up the o pp o rtu n ity to collect more info rm a tio n about the project, and hence, it is often argued, the NPV o f a project m ust n o t only be positive, b ut be great enough to compensate the firm fo r the value o f the fle xib ility i t is giving up.

11 For an excellent and accessible discussion of the importance of incorporating real options into project evaluation see Dixit and Pindyck (1995).

LEARNING OBJECTIVE 6 Understand the relationship between real options, managerial flexibility and firm value

REAL OPTIONS ANALYSIS

method of evaluating an investment opportunity that accounts for the value associated with managers having flexibility in their decisions about when to invest, how to manage the investment and when to divest themselves of the investment asset

REAL OPTIONS

the flexibility that a manager has in choosing whether to undertake or abandon a project or change the way a project is managed

B usiness finance

•

•

•

O ption to expand operations— when a firm firs t enters a m arket i t quite often does so on unprofitable terms. That is, firm s w ill quite w illin g ly enter in to a project th a t has a negative NPV. One explanation fo r this seemingly irra tion al behaviour is th a t by gaining a presence in the market, the firm is able to acquire valuable expansion options th a t would otherwise be unavailable. An example o f this type o f behaviour was the intro du ction o f V irg in Blue Airlines to the Australian m arket. In itia lly the airline provided only seven daily Brisbane-Sydney return flights. However, follow ing the collapse o f Ansett Airlines (the second largest domestic carrier in Australia at the tim e), V irg in Blue found itse lf in a position where it could rapidly expand to fill the void le ft by Ansett. O ption to abandon operations— once a firm makes the decision to proceed w ith a project, it generally retains the rig h t to abandon operations and sell o ff the assets dedicated to the project at th e ir salvage value. A t the outset, o f course, the firm does n o t expect to make use o f (or exercise) this option, b u t i t is im p orta nt th a t it has the a bility to do so i f m arket conditions were to move significantly against the project. This does not, however, im p ly th a t the firm w ill abandon operations as soon as a project becomes unprofitable, since by doing so the firm gives up the a bility to remain in the m arket were conditions to change back in the project’s favour. Once we accept the notion th a t managerial fle x ib ility is valuable, ide ntifyin g real options is relatively straightforw ard. The d ifficult p art is to tr y to then value them. A discussion o f the general principles underlying option pricing, as well as a more detailed discussion o f real options analysis, is provided in Chapter 18.

W hile finance academics have been very enthusiastic about the possible im plications o f real options analysis fo r financial managers, the international evidence in Figure 5.1 suggests th a t the actual usage of the technique has been relatively low over an extended tim e interval beginning at the tu rn o f the century. So who is using real options analysis and why are they doing so? In a survey o f the capital budgeting practices o f Fortune 1000 companies in the US, Block (2007) reports th a t users o f the technique tended to be concentrated in industries such as technology, energy and u tilitie s, where sophisticated analysis* was a standard part o f running the business. In a sim ilar survey o f Canadian firm s, Baker, D utta and Saadi (2011) report th a t the most popular reasons cited fo r using real options analysis were that the approach assists management in form ing th e ir strategic vision, fo r the firm while allowing fo r the impact o f managerial fle x ib ility in the analysis. Also o f interest are the factors th a t impede the im plem entation o f real options analysis. Block (2007) finds th a t the m ost frequently cited reason fo r avoiding the technique is *[a] lack o f top management support*. Baker, D utta and Saadi (2011) provide a helpful glimpse at the reason behind th a t lack o f support: th e ir respondent sample nominates a 'lack o f expertise or knowledge* as the m ost significant reason fo r not using the approach.

C hapter five Project

evaluation : principles a n d methods

Of the two discounted cash flow methods of investment evaluation, we recommend the net present value method because it is consistent with the objective of maximising shareholders' wealth. It is also simple to use and gives rise to fewer problems than the internal rate of return method. W e have shown that where mutually exclusive projects are being considered, the internal rate of return method may result in rankings that conflict with those provided by the net present value method. In addition, we have shown that even if investment projects are independent, it is possible that a project's pattern of cash flows may give rise to multiple internal rates of return, or to no internal rate of return at all. If the net present value method is adopted, the rules for making correct investment decisions are straightforward: • Calculate each project's net present value, using the required rate of return as the discount rate.

•

If the projects are independent, accept a project if its net present value is greater than zero, and reject it if its net present value is less than zero. • If the projects are mutually exclusive, accept the project with the highest net present value, provided that it is greater than zero. • In practice, companies often use one method of project evaluation in conjunction with other methods. For example, one of the discounted cash flow methods may be used to measure a project's profitability, but the payback period may also be used, either as a check on liquidity effects or as a means of monitoring the project's cash flows against expectations. • Whereas the evaluation methods considered throughout the chapter tend to treat projects as 'now-or-never7 prospects, and ignore the ability of management to intervene in an ongoing project, real options analysis considers the value associated with managerial flexibility.

KEY TERMS accounting rate of return 1 18 benefit-cost ratio 117 discounted cash flow (DCF) methods independent project 107 internal rate of return (IRR) 107

107

mutually exclusive projects 113 net present value (NPV) 107 payback period 118 real options 123 real options analysis 123

SELF-TEST PROBLEMS The management of a company is considering an investment of $1 8 0 0 0 0 in a project that will generate net cash flows of $101 80 0 at the end of the first year, $ 9 0 0 0 0 at the end of the second year and $ 8 0 0 0 0 at the end of the third year. Assuming a required rate of return of 10 per cent per annum, calculate the project's net present value. Calculate the internal rate of return for the investment in Question 1. Calculate the benefit-cost ratio for the investment in Question 1. Solutions to self-test problems are available in Appendix B.

QUESTIONS 1

[LO 1 ] Outline the four steps in the capital-expenditure process.

2

[LO 2 】What factors does the required rate of return of a project reflect?

3

[LO 2] Compare the internal rate of return and net present value methods of project evaluation. Do these methods always lead to comparable recommendations? If not, why not?

4

[LO 2] Distinguish between independent and mutually exclusive investment projects.

5

[LO 3] Evidence suggests that financial managers use more than one method to evaluate investment projects. Comment on this statement.

C H A P T E R FIVE R E V I E W

SUMMARY

B usiness finance

6

[ L 0 3 ] The internal rate o f return m ethod o f p ro je c t evaluation is easier to use because it avoids the need to

calculate a re q u ire d rate o f return. C o m m e n t o n th is s ta te m e n t. 7

[L O 3 ]

W h a t p ro b le m s a r e a s s o c ia te d w ith th e use o f th e a c c o u n tin g r a te o f re tu rn m e th o d f o r th e

e v a lu a tio n o f in v e s tm e n t p ro p o s a ls ? W h y m ig h t m a n a g e rs b e a ttr a c te d to its use? 8

9

[L O 4 ] Even w here projects are independent, the uncritical use o f the internal rate o f return m ethod can seriously m islead management. D iscuss. [L O 4

】D e m o n s tra te ,

fo r in d e p e n d e n t in v e s tm e n t p ro je c ts , th a t th e in te rn a l ra te o f re tu rn a n d n e t p re s e n t

v a lu e m e th o d s o f e v a lu a tio n y ie ld id e n tic a l d e c is io n s . S p e c ify a n y a s s u m p tio n s y o u m a k e . 10

[LO 4 ] U s in g th e N P V p r o file te c h n iq u e , e x p la in w h y th e IRR a n d N P V ru le s w ill a lw a y s re s u lt in th e s a m e a c c e p t o r r e je c t d e c is io n f o r in d e p e n d e n t p ro je c ts .

11

12

[LO 4 The p a y b a c k p e rio d m ethod o f p ro je c t evaluation is b ia se d a g a in st projects w ith lo n g e r developm ental lives, even w here they ultim ately generate g re a t value fo r the firm. Discuss. [L 0 5 ]

A s th e p re s e n t v a lu e o f a stre a m o f EVAs f o r a n in v e s tm e n t is th e s a m e a s its n e t p re s e n t v a lu e , w h y

d o a n a ly s ts use EVA? 13

[L O 6 ] T h e re is s o m e e v id e n c e th a t w h e n m a n a g e rs e v a lu a te p ro je c ts , th e y s y s te m a tic a lly e m p lo y d is c o u n t ra te s th a t e x c e e d th e ris k -a d ju s te d r e q u ire d ra te o f re tu rn . H o w is th is o b s e r v a tio n c o n s is te n t w ith th e n o tio n th a t re a l o p tio n s a r e im p o r ta n t in p r o je c t e v a lu a tio n ?

14

[L O 6 ] Real options analysis prom ises to be a ve ry p o w e rfu l to o l fo r fin a n c ia l m anagers. D e s c rib e th e e v id e n c e c o n c e r n in g th e p o p u la r ity o f th e a p p r o a c h — re la tiv e to d is c o u n te d c a s h f lo w t e c h n iq u e s — a n d s u g g e s t p o s s ib le re a s o n s f o r th e se resu lts.

cA 1

PROBLEMS

Discount rates, IRR and N P V analysis [LO 2]

A s s u m e th a t y o u a re a s k e d to a n a ly s e th e fo llo w in g th re e p ro je c ts :

A

-2 0 0 0 0 0

20000

20000

20000

20000

220000

B

-2 0 0 0 0 0

52760

52760

52760

52 760

52760

C

-2 0 0 0 0 0

一

一

一

一

322100

C o n s tru c t a s p re a d s h e e t, a n d a s s o c ia te d g ra p h s , th a t w ill e n a b le y o u to a n a ly s e th e im p a c t o f d iffe re n t d is c o u n t ra te s o n th e N P V o f a p r o je c t as w e ll a s c a lc u la te th e IRR fo r a p r o je c t (a n e x a m p le is p r o v id e d in F ig u re 5 .2 ). a)

R a nk th e th re e p ro je c ts a s s u m in g th e a p p r o p r ia te d is c o u n t ra te is: i) 6 p e r c e n t p e r a n n u m

b)

2

ii)

10 per cent per annum

iii)

15 p e r ce n t p e r a n nu m .

C a lc u la te th e IRR fo r e a c h o f th e p ro je c ts , th e n ra n k th e m .

IRR and N P V analysis for independent projects [LO 2] T he fo llo w in g in v e s tm e n t p ro p o s a ls a re in d e p e n d e n t. A s s u m in g a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t, a n d u s in g b o th th e in te rn a l ra te o f re tu rn a n d n e t p re s e n t v a lu e m e th o d s , w h ic h o f th e p ro p o s a ls a r e a c c e p ta b le ? C a s h f lo w ($ )

126

P ro p o s a l

Year 0

Year 1

Year 2

A

-4 0 0 0 0

8000

48000

B

-4 0 0 0 0

42000

C

-4 0 0 0 0

48000

C hapter five Project

evaluation : principles a n d methods

U s in g th e fo llo w in g d a ta , c a lc u la te th e : a)

a c c o u n tin g ra te o f re tu rn

b)

p a y b a c k p e rio d

c)

in te rn a l ra te o f re tu rn

d)

n e t p re s e n t v a lu e . P ro je c t co st:

$100000

E stim a te d life :

5 y e a rs

E s tim a te d re s id u a l v a lu e :

$20000

A n n u a l n e t c a sh f lo w :

$30000

R e q u ire d ra te o f re tu rn :

10%

U se th e s tra ig h t-lin e m e th o d o f d e p r e c ia tio n in y o u r c a lc u la tio n s . H o w w o u ld y o u r a n s w e rs d iff e r if th e n e t c a s h flo w s w e r e a s fo llo w s ? Y e a r 1:

$30000

Year 2:

$40000

Year 3:

$60000

Year 4 :

$20000

Year 5:

$50000

C H A P T E R FIVE R E V I E W

A c c o u n tin g ra te o f r e tu r n , p a y b a c k p e r io d , IRR a n d N P V [L O 2 ]

A c c o u n tin g r a te o f re tu r n a n d p a y b a c k p e r io d [L O 3 ] U s in g th e f o llo w in g d a ta , c a lc u la te : a)

th e a c c o u n tin g ra te o f re tu rn

b)

th e p a y b a c k p e r io d . P ro je c t co st:

$40000

E stim a te d p r o je c t life :

5 y e a rs

E stim a te d re s id u a l v a lu e :

$8000

A n n u a l a c c o u n tin g p r o fit (e q u a l to a n n u a l n e t c a s h in flo w ):

$ 12000

Use th e s tra ig h t-lin e m e th o d o f d e p r e c ia tio n in y o u r c a lc u la tio n s . H o w w o u ld y o u r a n s w e rs to (a) a n d (b) d iffe r if th e e s tim a te d d o lla r re tu rn s w e r e a s fo llo w s ? Year 1

$12000

Year 2

$16000

Year 3

$24000

Year 4

$20000

Year 5

$8000

IRR a n d N P V a n a ly s is [L O 4 ] E ach o f th e fo llo w in g m u tu a lly e x c lu s iv e in v e s tm e n t p ro je c ts in v o lv e s a n in itia l c a sh o u tla y o f $ 2 4 0 0 0 0 . T he e s tim a te d n e t c a s h flo w s fo r th e p ro je c ts a re a s fo llo w s : C a s h f lo w ($) P ro je ct

1

140000

20000

2

80000

40000

3

60000

60000

4

20000

100000

5

20000

180000

127

B usiness finance

T he c o m p a n y 's re q u ire d ra te o f re tu rn is 1 1 p e r ce n t. C o n s tru c t a s p re a d s h e e t, a n d a s s o c ia te d g ra p h s , th a t w ill e n a b le y o u to a n a ly s e th e im p a c t o f d iffe re n t d is c o u n t rates o n th e N P V o f a p r o je c t as w e ll as c a lc u la te th e IRR fo r a p ro je c t. W h a t is th e N P V a n d IRR fo r b o th p ro je c ts ? W h ic h p r o je c t s h o u ld b e c h o s e n ? W h y ?

6

N P V and IRR analysis for mutually exclusive projects [LO 4 】 A c o m p a n y w is h e s to e v a lu a te th e fo llo w in g m u tu a lly e x c lu s iv e in v e s tm e n t p ro p o s a ls :

P ro p o s a l

a)

A

-97400

34000

34000

34000

34000

34000

B

-63200

24000

24000

24000

24000

24000

C a lc u la te e a c h p r o p o s a l’s n e t p re s e n t v a lu e a n d in te rn a l ra te o f re tu rn . A s s u m e th e re q u ire d ra te o f re tu rn is 8 p e r ce n t.

b)

H o w w o u ld y o u e x p la in th e d iffe re n t ra n k in g s g iv e n b y th e n e t p re s e n t v a lu e a n d in te rn a l ra te o f re tu rn m e th o d s?

7

N P V a n d IRR a n a ly s is [L O 4 】 You h a v e b e e n a s k e d to e v a lu a te th e f o llo w in g in v e s tm e n t p ro p o s a ls : C a s h f lo w ($ ) P ro p o s a l

Year 0

Year 1

A

100000

-140000

60000

B

-12000

24000

-20000

Year 2

C a lc u la te th e n e t p re s e n t v a lu e (a s s u m in g a re q u ire d ra te o f re tu rn o f 1 2 p e r cen t) a n d th e in te rn a l ra te o f re tu rn fo r e a c h p ro je c t. E x p la in y o u r results.

REFERENCES Baker, H., Dutta, S. & Saadi, S., 'M anagem ent views on real options in capital budgeting', Journal of A pplied Finance, February 2 0 1 1 , pp. 1 8 -2 9 .

Dixit, A.K. & Pindyck, R.S., 'The options approach to capital investment7, Harvard Business Review, M ay-June 1995, pp. 1 0 5 -1 5 .

Bierman, H. Jr & Smidt, S., The Capital Budgeting Decision: Economic Analysis of Investment Projects, 8th edn, M acmillan Company, N ew York, 1993.

Graham, J.R. & Harvey, C.R., 'The theory and practice of corporate finance: evidence from the field', Journal of Financial Economics, May-June 2 0 0 1 , pp. 1 8 7 -2 4 3 .

Block, S., 'Are "real options” actually used in the real world?' The Engineering Economist, 2 0 0 7 , pp. 2 5 5 -6 7 .

W alker, E.D., Introducing project management concepts using a jewelry store robbery7, Decision Sciences Journal of Innovative Education, Spring 2 0 0 4 , pp. 6 5 -9 .

Burns, R.M. & W a lk e r,」•，'C apital budgeting surveys: The future is now ', jo u m a / o f >App//ec/ 尸 /nance, 2 0 0 9 , pp. 7 8 -9 0 Coleman, L , Maheswaran, K. & Pinder, S., 'N arratives in managers7 corporate finance decisions', Accounting and Finance, September 2 0 1 0 ; pp. 6 0 5 -3 3 .

128

▼ CHAPTER CONTENTS m

H H

I n t r o d u c tio n

130

A n a ly s in g p r o je c t ris k

149

A p p lic a t io n o f th e n e t p r e s e n t v a lu e m e th o d

130

D e c is io n - tr e e a n a ly s is

153

T a x is s u e s in p r o je c t e v a lu a t io n

134

QQj

Q u a lit a t iv e f a c t o r s a n d th e s e le c tio n o f p r o je c ts

156

P r o je c t s e le c tio n w it h r e s o u r c e c o n s tr a in ts

157

C o m p a r in g m u tu a lly e x c lu s iv e p r o je c ts t h a t h a v e d if f e r e n t liv e s

139

H H

D e c id in g w h e n to r e t ir e ( a b a n d o n ) o r r e p la c e a p r o je c t

146

LEARNING OBJECTIVES A f te r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

e x p la in th e p r in c ip le s u s e d in e s t im a tin g p r o je c t c a s h f lo w s

2

e x p la in th e e ffe c ts o f t a x e s o n p r o je c t c a s h flo w s

3

c o m p a r e m u t u a lly e x c lu s iv e p r o je c ts t h a t h a v e d if f e r e n t liv e s

4

d e t e r m in e w h e n to r e t ir e ( a b a n d o n ) o r r e p la c e a s s e ts

5

e x p la in h o w s e n s itiv ity a n a ly s is , b r e a k - e v e n a n a ly s is a n d s im u la t io n a s s is t in a n a ly s in g p r o je c t r is k

6

u s e d e c is io n - tr e e a n a ly s is to a n a ly s e s e q u e n tia l d e c is io n s

7

e x p la in th e r o le o f q u a lit a t iv e f a c t o r s in p r o je c t s e le c tio n

8

e x p la in th e e ffe c ts o f r e s o u r c e c o n s t r a in ts o n p r o je c t s e le c tio n .

B usiness finance

Introduction In C h a p te r 5, m e th o d s o f p ro je c t e v a lu a tio n w e re discussed a n d th e reasons f o r u s in g th e n e t p re s e n t va lu e m e th o d o f p ro je c t e v a lu a tio n w e re o u tlin e d . H o w e ve r, in C h a p te r 5 i t was a ssu m ed t h a t a p ro je c ts cash flo w s a n d th e d is c o u n t ra te a p p lic a b le to th o s e cash flo w s w e re b o th k n o w n . In p ra c tic e , a p ro je c t s cash flo w s a n d re q u ire d ra te o f r e tu r n are n o t k n o w n w it h c e rta in ty b u t m u s t be e s tim a te d . In o th e r w o rd s, p ra c tic a l p ro je c t e v a lu a tio n in v o lv e s im p o r t a n t issues c o n c e rn in g th e e s tim a tio n o f cash flo w s an d ris k . These a n d o th e r issues are th e s u b je c t o f th is c h a p te r. In p a rtic u la r, th e m a tte rs c o n s id e re d in th is c h a p te r in c lu d e : •

th e a p p lic a tio n o f th e n e t p re s e n t v a lu e m e th o d , in c lu d in g th e e s tim a tio n o f cash flo w s

•

u s in g th e n e t p re s e n t v a lu e m e th o d to solve p ro b le m s , such as c o m p a rin g p ro je c ts w it h d iffe re n t liv e s a n d a sse t-re p la ce m e n t de cisio ns

•

th e a p p lic a tio n o f te c h n iq u e s t h a t a llo w m an ag ers to analyse th e r is k o f p ro je c ts

•

th e in flu e n c e o f q u a lita tiv e fa c to rs o n th e s e le c tio n o f in v e s tm e n t p ro je c ts

•

th e p ro b le m s associated w it h u s in g th e n e t p re s e n t v a lu e m e th o d w h e re co m p a n ie s are assu m ed to have o n ly lim ite d access to reso urce s.1

6.2 LEARNING OBJECTIVE 1 Explain the principles used in estimating project cash flows

A pp lica tio n of the net present value method

A n y a p p lic a tio n o f th e n e t p re s e n t va lu e m e th o d re q u ire s e s tim a te s o f p ro je c t cash flo w s . This s e c tio n discusses issues t h a t are im p o r t a n t in d e fin in g th e re le v a n t cash flo w s.

6.2.1 | Estimation of cash flows in project evaluation Issues t h a t a rise in d e fin in g th e re le v a n t cash flo w s in c lu d e th e : •

tre a tm e n t o f fin a n c in g charges

•

in c lu s io n o f in c re m e n ta l cash flo w s

•

im p o rta n c e o f e x c lu d in g s u n k costs

•

tre a tm e n t o f a llo c a te d costs

•

tre a tm e n t o f a p ro je c ts re s id u a l value

•

t im in g o f th e cash flo w s

•

tr e a tm e n t o f in fla tio n . These issues are discussed in tu r n .

Financing charges C o m pa nie s s h o u ld use th e re q u ire d ra te o f r e tu r n to d is c o u n t a p ro je c ts n e t cash flo w s . The re q u ire d rate o f r e tu r n is th e r e tu r n t h a t is s u ffic ie n t to co m p e n sa te s h a re h o ld e rs a n d d e b th o ld e rs f o r th e resources c o m m itte d to th e p ro je c t. I t in clu d e s b o th in te re s t p a id to d e b th o ld e rs a n d re tu rn s to sha reh old ers. T h ere fore, fin a n c in g charges such as in te re s t a n d d iv id e n d s s h o u ld n o t be in c lu d e d in th e c a lc u la tio n o f a p ro je c ts n e t cash flo w s . The in c lu s io n o f fin a n c in g charges in a p ro je c t s n e t cash flo w s a n d in th e d is c o u n t ra te w o u ld re s u lt in d o u b le c o u n tin g .

Incremental cash flows In c a lc u la tin g a p ro je c t s n e t cash flo w s , i t is th e in c re m e n ta l n e t cash flo w s t h a t are im p o r ta n t. A n a n a ly s t s h o u ld in c lu d e

all cash flo w s

t h a t change i f th e p ro je c t is u n d e rta k e n . W h e n d e c id in g w h e th e r a p a rtic u la r

ite m s h o u ld be in c lu d e d , th e a n a ly s t is in te re s te d in th e an sw e rs to tw o q u e s tio n s :

1

The effects of taxes on discount rates are discussed in Chapter 14.

C hapter six T he

application of project evaluation methods

cash ite m ?

a

Is i t a

b

W ill th e a m o u n t o f th e ite m

change i f

th e p ro je c t is u n d e rta k e n ?

I f th e an sw e r to b o th q u e s tio n s is ‘yes’，th e n th e ite m is an in c re m e n ta l cash flo w . I f th e a n sw e r to e ith e r q u e s tio n is ‘n o ’，th e n th e ite m is irre le v a n t to th e an alysis. F o r e xa m p le , assum e t h a t a c o m p a n y is re c e iv in g $ 4 0 0 0 0 p e r yea r fr o m r e n tin g a p o r tio n o f its fa c to ry , a n d t h a t i t is c o n s id e rin g u s in g th a t space to m a n u fa c tu re a p ro d u c t t h a t w i ll r e tu r n n e t cash flo w s o f $ 1 0 0 0 0 0 p e r year. In t h is case, $ 1 0 0 000 o ve rsta tes th e n e t cash flo w s f r o m th e p ro d u c t b y an a m o u n t o f $ 4 0 0 0 0 ; th e cash in flo w fo rg o n e because a p o r tio n o f th e fa c to ry w ill n o t be re n te d . The in c re m e n ta l n e t cash flo w in th is case is $ 6 0 0 0 0 p e r year. The p rin c ip le o f in c lu d in g o n ly in c re m e n ta l cash flo w s m a y seem sim p le , b u t i t s o m e tim e s in v o lv e s d iffic u ltie s such as id e n tify in g s u n k costs a n d a llo c a te d costs.

Sunk costs Suppose t h a t th e S p ilt O il C o m p a n y has s p e n t $ 2 0 m illio n e x p lo rin g a p a r tic u la r area w ith o u t success. H a rv e y M ills , th e g e o lo g is t w h o o r ig in a lly id e n tifie d th a t area as p o te n tia lly va lu a b le , argues t h a t th e co m p a n y s h o u ld spe nd a n o th e r $5 m illio n to d r ill an a d d itio n a l w e ll because: ‘I f w e d o n ’t, th e $ 2 0 m illio n th a t we have a lre a d y s p e n t w i ll be lost*. M r M ills s a rg u m e n t is in c o rre c t because th e $ 2 0 m illio n is a sunk

SUNK COST

cost.

cost that has already been incurred and is irrelevant to future decision making

S u n k costs are p a s t o u tla y s a n d s h o u ld be ig n o re d in m a k in g de cisio n s a b o u t w h e th e r to c o n tin u e a

p ro je c t o r to te rm in a te it . In t h is case, th e $ 2 0 m illio n has a lre a d y b e en s p e n t. T his fig u re w i ll n o t change i f th e p ro je c t is c o n tin u e d o r a b a n d o n e d . A llo w in g s u n k costs to in flu e n c e d e cisio n s can lead to t h r o w in g good m o n e y a fte r b a d 1. R egardless o f w h e th e r $2 o r $2 0 m illio n has a lre a d y be en s p e n t, d e cisio n s o n w h e th e r to c o n tin u e a p ro je c t s h o u ld be based o n ly o n e xp ected

future costs

a n d b e n e fits .

Allocated costs C om panies o fte n a llo ca te costs such as re n t, p o w e r, w a te r, research a n d d e v e lo p m e n t, he ad o ffic e costs, tra v e l an d o th e r ove rh e a d costs to t h e ir d iv is io n s . T h ere fore, w h e n th e p r o fita b ilit y o f a p ro je c t is e stim a te d , th e costs a ttr ib u te d to th e p ro je c t m a y in c lu d e a share o f th e se a llo c a te d costs. The a n a ly s t s h o u ld re m e m b e r t h a t w h e n a p ro je c t is b e in g eva lu ated , o n ly in c re m e n ta l cash flo w s s h o u ld be in c lu d e d . In som e cases, im p le m e n tin g an a d d itio n a l p ro je c t m a y re s u lt in s ig n ific a n tly h ig h e r o v e rh e a d costs, b u t in o th e r cases a n y increase m a y be n e g lig ib le . W h e n e s tim a tin g p ro je c t cash flo w s , a n y a llo c a te d costs s h o u ld be e x a m in e d c a re fu lly to d e te rm in e w h e th e r th e y w o u ld change i f th e p ro je c t w e re to go ahead. I f th e y w o u ld n o t change th e y s h o u ld be exclud ed.

Residual value W h e n a p ro je c t is te rm in a te d , i t is lik e ly t h a t a p o r tio n o f th e in it ia l c a p ita l o u tla y w ill be recovered. This is o fte n te rm e d th e p ro je c ts

residual value.

A p ro je c ts re s id u a l va lu e w ill be th e d isp o sa l va lu e o f th e

p ro je c ts assets, less a n y d is m a n tlin g a n d re m o v a l costs associated w it h th e te r m in a tio n o f th e p ro je c t.

Timing of the cash flows In som e cases, fin a n c ia l c a lc u la tio n s are based o n th e precise t im in g o f th e re le v a n t cash flo w s . F o r exam ple, such p re c is io n is s ta n d a rd p ra c tic e w h e n c a lc u la tin g th e va lu e o f m a rk e ta b le d e b t s e c u ritie s such as b o n d s a n d b a n k b ills . In the se cases, b o th th e a m o u n t a n d th e t im in g o f th e cash flo w s are k n o w n . H o w eve r, w h e n an in v e s tm e n t p ro je c t is e va lu a te d , th e m a g n itu d e o f th e cash flo w s is ra re ly k n o w n b u t m u s t be e s tim a te d , u s u a lly w it h som e degree o f e rro r. S im ila rly , th e t im in g o f cash flo w s can ra re ly be e s tim a te d p re c is e ly a n d th e s im p lify in g a s s u m p tio n t h a t n e t cash flo w s are rece ive d a t th e e n d o f a p e rio d is u s u a lly a d o p te d . T his a s s u m p tio n reduces th e c o m p le x ity o f th e n e t p re s e n t v a lu e c a lc u la tio n s w ith o u t causing a m a rk e d decrease in th e ir re lia b ility , a n d i t is th e a s s u m p tio n a d o p te d in th e re m a in d e r o f th is cha pter.

Inflation and project evaluation The A u s tra lia n e co n o m y has a t tim e s e xp e rie n ce d p ro lo n g e d p e rio d s o f in fla tio n . D u rin g a p e rio d o f in fla tio n th e re is an in crea se in th e g e n e ra l le v e l o f p rice s a n d hence a fa ll in th e p u rc h a s in g p o w e r o f m oney. There are tw o a p pro ache s to in c o rp o ra tin g th e e ffe cts o f in fla t io n in to p ro je c t e v a lu a tio n .

RESIDUAL VALUE

disposal value of a project's assets less any dismantling and removal costs associated with the project's termination

B o th ap pro ache s, a p p lie d c o n s is te n tly , w ill g ive th e sam e n e t p re s e n t value . B o th re q u ire th e a n a ly s t to e s tim a te th e f u tu r e ra te o f in fla tio n . O ne a p p ro a ch in v o lv e s m a k in g e s tim a te s o f cash flo w s t h a t are based o n a n tic ip a te d p rice s d u rin g each y e a r o f a p ro je c ts life , a n d d is c o u n tin g th o s e cash flo w s a t th e n o m in a l re q u ire d ra te o f r e tu rn . In th is case, th e e s tim a te d n e t cash flo w s fr o m a p ro je c t in , say, its f o u r t h y e a r o f o p e ra tio n are based on th e p ric e s e xp ected in t h a t f o u r t h year. The presence o f in fla t io n th e re fo re m akes th e jo b o f e s tim a tin g n e t cash flo w s m o re d iffic u lt, esp e cia lly i f p rice s are e xp e cte d to increase a t a ra p id ra te . The use o f th e

nominal re q u ire d

ra te o f r e tu r n m ea ns t h a t th e d is c o u n t ra te re fle c ts th e m a rk e ts e x p e c ta tio n s a b o u t th e

ra te o f in fla tio n . I f i t is e xp e cte d t h a t th e ra te o f in fla t io n w ill increase in th e fu tu re , th e n m a rk e t pressure s h o u ld le a d to an increase in th e n o m in a l re q u ire d ra te o f r e t u r n o n an in v e s tm e n t. T h e re fo re , o b serve d n o m in a l ra te s o f r e tu r n have b u ilt in to th e m e xp ected f u tu r e in fla t io n rates. T his a p p ro a ch is c o n s is te n t, in t h a t n e t cash flo w s based o n a n tic ip a te d f u tu r e p ric e le vels are d is c o u n te d a t th e n o m in a l re q u ire d rate o f r e tu r n , w h ic h also has b u ilt in to i t e xp ected in fla t io n rates. The o th e r a p p ro a ch in v o lv e s e s tim a tin g th e n e t cash flo w s w ith o u t a d ju s tin g th e m f o r a n tic ip a te d changes in p rice s, a n d d is c o u n tin g th o se cash flo w s a t th e

real re q u ire d

ra te o f re tu rn . In o th e r w o rd s, th e

n e t cash flo w s are e s tim a te d u s in g e x is tin g (c o n s ta n t) prices. To be c o n s is te n t i t is n e cessa ry to d is c o u n t the se n e t cash flo w s a t th e real re q u ire d ra te o f re tu rn , w h ic h excludes e xp e cte d in fla tio n . E xa m p le 6.1 illu s tra te s t h a t th e tw o approaches, a p p lie d c o n s is te n tly , g ive th e sam e re s u lt.

Example 6.1 A s s u m e th a t a n in v e s tm e n t o f $ 1 0 0 0 is e x p e c te d to g e n e r a te c a s h flo w s o f $ 5 0 0 , a t c o n s ta n t p ric e s , a t th e e n d o f e a c h o f 3 y e a rs . A s s u m e a ls o th a t p ric e s a r e e x p e c te d to in c re a s e a t th e ra te o f 1 0 p e r c e n t p e r a n n u m a n d th a t th e n o m in a l r e q u ire d ra te o f re tu rn is 1 5 p e r c e n t p e r a n n u m . W h a t is th e p r o je c t's n e t p re s e n t v a lu e ?

SOLUTION U s in g th e firs t a p p r o a c h , th e n e t p re s e n t v a lu e o f th e in v e s tm e n t is a s fo llo w s :

$]〇〇〇| $500 (1.10 ) f $ 5 0 0 (1 .10)2 ( $ 5 0 0 (1 .10)3 1.15

(1.15)2

(1.15 )3

= $ 1 0 0 0 = $550 + ^ + 1.15 1.3225 1 .5 209 = $ 3 73 U s in g th e s e c o n d a p p r o a c h , th e n e t c a s h f lo w o f $ 5 0 0 p e r a n n u m a t c o n s ta n t p ric e s is d is c o u n te d a t th e re a l r e q u ire d ra te o f re tu rn . A s d is c u s s e d in S e c tio n s 1 . 5 . 4 a n d 3 . 4 . 4 , th e re a l ra te m a y b e e x p re s s e d in te rm s o f th e n o m in a l ra te a s fo llo w s :

1+p w h e re

i* = th e

re a l ra te o f re tu rn p e r a n n u m

/ = th e n o m in a l ra te o f re tu rn p e r a n n u m p = th e a n t ic ip a t e d ra te o f in fla tio n p e r a n n u m T h e re fo re :

1.10 = 4 .5 5 % T he n e t p re s e n t v a lu e is th e n c a lc u la te d a s fo llo w s :

$500

$500

$500

1 .0 455

(1.0455)2

(1 .0 4 5 5 )3

-$ 1 0 0 0 + J 5 0 ^ + J 5 0 ^ + J 5 0 ^ 1.0455

= $373

1.0931

1.1428

C hapter six T he

application of project evaluation methods

In su b se q u e n t exam ples, th e f ir s t a p p ro a ch to in c o rp o ra tin g th e e ffe c t o f in fla t io n in to p ro je c t e v a lu a tio n is g e n e ra lly a d o p te d . U n lik e th e second ap p ro a ch , i t can be re a d ily a p p lie d w h e re th e a n a ly s t w ishes to in c o rp o ra te d iffe re n t rates o f change in p rice s f o r d iffe re n t c o m p o n e n ts o f a p ro je c ts cash flo w s. F o r exam ple, th e ra te o f change in wage rates m a y be fo re c a s t to be d iffe re n t fr o m th e ra te o f change in ra w m a te ria ls prices. In a d d itio n , th e seco nd a p p ro a ch re q u ire s re lia b le e s tim a te s o f th e a n tic ip a te d ra te o f in fla tio n , w h ic h m a y be d iff ic u lt to o b ta in . T h e re fo re , th e f ir s t a p p ro a ch is easier to h a n d le in practice.

6 .2 .2 1 Illustration of cash-flow information in project evaluation The cash flo w in fo r m a tio n t h a t s h o u ld be c o m p ile d f o r p ro je c t e v a lu a tio n is illu s tra te d in E xa m p le 6.2.

Example 6.2 T he F ra n k S to n e C o m p a n y is c o n s id e r in g th e in tr o d u c tio n o f a n e w p ro d u c t. G e n e r a lly , th e c o m p a n y 's p ro d u c ts h a v e a life o f a b o u t 5 y e a rs , a fte r w h ic h th e y a r e d e le te d fro m th e r a n g e o f p ro d u c ts th a t th e c o m p a n y sells. T he n e w p r o d u c t re q u ire s th e p u rc h a s e o f n e w e q u ip m e n t c o s tin g $ 4 0 0 0 0 0 0 , in c lu d in g f r e ig h t a n d in s ta lla tio n c h a rg e s . T h e u se fu l life o f th e e q u ip m e n t is 5 y e a rs , w ith a n e s tim a te d re s id u a l v a lu e o f $1 5 7 5 0 0 0 a t th e e n d o f th a t p e r io d . T he n e w p r o d u c t w ill b e m a n u fa c tu re d in a f a c t o r y a lr e a d y o w n e d b y th e c o m p a n y . T h e fa c to r y o r ig in a lly c o s t $1 5 0 0 0 0 0 to b u ild a n d h a s a c u r r e n t re s a le v a lu e o f $ 3 5 0 0 0 0 0 , w h ic h s h o u ld re m a in f a ir ly s ta b le o v e r th e n e x t 5 y e a rs . T h is f a c t o r y is c u r r e n tly b e in g re n te d to a n o th e r c o m p a n y u n d e r a le a s e a g r e e m e n t th a t h a s 5 y e a rs to ru n a n d p r o v id e s f o r a n a n n u a l re n ta l o f $ 1 5 0 0 0 0 . U n d e r th e le a s e a g re e m e n t, th e F ra n k S to n e C o m p a n y c a n c a n c e l th e le a s e b y im m e d ia te ly p a y in g th e le ssee c o m p e n s a tio n e q u a l to 1 y e a r 's re n ta l p a y m e n t. It is e x p e c te d th a t th e p r o d u c t w i ll in v o lv e th e c o m p a n y in s a le s p r o m o tio n e x p e n d itu re s th a t w ill a m o u n t to $ 5 0 0 0 0 0 d u r in g th e firs t y e a r th e p r o d u c t is o n th e m a rk e t. A d d it io n s to c u r r e n t a sse ts w ill re q u ire $ 2 2 5 0 0 0 a t th e c o m m e n c e m e n t o f th e p r o je c t a n d a r e a s s u m e d to b e fu lly r e c o v e r a b le a t th e e n d o f th e fifth y e a r. T h e n e w p r o d u c t is e x p e c te d to g e n e r a te n e t o p e r a tin g c a s h flo w s a s fo llo w s : Y e a r 1: $ 2 0 0 0 0 0 0 Year 2 : $ 2 5 0 0 0 0 0 Year 3: $3 2 5 0 0 0 0 Year 4 : $ 3 0 0 0 0 0 0 Year 5 : $ 1 5 0 0 0 0 0 It is a s s u m e d th a t a ll c a s h flo w s a r e re c e iv e d a t th e e n d o f e a c h y e a r a n d th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m . W h a t is th e n e t p re s e n t v a lu e o f a d d in g th e n e w p ro d u c t?

SOLUTION T he s o lu tio n to th is e x a m p le is se t o u t in T a b le 6 . 1 .

TABLE 6.1 Cash flow information for adding the new product C ash Item

1.

I n it ia l o u tla y

2.

Sale o f e q u ip m e n t

Year 0

Year 1

flows ($，_

Year 2

Year 3

Year 4

Year 5

(4000) 1575

continued

B usiness finance

T a ble 6.1

3.

continued

Factory The cost and the c u rre n t resale value o f th e fa c to ry are b o th irre le v a n t (a) Cancel lease

(150)

(b) N e t cash flo w forgo ne due to re n t forgone

(150)

4.

M a rk e t research o u tla y

(500)

5.

A d d itio n s to cu rre n t assets

6.

(150)

(150)

(150)

(225)

(150)

225

N e t cash flow s fro m operations: Year 1: $2 000 000

2000

Year 2: $ 2 5 0 0 000

2500

Year 3: $ 3 2 5 0 0 0 0

3250

Year 4: $ 3 0 0 0 0 0 0

3000

Year 5: $ 1 5 0 0 0 0 0 T otal

1500 (4375)

1350

2350

3100

2850

3150

1.000 00

0.909 09

0.826 45

0.751 31

0.683 01

0.620 92

Present value o f n e t cash flow s

(4375)

1227.3

1942.1

2329.1

1946.6

1955.9

N e t pre sen t value

$5026

D is c o u n t fa c to r a t 10%

O n th e b a s is o f th is q u a n tita tiv e a n a ly s is th e c o m p a n y s h o u ld a d d th e n e w p r o d u c t to its p r o d u c t lin e .

6.3

Tax issues in project evaluation

So fa r in o u r d iscu ssio n o f a lte rn a tiv e m e th o d s o f p ro je c t e v a lu a tio n w e have o u tlin e d th e reasons fo r LEARNING OBJECTIVE 2 Explain the effects of taxes on project cash flows

p r e fe r r in g th e use o f th e n e t p re s e n t va lu e m e th o d . H o w e ve r, th e e ffe cts o f taxes have so fa r b e en ig n o re d . The e ffe c ts o f taxes are c o n sid e re d in th is se ctio n .

6.3.1 | Effect of taxes on net cash flows I f th e re w e re n o taxes, th e m a g n itu d e a n d t im in g o f a p ro je c ts cash in flo w s a n d o u tflo w s w o u ld be th e o n ly re le v a n t cash flo w in fo r m a tio n f o r p ro je c t e v a lu a tio n p u rp o se s. H o w e ve r, u n d e r th e p ro v is io n s o f th e

Income TaxAssessmentAct 1936} ta x is assessed o n th e ta x a b le in c o m e o f in d iv id u a ls a n d com p an ies. Taxable in co m e is th e d iffe re n c e b e tw e e n gross in c o m e a n d c e rta in a llo w a b le d e d u c tio n s s p e c ifie d in th e A c t. In c o m e ta x pa yab le is g e n e ra lly c a lc u la te d as a pe rce n ta g e o f ta x a b le in co m e . In c o m e ta x is a m a jo r cash o u tflo w f o r m o s t co m p a n ie s a n d its e ffe c t s h o u ld be co n sid e re d to g e th e r w it h o th e r cash in flo w s a n d o u tflo w s . The ta x re la tin g to a p ro je c t s h o u ld be tre a te d as a cash o u tflo w w h e n th e ta x is p a id . F o r exa m ple, i f

^0^

ta x w ere u s u a lly p a id a t th e en d o f th e y e a r fo llo w in g th e ye a r o f in c o m e , th e n a 1 2 -m o n th la g w o u ld be

C hapter six T he

application of project evaluation methods

a p p ro p ria te f o r c a lc u la tin g a fte r-ta x n e t cash flo w s . H o w e ve r, f o r ease o f c a lc u la tio n , w e assum e t h a t ta x is p a id w h e n th e associated cash in flo w is received. A p ro je c ts a fte r-ta x n e t cash flo w s f o r each p e rio d m a y be c a lc u la te d as: A fte r-ta x n e t cash flo w = n e t cash flo w b e fo re ta x x (1 - tc)

m

w h ere tc = s ta tu to r y c o m p a n y in c o m e ta x ra te 2 H ow ever, th is e q u a tio n ig n o re s th e e ffe c t o f th e ta x d e d u c tib ility o f expenses t h a t do n o t in v o lv e a cash o u tflo w . In p a rtic u la r, d e p re c ia tio n o f n o n -c u rre n t assets, e x c lu d in g la n d an d, in som e cases, b u ild in g s , is an a llo w a b le d e d u c tio n f o r in c o m e ta x p u rp o se s. D e p re c ia tio n is n o t it s e lf a n o u tflo w o f cash, b u t th e fa ct th a t d e p re c ia tio n is d e d u c tib le f o r ta x p u rp o se s reduces th e in c o m e ta x th a t w o u ld o th e rw is e be payable— a n d in c o m e ta x is d e fin ite ly a cash o u tflo w . The h ig h e r is th e d e p re c ia tio n charge, th e lo w e r is th e in co m e ta x payable b y th e co m p a n y a n d hence th e h ig h e r w ill be th e c o m p a n y s a fte r-ta x n e t cash flow . This increase in a fte r-ta x n e t cash flo w s is re p re s e n te d b y th e ta x savings o n d e p re c ia tio n , w h ic h is calcula ted as fo llo w s :

6.2

Tax savings o n d e p re c ia tio n = d e p re c ia tio n x tc

T herefore, th e a fte r-ta x n e t cash flo w s g e n e ra te d b y an in v e s tm e n t p ro je c t m a y be c a lc u la te d b y s u m m in g E q u a tio n s 6.1 a n d 6 .2 as fo llo w s : A fte r - ta x n e t cash flo w = n e t cash flo w x (1 - tc)

+ d e p re c ia tio n

x tc

6.3

E xam p le 6.3 illu s tra te s th e a p p lic a tio n o f E q u a tio n 6.3.

Example 6.3 A p ro je c t's b e fo re -ta x n e t c a s h f lo w is e x p e c te d to b e $ 1 0 0 0 0 0 p e r a n n u m . F o r ta x p u rp o s e s th e d e p r e c ia tio n c h a r g e is $ 1 0 0 0 0 p e r a n n u m a n d th e c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r . The a fte r-ta x n e t c a s h f lo w is c a lc u la te d a s fo llo w s :

After-tax net cash flow = $ 1 0 0 000(1 - 0 . 3 0 ) + $ 1 0 0 0 0 (0.30) = $ 7 0 0 0 0 + $7000 =$77000

The e ffe c t o f d e p re c ia tio n o n p ro je c t cash flo w s is m o re co m p le x th a n E xa m p le 6.3 suggests because th e Income Tax A ssessm en t A ct a llo w s tw o m e th o d s o f c a lc u la tin g d e p re c ia tio n : th e straight-line (or prime-

cost) method a n d th e reducing-balance (or dim inishing-value) method. I f th e re d u cin g -b a la n ce m e th o d is used, th e a llo w a b le d e p re c ia tio n ra te is g e n e ra lly tw ic e th e s tra ig h t-lin e ra te .3 The d e p re c ia tio n charge c a lc u la te d f o r ta x p u rp o se s m a y b e a r n o re la tio n s h ip to t h a t ca lcu la te d f o r fin a n c ia l r e p o rtin g p u rp o s e s . F o r exa m ple, a co m p a n y m a y use th e s tra ig h t-lin e m e th o d f o r re p o rtin g p u rpo ses a n d th e re d u c in g -b a la n c e m e th o d f o r in c o m e ta x p u rp o se s. S tra ig h t-lin e d e p re c ia tio n in v o lv e s a llo c a tin g th e asse ts co st in e q u a l a m o u n ts o v e r its e s tim a te d u s e fu l life . T h a t is, g iv e n th e a sse ts in it ia l cost, C, a n d its e s tim a te d u s e fu l life o f n years, th e s tra ig h t-lin e d e p re c ia tio n charge in each ye a r o f th e assets life is C /n .4SF o r e xa m p le , i f an asset costs $ 1 0 0 0 0 0 a n d has a 1 0 -y e a r life , th e a n n u a l d e p re c ia tio n charge is $ 1 0 0 0 0 0 / 1 0 = $ 1 0 0 0 0.

2 3

4

As discussed in Section 14.3, under the imputation system that exists in Australia, a company's effective tax rate may be less than the statutory tax rate and in most cases it is appropriate for the effective tax rate to be used. For eligible assets purchased after 10 May 2006, the allowable depreciation rate using the reducing-balance method is twice the straight-line rate. For assets purchased prior to that date, the allowable depreciation rate using the reducingbalance method is 1.5 times the straight-line rate. Taxpayers have at times been able to claim an investment allowance that is essentially an additional depreciation deduction—for example, as part of its economic stimulus package announced in 2009, the Australian Government permitted small businesses to claim a one-off additional 50 per cent tax deduction on the purchase of eligible new assets or the improvement of eligible existing assets. Assets that qualified for the allowance were basically those that could be depreciated for tax purposes. This contrasts with the method of calculating depreciation for financial reporting purposes. In accounting, the straight-line depreciation charge is: (C -S )/n

where C = initial cost S = estimated residual value or scrap value n = estimated useful life in years

B usiness finance

Example 6.4 Table 6.2 shows the calculation of the present value of the tax effects associated with depreciation and disposal of an asset that costs $100000, has an estimated useful life of 5 years and a disposal value of $7776 at the end of the fifth year. The company income tax rate is 30 per cent and the after-tax discount rate is 10 per cent per annum. Table 6.2 shows that the reducing-balance method should be preferred because it results in a higher present value of tax savings and net sale proceeds.

TABLE 6.2 Tax effects of depreciation and sale of an asset -

I

Depreciation method

-------------------------------------------------------------------- ------------------------------Straight lin e ^

—

Reducing balance⑹

($)

Present value of tax savinqs and proceeds of sale, net of tax ($)

40000

12 000

10909

4959

24000

7200

5 950

6000

4508

14400

4320

3 246

20000

6000

4098

8640

2592

1770

20000

6000

3 726

5184

1555

966

End of year

Present value factor

1

0.90909

20000

6000

5454

2

0.82645

20000

6000

3

0.75131

20000

4

0 .6 8 3 0 1

5

0.62092

Disposal

Allowable Tax depreciation savings^ expense ($)' ($)

Present value of tax savings and proceeds Allowable of sale, net depreciation of tax ($) expense ($)

Tax savings

—

7 7 7 6 (b )

—

4828

7776

—

4828

—

7776

—

—

0

—

—

—

—

(2332)

(1448)

—

—

一

26124

一

value G ain on sale Tax on

0

0

gain T o ta l

_

一

27669

(a) Straight-line depreciation is charged at a rate of 20 per cent of acquisition cost, and reducing-balance depreciation is charged at a rate of 40 per cent of the written-down value. (b) It is assumed that at the end of Year 5 the asset is sold for $7776. Under the reducing-balance method of depreciation, this is equal to the written-down value at the end of Year 5 and there is no gain or loss on sale. Consequently, there is no tax effect on the $7776. The present value of the cash inflow is calculated in the usual way and equals $7776 x (0.620 92) = $4828. Under the straight-line method of depreciation, as the whole of the asset's acquisition cost has been written off for tax purposes by the end of Year 5, the $7776 received at that time is regarded as a gain on sale for tax purposes, and increases tax payable by $2332. The present value of this tax payment is $ 1448. (c) Tax savings are equal to allowable depreciation expenses x 0.30.

C hapter six T he

In c o n tra s t, re d u c in g -b a la n c e d e p re c ia tio n in v o lv e s c h a rg in g a fix e d

amount)

percentage

application of project evaluation methods

(ra th e r th a n a fix e d

o f th e asse ts w r itte n - d o w n (o r a d ju s ta b le ) v a lu e in each year. The a sse ts w r itte n - d o w n value

is equal to its cost o r o th e r v a lu e (such as a re v a lu e d a m o u n t) less a c c u m u la te d d e p re c ia tio n , w h e re a ccu m u la te d d e p re c ia tio n is eq u a l to th e s u m o f th e d e p re c ia tio n charges in p re v io u s years. In c o m p a ris o n w ith s tra ig h t-lin e d e p re c ia tio n , th e re d u cin g -b a la n ce m e th o d o f d e p re c ia tio n re s u lts in la rg e r d e p re c ia tio n charges in th e e a rly years o f a n a s s e ts life a n d s m a lle r charges in la te r years. T h ere fore, co m p a re d w ith th e s tra ig h t-lin e m e th o d , re d u c in g -b a la n c e d e p re c ia tio n re s u lts in lo w e r taxes a n d h ig h e r a fte r-ta x cash flo w s in th e e a rly years. The t o t a l in c o m e ta x p a id is n o t re d u ce d b y u s in g th e re d u cin g -b a la n ce m e th o d . H ow ever, a p o r tio n o f th e ta x payable is p o s tp o n e d in th e e a rly years o f th e p ro je c ts life . G ive n t h a t a d o lla r to d a y is w o r th m o re th a n a d o lla r in a y e a rs tim e , i t fo llo w s t h a t th e use o f th e re d u cin g -b a la n ce m e th o d is g e n e ra lly a d va n ta g e o u s to an asset’s ow ne r. The a fte r-ta x cash flo w s a sso cia te d w it h o w n e rs h ip o f a d e p re cia b le asset also d e p e n d o n th e re la tio n s h ip b e tw e e n th e a s s e ts d isp o sa l v a lu e a n d its w r itte n - d o w n value. I f th e d isp o sa l va lu e is eq ua l to th e w r itte n - d o w n va lu e , th e n sale o f th e asset has n o e ffe c t o n ta x p a id b y th e seller. H o w e ve r, i f th e tw o values d iffe r, th e re are tw o p o s s ib ilitie s :

a

The asse ts d isp o sa l v a lu e is less th a n it s w r itte n - d o w n value Suppose t h a t an asset is s o ld f o r $ 1 0 0 0 0 0 b u t its w r itte n - d o w n va lu e is $ 2 5 0 00 0. The d iffe re n c e o f $ 1 5 0 0 0 0 is reg ard ed as a loss o n sale, w h ic h is ta x d e d u c tib le . I f t c = 0 .3 0 , th e ta x sa vin g o n th e loss o f $ 1 5 0 0 0 0 is $ 1 5 0 0 0 0 x 0 .3 0 = $ 4 5 0 0 0. T his ta x s a vin g is tre a te d as a cash in flo w , so th e n e t a fte r ­ ta x proceeds are $ 1 4 5 0 0 0. The asset s d is p o s a l va lu e is m o re th a n its w r itte n - d o w n value

b

Suppose t h a t an asset is s o ld f o r $ 3 0 0 00 0, w h ic h is $ 5 0 0 0 0 m o re th a n its w r itte n - d o w n va lu e . In th is case th e g a in o n sale o f $ 5 0 0 0 0 is re g ard ed as re c o v e ry o f d e p re c ia tio n d e d u c tio n s t h a t w ere p re v io u s ly cla im e d . T h e re fo re , th e g a in is ta xa b le b u t th e ta x m a y be d e fe rre d b y d e d u c tin g th e g a in fro m th e w r itte n - d o w n v a lu e o f a re p la c e m e n t asset o r o th e r de p re cia b le assets.5 I f th e g a in is ta xe d im m e d ia te ly , th e n e t sale pro cee ds are $ 3 0 0 0 0 0 - $ 5 0 0 0 0 x 0 .3 0 = $ 2 8 5 0 0 0 . The ta x e ffe cts o f th e s tra ig h t-lin e a n d re d u cin g -b a la n ce m e th o d s are co m p a re d in E xa m p le 6.4.

6 .3 .2 1 Illustration of cash-flow information in project evaluation with taxes E a rlie r in th is c h a p te r w e co n s id e re d th e c a s h -flo w in fo r m a tio n t h a t s h o u ld be c o m p ile d f o r p ro je c t e va lu a tio n . E xam p le 6.5 illu s tra te s h o w taxes s h o u ld be in c o rp o ra te d in to th e c o m p ila tio n o f cash flo w s.

E xample 6.5 The C la r e n d o n C o m p a n y is c o n s id e r in g th e in tr o d u c tio n o f a n e w p r o d u c t. G e n e r a lly , th e c o m p a n y 's p ro d u c ts h a v e a life o f a b o u t 5 y e a rs , a fte r w h ic h th e y a r e d e le te d fro m th e ra n g e o f p ro d u c ts th a t th e c o m p a n y sells. T he n e w p r o d u c t r e q u ire s th e p u rc h a s e o f n e w e q u ip m e n t c o s tin g $ 6 0 0 0 0 0 , in c lu d in g f r e ig h t a n d in s ta lla tio n c h a rg e s . T h e u s e fu l life o f th e e q u ip m e n t is 5 y e a rs , w ith a n e s tim a te d r e s id u a l v a lu e o f $ 2 3 6 5 0 0 a t th e e n d o f th a t p e r io d . T h e e q u ip m e n t w ill b e d e p r e c ia te d fo r ta x p u rp o s e s b y th e r e d u c in g - b a la n c e m e th o d a t a ra te o f 2 0 p e r c e n t p e r a n n u m . T he n e w p r o d u c t w ill b e m a n u fa c tu re d in a f a c t o r y a lr e a d y o w n e d b y th e c o m p a n y . T h e f a c t o r y o r ig in a lly c o s t $ 2 0 0 0 0 0 to b u ild a n d h a s a c u rre n t re s a le v a lu e o f $ 5 0 0 0 0 0 , w h ic h s h o u ld re m a in f a ir ly s ta b le o v e r th e n e x t 5 y e a rs . T h is f a c t o r y is c u rre n tly b e in g re n te d to a n o th e r c o m p a n y u n d e r a le a s e a g r e e m e n t th a t h a s 5 y e a r s to ru n a n d p r o v id e s f o r a n a n n u a l re n ta l o f $ 2 0 0 0 0 . U n d e r th e

continued 5

Replacement decisions are discussed in Section 6.5.2.

continued le a s e a g r e e m e n t th e C la r e n d o n C o m p a n y c a n c a n c e l th e le a s e b y p a y in g th e le sse e c o m p e n s a tio n e q u a l to 1 y e a r 's re n ta l p a y m e n t. T h is a m o u n t is n o t d e d u c tib le fo r in c o m e ta x p u rp o s e s . It is e x p e c te d th a t th e p r o d u c t w ill in v o lv e th e c o m p a n y in s a le s p r o m o tio n e x p e n d itu re s , w h ic h w ill a m o u n t to $ 6 0 0 0 0 d u r in g th e firs t y e a r th e p r o d u c t is o n th e m a rk e t. T h is a m o u n t is d e d u c tib le fo r in c o m e ta x p u rp o s e s in th e y e a r in w h ic h th e e x p e n d itu re is in c u rre d . A d d it io n s to c u rre n t a sse ts w ill re q u ire $ 3 2 0 0 0

a t th e c o m m e n c e m e n t o f th e p r o je c t a n d a re

a s s u m e d to b e fu lly r e c o v e r a b le a t th e e n d o f th e fifth y e a r. T he n e w p r o d u c t is e x p e c te d to g e n e r a te n e t o p e r a tin g c a s h flo w s (b e fo re d e p r e c ia t io n a n d in c o m e ta x ) a s fo llo w s : •

Y e a r 1: $ 3 0 0 0 0 0

•

Year 2: $ 3 7 5 0 0 0

•

Year 3: $ 4 9 0 0 0 0

•

Year 4: $ 4 5 0 0 0 0

•

Year 5 : $ 2 2 5 0 0 0 It is a s s u m e d th a t a ll c a s h flo w s a r e re c e iv e d a t th e e n d o f e a c h y e a r a n d th a t in c o m e t a x is p a id

a t th e e n d o f th e y e a r in w h ic h th e in flo w o c c u rre d . T h e c o m p a n y in c o m e t a x ra te is 3 0 c e n ts in th e d o lla r . T h e c o m p a n y h a s a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t a fte r ta x . T h e s o lu tio n to th is e x a m p le is se t o u t in T a b le 6 . 3 .

SOLUTION TABLE 6 . 3

C a s h - flo w in f o r m a tio n f o r th e e v a lu a tio n o f th e p u r c h a s e o f n e w e q u ip m e n t After-tax cash flows Item

Year 0

1. I n itia l o u tla y 2. D e p re c ia tio n Year

Year 1

Year 2

；

Year 3 j Year 4

Year 5

(600000)

Writtendown value ($)

Depreciation

1

600000

20

120000

36000

—

36000

—

—

—

—

2

480000

20

96000

28800

—

—

28800

—

—

—

3

384000

20

76800

23040

—

—

—

23 040

—

—

4

307200

20

61440

18432

—

—

—

—

18432

—

5

245 760

20

49152

14746

—

—

—

—

—

14746

( %) ( $ )

Tax savings at 30c in $

3. S ale o f e q u ip m e n t Sale

$236500

W ritten-down value

$196608

Gain on sale

$39892

Tax on gain at 30%

$11968

Total proceeds

$236500 -$ 1 1 9 6 8

—

—

—

—

—

224532

C hapter six T he

T able 6 .3

application of project evaluation methods

continued

4. Factory

—

—

—

—

—

The cost and th e c u rre n t resale value o f the fa c to ry are b o th irre le v a n t a.

Cancel lease

b.

N e t cash flo w forgone due to re n t

(2 0 0 0 0 )

forgone $20000 ( 1 -0 .3 0 ) 5.

—

(1 4 0 0 0 ) (1 4 0 0 0 ) (1 4 0 0 0 ) (1 4 0 0 0 )

(1 4 0 0 0 )

—

(4 2 0 0 0 )

(32 000)

—

—

_

—

32000

Market research outlays

O u tla y

$60000

Less n e t ta x savings a t 30%

$18000 $42000

6. Addition to current assets

______ ______________________________

7. Net cash flows from operations after

deducting company income tax Year 1: $ 3 0 0 0 0 0

(1 - 0 .3 0 )

—

210000

—

—

—

—

Year 2: $ 3 7 5 0 0 0

(1 - 0 .3 0 )

—

—

262500

—

—

—

Year 3: $ 4 9 0 0 0 0

(1 - 0.30)

—

—

—

343000

—

—

Year 4: $ 4 5 0 0 0 0

(1 - 0 .3 0 )

—

—

—

—

315000

—

Year 5: $ 2 2 5 0 0 0

(1 - 0 .3 0 )

—

—

—

—

—

157500

-6 5 2 0 0 0

190000

277300

352040

319432

414778

0.90909 0.82645 0.75131 0.68301

0.62092

218176

257544

Total D iscoun t fa c to r a t 10% Present value o f n e t cash flow s

1.0000 -6 5 2 000

172727

229173

264493

N et present value = $ 4 9 0 1 1 4 O n th e b a s is o f th is q u a n tita tiv e a n a ly s is , th e n e w p r o d u c t s h o u ld b e m a n u fa c tu re d .

6.4

C om paring mutually exclusive projects that have different lives

In C h a p te r 5 w e c o m p a re d m u t u a lly e xclu sive p ro je c ts t h a t h a d th e sam e life . In p ra c tic e , m a n a g e m e n t w ill fr e q u e n tly have to c o m p a re m u tu a lly e x c lu s iv e p ro je c ts t h a t ha ve d iffe re n t e c o n o m ic liv e s . Such p ro je c ts w i ll o fte n in v o lv e e q u ip m e n t t h a t is o f d iffe re n t q u a lity a n d th e re fo re also o f d iff e r e n t cost. Suppose t h a t a coffee sh o p can b u y e ith e r a T it a n co ffe e m a k e r w it h a life o f 3 yea rs o r th e h ig h e r q u a lity , m o re e xp e n sive , V u lc a n co ffe e m a k e r w it h a lif e o f 5 yea rs to p e r fo r m th e sam e jo b . B o th coffee m a ke rs ge n e ra te th e sam e cash in flo w s , so one w a y to co m p a re th e m w o u ld be to c a lc u la te th e p re s e n t v a lu e o f th e cash o u tflo w s f o r each o f th e m . S uppose t h a t th e p re s e n t v a lu e o f cash o u tflo w s is $ 4 0 0 0 f o r th e T ita n a n d $ 5 0 0 0 f o r th e V u lc a n . T h is does n o t n e c e s s a rily m e a n t h a t th e T it a n s h o u ld be p re fe rre d . I f th e T it a n is p u rc h a s e d , i t w i ll have to be re p la c e d 2 years e a rlie r th a n th e V u lc a n . The a lte rn a tiv e s are n o t d ir e c tly c o m p a ra b le because th e d iffe re n c e in liv e s m e a n s t h a t th e y in v o lv e d iffe re n t f u tu r e cash flo w s , w h ic h have n o t b e e n co n s id e re d . O n e s o lu tio n w o u ld be to assum e t h a t th e V u lc a n is s o ld a fte r 3 years. H o w e v e r, th e d is p o s a l v a lu e m a y n o t re fle c t it s v a lu e in use, a n d i t is u s u a l

LEARNING OBJECTIVE 3 Compare mutually exclusive projects that have different lives

B usiness finance

to m a ke o th e r a s s u m p tio n s a b o u t w h a t w i ll h a p p e n a t th e e n d o f th e u s e fu l liv e s o f th e e q u ip m e n t. CONSTANT CHAIN

C o n s id e r th e fo llo w in g tw o ap pro ache s:

OF REPLACEMENT ASSUMPTION

may be used to evaluate mutually exclusive projects of unequal lives; in this case, each project is assumed to be replaced at the end of its economic life by an identical project

a

I t m a y be assum ed t h a t th e co m p a n y w ill re in v e s t in a p ro je c t t h a t is id e n tic a l to t h a t w h ic h is

b

S pe cific a s s u m p tio n s m a y be m ade a b o u t th e re in v e s tm e n t o p p o r tu n itie s t h a t w ill be com e ava ila ble

c u r r e n tly b e in g a n alysed. T his is k n o w n as th e

con stan t chain o f replacem ent assum ption,

in th e fu tu re . The second ap p ro a ch is th e m o re re a lis tic a n d c o u ld be im p le m e n te d w h e re th e fu tu r e in v e s tm e n t o p p o r tu n itie s are k n o w n . H o w e ve r, in p ra c tic e th is a p p ro a ch is d iff ic u lt to im p le m e n t unless m anagers have co n sid e ra b le fo re s ig h t. T h ere fore, th e f ir s t a p p ro a ch is o fte n used. T his a p p ro a ch is illu s tra te d in E xa m p le 6.6.

E xample 6 .6 A s s u m e th a t a c o m p a n y is c o n s id e r in g th e p u rc h a s e o f t w o d iffe r e n t p ie c e s o f e q u ip m e n t, A a n d B, th a t w i ll p e rfo rm th e s a m e ta s k a n d g e n e r a te th e s a m e c a s h in flo w s . T h e re fo re , A a n d B c a n b e c o m p a r e d o n th e b a s is o f th e ir c a s h o u tflo w s . T he in fo r m a tio n in T a b le 6 . 4 re la te s to A a n d B.

TABLE 6.4 Cash outflows for equipment In itia l a n d o p e r a tin g costs ($ ) E q u ip m e n t

Year 0

Year 1

A (life 1 year)

15 000

6000

B (life 3 years)

20000

10000

Year 2

Year 3

10000

10000

A s s u m in g a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t p e r a n n u m f o r b o th p ie c e s o f e q u ip m e n t, c a lc u la te th e p re s e n t v a lu e s o f th e costs o f A a n d B.

SOLUTION T he p re s e n t v a lu e s o f th e co sts o f A a n d B a r e a s fo llo w s :

PV of costs for A = $ 15 000 + $ 6 〇〇〇 1.1 = $ 20 45 5

PV of costs for B = $20 000 + $ 10 000

n . i) 3 0.1

=$ 44 869 If m a n a g e m e n t c o m p a re s th e se fig u re s , th e n in v e s tm e n t in E q u ip m e n t A w o u ld a p p e a r to b e m o re d e s ir a b le . H o w e v e r, th is c o m p a r is o n is in v a lid b e c a u s e it ig n o re s th e fa c t th a t A a n d B h a v e d iffe re n t live s. To m a k e a v a lid c o m p a r is o n it is a s s u m e d th a t a t th e e n d o f b o th th e firs t a n d th e s e c o n d y e a rs E q u ip m e n t A w o u ld b e p u rc h a s e d a g a in . If E q u ip m e n t A w e r e r e p la c e d a t th e e n d o f Y e a rs 1 a n d 2 w ith th e s a m e e q u ip m e n t (a c h a in o f re p la c e m e n t), th e co sts w o u ld b e as s h o w n in T a b le 6 . 5 .

TABLE 6.5 Costs for chain of replacement over 3i years In itia l a n d o p e r a tin g costs ($) E q u ip m e n t

Year 0

Year 1

Year 2

A

15 000

15000

15 000

6000

6000

6000

21000

21000

6000

A T otal

15 000

Year 3

C hapter SIX T he APPLICATION 〇F PROJECT EVALUATION METHODS

In th is c a s e ,

DV/ ,

‘ f A ⑴ 識 $21000 $21000 for A = $ 15 0 0 0 + ------------- + -----------

PVof costs

1.1

( l.l) 2

$6000 ( l. l) 3

= $ 5 5 954 B a s e d o n th is c o m p a r is o n o v e r 3 y e a rs , th e p re s e n t v a lu e o f th e co sts f o r A ( $ 5 5 9 5 4 ) is g r e a te r th a n th e p re s e n t v a lu e o f th e co sts f o r B ( $ 4 4 8 6 9 ) a n d , th e re fo re , B s h o u ld b e p u rc h a s e d .

In th e re m a in d e r o f th is s e c tio n i t is assum ed t h a t m a n a g e m e n t a d o p ts th is a p p ro a ch a n d t h a t each p ro je c t is re p lic a te d o v e r th e years. A v a lid c o m p a ris o n o f tw o cha in s o f re p la c e m e n t can be m ade o n ly w h e n b o th cha in s are o f e q u a l le n g th . T his c o m p a ris o n can be ach ie ved in tw o ways: a

S uppose t h a t P ro je c t A has a life o f 6 years a n d P ro je c t B has a life o f 9 years. I f A is u n d e rta k e n th re e tim e s a n d B tw ic e , th e re p la c e m e n t c h a in s w i ll be o f eq ua l le n g th — t h a t is, 18 years. In th is exam ple, 18 is th e lo w e s t c o m m o n m u ltip le o f 6 a n d 9, so th is a p p ro a ch is u s u a lly called th e

common multiple method. A lth o u g h

lowest

th e use o f th is m e th o d c o rre c tly ra n k s m u tu a lly e xclusive p ro je c ts

w ith d iffe re n t live s, i t can be cu m b e rso m e . F o r e xa m p le , tw o p ro je c ts w ith liv e s o f 1 9 a n d 21 years, resp ective ly, have a lo w e s t c o m m o n m u ltip le o f 3 9 9 years a n d th e cash flo w s f o r each o f these 3 9 9 years w o u ld have to be d is c o u n te d to a p re s e n t value,

b

A less c o m p le x a p p ro a c h , w h ic h ra n k s p ro je c ts id e n tic a lly to th e lo w e s t c o m m o n m u ltip le m e th o d , is to assum e t h a t b o t h c h a in s c o n tin u e in d e fin ite ly . In t h is case th e ‘le n g th s ’ o f th e c h a in s are ^ q u a r in th e sense t h a t th e y are b o th in fin it e . T his m e th o d is k n o w n as th e constant chain of replacement in perpetuity method. I f th e N P V o f each re p la c e m e n t p ro je c t is N d o lla rs a n d th e life o f each p ro je c t is n yea rs, th e n th e c o n s ta n t c h a in o f re p la c e m e n t is e q u iv a le n t to re c e iv in g a cash in flo w o f N d o lla rs a t tim e s 0, n, 2rz, 377, a n d so o n , fo re v e r. T h e re fo re , th e N P V o f th e c h a in c o n sists o f N d o lla rs a t t im e 0 p lu s a p e r p e tu ity o f N d o lla rs pa yab le a t n, 2n, 3n, a n d so on. T h ere fore:

N

NPV = N +

N

(1 + k )n

(1 + k)

1

N

(1 +

2n

1

k)n

(1 +

k)2n

1

N

1

( l + k )n j

.

k)n + k)n- l

(1 +

N

(1

The n e t p re s e n t v a lu e o f th e in fin it e ch a in , N P V ^ , is th e re fo re :

層

一

6.4

。

w h e re N P V 〇 = n e t p re s e n t v a lu e o f each re p la ce m e n t. A v a r ia n t o f t h is m e th o d is th e

equivalent annual value m ethod.

th e q u e s tio n : W h a t a m o u n t, to be re ce ive d each y e a r f o r p re s e n t v a lu e o f a p ro je c t w h o s e life is

value (E A V ),

n years?

n yea rs,

T his m e th o d in v o lv e s a n s w e rin g

is e q u iv a le n t to re c e iv in g th e n e t

T his a m o u n t, w h ic h is k n o w n as th e

equivalent annual

is c a lc u la te d f o r each p ro je c t. The p ro je c t w it h th e h ig h e r E A V is p re fe rre d to th e p ro je c t

w it h th e lo w e r EAV, p ro v id e d t h a t b o th p ro je c ts have th e sam e r is k , a n d th e re fo re th e sam e re q u ire d ra te o f re tu rn . The s tre a m o f EAVs o v e r a n n u ity is g iv e n by:

n years

is an o rd in a ry a n n u ity a n d th e re fo re th e n e t p re s e n t v a lu e o f th e

EQUIVALENT A N N U A L VALUE METHOD

involves calculating the annual cash flow of an annuity that has the same life as the project and whose present value equals the net present value of the project

or: (1 + k )n

NPV = EAV 〇

k

T herefore:

NPV

〇

EAV =

(1 W

7

k

The re la tio n s h ip b e tw e e n th e c o n s ta n t c h a in o f re p la c e m e n t a n d E A V m e th o d s is s tra ig h tfo rw a rd . A ssu m e t h a t a p ro je c t is re p lic a te d in d e fin ite ly . The p re s e n t v a lu e o f an in f in it e s tre a m o f EAVs is:

EAV

PV--

k

NPV

〇

(1 + k )n 1

■NPV 〇

1 (1 w

NPVq

(1 + k )u

(1 + k )r

NPVoo T h a t is, th e p re s e n t v a lu e o f an in fin it e s tre a m o f EAVs is e q u a l to th e n e t p re s e n t v a lu e o f th e c o n s ta n t c h a in o f re p la c e m e n t in p e rp e tu ity . T h e re fo re , i f th e n e t p re s e n t v a lu e o f th e in fin it e c h a in c a lcu la te d , th e n th e E AV can be fo u n d b y m u ltip ly in g

NPV^ b y

NPV^ has been

th e re q u ire d ra te o f r e t u r n — t h a t is, th e

E A V is g iv e n by:

6.6

EAV=kNPV(X

The c o n s ta n t c h a in o f re p la c e m e n t a n d e q u iv a le n t a n n u a l va lu e m e th o d s are illu s tr a te d in E xa m p le 6.7.

Example 6.7 S u p p o s e th a t tw o a sse ts, A a n d B, a r e m u tu a lly e x c lu s iv e p ro je c ts a n d h a v e th e c h a r a c te r is tic s s h o w n in T a b le 6 . 6 .

TABLE 6.6 Characteristics of two mutually exclusive projects C a sh in flo w s ($ ) A sset

Life ( Y r s ) , In itia l cash

Year 1

Year 2

Year 3

Year 4

Year 5

o u tla y ($ )

A

3

10000

10000

23000

25 000

—

—

B

5

30000

12000

15000

25 000

30000

30000

It is a ls o a s s u m e d th a t th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m fo r b o th p ro je c ts . W h ic h a s s e t s h o u ld b e p u rc h a s e d ?

C hapter SIX T he APPLICATION OF PROJECT EVALUATION METHODS

SOLUTION The n e t p re s e n t v a lu e o f A s s e t A a t tim e z e r o is:

N PVAo = -$ 1 0 0 0 0 . ^

00 + 1.1

+ $25000 ( l. l) 2

( l.l) 3

= $ 3 6 8 8 2 .0 4 T he n e t p re s e n t v a lu e o f A s s e t B a t tim e z e r o is:

md' / d NPVBr, =

$12000 $15000 $25000 $30000 $30000 -$30000 + ----------+ -------- + ------------------------- — + -------

广

1.1

( i . i )2

( i . i )3

( i . i )4

( i . i )5

=$51 206.70 U s in g E q u a tio n 6 . 4 , th e n e t p re s e n t v a lu e s o f th e in fin ite c h a in s o f re p la c e m e n t a re :

NPVAX

= ($36 882.04)

(1^ —

=$148 308.14 N P V B 〇c = ($51

2 0 6 .7 0 )-^ — '

=$135081.98 T h e re fo re , A s s e t A s h o u ld b e a c c e p te d , n o tw ith s ta n d in g th a t its n e t p re s e n t v a lu e (o v e r its 3 -y e a r life ) is less th a n th e n e t p re s e n t v a lu e o f A s s e t B (o v e r its 5 - y e a r life ). U s in g E q u a tio n 6 . 5 , th e e q u iv a le n t a n n u a l v a lu e m e th o d , it is fo u n d th a t:

$36 882.04

EAVA = " '1

1 (1 H -0 .1 0 )3

0.10 $14830.81 $51 206.70

EAVb

T T T Z Z r ^ r (1 + 0 . 1 0 ) 5 a io

$13508.20 T h e re fo re , A s s e t A s h o u ld b e c h o s e n b e c a u s e its E A V is g r e a te r th a n th a t o f A s s e t B. A lte r n a tiv e ly , th e e q u iv a le n t a n n u a l v a lu e s c o u ld h a v e b e e n c a lc u la te d fro m th e n e t p re s e n t v a lu e s o f th e in fin ite c h a in s o f r e p la c e m e n t ( N P V ^ ) u s in g E q u a tio n 6 . 6 , E AV = fc N P V ^ a s fo llo w s :

EAVA=

(0.1)($148 308.14

=$14830.81 EAVB= (0.1)($135081.98 =$13508.20 T hese resu lts a r e id e n tic a l to th o s e o b ta in e d u s in g E q u a tio n 6 . 5 . In s u m m a ry , th e resu lts fo r A s s e t A s h o w th a t a n in v e s to r w o u ld b e in d iffe r e n t b e tw e e n re c e iv in g p a y m e n ts o f $ 3 6 8 8 2 . 0 4

e v e r y 3 y e a rs , o r a s in g le p a y m e n t o f $ 1 4 8 3 0 8 . 1 4

p a y m e n ts o f $ 1 4 8 3 0 . 8 1

fo re v e r. T h e c o r r e s p o n d in g a m o u n ts fo r A s s e t B a r e $ 5 1 2 0 6 . 7 0 e v e ry

5 y e a rs , $ 1 3 5 0 8 1 . 9 8

now , or annual

n o w , o r $ 1 3 5 0 8 . 2 0 a n n u a lly f o r e v e r . 〇f th e se th re e p a ir s o f fig u re s , th e

s e c o n d a n d th ird p a ir s a d ju s t f o r th e u n e q u a l live s o f th e a sse ts, a n d b o th s h o w th a t A s s e t A s h o u ld b e p re fe rre d .

B usiness finance

E xa m p le 6 .8 p ro v id e s a m o re d e ta ile d illu s t r a t io n o f th e c o n s ta n t c h a in o f re p la c e m e n t m e th o d .

E xample 6 .8 A s s u m e t h a t M a d is o n C o m p a n y , w h ic h o p e ra te s a fle e t o f tru c k s , is c o n s id e r in g r e p la c in g th e m w ith a n e w m o d e l. T h e d a t a in T a b le 6 . 7 a r e a v a ila b le f o r th e o ld a n d th e n e w tru c k s .

TABLE 6.7 Data for old and new trucks Item

O ld tru cks

N e w tru c k s

1. N e t cash flow s

$45 000 p.a.

$ 5 0 0 0 0 p.a.

2. E s tim a te d life

2 years

4 years

3. D isposal value: (a) at pre se n t

$10000

(b) in 4 years, tim e

N il

$10000

4. Cost o f new tru cks

$60000

5. R equired rate o f re tu rn (real)

10% p.a.

10% p.a.

M a n a g e m e n t is c o n s id e r in g tw o p r o p o s a ls : a)

R e p la c e th e o ld tru c k s n o w a n d a s s u m e th a t th e n e w tru c k s a r e o p e r a te d f o r 4 y e a r s a n d r e p la c e d in p e rp e tu ity .

b)

R e p la c e th e o ld tru c k s in 2 y e a r s ' tim e a n d a s s u m e th a t th e n e w tru c k s a r e o p e r a te d f o r 4 y e a rs a n d r e p la c e d in p e rp e tu ity . W h ic h o f th e se p r o p o s a ls s h o u ld m a n a g e m e n t a c c e p t?

SOLUTION O b v io u s ly th e re a r e o th e r a lte r n a tiv e s th a t m a n a g e m e n t c o u ld c o n s id e r, su ch a s r e p la c in g th e p re s e n t tru c k s in 1 y e a r ’s tim e o r r e p la c in g th e o ld tru c k s n o w a n d th e n e w o n e s in 2 y e a r s ' tim e . H o w e v e r, it is a s s u m e d th a t th e se p o s s ib ilitie s h a v e b e e n c o n s id e r e d a n d r e je c te d b y m a n a g e m e n t. It is a ls o a s s u m e d th a t th e re a r e n o e x p e c te d im p ro v e m e n ts in tru c k d e s ig n th a t w o u ld m a k e th e n e w tru c k o b s o le te . P ro p o s a ls (a) a n d (b) w ill th e re fo r e b e e v a lu a te d a s s u m in g a c o n s ta n t c h a in o f re p la c e m e n t. T he p r o p o s a l w ith th e la r g e r n e t p re s e n t v a lu e , p r o v id e d th a t it is g r e a te r th a n z e r o , w ill b e a c c e p te d , o th e r th in g s b e in g e q u a l. In th e f o llo w in g e v a lu a tio n th e n e t p re s e n t v a lu e f o r a s in g le tru c k is c a lc u la te d . If th e re a r e 1 0 tru c k s in th e fle e t, th e n th e n e t p re s e n t v a lu e s o f th e t w o p r o p o s a ls w ill b e m u ltip lie d b y 1 0 to f in d th e ir to ta l n e t p re s e n t v a lu e s . a)

R e p la c e th e o ld tru c k s n o w , o p e r a te th e n e w tru c k s f o r 4 y e a r s a n d r e p la c e th e m in p e rp e tu ity . T h e n e t p re s e n t v a lu e o f a n e w tru c k is:

NPV0 = - $ 6 0 0 0 0

+ $50000

(1 + 0 . 1 0 ) 4

0.10

$10000 ( i.i) 4

= - $ 6 0 0 0 0 + $ 1 5 8 4 9 3 .2 7 + $6 8 3 0 .1 3 = $ 1 0 5 3 2 3 .4 0 T h e p re s e n t v a lu e o f a n in fin ite c h a in o f th e s e tru c k s is th e re fo re :

NPV 〇 〇 = ($ 1 0 5 3 2 3 .4 0 ) = $ 3 3 2 265

O ' 1/

C hapter s ix T he

application of project evaluation methods

In a d d itio n , a t th e s ta rt o f th is c h a in M a d is o n C o m p a n y re c e iv e s a c a s h in flo w o f $ 1 0 0 0 0 fro m th e d is p o s a l o f th e o ld tru c k . T h e re fo re , th e total n e t p re s e n t v a lu e is: $332265 + $10000 = $342265 b)

R e p la c e th e o ld tru c k s in 2 y e a r s ' tim e , o p e r a te th e n e w tru c k s f o r 4 y e a rs , a n d r e p la c e th e m in p e rp e tu ity . A s in th e p re v io u s c a lc u la tio n , N P V 00= $ 3 3 2 2 6 5 . H o w e v e r, th e firs t o f th e c h a in o f n e w tru c k s is n o w p u rc h a s e d a t Y e a r 2 in s te a d o f a t Y e a r 0 a s p re v io u s ly . A s a re su lt, NPV 〇 〇m u st b e d is c o u n te d to Y e a r 0 :

$332 265 (I.” 2

=$274 599.17 In a d d itio n , M a d is o n C o m p a n y o b ta in s th e n e t p re s e n t v a lu e o f o p e r a tin g th e o ld tru c k s f o r th e firs t 2 y e a rs . T h is is g iv e n b y :

$45 000

$45 000

i. i

( i.i) 2

=$78 099.17 The total n e t p re s e n t v a lu e is th e re fo re : $ 2 7 4 5 9 9 .1 7 + $ 7 8 0 9 9 .1 7 = $ 3 5 2 6 9 8 .3 4 T he n e t p re s e n t v a lu e o f P ro p o s a l (b) is g r e a te r th a n th e n e t p re s e n t v a lu e o f P ro p o s a l (a) a n d m a n a g e m e n t s h o u ld r e p la c e th e o ld tru c k s in 2 y e a r s 7 tim e .

Chain of replacement methods and inflation C h a in o f re p la c e m e n t m e th o d s re ly o n th e a s s u m p tio n t h a t each p ro je c t w ill, a t th e e n d o f its life , be replaced b y an id e n tic a l p ro je c t— t h a t is, each re p la c e m e n t w i ll c o st th e sam e a m o u n t, g e n e ra te th e sam e cash flo w s , a n d la s t f o r th e sam e tim e . C learly, i f th e re is in fla tio n , fu tu r e costs a n d cash flo w s w ill n o t be exp ected to re m a in th e sam e in n o m in a l te rm s , b u t th e y m a y re m a in th e sam e in re a l te rm s . To e n sure t h a t in fla t io n is tre a te d c o n s is te n tly , a ll cash flo w s a n d th e re q u ire d ra te o f r e t u r n s h o u ld g e n e ra lly be expressed in re a l te rm s w h e n a c h a in o f re p la c e m e n t m e th o d is use d .6

Is the chain of replacement method realistic? A possible p ro b le m w ith th e c o n s ta n t c h a in o f re p la c e m e n t m o d e l is t h a t i t em p lo ys u n re a lis tic a s s u m p tio n s a b o u t th e re p la c e m e n t assets in th e ch a in , n a m e ly th a t th e assets a n d th e services th e y p ro v id e are id e n tic a l in e ve ry respect. These a s s u m p tio n s are u n re a lis tic . H o w eve r, th e fa c t t h a t th e re p la ce m e n ts m ay be m a n y years in th e fu tu re , a n d th e fa c t t h a t t h e ir cash flo w s w ill be d is c o u n te d to a p re s e n t value, reduces th e im p a c t o f m a k in g such u n re a lis tic a s s u m p tio n s . I t m a y be even m o re u n re a lis tic to assum e th a t m a n a g e m e n t has s u ffic ie n t fo re s ig h t to be able to p re d ic t such fa c to rs as th e c a p ita l o u tla y, n e t cash flo w s , life a n d re s id u a l value o f re p la ce m e n t assets. H o w eve r, i f such in fo r m a tio n is available, i t is n o t a d iffic u lt m a tte r to in s e rt in to th e a n alysis th e re p la c e m e n t o f an e x is tin g asset w it h an asset o f im p ro v e d d e sig n .7 The m e th o d s discussed in th is se ctio n are v e ry u s e fu l b u t som e p o in ts s h o u ld be n o te d . F irs t, i t is n o t necessary to use the se m e th o d s in a ll cases w h e re p ro je c ts have d iffe re n t lives. F o r in d e p e n d e n t p ro je c ts , th e n e t p re se n t value m e th o d a u to m a tic a lly a llo w s f o r a n y such diffe re nce s. The d iffe re n t lives p ro b le m , arises o n ly f o r m u tu a lly e xclusive p ro je cts. Second, i t is p a rtic u la rly im p o r ta n t, w h e n u s in g c h a in o f re p la ce m e n t m e th o d s, to be c o n s is te n t in th e tre a tm e n t o f in fla tio n . T h ird , in m a n y cases m u tu a lly exclusive p ro je c ts w ill in v o lv e th e same b e n e fits (cash in flo w s ) b u t d iffe re n t costs (cash o u tflo w s ). In these cases th e cash in flo w s can be ig n o re d a nd th e a lte rn a tiv e s can be co m p a re d o n th e basis o f th e ir cash o u tflo w s , as in E xam p le 6.3.

6 7

For a discussion of this issue and presentation of a nominal version of the constant chain of replacement model, see Faff and Brailsford (1992). Brown and Davis (1998) highlight the real options that are ignored in using the constant chain of replacement model. For a discussion of real options, see Chapters 5 and 18.

B usiness finance

continued

SOLUTION If th e m a c h in e is p u rc h a s e d , u s e d fo r o n ly 1 y e a r a n d th e n s o ld , its n e t p re s e n t v a lu e w o u ld b e as fo llo w s :

吟

-$ 2 〇 o〇 〇+ $I ^ 2

1

+ i l ^

1.1

1.1

= $ 5 455 If th e m a c h in e is u se d f o r 2 y e a rs a n d th e n s o ld , th e n e t p re s e n t v a lu e w o u ld b e a s fo llo w s :

NPV2 = - $ 2 0 0 0 0

+

$12000

$11500

$14000

i.i

( i . i )2

( i . i r

$11 983 S im ila rly , n e t p re s e n t v a lu e s c a n b e c a lc u la te d b a s e d o n use f o r 3 , 4 a n d 5 y e a r s . H o w e v e r , th e se n e t p re s e n t v a lu e s c a n n o t b e c o m p a r e d , b e c a u s e th e y a r e b a s e d o n d iffe r e n t liv e s . A s w e n o te d in S e c tio n 6 . 4 , th is d iff ic u lt y c a n b e o v e r c o m e b y a s s u m in g a c o n s ta n t c h a in o f r e p la c e m e n t. If it is a s s u m e d th a t th e m a c h in e is r e p la c e d e v e r y y e a r in p e rp e tu ity , th e n e t p re s e n t v a lu e w ill b e a s fo llo w s :

NPV(1,〇〇 ) = $5 4 5 4 .5 5

(1 1 ) ( l- l) - l

=$60000 If th e m a c h in e is r e p la c e d e v e r y s e c o n d y e a r in p e rp e tu ity , th e n e t p re s e n t v a lu e w ill b e a s fo llo w s :

NPV(2/X)) = $ 1 1 9 8 3 .4 7

,2 ( i.ir

= $69048 T h e n e t p re s e n t v a lu e s , a s s u m in g th a t th e m a c h in e is r e p la c e d in p e rp e tu ity , a t th e e n d o f th e th ir d , fo u rth a n d fifth y e a rs , re s p e c tiv e ly , a r e a s fo llo w s :

NPV[3, ) = $ 1 7 6 9 3 .4 6

(1 .1 )

3

〇〇

= $ 7 1 148

NPV

〇 〇 ) =

(1 -1 )4

'

$ 1 9 9 4 7 -41

= $ 6 2 92 6

NPV(5o〇) = $22 0 5 8 .5 4

(1 .1 )

5

= $ 5 8 190 T h e se resu lts s h o w th a t th e m a c h in e s h o u ld b e r e p la c e d a fte r 3 y e a rs . In g e n e r a l th e d e c is io n ru le is to c h o o s e th e re p la c e m e n t fr e q u e n c y th a t m a x im is e s th e p r o je c t's n e t p re s e n t v a lu e f o r a p e rp e tu a l c h a in o f r e p la c e m e n t, o r th a t m a x im is e s its e q u iv a le n t a n n u a l v a lu e .

Non-identical replacement Suppose t h a t a m a c h in e is p h y s ic a lly s o u n d b u t te c h n ic a lly ob solete. W h e n th e m a c h in e is replaced, its re p la c e m e n t w ill be o f a n e w d e sig n t h a t m a y have th e sam e ca p a c ity b u t costs less to op era te . The q u e s tio n is: W h e n s h o u ld th e o ld m a c h in e be d isca rd e d in fa v o u r o f th e n e w one? The s o lu tio n in v o lv e s tw o steps. F irs t, th e o p tim u m re p la c e m e n t fre q u e n c y f o r th e n e w m a c h in e is d e te rm in e d u s in g th e m e th o d illu s tra te d in E xa m p le 6.1 0. Second, th e e q u iv a le n t a n n u a l va lu e o f th e n e w m a c h in e a t it s o p tim u m re p la c e m e n t fre q u e n c y is c o m p a re d w it h th e n e t p re s e n t va lu e o f c o n tin u in g to o p e ra te th e o ld m a ch in e ,

C hapter s ix T he

application of project evaluation methods

as s h o w n in E xam p le 6.9. The d e c is io n ru le is t h a t th e cha n g e o ve r s h o u ld be m ade w h e n th e n e t p re s e n t value o f c o n tin u in g to o p e ra te th e o ld m a c h in e f o r one m o re y e a r is less th a n th e e q u iv a le n t a n n u a l v alue o f th e n e w m a ch in e .

6.6

Analysing project risk

The e ffe c t o f r is k o n th e v a lu e o f a p ro je c t is n o r m a lly in c lu d e d in th e e v a lu a tio n b y u s in g a re q u ire d ra te o f re tu r n t h a t re fle c ts th e r is k o f th e p ro je c t. H o w e ve r, th e c a lc u la te d n e t p re s e n t v a lu e is o n ly an e s tim a te th a t relies o n foreca sts o f th e p ro je c ts cash flo w s . In p ra c tic e the se fo re ca sts w ill, a lm o s t c e rta in ly , t u r n o u t to be in c o rre c t, p e rh a p s because th e v o lu m e o f sales tu r n s o u t to be m o re o r less th a n expected, th e p ric e o f th e p ro d u c t is h ig h e r o r lo w e r th a n expected, o r o p e ra tin g costs d iffe r fr o m th e fo re ca st. Therefore, in m a n y cases m a n a g e rs a n a ly s in g p ro p o s e d p ro je c ts w ill ne ed to a n sw e r q u e s tio n s such as: •

W h a t are th e k e y v a ria b le s t h a t are lik e ly to d e te rm in e w h e th e r th e p ro je c t is a success o r a fa ilu re ?

•

H o w fa r can sales fa ll o r costs increase b e fo re th e p ro je c t loses m on ey?

LEARNING OBJECTIVE 5 Explain how sensitivity analysis, break­ even analysis and simulation assist in analysing project risk

M an ag ers can use v a rio u s te c h n iq u e s to a n s w e r the se a n d o th e r re la te d q u e s tio n s . The te c h n iq u e s we discuss are s e n s itiv ity an alysis, bre a k-e ve n a n a lysis a n d s im u la tio n .

6 .6 .1 1 Sensitivity analysis A p ro je c ts cash flo w s a n d re q u ire d ra te o f r e tu r n are u s u a lly s p e c ifie d as cb e s t e stim a te s* o r exp ected values1 an d th e re s u ltin g n e t p re s e n t value , o fte n re fe rre d to as th e best e s tim a te o r e xp e cte d va lu e .

Sensitivity an alysis

base-case net present value, is

also a

in v o lv e s assessing th e e ffe c t o f changes o r e rro rs

SENSITIVITY ANALYSIS

in th e e s tim a te d v a ria b le s o n th e n e t p re s e n t v a lu e o f a p ro je c t. T his is a ch ie ved b y c a lc u la tin g n e t p re s e n t

analysis of the effect of changing one or more input variables to observe the effects on the results

values based o n a lte rn a tiv e e s tim a te s o f th e va ria b le s. F o r in sta n ce , m a n a g e m e n t m a y w is h to k n o w th e e ffe ct o n n e t p re s e n t va lu e i f a p ro je c ts n e t cash flo w s are e ith e r 20 p e r c e n t less th a n , o r 20 p e r ce n t g re a te r th a n , th o se e s tim a te d . K n o w le d g e o f th e s e n s itiv ity o f n e t p re s e n t va lu e to changes o r e rro rs in th e va ria b le s places m a n a g e m e n t in a b e tte r p o s itio n to decide w h e th e r a p ro je c t is to o r is k y to accept. A lso , i f m a n a g e m e n t k n o w s t h a t th e n e t p re s e n t va lu e is s e n s itiv e to changes in p a r tic u la r v a ria b le s , i t can e xa m in e th e e stim a te s o f the se v a ria b le s m o re th o ro u g h ly , o r c o lle c t m o re d a ta in an e f f o r t to reduce e rro rs in fo re ca stin g . A s s u m in g t h a t a ll v a ria b le s in th e a n a lysis are u n c e rta in , a s im p le e xa m p le o f s e n s itiv ity a n alysis in vo lve s th e fo llo w in g steps:

a

P essim istic, o p tim is tic a n d e xp ected e s tim a te s are m ad e f o r each v a ria b le .

b

N e t p re s e n t va lu e is ca lcu la te d u s in g th e e xp ected e s tim a te s f o r e v e ry v a ria b le exce pt one, th e value fo r w h ic h is, in t u r n , its o p tim is tic a n d p e s s im is tic e s tim a te . This p ro c e d u re is re p e a te d u n t il a n e t p re s e n t va lu e has been ca lcu la te d u s in g an o p tim is tic a n d p e s s im is tic e s tim a te f o r each v a ria b le , in c o m b in a tio n w it h th e e xp ected values o f th e o th e r v a ria b le s.

C

The d iffe re n c e b e tw e e n th e o p tim is tic a n d p e s s im is tic n e t p re s e n t values is ca lcu la te d f o r each va ria b le . A s m a ll d iffe re n c e b e tw e e n th e n e t p re s e n t value s suggests t h a t th e p ro je c ts n e t p re s e n t value is in s e n s itiv e to changes o r e rro rs in t h a t v a ria b le . A la rg e d iffe re n c e b e tw e e n th e n e t p re s e n t values suggests th e o p p o s ite . F o r exa m ple, suppose t h a t in a p ro je c t in v o lv in g th e use o f a n e w m a c h in e , th e re are o n ly fiv e u n c e rta in

variab les: sales p rice , v a ria b le cost, sales v o lu m e , fix e d o p e ra tin g costs a n d th e life o f th e m a c h in e . In th is case, e ig h t n e t p re s e n t v a lu e c a lc u la tio n s are m ade, u s in g th e d a ta in p u ts s h o w n in T able 6 .1 0 . The s y m b o l O in d ic a te s th e o p tim is tic v a lu e o f th e v a ria b le , P in d ic a te s th e p e s s im is tic va lu e o f th e v a ria b le , a n d E in d ic a te s th e e xp ected va lu e o f th e v a ria b le . The a p p lic a tio n o f s e n s itiv ity a n a lysis to p ro je c t e v a lu a tio n in a case such as t h a t s h o w n in Table 6.1 0 is illu s tra te d in E xam p le 6.1 1. The use o f s e n s itiv ity a n a lysis in v o lv e s som e p ro b le m s . O ne is t h a t fr e q u e n tly i t is d iff ic u lt to sp e cify p re c is e ly th e re la tio n s h ip b e tw e e n a p a r tic u la r v a ria b le a n d n e t p re s e n t value . I f th e assum ed re la tio n s h ip is based o n p a s t o u tco m e s, th e re is alw ays th e p o s s ib ility t h a t th is re la tio n s h ip m a y n o t h o ld in th e fu tu re . I t is f u r t h e r c o m p lic a te d b y re la tio n s h ip s b e tw e e n th e v a ria b le s . F o r e xa m p le , i t is

TABLE 6.10 Combinations of variable values for sensitivity analysis Estim ates

(i)

Sales price

0

P

E

E

E

Variable cost

E

E

〇

P

Sales vo lu m e

E

E

E

Fixed o p e ra tin g

E

E

E

E

(v ii)

(v iii)

(ix )

(x)

E

E

E

E

E

E

E

E

E

E

E

E

〇

P

E

E

E

E

E

E

E

E

〇

P

E

E

E

E

E

E

E

E

〇

P

(iii)

N

(v)

M

costs M ach in e life

E xample 6.11 A s s u m e th a t a m a n a g e r is c o n s id e r in g w h e th e r to p u rc h a s e a n e w m a c h in e th a t c o sts $ 5 0 0 0 0 0 . It is a s s u m e d th a t th e re a r e o n ly fiv e u n c e rta in v a r ia b le s : sa le s p r ic e , v a r ia b le c o s t, s a le s v o lu m e , fix e d o p e r a tin g co sts a n d th e life o f th e n e w m a c h in e . T he sa le s p r ic e is e x p e c te d to b e $ 7 0 p e r u n it, th e v a r ia b le c o s t is e x p e c te d to b e $ 4 8 p e r u n it, s a le s v o lu m e is e x p e c te d to b e 1 5 0 0 0 u n its p e r a n n u m , w ith fix e d o p e r a tin g co sts o f $ 2 0 0 0 0 0 d u r in g a n e x p e c te d life o f 1 0 y e a rs . A ll o th e r v a r ia b le s a re e x p e c te d to re m a in c o n s ta n t d u r in g th e m a c h in e 's life . T h e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r annum . T he e x p e c te d a n n u a l n e t c a s h flo w s a r e ( $ 7 0 - $ 4 8 ) x 1 5 0 0 0 - $ 2 0 0 0 0 0 = $ 1 3 0 0 0 0 , a n d th e b a s e -c a s e n e t p re s e n t v a lu e is:

Base-case N P V =

-$500 000 + $ 130 000 — 1 J 0.1

=$298 794 T he in fo r m a tio n n e e d e d f o r th e s e n s itiv ity a n a ly s is is s h o w n in T a b le 6 .1 1, w h ic h p re s e n ts : •

f o r e a c h u n c e rta in v a r ia b le , e x p e c te d (c o lu m n 1), o p tim is tic (c o lu m n 2 ) a n d p e s s im is tic (c o lu m n 3 ) e s tim a te s

•

th e n e t p re s e n t v a lu e (c o lu m n 4 ) w h e n o n e o f th e u n c e rta in v a r ia b le s is set a t its o p tim is tic e s tim a te

•

th e n e t p re s e n t v a lu e (c o lu m n 5 ) w h e n o n e o f th e u n c e rta in v a r ia b le s is se t a t its p e s s im is tic e s tim a te

a n d e a c h o f th e o th e r v a r ia b le s is set a t its e x p e c te d v a lu e

a n d e a c h o f th e o th e r v a r ia b le s is set a t its e x p e c te d v a lu e •

in c o lu m n 6, th e d iffe re n c e b e tw e e n c o lu m n s 4 a n d 5, w h ic h is fr e q u e n tly c a lle d th e 'r a n g e o f th e n e t p re s e n t v a lu e ’ . T a b le 6 .1 1 s h o w s th a t th e e s tim a te o f n e t p re s e n t v a lu e is m o re s e n s itiv e to c h a n g e s in s a le s p ric e

th a n to c h a n g e s in th e o th e r u n c e rta in v a r ia b le s . In a d d it io n , it s h o w s th a t if th e p e s s im is tic e s tim a te o f e ith e r s a le s p r ic e o r s a le s v o lu m e o c c u rs , th e p u rc h a s e o f th e m a c h in e w i ll g e n e r a te a n e g a tiv e n e t p re s e n t v a lu e . B e fo re d e c id in g to p u rc h a s e th e n e w m a c h in e , m a n a g e m e n t is th e re fo re lik e ly to g a th e r m o re in fo r m a tio n o n s a le s p r ic e a n d s a le s v o lu m e in a n e ffo r t to m in im is e fo r e c a s tin g e rro rs . In c o n tra s t, th e v a lu e o f a d d itio n a l d a ta a b o u t th e m a c h in e 's v a r ia b le co sts, fix e d o p e r a tin g c o sts a n d u s e fu l life is r e la tiv e ly s m a ll. T he p r o je c t is still a c c e p ta b le , b a s e d o n th e p e s s im is tic v a lu e s f o r th o s e v a r ia b le s , a n d th e re fo re th e c o m p a n y is u n lik e ly to m a k e a lo ss o n th e p r o je c t e v e n if th e s e v a r ia b le s h a v e b e e n in c o r r e c tly e s tim a te d .

C hapter six T he

application of project evaluation methods

TABLE 6.11 Sensitivity analysis of the purchase of a new machine, based on optimistic and pessimistic estimates of the values of each variable

V a r ia b le

E x p e cte d

O p tim is tic

P essim istic

⑴

⑵

(31

NPV:

NPV:

o p tim is tic

p e s s im is tic

e s tim a te ($1 ⑹ e s tim a te

.

(4)

($)⑹

R ange o f N P V ($ )

(5 )

—1 6 T

Sales price $

70

76

63

(i) 8 5 1 8 0 5

(ii) 3 4 6 3 8 6

1198191

Variable

48

46

50

(iii) 4 8 3 1 3 1

(iv) 1 1 4 4 5 7

368674

15 000

17000

12500

(v) 5 6 9 1 5 5

(vi) 3 9 1 5 7

608312

200000

190000

205000

(v ii) 3 6 0 2 3 9

(v iii) 2 6 8 0 7 1

92169

10

12

9

(ix) 385 780

(x) 248 673

137107

cost $ Sales volum e Fixed operating costs $ Life o f machine (years) The figures in lower case Roman numerals in these columns indicate the net present value calculation that corresponds to the input shown in Table 6.10.

in a p p ro p ria te to e xa m in e th e e ffe c t o n n e t p re s e n t va lu e o f a 20 p e r c e n t re d u c tio n in sales v o lu m e w ith o u t re c o g n is in g t h a t lo w e r sales v o lu m e m a y also m e a n t h a t th e s e llin g p ric e is lo w e r th a n expected. A llo w in g f o r these in te rd e p e n d e n c ie s w i ll c o m p lic a te th e an alysis. A n o th e r p ro b le m is t h a t th e te rm s ‘o p tim is tic ’ a n d ‘p e s s im is tic ’ are su b je c t to in te r p r e ta tio n , a n d th e re s u lts m a y be s o m e w h a t a m b ig u o u s. F o r exa m ple, th e m a rk e tin g d e p a rtm e n t’s ‘o p t im is t ic ’ sales fo re ca sts m a y be so o p tim is tic t h a t th e y are v ir t u a lly u n a ch ie va b le , w h ile a n o th e r d e p a rtm e n ts o p t im is t ic , e s tim a te s o f o th e r v a ria b le s m a y be m o re co n se rva tive .

6 .6 .2 1 Break-even analysis B r e a k - e v e n a n a ly s is is a f o r m o f s e n s itiv ity an alysis. S e n s itiv ity a n a lysis g e n e ra lly in v o lv e s fin d in g

BREAK-EVEN ANALYSIS

answ ers to *w ha t if* q u e s tio n s such as: W h a t w ill be th e n e t p re s e n t v a lu e o f th e p ro je c t i f sales are 10 p e r

analysis of the amounts by which one or more input variables may change before a project ceases to be profitable

cen t less th a n expected? In b re a k-e ve n a n alysis th e q u e s tio n is tu r n e d a ro u n d , in t h a t th e m a n a g e r asks: H o w p o o r can sales v o lu m e be co m e b e fo re th e p ro je c t loses m o n e y? The b re a k-e ve n p o in t is th e sales v o lu m e a t w h ic h th e n e t p re s e n t va lu e is zero. B reak-even a n a lysis is illu s tra te d in th e fo llo w in g e xa m ple b y re -e x a m in in g th e in fo r m a t io n in E xa m p le 6.11.

Example 6.12 F or e a c h o f th e fiv e u n c e rta in v a r ia b le s , th e n e t p re s e n t v a lu e is c a lc u la te d u s in g th e e x p e c te d v a lu e s o f th e o th e r fo u r v a r ia b le s , w ith th e v a lu e s o f th e fifth v a r ia b le b e in g th e o n e th a t re su lts in th e n e t p re s e n t v a lu e b e in g z e ro . T h e resu lts f o r a ll v a r ia b le s a r e s h o w n in T a b le 6 .1 2 w ith th e resu lts f o r s a le s v o lu m e a ls o b e in g s h o w n in F ig u re 6 . 1 . T he n e t p re s e n t v a lu e o f p u r c h a s in g th e m a c h in e w ill b e p o s itiv e if th e e x p e c te d v a lu e s o f th e o th e r fo u r u n c e rta in v a r ia b le s a r e a c h ie v e d a n d th e s a le s p r ic e is g r e a te r th a n o r e q u a l to $ 6 7 . S im ila rly , th e n e t p re s e n t v a lu e o f p u r c h a s in g th e m a c h in e w ill b e p o s itiv e if th e e x p e c te d v a lu e s o f th e o th e r fo u r u n c e rta in v a r ia b le s a r e a c h ie v e d a n d s a le s v o lu m e is 1 2 7 9 0 o r m o re un its.

continued

B usiness finance

continued

TABLE 6.12 Breat:-even analysis of the purchase of a new rnachine Variable

Expected

Break even

Sales p rice $

70

67

V ariable cost $

48

51

15000

12 790

Fixed o p e ra tin g costs $

200000

248627

Life o f m achine (years)

10

6

Sales volum e

6 .6 .3 1 Simulation S e n s itiv ity a n alysis in v o lv e s c h a n g in g one v a ria b le a t a tim e a n d e x a m in in g th e e ffe cts o f th e changes SIMULATION

analysis of the effect of changing all of the input variables whose values are uncertain to observe the effects on the results

夺

o n th e p r o f it a b ilit y o f a p ro je c t. O n th e o th e r h a n d ,

sim ulation

a llo w s a m a n a g e r to c o n s id e r th e effects

o f c h a n g in g a ll th e v a ria b le s w h ose values are u n c e rta in . The f ir s t ste p in a s im u la tio n is to id e n tify th e re le v a n t v a ria b le s a n d to s p e c ify th e p ro b a b ility d is tr ib u tio n o f each v a ria b le . F o r e xa m p le , in th e case o f th e pu rcha se o f th e n e w m a c h in e in E xam p le s 6 .1 1 a n d 6 .1 2 , th e v a ria b le s c o u ld in c lu d e s e llin g p rice , v a ria b le cost, sales v o lu m e , fix e d o p e ra tin g costs a n d th e u s e fu l life o f th e m a ch in e . The second step is to s p e c ify a n y re la tio n s h ip s b e tw e e n th e va ria b le s. F o r exa m ple, a h ig h e r sales v o lu m e m a y re s u lt in

C hapter s ix T he

application of project evaluation methods

econom ies o f scale in p r o d u c tio n a n d d is tr ib u tio n , w h ic h s h o u ld be re fle c te d in th e v a ria b le costs. The t h ir d step in v o lv e s u s in g a c o m p u te r to s im u la te th e p ro je c t s cash flo w s . E sse n tia lly, th e p ro c e d u re is as fo llo w s: a b

The c o m p u te r selects value s ra n d o m ly fr o m th e d is tr ib u tio n o f each o f th e sp e cifie d v a ria b le s, In th e f ir s t ru n o f th e s im u la tio n th e c o m p u te r calcula tes values f o r th e p ro je c ts cash flo w s f o r each year.

C

The re s u lts o f th e f ir s t r u n are s to re d a n d a n e w s e t o f values is cho sen a n d used in th e seco nd ru n o f th e s im u la tio n , w h ic h gives f u r t h e r re su lts t h a t are also sto re d . T his p ro c e d u re is re p e a te d a t le a s t one h u n d re d an d p e rh a p s th o u s a n d s o f tim e s .

d

The re s u lts o f a ll th e in d iv id u a l ru n s are c o m b in e d to p ro d u ce a p r o b a b ility d is tr ib u tio n f o r th e p ro je c ts cash flo w s. S im u la tio n is a p o te n tia lly va lu a b le to o l t h a t a llo w s m an ag ers to analyse m a n y aspects o f th e ris k s

associated w it h a p ro je c t. I t is g e n e ra lly used fo r la rge p ro je c ts w h e re th e size o f th e in v e s tm e n t can ju s t if y th e cost o f d e v e lo p in g th e s im u la tio n m o d e l. W h ile s p e c ify in g th e m o d e l can be tim e c o n s u m in g , once i t has been d e ve lo p e d i t is re la tiv e ly easy to e xa m in e th e e ffe cts o f c h a n g in g th e p r o b a b ility d is tr ib u tio n f o r one o r m o re va ria b le s. H o w e ve r, users o f th e te c h n iq u e s h o u ld rea lise it s lim ita tio n s . These in c lu d e th e fo llo w in g : •

S im u la tio n is a te c h n iq u e f o r p ro ce ssin g in fo r m a tio n a n d p re s e n tin g th e re s u lts o f t h a t p ro ce ssin g in a p a rtic u la r way. T h e re fo re , th e re s u lts o f a s im u la tio n c a n n o t be a n y m o re re lia b le th a n th e in p u t d a ta a n d th e m o d e l t h a t spe cifie s th e re la tio n s h ip s b e tw e e n v a ria b le s. P ro v id in g re a lis tic e s tim a te s o f th e p ro b a b ility d is tr ib u tio n s f o r th e v a ria b le s a n d o f th e re la tio n s h ip s b e tw e e n th e v a ria b le s can be v e ry d iffic u lt.

•

S im u la tio n re s u lts can be d iff ic u lt to in te r p r e t. The o u t p u t fr o m th e s im u la tio n co n sists o f a p ro b a b ility d is tr ib u tio n f o r th e p ro je c ts cash flo w s f o r each ye a r o f its life . H o w s h o u ld a m a n a g e r use th is data? The o b v io u s f ir s t ste p is to use th e m e a n o r e xp e cte d fo re c a s t cash flo w s f o r each y ea r to e s tim a te th e p ro je c ts n e t p re s e n t v alue . The n e x t ste p m ig h t be to use o th e r p o ssib le v alue s fo r th e cash flo w s to calcula te a d is tr ib u tio n o f n e t p re s e n t values. Suppose t h a t the se steps are c a rrie d o u t a n d th e re s u lts s h o w t h a t th e e xp ected n e t p re s e n t va lu e o f a p ro je c t is $2 m illio n , b u t th e re is a 20 p e r c e n t p ro b a b ility t h a t th e a c tu a l n e t p re s e n t v a lu e w ill be n e g a tive . D iffe r e n t in d iv id u a ls are lik e ly to have d iffe re n t o p in io n s a b o u t w h e th e r th e p ro je c t s h o u ld be accepted— t h a t is, s im u la tio n does n o t p ro v id e an u n a m b ig u o u s a c c e p t/re je c t sig n a l f o r p ro je c ts .

•

S im u la tio n focuses o n th e to t a l r is k o f a p ro je c t a n d ig n o re s th e p o s s ib ility t h a t m u c h o f th is ris k m ig h t be re m o v e d b y d iv e rs ific a tio n . As discussed in S e ctio n 7.5, i t is th e s y s te m a tic o r n o n d iv e rs ifia b le r is k o f a p ro je c t t h a t is im p o r t a n t in d e te rm in in g its re q u ire d ra te o f r e tu rn . In s u m m a ry, s im u la tio n is a p o te n tia lly va lu a b le te c h n iq u e f o r a n a ly s in g th e ris k s a sso cia te d w ith a

p ro je c t, b u t users s h o u ld be aw are o f it s lim ita tio n s .

6.7

Decision-tree analysis

M a n a g e m e n t is s o m e tim e s faced w it h th e ne ed to e va lu a te a lte rn a tiv e s in v o lv in g a

sequence o f

d e cisio n s

ove r tim e . D e c is io n -tre e a n a lysis p ro v id e s a m eans o f e v a lu a tin g such d e cisio ns. The d e c is io n -tre e a p pro ach takes in to a c c o u n t th e p ro b a b ility o f v a rio u s e ve n ts o c c u rrin g a n d th e e ffe c t o f th o s e eve nts o n th e expected n e t p re s e n t v a lu e o f a p ro je c t. D e c is io n -tre e a n a lysis uses th e c o n c e p t o f ‘ro ll-b a c k ’ to eva lu ate a lte rn a tiv e d e cisio n s. T his is illu s tra te d in E xa m p le 6 .1 3 .8 This ap p ro a ch to e v a lu a tin g a sequence o f d e cisio n s re la tin g to an in v e s tm e n t in a r is k y p ro je c t is o p e ra tio n a l f o r o u r s im p le exa m p le . I t has th e ad van ta ge t h a t i t forces m a n a g e m e n t to c o n s id e r fu tu re in v e s tm e n t d e cisio n s w h e n m a k in g c u rre n t in v e s tm e n t de cisio n s. H o w e ve r, th e c o m p le x ity o f d e c is io n tre e analysis is in crea sed c o n s id e ra b ly since a d d itio n a l a lte rn a tiv e s , such as a llo w in g f o r a m e d iu m -s iz e d p la n t a n d a m e d iu m le vel o f d e m a n d , are in c lu d e d in th e d e c is io n process.

8

For a simple discussion of decision-tree analysis, see Levin, Kirkpatrick and Rubin (1992).

m

LEARNING OBJECTIVE 6 Use decision-tree analysis to analyse sequential decisions

B usiness finance

Example 6.13 T he m a n a g e m e n t o f a V ic to r ia n - b a s e d c o m p a n y is c o n s id e r in g th e p r o p o s e d c o n s tru c tio n o f a p la n t to m a n u fa c tu r e its p ro d u c ts in C h in a . In itia lly , m a n a g e m e n t is fa c e d w ith th e c h o ic e o f c o n s tru c tin g e ith e r a la r g e o r a s m a ll p la n t. If it c o n s tru c ts a la r g e p la n t, th e in itia l o u tla y w ill b e $ 2 m illio n , w h e r e a s if it c o n s tru c ts a s m a ll p la n t, th e in it ia l o u tla y w ill b e $1 m illio n . If a s m a ll p la n t is c h o s e n , m a n a g e m e n t w ill r e c o n s id e r its d e c is io n a fte r 2 y e a rs . A t th a t tim e , m a n a g e m e n t m a y , if it b e lie v e s th a t fu rth e r e x p a n s io n is w a r r a n t e d , e x p a n d th e s m a ll p la n t to a c h ie v e th e s a m e c a p a c ity a s a la r g e p la n t. The e x p a n s io n w ill c o s t $ 1 . 2 5 m illio n . T he c o m p a n y h a s e s tim a te d th e e x p e c te d n e t c a s h flo w s to b e g e n e r a te d b y a la r g e p la n t, a s m a ll p la n t a n d a n e x p a n d e d p la n t o n th e b a s is o f a tw o - w a y c la s s ific a tio n o f d e m a n d : h ig h d e m a n d a n d lo w d e m a n d . T h e se e x p e c ta tio n s a r e s u m m a ris e d in T a b le 6 . 1 3 .

TABLE 6.13 Expected net cash flows for different plants and levels of demand P o s s ib ilitie s

E x p e c te d n e t c a sh f lo w p .a . ($ m )

Large p la n t, h ig h dem and

0.8000

Large p la n t, lo w dem and

0.1000

Sm all p la n t, h ig h dem and

0.4000

Sm all p la n t, lo w dem and

0.3500

Expanded p la n t, h ig h dem and

0.5000

Expanded p la n t, lo w dem and

0.0750

M a n a g e m e n t h a s a ls o e s tim a te d th e p r o b a b ilit y o f a c h ie v in g e ith e r h ig h d e m a n d o r lo w d e m a n d d u r in g th e p r o je c t's 1 0 - y e a r life . It h a s e s tim a te d th e lik e lih o o d o f h ig h d e m a n d t h r o u g h o u t th e p ro je c t's life to b e 0 . 6 , th e p r o b a b ilit y o f a c h ie v in g h ig h d e m a n d f o r th e firs t 2 y e a rs a n d lo w d e m a n d fo r th e re m a in in g 8 y e a rs to b e 0 . 2 , a n d th e p r o b a b ilit y o f lo w d e m a n d th r o u g h o u t th e p ro je c t's life to b e 0 . 2 . T he p r o b a b ilit ie s a n d th e e x p e c te d n e t c a s h flo w s a r e s h o w n in F ig u re 6 . 2 in th e fo rm o f a

decision tree. T he s q u a re s in F ig u re 6 . 2 re p re s e n t d e c is io n p o in ts a n d th e s m a ll c irc le s re p re s e n t c h a n c e e v e n ts th a t m a y o c c u r d u r in g th e life o f th e p r o je c t. T he b a s e o f a d e c is io n tre e is th e b e g in n in g , D e c is io n p o in t 1. Its b ra n c h e s b e g in a t th e firs t c h a n c e e v e n t. E a ch c h a n c e e v e n t p r o d u c e s tw o o r m o re p o s s ib le o u tc o m e s , s o m e o f w h ic h le a d to o th e r c h a n c e e v e n ts a n d / o r s u b s e q u e n t d e c is io n p o in ts . T h e o p tim u m s e q u e n c e o f d e c is io n s is d e te r m in e d u s in g a ro llb a ck p r o c e d u r e , w h ic h m e a n s th a t th e m o s t d is ta n t d e c is io n — in th is c a s e , th e d e c is io n w h e th e r to e x p a n d th e s m a ll p la n t — is e v a lu a te d firs t. E a c h a lte r n a tiv e is e v a lu a te d o n th e b a s is o f its e x p e c te d n e t p re s e n t v a lu e . T h e r e q u ir e d ra te o f re tu rn is a s s u m e d to b e 9 p e r c e n t p e r a n n u m .

Decision 2: Whether to expand the small plant EXPAND:

r, N P V = 0 .7 5 [$0 .5 m )

1 i (1+0.0918 0.09

[1 + 0.25($0.075m)

1 1 (1+0 .0 9)8 - $ 1.25m 0.09

=$929355 D O N O T EXPAND:

「

NPV= 0.75 ($0.4m)

$2 144 743

1-

1 1 [1 (1 +0.09)8 + 0.25($0.035m) 0.09

1 1 |1 +0.09)8 0.09

C hapter s ix T he

Demand level

Expected cash flo w

P robability - Years 0 -2

Demand level

P rob ab ility

—

application of project evaluation methods

Expected cash flo w

Years 3 - 1 0

0 . 7 5 --------- $0.8rr

0.8

$0.8m 0 .25 ---------- $0.1n

0.2

$0.1 r

0.8

1.0

$0.1 m

0.75

$0.5m

0.25

$0.075m

0.75

$0.4m

0.25

$0.35m

1.0

$0.35m

$0.4m

Small plant

($lm)

0.2

$0.35rr

T h e re fo re , th e o p tim u m c h o ic e is n o t to e x p a n d th e s m a ll p la n t a t th e e n d o f th e s e c o n d y e a r. T he r o llb a c k m e th o d s im p lifie s th e e v a lu a tio n b y e lim in a tin g th e a lte r n a tiv e o f b u ild in g a s m a ll p la n t a n d th e n e x p a n d in g it a fte r 2 y e a rs . O n c e m a n a g e m e n t k n o w s w h a t it o u g h t to d o if fa c e d w ith th e e x p a n s io n d e c is io n , it c a n 'r o ll b a c k 7 to t o d a y 's d e c is io n . T h is d e c is io n is w h e th e r to b u ild a la r g e p la n t o r a s m a ll p la n t to b e o p e r a te d f o r 1 0 y e a rs .

Decision 1: Construct either a large plant or a small plant and operate for 10 years LAR G E PLANT:

( 1 + 0 .0 9 〆

Expected NPV = 0 .8 ($0 .8 m )

0 .0 9

■ 0 .8 [0 .7 5 ($ 0 .8 m )

(1 + 0 . 0 9 广

(1 .0 9 )

-2

0 .0 9

-0 .2 5 ($ 0 .1 m )

(1 + 0 . 0 9

广

(1 .0 9 )-2]

0 .0 9 1 -0 .2 0 ($ 0 .1 m )

(1 + 0 . 0 9 )

10 - $2m

0 .0 9

$ 1 5 8 3 0 0 0 (to the nearest thousand dollars)

continued

B usiness finance

continued S M A L L PLA N T:

Expected NPV = 0 .8 ($0 .4 m )

(1 + 0 . 0 9 卜 0 .0 9

+ 0 .0 8 [$ 2 1 4 4 743 (1 .0 9 )-2 ] 1 •0 .2 ($ 0 .3 5 m )

(1 + O .Q 9 )10

■$lr

0 .0 9

= $ 1 4 5 6 0 0 0 (to the nearest thousand dollars) In th is c a s e th e e x p e c te d n e t p re s e n t v a lu e o f b u ild in g a la r g e p la n t e x c e e d s th a t o f b u ild in g a s m a ll p la n t.

6.8 LEARNING OBJECTIVE 7 Explain the role of qualitative factors in project selection

Q ualitative factors and the selection of projects

A f te r th e q u a n tita tiv e a n alysis has been co m p le te d , m a n a g e m e n t has to decide w h ic h p ro je c ts to im p le m e n t. W h ile th e a im is to m a x im is e s h a re h o ld e rs , w e a lth , i t does n o t ne ce ssa rily f o llo w t h a t p ro je c t s e le c tio n d e cisio n s s h o u ld be g u id e d o n ly b y th e re s u lts o f th e q u a n tita tiv e an alysis. M a n a g e m e n t s h o u ld also c o n s id e r a n y q u a lita tiv e fa c to rs t h a t m a y a ffe c t th o s e p ro je c ts . E s s e n tia lly , q u a lita tiv e fa c to rs are th o se t h a t m a n a g e m e n t w o u ld lik e to in c lu d e in th e q u a n tita tiv e an alysis b u t is u n a b le to in c lu d e because th e y are d iffic u lt, i f n o t im p o s s ib le , to m ea sure in d o lla rs . F o r th is rea son th e y are assessed separately, a fte r th e q u a n tita tiv e a n a lysis o f th e a lte rn a tiv e s has been co m p le te d . Q u a lita tiv e fa c to rs m a y p la y a v it a l ro le in p ro je c t se le ctio n . F o r e xa m p le , suppose t h a t q u a n tita tiv e a n a lysis sho w s t h a t i t is che ap er f o r a tr a n s p o r t c o m p a n y to c o n tin u e u s in g som e o ld tru c k s f o r a n o th e r ye a r ra th e r th a n re p la c in g th e m no w . H o w e ve r, m a n a g e m e n t m a y decide to replace th e o ld tru c k s n o w because o f q u a lita tiv e fa c to rs such as th e de sire to m a in ta in a m o d e rn im a ge f o r th e c o m p a n y a n d th e im p ro v e d s a tis fa c tio n , a n d c o n s e q u e n tly th e im p ro v e d p ro d u c tiv ity , o f th e d riv e rs re s u ltin g fr o m th e c o m fo rt o f th e n e w tru c k s . Som e f u r t h e r exa m ples o f q u a lita tiv e fa c to rs t h a t m a y a ffe c t m a n a g e m e n ts d e cisio n s a b o u t p ro je c ts are: •

The in tr o d u c tio n o f la b o u r-s a v in g m a c h in e ry m a y be d e fe rre d (p e rh a p s in d e fin ite ly ) because o f u n io n o p p o s itio n , even th o u g h o n th e basis o f th e q u a n tita tiv e a n a lysis th e p ro p o s a l to in tro d u c e th e m a c h in e ry has a n e t p re s e n t v a lu e g re a te r th a n zero.

•

T w o m u tu a lly e xclu sive in v e s tm e n ts m a y have n e t p re s e n t values t h a t are a lm o s t eq ua l, b u t one re q u ire s m u c h m o re m a n a g e m e n t s u p e rv is io n , o r th e use o f som e o th e r scarce h u m a n resource. The use o f th is scarce reso urce in v o lv e s an o p p o r tu n ity cost th a t, w h ile re co g n ise d b y m a n a g e m e n t, is d iff ic u lt to q u a n tify . T h e re fo re , ra th e r th a n a tte m p tin g to m ea sure th e o p p o r tu n it y co st o f u s in g th e scarce h u m a n resources, m a n a g e m e n t m a y s im p ly select th e p ro p o s a l t h a t i t b e lie ve s w ill use fe w e r o f th o s e resources, o th e r th in g s b e in g equal. I t is e s s e n tia l t h a t such q u a lita tiv e fa c to rs be c o n sid e re d b e fo re s e le c tin g a p ro je c t. H o w eve r, th e

re c o g n itio n o f q u a lita tiv e fa c to rs is n o t a g e n e ra l p re s c rip tio n f o r ig n o r in g o r re d u c in g th e im p o rta n c e o f th e q u a n tita tiv e a n a lysis. As a ll fa c to rs c a n n o t be in c o rp o ra te d in to th e q u a n tita tiv e an alysis, a c o m p a ris o n o f a lte rn a tiv e in v e s tm e n t p ro p o s a ls is in c o m p le te w ith o u t an asse ssm en t o f th e po ssib le e ffe cts o f th e q u a lita tiv e fa c to rs . Ind e e d , th e in flu e n c e o f q u a lita tiv e fa c to rs m a y be s u ffic ie n tly im p o r ta n t to cause m a n a g e m e n t to select p ro p o sa ls w ith lo w e r c a lc u la te d n e t p re s e n t values.

C hapter SIX T he APPLICATION 〇F PROJECT EVALUATION METHODS

6.9

Project selection with resource constraints

So fa r i t has been a ssu m ed t h a t m a n a g e m e n t is w illin g a n d able to accept a ll in d e p e n d e n t in v e s tm e n t p ro je c ts th a t have a n e t p re s e n t v a lu e g re a te r th a n zero an d, i f m u tu a lly e xclusive p ro je c ts are b e in g com pared, th o se p ro je c ts w it h th e h ig h e s t p o s itiv e n e t p re s e n t value. H o w e ve r, so m e tim e s a c o m p a n y s

LEARNING OBJECTIVE 8 Explain the effects of resource constraints on project selection

m anagers be lie ve t h a t th e y are p re v e n te d fr o m u n d e rta k in g a ll acceptable p ro je c ts because o f a sho rta ge * o f fu n d s .

C apital ration in g

is th e te rm used to de scrib e such a s itu a tio n . I t m a y be c la s s ifie d f u r t h e r in to

in te rn a l (o r ‘s o f t ’）c a p ita l ra tio n in g a n d e x te rn a l (o r ‘h a rd ’）c a p ita l ra tio n in g .

Internal capital rationing

occurs w h e n m a n a g e m e n t lim it s th e a m o u n t t h a t can be in v e s te d in n e w

p ro je c ts d u rin g som e s p e c ifie d tim e p e rio d . There are seve ral reasons w h y m a n a g e m e n t m a y im p o s e a li m it o n c a p ita l e x p e n d itu re . O n e is t h a t m a n a g e m e n t is c o n s e rv a tiv e a n d has a p o lic y o f fin a n c in g a ll p ro je c ts fro m in te r n a lly g e n e ra te d cash because i t is u n w illin g to b o rro w . S im ila rly , m a n a g e m e n t m a y be u n w illin g to issue m o re shares because o f p o ssib le e ffe cts o n th e c o n tro l o f th e com p an y. A lte rn a tiv e ly , im p o s in g c a p ita l e x p e n d itu re lim it s can be a w a y o f m a in ta in in g fin a n c ia l c o n tro l. F o r e xa m p le , in a la rg e com p an y, m anagers m a y a tte m p t to e x p a n d t h e ir d iv is io n s b y p ro p o s in g m a n y n e w p ro je c ts , som e o f w h ic h o n ly

appear to

be p ro fita b le because th e cash flo w fo re ca sts are v e ry o p tim is tic . To a v o id th is p ro b le m , to p

m a n a g e m e n t m a y delegate a u t h o r ity f o r c a p ita l e x p e n d itu re d e cisio n s to d iv is io n a l m an ag ers, b u t re ta in o ve ra ll c o n tro l b y g iv in g each d iv is io n a c a p ita l e x p e n d itu re lim it . The a im is to fo rce each d iv is io n a l m an ag er to decide w h ic h o f th e p o ssib le p ro je c ts re a lly s h o u ld be a d op te d. A n o th e r p o s s ib ility is t h a t i t m a y be d e sira b le to li m i t th e ra te a t w h ic h a c o m p a n y exp an ds because o f th e o rg a n is a tio n a l d iffic u ltie s in h e re n t in h ir in g a n d t r a in in g m a n y a d d itio n a l s ta ff. M a n a g e m e n t m a y be con cern ed t h a t ra p id e x p a n s io n w ill le a d to in e ffic ie n c y a n d h ig h e r costs. To a v o id th e se p ro b le m s i t m a y lim it th e n u m b e r o f n e w p ro je c ts t h a t are im p le m e n te d . In th is case, a c a p ita l e x p e n d itu re li m i t is used to im p ose th e d e sire d r e s tr ic tio n , b u t i t is n o t

capital t h a t

is th e scarce resource. R a th e r, th e scarce resource

is m a n a g e m e n t tim e , a n d th e re a l c o n ce rn is t h a t th is c o n s tra in t m a y re s u lt in s u p e rv is io n p ro b le m s .

External capital rationing occu rs

w h e n th e c a p ita l m a rk e t is u n w illin g to s u p p ly th e fu n d s necessary

to fin a n ce th e p ro je c ts t h a t a c o m p a n y s m a n a g e m e n t w ishes to u n d e rta k e . I n th is case, th e c o m p a n y has p ro je c ts t h a t o ffe r p o s itiv e n e t p re s e n t value s b u t c a n n o t raise, a t a co st t h a t m a n a g e m e n t con sid ers acceptable, th e fu n d s necessary to fin a n c e th e m . T h is s itu a tio n can o ccu r i f fin a n c ia l in te rm e d ia rie s are sub je ct to c o n tro ls such as lim it s o n th e v o lu m e o r g r o w th ra te o f t h e ir le n d in g . H o w e ve r, i t is d iffic u lt to see w h y i t s h o u ld o ccu r in d e re g u la te d fin a n c ia l m a rk e ts . A n y c o m p a n y t h a t has a p ro je c t exp ected to be p ro fita b le s h o u ld be able to o b ta in th e necessary c a p ita l, n o m a tte r h o w s m a ll its c a p ita l b u d g e t. F or exam ple, suppose t h a t a s m a ll com p an y, w h ic h p la n s to in v e s t n o m o re th a n , say, $ 5 0 0 0 0 in th e c u rre n t year, discove rs an in e x p e n s iv e w a y o f e x tra c tin g g o ld fr o m th e oceans. R a is in g c a p ita l to b u ild th e e x tra c tio n p la n t s h o u ld n o t be a p ro b le m . E m p iric a l evidence suggests t h a t c a p ita l r a tio n in g is m o re lik e ly to re s u lt fr o m e x p e n d itu re lim it s im p o se d b y m a n a g e m e n t o f its o w n v o lit io n th a n fr o m an u n w illin g n e s s o f th e c a p ita l m a rk e t to s u p p ly fu n d s (P ike 1 9 8 3 ). I f m a n a g e m e n ts de cisio n s re s u lt in th e re je c tio n o f p ro je c ts w it h p o s itiv e n e t p re s e n t values, th e n m a n a g e m e n t is a d o p tin g a p o lic y in c o n s is te n t w it h th e o b je c tiv e o f m a x im is in g th e m a rk e t value o f th e c o m p a n y ’s shares. I f c a p ita l ra tio n in g is e s s e n tia lly an in te r n a l ‘p ro b le m ’, i t m ig h t a p p e a r th a t th e s o lu tio n s h o u ld be sim p le . M a n a g e m e n t s h o u ld re m o ve th e c o n s tra in ts so t h a t a ll p o s itiv e n e t p re s e n t value p ro je c ts can be im p le m e n te d . In som e cases, th is does occur. F o r e xa m p le , in cases w h e re c a p ita l e x p e n d itu re lim it s are used to m a in ta in fin a n c ia l c o n tro l, th e lim it s are lik e ly to be fle x ib le , a n d a d d itio n a l fu n d s w ill be p ro v id e d i f a p ro fita b le in v e s tm e n t o p p o r tu n ity arises u n e xp e cte d ly. H o w eve r, as discussed above, c a p ita l e x p e n d itu re lim it s m a y be im p o s e d f o r v a lid reasons t h a t do n o t re fle c t a sh o rta g e o f c a p ita l. R a th e r, th e re a l c o n s tra in t m a y be a s h o rta g e o f o th e r resources such as m a n a g e m e n t tim e . T h e re fo re , c a p ita l r a tio n in g can be a real p h e n o m e n o n a n d m an ag ers m a y ne ed to choose th e set o f p ro je c ts t h a t m a x im is e s n e t p re s e n t value , s u b je c t to a reso urce c o n s tra in t. O n th e o th e r ha n d , i f e x te rn a l c a p ita l r a tio n in g e xists, a tte m p ts to m a x im is e n e t p re s e n t value , su b je c t to a c a p ita l e x p e n d itu re lim it , in v o lv e a n in h e re n t c o n tra d ic tio n . The p ro b le m is t h a t a p ro je c ts n e t p re s e n t va lu e is ca lcula ted u s in g a re q u ire d ra te o f r e tu r n , b u t th e existe nce o f an e x te rn a l l i m i t o n th e a v a ila b ility o f c a p ita l im p lie s t h a t once th e li m it is reached, th e re q u ire d ra te o f r e tu r n is in fin ite . In th e fo llo w in g

CAPITAL RATIO NING

a condition where a firm has limited resources available for investment

d iscu ssio n , th e re fo re , i t w ill be assu m ed t h a t c a p ita l r a tio n in g e xists o n ly because o f in te r n a lly im p o s e d c o n s tra in ts . A m a n a g e r a tte m p tin g to ‘m a x im is e , th e m a rk e t value o f th e c o m p a n y ’s shares w it h in these s e lf-im p o s e d c o n s tra in ts s h o u ld calcula te th e n e t p re s e n t value o f each p ro je c t b y d is c o u n tin g its cash flo w s a t th e re q u ire d ra te o f re tu rn , a n d th e n choose th e c o m b in a tio n o f p ro je c ts t h a t m a xim ise s n e t p re s e n t v a lu e . The fo llo w in g e xa m p le illu s tra te s th is ap pro ach.

E xample 6.14 S u p p o s e th a t a c o m p a n y is c o n s id e r in g th e p r o p o s a ls lis te d in T a b le 6 . 1 4 . A s s u m e th a t it h a s a c a p it a l e x p e n d itu re lim it o f $ 6 0 0 0 0 0 , a ll p ro je c ts a r e in d e p e n d e n t, th e p ro je c ts a r e n o t d iv is ib le a n d it is n o t e n v is a g e d th a t a n e x p e n d itu re lim it w ill e x is t in fu tu re y e a rs .

TABLE 6.14 Ranking of projects under capital rationing Project

Initial cash outlay ($)

Net present value ($)

A

200000

28000

B

200000

20000

C

200000

15 000

D

200000

35 000

E

400000

45 000

F

400000

22000

M a n a g e m e n t m u st f in d th e c o m b in a tio n o f p ro je c ts th a t m a x im is e s n e t p re s e n t v a lu e , s u b je c t to th e e x p e n d itu re lim it o f $ 6 0 0 0 0 0 .

SOLUTION In th is e x a m p le , e x a m in a tio n o f a ll p o s s ib le o u tc o m e s s h o w s th a t th e la rg e s t n e t p re s e n t v a lu e w ill b e a c h ie v e d b y th e c o m b in a tio n o f P ro je cts D, A a n d B. T h is c o m b in a tio n resu lts in a n e t p re s e n t v a lu e o f $ 8 3 0 0 0 . B y c o m p a r is o n , th e n e x t b e s t a lte r n a tiv e , a c o m b in a tio n o f P ro je cts D a n d E, resu lts in a n e t p re s e n t v a lu e o f $ 8 0 0 0 0 . A s a re s u lt o f th e e x p e n d itu re lim it, e v e n th o u g h P ro je c ts C , E a n d F h a v e p o s itiv e n e t p re s e n t v a lu e s , th e c o m p a n y is u n a b le to im p le m e n t th e m th is y e a r . W it h o u t th e e x p e n d itu r e lim it, a ll th e p ro je c ts s h o w n in T a b le 6 . 1 4 c o u ld h a v e b e e n a c c e p te d a n d th e to ta l n e t p re s e n t v a lu e w o u ld h a v e b e e n $ 1 6 5 0 0 0 in s te a d o f $ 8 3 0 0 0 .

In re a lity , ra n k in g o f in v e s tm e n t p ro je c ts w h e re th e re is c a p ita l r a tio n in g is m u c h m o re co m p le x because o f th e la rg e n u m b e r o f in v e s tm e n t a lte rn a tiv e s g e n e ra lly a va ila b le to a co m p a n y. To f in d s o lu tio n s to such p ro b le m s , m a th e m a tic a l p ro g ra m m in g m o d e ls have b e en de velope d. W e n o w r e tu r n to th e e a rlie r p o in t t h a t th e im p o s itio n o f c a p ita l r a tio n in g b y m a n a g e m e n t can p re v e n t th e m a x im is a tio n o f s h a re h o ld e rs ’ w e a lth . C a p ita l r a tio n in g is n o t in th e s h a re h o ld e rs ’ b e s t in te re s t i f p ro je c ts w it h p o s itiv e n e t p re s e n t values are rejected . In E x a m p le 6 .1 4 , P ro je cts C, E a n d F, w ith p o s itiv e n e t p re s e n t values t o t a llin g $ 8 2 00 0, are re je cte d because o f a c a p ita l c o n s tra in t. U n less th e c o m p a n y faces a re a l c o n s tra in t, such as a s h o rta g e o f p e rs o n n e l, o r ra p id e x p a n s io n in v o lv e s excessive r is k , m a n a g e m e n t s h o u ld raise th e fu n d s necessary to fin a n c e the se p ro je c ts b y re d u c in g d iv id e n d s , b o rro w in g , is s u in g m o re shares o r som e c o m b in a tio n o f the se a ctio n s.

C hapter six T he

application of project evaluation methods

This c h a p te r h a s d is c u s s e d s e v e ra l im p o r ta n t a s p e c ts

c h a in

o f p r o je c t e v a lu a tio n , b e g in n in g w ith th e e s tim a tio n o f

th e e q u iv a le n t a n n u a l v a lu e o f e a c h p r o je c t. T hese

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c a s h flo w s .

m e th o d s a ls o p r o v id e a c o n v e n ie n t w a y o f a n a ly s in g

•

a s s e t r e p la c e m e n t d e c is io n s .

In e s tim a tin g c a s h flo w s , f in a n c in g c h a rg e s s h o u ld b e e x c lu d e d , a s to o s h o u ld a llo c a te d costs a n d su n k

•

•

W h ile

th e e ffe c ts o f ris k c a n

be

in c o r p o r a t e d

in

p r o je c t e v a lu a tio n b y u s in g a ris k -a d ju s te d d is c o u n t

costs. C o n v e rs e ly , a ll in c re m e n ta l c a s h flo w s m ust b e in c lu d e d . T he c o r r e c t tre a tm e n t o f in fla tio n re q u ire s

ra te , th e re a r e s e v e ra l m e th o d s o f p r o je c t a n a ly s is

th a t c a s h flo w s a n d th e r e q u ir e d ra te o f re tu rn b e

th a t c a n b e u se fu l in d e s c r ib in g ris k a n d p r o v id in g

d e fin e d in a c o n s is te n t m a n n e r.

m a n a g e rs w ith in fo r m a tio n a b o u t th e ris k o f a p r o je c t.

In d iv id u a ls a n d firm s a r e

T he m e th o d s d is c u s s e d in th e c h a p te r a r e s e n s itiv ity

r e q u ire d to p a y in c o m e

ta x e s to th e g o v e rn m e n t. H e n c e , it is im p o r ta n t th a t

a n a ly s is ,

p r o je c t e v a lu a tio n m e th o d s ta k e in to a c c o u n t ite m s

D e c is io n -tre e

th a t q u a lif y as a s s e s s a b le in c o m e a n d

e v a lu a tin g s e q u e n tia l d e c is io n s w h e r e p r o b a b ilit ie s

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w h ile a n in c re a s e in a llo w a b le d e d u c tio n s re su lts in •

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e v a lu a tio n , a n d c o n c lu d e d w ith a d is c u s s io n o f th e e ffe c ts o f re s o u rc e c o n s tra in ts o n p r o je c t e v a lu a tio n .

KEY TERMS b re a k -e v e n a n a ly s is c a p ita l r a tio n in g

re s id u a l v a lu e

151

131

s e n s itiv ity a n a ly s is

157

c o n s ta n t c h a in o f re p la c e m e n t a s s u m p tio n e q u iv a le n t a n n u a l v a lu e m e th o d

s im u la tio n

140

su n k co st

141

149

152 131

SELF-TEST PROBLEMS A c o m p a n y is c o n s id e r in g th e p u rc h a s e o f e q u ip m e n t c o s tin g $ 8 4 0 0 0 , w h ic h w ill p e r m it it to re d u c e its e x is tin g la b o u r co sts b y $ 2 0 0 0 0 a y e a r fo r 1 2 y e a rs . T h e c o m p a n y e s tim a te s th a t it w ill h a v e to s p e n d $ 2 0 0 0 e v e r y 2 y e a rs o v e r h a u lin g th e e q u ip m e n t. The e q u ip m e n t m a y b e d e p r e c ia te d f o r t a x p u rp o s e s b y th e s tr a ig h t-lin e m e th o d , o v e r a 1 2 -y e a r p e r io d . T he c o m p a n y ta x ra te is 3 0 c e n ts in th e d o lla r a n d th e a fte r-ta x c o s t o f c a p it a l is 1 0 p e r c e n t p e r a n n u m . A s s u m in g a ll c a s h flo w s , in c lu d in g ta x p a y m e n ts , a r e m a d e a t th e e n d o f e a c h y e a r, s h o u ld th e c o m p a n y p u rc h a s e th e e q u ip m e n t? T he m a n a g e m e n t o f th e T M T C o m p a n y is c o n s id e r in g p u r c h a s in g a n e w m a c h in e a n d it h a s g a th e r e d th e f o llo w in g d a ta : a)

The c a s h n e e d e d to p u rc h a s e th e n e w m a c h in e is $ 6 4 0 0 0 .

b) The re s id u a l v a lu e a n d a n n u a l c a s h o p e r a tin g e x p e n s e s fo r th e n e x t 5 y e a rs a r e e s tim a te d to be: R e sid u a l v a lu e a t e n d

A n n u a l ca sh o p e r a tin g

Year

o f y e a r ($ )

e xp e n se s ($ }

1

50000

11000

2

40000

13000

3

30000

18000

4

23000

24000

5

3500

28000

C H A P T E R SIX R E V I E W

SUMMARY

B usiness finance

c)

N o cha ng es in residual values o r a n n u a l cash o p e ra tin g expenses a re exp ected .

d) The re q u ire d rate o f return is 15 per cent pe r annum . e) The effects o f c o m p a n y in com e ta x m a y be ig n o re d . W h a t is the o p tim u m re p la ce m e n t p o lic y fo r this m achine? 3

The m a n a g e m e n t o f A B C T ra n sp o rt Ltd, w h ic h is e n g a g e d in interstate tra n s p o rt, is c o n s id e rin g the re p la c e m e n t o f its pre sen t fle e t o f 1 0 CB sem i-trailers w ith six A Z F lexivans. A su rve y has re ve a le d the fo llo w in g estim ates o f costs, a n d so on, p e r vehicle: CB s e m i-tra ile rs

R em aining life

E stim ate s

3 years

A Z F le x iv a n s

E stim ates

E stim ate d life

5 years

1

Residual value: A t th e p re se n t tim e

$5 000

Cost

$70000

In 3 years’ tim e

$1000

A n n u a l n e t cash flow s

$40000

A n n u a l n e t cash flow s

$30000

Residual value a fte r

$5 000

5 years’ o p e ra tio n O th e r in fo r m a tio n is a s fo llo w s : •

N e t c a s h flo w s a r e to b e r e g a r d e d a s re c e iv e d a t th e e n d o f e a c h y e a r.

•

T he r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m .

S h o u ld m a n a g e m e n t: a)

re ta in th e C B s e m i-tra ile rs f o r 3 y e a rs a n d th e n re p la c e th e m w ith A Z F le x iv a n s ?

b)

re p la c e th e C B se m i-tra ile rs w ith th e A Z F le x iv a n s n o w ?

Solutions to self-test problems ore available in Appendix B.

QUESTIONS 1

[LO 1! A p r o p e r ty d e v e lo p m e n t c o m p a n y p la n s to d e m o lis h th e b u ild in g o n a site th a t it a lr e a d y o w n s , a n d th e n b u ild a c o n v e n ie n c e sto re . W h ic h o f th e f o llo w in g ite m s s h o u ld b e in c lu d e d a s in c re m e n ta l c a s h flo w s w h e n th e p r o je c t is e v a lu a te d :

2

a)

th e m a rk e t v a lu e o f th e p r o p e r ty

b)

th e c o s t o f d e m o lis h in g th e o ld b u ild in g

c)

th e co st o f n e w w a te r a n d e le c tric p o w e r c o n n e c tio n s in s ta lle d 3 m o n th s a g o

d)

a p o rtio n o f th e c o s t o f le a s in g c a rs use d b y th e c o m p a n y 's e x e c u tiv e s

e)

m o n e y th a t ha s a lr e a d y b e e n s p e n t o n a rc h ite c tu ra l c o n c e p t p la n s fo r th e n e w b u ild in g ?

[L O 1] E x p la in th e re la tio n s h ip b e tw e e n

nominal a n d real d is c o u n t ra te s . O u t lin e its a p p lic a t io n to p r o je c t

e v a lu a tio n in th e c o n te x t o f a n in fla t io n a r y e c o n o m y . 3

[LO 1] L e a v in g a s id e th e e ffe c t o f ta x e s , w h ic h o f th e f o llo w in g ite m s s h o u ld b e c o n s id e r e d in th e in itia l o u tla y o n a n e w m a c h in e f o r p r o je c t e v a lu a tio n p u rp o s e s ? G iv e re a s o n s . a)

T he d is p o s a l v a lu e o f th e o ld m a c h in e , w h ic h is $ 6 0 0 0 .

b) T he $ 4 0 0 c o s t o f in s ta llin g th e n e w m a c h in e .

4

5

c)

A d d it io n a l in v e s tm e n t o f $ 1 0 0 0 0 in c u rre n t assets th a t w ill b e re q u ire d .

d)

C o sts o f $ 3 0 0 0 re c e n tly in c u rre d in a sse ssin g th e s u ita b ility o f th e n e w m a c h in e .

[L O 2 】It

doesn't matter whether the straight-line method or reducing-balance method o f depreciation is used since the total tax b ill over the life o f the project is the some. C o m m e n t o n th is s ta te m e n t.

[LO 3 】 O u t lin e tw o m e th o d s o f s o lv in g p r o je c t e v a lu a tio n p ro b le m s w h e r e th e p ro je c ts u n d e r c o n s id e r a tio n d o n o t h a v e c o m m o n te r m in a l d a te s .

160

C hapter six T he

[L O 3 ] D e fin e th e te rm 'm u tu a lly e x c lu s iv e p r o je c ts ' a n d p r o v id e a s im p le e x a m p le . O u tlin e a n d ju s tify th e b a s ic n e t p re s e n t v a lu e ru le a p p lic a b le to th e m . H o w s h o u ld th is ru le b e m o d ifie d w h e n such p ro je c ts h a v e u n e q u a l live s?

7

[L O 4 ] H o w s h o u ld th e o p tim u m life o f a p r o je c t b e d e te rm in e d ?

8

[L O 4 ] D is tin g u is h b e tw e e n re p la c e m e n t d e c is io n s a n d re tire m e n t d e c is io n s .

9

[L O 5 ]

10

[L O 5 ] O u tlin e th e w e a k n e s s e s o f s e n s itiv ity a n a ly s is .

Sensitivity analysis may be used to identify the variables that ore most important for a project's success. D iscuss.

11

[LO 5 ]

12

[L 0 5 ]

Simulation is only useful for large-scale investment projects. D iscuss.

Simulation is extremely valuable because it is useful in refining cash flow forecasts and it avoids the need to estimate a project's required rote o f return. D o y o u a g r e e w ith th e se c la im s ? G iv e re a s o n s f o r y o u r

a n s w e r. 13

[LO 8 ] D is tin g u is h b e tw e e n in te rn a l a n d e x te rn a l c a p it a l r a tio n in g . G iv e e x a m p le s o f e a c h .

14

[L0 8] a)

O u tlin e p o s s ib le re a s o n s fo r th e im p o s itio n b y m a n a g e m e n t o f c a p ita l ra tio n in g . D o e s th e im p o s itio n o f

b)

If a c o m p a n y is s u b je c t to c a p ita l ra tio n in g , d o e s th is m a k e a n y d iffe re n c e to p r o je c t e v a lu a tio n u s in g th e

C H A P T E R SIX R E V I E W

6

application of project evaluation methods

in te rn a l c a p ita l r a tio n in g im p ly th a t m a n a g e m e n t is f a ilin g to m a x im is e s h a re h o ld e rs 7 w e a lth ?

n e t p re s e n t v a lu e m e th o d ? G iv e re a so n s.

CA

PROBLEMS

1

Application of the N P V method [LO 1] The fu rn itu re d iv is io n o f P la y fu rn Ltd, a p ro fita b le , d iv e rs ifie d c o m p a n y , p u rc h a s e d a m a c h in e 5 y e a rs a g o fo r $ 7 5 0 0 0 . W h e n it w a s p u rc h a s e d th e m a c h in e h a d a n e x p e c te d use ful life o f 1 5 y e a rs a n d a n e s tim a te d v a lu e o f z e ro a t th e e n d o f its life . T h e m a c h in e c u rre n tly h a s a m a rk e t v a lu e o f $ 1 0 0 0 0 . T he d iv is io n m a n a g e r re p o rts th a t he c a n b u y a n e w m a c h in e fo r $ 1 6 0 0 0 0 (in c lu d in g in s ta lla tio n ) w h ic h , o v e r its 1 0 -y e a r life , w ill re su lt in a n e x p a n s io n o f sa le s fro m $ 1 0 0 0 0 0 to $1 1 0 0 0 0 p e r a n n u m . In a d d itio n , it is e s tim a te d th a t th e n e w m a c h in e w ill re d u c e a n n u a l o p e r a tin g costs fro m $ 7 0 0 0 0 to $ 5 0 0 0 0 . If th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m , s h o u ld P la y fu rn b u y th e n e w m a c h in e ?

2

Application of the N P V method [LO 1] T he T w o-B it M in in g C o m p a n y h a s c o n s tru c te d a to w n a t B ig B o re , n e a r th e site o f a ric h m in e ra l d is c o v e r y in a re m o te p a r t o f A u s tr a lia . T he to w n w ill b e a b a n d o n e d w h e n m in in g o p e ra tio n s c e a s e a fte r a n e s tim a te d 1 0 -y e a r p e r io d . T he fo llo w in g e s tim a te s o f in v e s tm e n t costs, sa le s a n d o p e r a tin g e x p e n s e s re la te to a p r o je c t to s u p p ly B ig B o re w ith m e a t a n d a g ric u ltu r a l p ro d u c e o v e r th e 1 0 -y e a r p e r io d b y d e v e lo p in g n e a r b y la n d . a)

In v e s tm e n t in la n d is $ 1 0 m illio n , fa rm b u ild in g s $ 2 0 0 0 0 0 0 a n d fa rm e q u ip m e n t $ 4 0 0 0 0 0 0 . T he la n d is e x p e c te d to h a v e a re a lis a b le v a lu e o f $ 5 0 0 0 0 0 0 in 1 0 y e a rs ' tim e . T he re s id u a l v a lu e o f th e b u ild in g s a fte r 1 0 y e a rs is e x p e c te d to b e $ 5 0 0 0 0 0 . T he fa rm e q u ip m e n t ha s a n e s tim a te d life o f 1 0 y e a rs a n d a z e r o re s id u a l v a lu e .

b)

In ve stm e n t o f $ 2 5 0 0 0 0 0 in c u rre n t assets w ill b e re c o v e re d a t th e te rm in a tio n o f th e v e n tu re .

c)

A n n u a l c a s h sales a r e e s tim a te d to b e $ 2 4 . 8 m illio n .

d)

A n n u a l c a s h o p e r a tin g costs a r e e s tim a te d to b e $ 2 2 m illio n .

Is th e p ro je c t p r o fita b le , g iv e n th a t th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m ?

3

Application of the N P V method [LO 1] A s o ftw a re p r o v id e r b u y s b la n k B lu -ra y D V D s a t $ 5 5 0 p e r h u n d re d a n d c u rre n tly uses 2 m illio n D V D s p e r y e a r. The m a n a g e r b e lie v e s th a t it m a y b e c h e a p e r to m a k e th e D V D s ra th e r th a n b u y th e m . D ire c t p r o d u c tio n costs (la b o u r, m a te ria ls , fu e l) a r e e s tim a te d a t $ 2 . 5 0 p e r D V D . T he e q u ip m e n t n e e d e d w o u ld c o s t $ 3 m illio n . T he e q u ip m e n t s h o u ld la s t fo r 1 5 y e a rs , p r o v id e d it is o v e rh a u le d e v e ry 5 y e a rs a t a c o s t o f $ 2 5 0 0 0 0 e a c h tim e . The o p e r a tio n w ill re q u ire a d d itio n a l c u rre n t assets o f $ 4 0 0 0 0 0 . The c o m p a n y 's r e q u ire d ra te o f re tu rn is 1 2 p e r c e n t. E v a lu a te th e p ro p o s a l.

161

B usiness finance

4

Application of the N P V method [LO 1] O z z ie N a tio n w id e In d u strie s Ltd is a la r g e c o m p a n y w ith in te re sts in m in in g , s h ip b u ild in g , e n te rta in m e n t, fo o d p ro c e s s in g a n d in te rs ta te fr e ig h t h a u la g e . Its fo o d p ro c e s s in g d iv is io n is in v e s tig a tin g th e p o s s ib ility o f a d d in g m a n d a rin -fla v o u re d y o g h u r t to its c u rre n t ra n g e o f b a n a n a , s tr a w b e r r y a n d a p p le . C u rre n tly , a ll fla v o u rs a re s o ld a t a p ric e o f $ 1 . 5 0 p e r c a rto n a n d sa le s a re e ve n th ro u g h o u t th e y e a r. O z z ie re c e n tly h ir e d M e lb o u r n e M a r k e t R e se a rch Ltd to s u rv e y co n s u m e rs to ju d g e th e lik e ly p o p u la r ity o f th e n e w fla v o u r. The r e p o r t c o s t $ 4 0 0 0 0 a n d s u g g e s te d th a t th e c o m p a n y s h o u ld b e a b le to sell 4 0 0 0 0 0 c a rto n s o f th e n e w fla v o u r n e x t y e a r, a n d 8 0 0 0 0 0 in e a c h o f th e f o llo w in g 2 y e a rs . A fte r th a t tim e , th e fa d fo r m a n d a r in fla v o u r is e x p e c te d to h a v e run its c o u rs e . O z z ie 's c o s tin g d e p a rtm e n t h a s a d v is e d th a t th e in c re m e n ta l c o s t o f p ro d u c tio n is $ 1 . 2 0 p e r c a rto n . O z z ie 's sales d e p a rtm e n t h a s a d v is e d th a t it is e s s e n tia l th a t a ll fla v o u rs in th e ra n g e s h o u ld b e so ld a t th e s a m e p ric e . O z z ie 's e n g in e e rs h a v e a d v is e d th a t th e re is n o s p a re p ro d u c tio n c a p a c ity a lth o u g h th e re is p le n ty o f s p a re flo o r s p a c e in th e fa c to ry . T h e y h a v e a ls o a d v is e d th a t y o g h u r t p ro c e s s in g m a c h in e s h a v e a p r o d u c tio n c a p a c ity o f 4 0 0 0 0 0 c a rto n s p e r a n n u m a n d th a t th e c o s t o f o n e m a c h in e , fu lly in s ta lle d , is $ 2 3 0 0 0 0 . O z z ie 's fin a n c e d iv is io n ha s a d v is e d th a t th e c o m p a n y 's re q u ire d ra te o f re tu rn (n o m in a l) is e s tim a te d to b e 1 5 p e r c e n t p e r a n n u m . T he m a c h in e s h a v e a life o f 3 y e a rs a n d a t th a t p o in t h a v e o n ly a s c ra p v a lu e , w h ic h is e s tim a te d to b e o n ly $ 1 0 0 0 0 . H o w e v e r, th is a m o u n t u s u a lly o n ly ju st c o v e rs th e costs o f re m o v in g th e m a c h in e fro m th e fa c to ry . O z z ie 's p r o je c t a n a ly s t h a s re c o m m e n d e d a g a in s t p r o c e e d in g w ith th e n e w fla v o u r, b a s in g this r e c o m m e n d a tio n o n a n e t p re s e n t v a lu e a n a ly s is . T he n e t c a s h in flo w s w e r e fo re c a s t to b e $ 1 2 0 0 0 0 in th e firs t y e a r, a n d $ 2 4 0 0 0 0 in th e s e c o n d y e a r a n d th e th ird y e a r. T he in itia l o u tla y w a s $ 5 0 0 0 0 0 . T he N P V w a s c a lc u la te d as:

K(m/ $ 1 2 0 0 0 0 $240000 $240000 N P V = --------------- + -------------------1-$ 5 0 0 0 0 0 1.1 50 5 1 .1 5 15 1 .1 5 2-5 一

$ 2 4 2 64

The p r o je c t a n a ly s t's re p o r t c o n ta in e d th e u su al r a n g e o f s e n s itiv ity a n a ly s e s a n d s u p p o rtin g d is c u s s io n a n d d o c u m e n ta tio n b u t th is c a lc u la tio n w a s th e c e n tra l result. You h a v e b e e n a s k e d to r e v ie w th e p r o je c t a n a ly s t’s w o r k a n d re p o r t o n a n y e rro rs y o u d e te c t. P ro v id e re a s o n s. Ig n o re ta x . N o te th a t it is n o t n e c e s s a ry to re d o th e a n a ly s is , o r to s u g g e s t h o w th e a n a ly s is m ig h t b e e x te n d e d . Y o u r ta s k is to id e n tify e rro rs .

5

Application of the N P V method [LO 1] T he B e rtie H a m ilto n F is h in g C o m p a n y (BHF) p u rc h a s e d a tr a w le r 6 y e a rs a g o fo r $ 4 2 0 0 0 0 . A t th e tim e it w a s p u rc h a s e d , th e t r a w le r h a d a use ful life o f 1 0 y e a rs . If BHF w e r e to re ta in th is b o a t, it is a n tic ip a te d th a t u ltra s o n ic d e te c tio n e q u ip m e n t w o u ld h a v e to b e in s ta lle d in th e s e c o n d -la s t y e a r o f its life a t a c o s t o f $ 4 0 0 0 0 . H o w e v e r, th e C o m m e rc ia l T ra w le r C o m p a n y (CT) ha s re c e n tly la u n c h e d a fa ste r, co m p u te r-a s s is te d tr a w le r th a t BHF is c o n s id e rin g a s a re p la c e m e n t. T his tr a w le r w ill c o s t $ 6 0 0 0 0 0 b u t w ill n e e d im m e d ia te re fittin g to s u it th e p u rc h a s e r's s p e c ific a tio n s a t a n a d d itio n a l c o s t o f $ 1 5 0 0 0 . It h a s a n e x p e c te d use ful life o f 1 2 y e a rs . If p u rc h a s e d , th e n e w tr a w le r is lik e ly to in c re a s e c a s h o p e r a tin g costs b y $ 1 0 p e r to n n e o f fish , w h ic h c u rre n tly sells f o r $ 3 0 p e r to n n e . H o w e v e r, fu tu re c a tc h e s a re lik e ly to in c re a s e s ig n ific a n tly b y 6 0 0 0 to n n e s in th e firs t y e a r, a n d the n a t a ra te o f 1 0 0 0 to n n e s p e r a n n u m , s ta b ilis in g a t 1 2 0 0 0 to n n e s fro m Y e a r 7 o n w a r d . O w in g to in te n s iv e u s a g e , it is e x p e c te d th a t to w a r d s th e e n d o f th e fifth y e a r th e n e w tr a w le r w ill re q u ire a m in o r e n g in e o v e rh a u l a t a c o s t o f $ 3 0 0 0 0 . P a rt o f th e p u rc h a s e a g re e m e n t a ls o in v o lv e s a m a in te n a n c e c o n tra c t w ith C T c o v e rin g th e nets a n d t r a w lin g a p p a ra tu s , w h ic h w ill c o s t BHF $ 1 2 0 0 0 , p a y a b le a t th e e n d o f e v e r y fo u rth y e a r. A s a c o m p e titiv e stra te g y, C T o ffe rs a n o p tio n a l fin a n c in g p a c k a g e fo r u p to 8 0 p e r c e n t o f th e in v o ic e p ric e o n a n y b o a t. T h e ra te o f in te re s t o n th is a m o u n t is 1 2 p e r c e n t p e r a n n u m , w ith th e firs t p a y m e n t d e fe rre d 1 y e a r. If th e fin a n c in g p a c k a g e is a d o p te d , BHF m ust u n d e rta k e to sell th e tr a w le r b a c k to C T in 1 2 y e a rs ' tim e fo r $ 5 0 0 0 0 . BHF e s tim a te s th a t th e c u rre n t s e c o n d -h a n d p r ic e o f its p re s e n t tr a w le r is o n ly $ 1 4 0 0 0 0 . It is e s tim a te d th a t th e n e w tr a w le r c a n b e s o ld f o r $ 1 0 0 0 0 0 a t th e e n d o f its use fu l life . T h e c o m p a n y 's n o m in a l re q u ire d ra te o f re tu rn is 3 0 p e r ce n t. a)

E stim a te th e n e t c a s h f lo w (N C F ) a t th e b e g in n in g o f Y e a r 1.

bj

E stim a te th e N C F in Y e a r 4 .

C hapter six T he

M a n a g e m e n t b e lie v e s th a t re la tiv e to to d a y 's p ric e s , th e a v e r a g e in fla tio n ra te is e x p e c te d to b e 8 p e r c e n t p e r a n n u m o v e r th e n e x t 1 2 y e a rs . W h a t is th e Y e a r 3 in fla tio n -a d ju s te d N C F ?

d)

E stim a te th e a p p r o p r ia te d is c o u n t ra te to p e rfo rm a n N P V a n a ly s is in re a l te rm s.

Application of the N P V method [LO 1] A c o m p a n y m ust c h o o s e b e tw e e n tw o m a c h in e s . M a c h in e A costs $ 5 0 0 0 0 a n d th e a n n u a l o p e r a tin g e x p e n s e s a re e s tim a te d to b e $ 2 0 0 0 0 , w h ile M a c h in e B costs $ 8 5 0 0 0 a n d ha s e s tim a te d a n n u a l o p e r a tin g e x p e n s e s o f $ 1 5 0 0 0 . B o th m a c h in e s h a v e a 1 0 -y e a r life a n d w ill h a v e a z e ro re s id u a l v a lu e . a)

The c o m p a n y h a s a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t p e r a n n u m . W h ic h m a c h in e s h o u ld it p u rc h a s e ?

b)

R e w o rk th e p ro b le m fo r a 7 p e r c e n t r e q u ire d ra te o f re tu rn .

Application of the N P V method [LO 1] A c o m p a n y is c o n s id e rin g th e p u rc h a s e o f e q u ip m e n t c o s tin g $ 1 2 5 0 0 0 th a t w ill p e rm it it to re d u c e its e x is tin g la b o u r costs b y $ 2 0 0 0 0 a y e a r f o r 1 2 y e a rs . T h e c o m p a n y e s tim a te s th a t it w ill h a v e to s p e n d $ 3 0 0 0 e v e r y 2 y e a rs o v e rh a u lin g th e e q u ip m e n t. T h e re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m . A s s u m in g a ll c a s h flo w s a re m a d e a t th e e n d o f e a c h y e a r, s h o u ld th e c o m p a n y p u rc h a s e th e e q u ip m e n t?

Explaining the effects of taxes on project cash flows [LO 2 】 The F o u r a n d S ix S tore s Pty Ltd is c o n s id e rin g lo c a tin g a n o th e r o u tle t in a n e a s te rn s u b u rb o f M e lb o u r n e .

C H A P T E R SIX R E V I E W

c)

application of project evaluation methods

Estim ates o f sales a n d o p e r a tin g e x p e n s e s h a v e b e e n m a d e a n d a n e s tim a te d p r o fit a n d loss s ta te m e n t fo r the n e w s to re d r a w n u p . T he p r o fit a n d loss s ta te m e n t fo r Y e a r 1 is th o u g h t to b e re p re s e n ta tiv e o f e a c h o f th e 1 0 y e a rs o f th e e x p e c te d life o f th e n e w F o u r a n d S ix s to re . T he in itia l o u tla y to c o n s tru c t th e s to re is $ 4 0 0 0 0 0 0 , w h ile th e o u tla y n e c e s s a ry to sto ck th e s to re is $ 2 0 0 0 0 0 0 . T h e e s tim a te d s ta te m e n t o f fin a n c ia l p e rfo rm a n c e fo r th e n e w s to re fo r Y e a r 1 is s h o w n in th e fo llo w in g ta b le :

Revenue Less sales re tu rn s, discou nts

4000000 400 000 3 600000

N et revenue O pe ra ting expenses Cost o f goods sold

1600000

A d m in is tra tio n costs

600000

D e pre ciatio n

360000

In te re st

240000

2800000

N e t p ro fit before tax

800000

Tax (30% tax rate)

240000

N e t p ro fit a fte r tax

560000

E stim ate th e p ro je c t's a n n u a l a fte r-ta x c a s h flo w .

Explaining the effects of taxes on project cash flows [LO 2] A ll- N ig h t C o ffe e S h o p s Ltd is a su cce ssful p r o fita b le c o m p a n y o p e r a tin g s e v e ra l d o z e n c o ffe e sh o p s th ro u g h o u t th e m e tro p o lita n a r e a o f M e lb e r r a . H o w e v e r, th e s h o p in th e s u b u rb o f B u rn a b y h a s n o t b e e n w e ll p a tro n is e d , g e n e ra tin g a b e fo re -ta x n e t c a sh f lo w o f o n ly $ 5 0 0 0 0 in th e p a s t y e a r. T he B u rn a b y s h o p b e g a n tr a d in g 2 y e a rs a g o in p re m is e s le a s e d fro m C B D Ltd. T he le a s e is a b o u t to e x p ir e a n d A ll- N ig h t w ill n o t re n e w it. A c o m p e tito r, B ra z il C o ffe e S h o p s Ltd, h a s o ffe re d to b u y th e fix tu re s a n d fittin g s a n d th e e q u ip m e n t in th e B u rn a b y s h o p fo r $ 4 0 0 0 0 0 . A ll- N ig h t ha s a g r e e d to th is fig u re , e ve n th o u g h it is $ 3 0 0 0 0 0 less th a n th e c o s t o f th e fix tu re s a n d fittin g s a n d th e e q u ip m e n t 2 y e a rs a g o . A s s u m e th a t: a)

fo r ta x p u rp o s e s th e fix tu re s a n d fittin g s a n d th e e q u ip m e n t w e re d e p r e c ia te d o n a s tra ig h t-lin e b a s is a t

b)

th e a fte r-ta x c o m p a n y ta x ra te is 3 0 p e r ce n t.

10 pe r cent pe r annum

W h a t is th e a fte r-ta x n e t ca sh f lo w (fo r Y e a r 2 ) a ttr ib u ta b le to A ll- N ig h t's B u rn a b y sh o p ?

163

10

Explaining the effects of taxes on project cash flows [LO 2 】

It doesn't matter whether the straight-line or reducing-balance method o f depreciation is used, since the total tax bill over the life o f the project is the same. D iscuss th e v a lid ity (o r o th e rw is e ) o f this s ta te m e n t in th e c o n te x t o f th e fo llo w in g e x a m p le : A s s e t co st (n o w )

$10000

A sset life

5 years

Residual value (in 5 years)

$4700

A n n u a l n e t cash in flo w be fore ta x

$6000

S tra ig h t-lin e d e p re cia tio n rate (per an nu m )

10%

Reducing-balance de p re cia tio n rate (per a n nu m )

20%

C om pany incom e ta x rate

30%

Cost o f cap ital

11

10% p.a.

Explaining the effects of taxes on project cash flows [LO 2] A c o m p a n y is c o n s id e r in g p u rc h a s in g a n e w m a c h in e a t a c o s t o f $ 9 0 0 0 0 0 to re p la c e a m a c h in e p u rc h a s e d 6 y e a rs a g o f o r $1 m illio n . T h e d is p o s a l v a lu e o f th e o ld m a c h in e is $ 2 5 0 0 0 0 a n d th e a c c u m u la te d d e p r e c ia tio n , w h ic h h a s b e e n a llo w e d fo r ta x p u rp o s e s , is $ 6 0 0 0 0 0 . B oth m a c h in e s w ill h a v e s im ila r o u tp u ts a n d w ill p r o d u c e w o r k o f id e n tic a l q u a lity . T he e s tim a te d y e a r ly costs o f o p e r a tin g e a c h m a c h in e a re as fo llo w s : O ld m a c h in e ($)

N e w m a c h in e ($ ) 1

Wages

225 000

75 000

D e pre ciatio n

100000

225000

Supplies, repairs, po w e r

65 000

30000

Insurance and m iscellaneous

36000

20000

426000

350000

B oth m a c h in e s h a v e a n e s tim a te d re m a in in g life o f 4 y e a rs , a t w h ic h tim e b o th m a c h in e s w ill h a v e a n e s tim a te d d is p o s a l v a lu e o f $ 9 0 0 0 0 . A s s u m e th a t: a)

th e a fte r-c o m p a n y -ta x c o s t o f c a p ita l is 1 0 p e r c e n t p e r a n n u m

b)

th e o p e r a tin g co sts o f th e o ld m a c h in e a n d th e n e w m a c h in e a r e in c u rre d a t th e e n d o f e a c h y e a r

c)

th e c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r.

S h o u ld th e c o m p a n y p u rc h a s e th e n e w m a c h in e ?

12

Mutually exclusive projects with different lives [LO 3] T h e m a n a g e m e n t o f H a r b o u r F e rrie s Ltd is c o n s id e rin g th e re p la c e m e n t o f its e x is tin g fle e t o f s ix ste a m fe rrie s w ith th re e h y d ro fo ils . T he fo llo w in g e s tim a te s o f costs, a n d so o n , fo r e a c h vesse l h a v e b e e n c a lc u la te d : I S te a m fe rrie s

E stim ate d re m a in in g life

E stim ates

5 years

E stim a te d scrap value: N ow

$50000

In 5 years’ tim e

$10000

A n n u a l n e t cash flow s

$100000

H y d ro fo ils

E stim ate s

Cost

$500000

E stim ate d life

10 years

E stim ate d scrap value: In 5 years’ tim e

$200000

In 10 years’ tim e

$100000

A n n u a l n e t cash flow s

$200000

C hapter six T he

application of project evaluation methods

a v a ila b le in 5 y e a rs 7 tim e . T he fo llo w in g e stim a te s o f costs, a n d so o n , p e r h o v e rc ra ft h a v e b e e n p r o v id e d b y th e m a n u fa c tu re r:

H o v e rc ra ft

E stim ate s

Cost

$600000

E stim ated life

15 years

E stim ate d disposal value: $200000

A fte r 5 years* o p era tion

$50000

A fte r 15 years* op e ra tio n

$250000

A n n u a l n e t cash flow s

C H A P T E R SIX R E V I E W

M a n a g e m e n t is a ls o a w a r e o f th e d e v e lo p m e n t o f h o v e rc ra ft, w h ic h th e m a n u fa c tu re r e s tim a te s w ill b e

It is c o n s id e re d th a t tw o o f th e n e w h o v e rc ra ft w ill b e a d e q u a te to c a r r y th e e s tim a te d n u m b e r o f p a s s e n g e rs . O th e r in fo rm a tio n is a s fo llo w s : •

M a n a g e m e n t c a n n o t fo re s e e a n y fu rth e r d e v e lo p m e n ts b e y o n d th e h o v e rc ra ft.

•

T he a n n u a l n e t c a s h flo w s a r e re c e iv e d a t th e e n d o f e a c h y e a r.

•

T he c o m p a n y 's re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m .

You a re re q u ire d to a d v is e m a n a g e m e n t w h e th e r it s h o u ld : a)

re p la c e th e stea m fe rrie s w ith h y d ro fo ils n o w , a n d re p la c e th e la tte r w ith h o v e rc ra ft in 5 y e a r s ' tim e

b)

re ta in th e ste a m fe rrie s fo r 5 y e a rs , a n d th e n re p la c e th e m w ith h o v e rc ra ft

c)

re p la c e th e stea m fe rrie s w ith h y d ro fo ils n o w , a n d re p la c e th e la tte r w ith h o v e rc ra ft in 1 0 y e a r s 7 tim e .

O th e r a lte rn a tiv e s a re n o t to b e c o n s id e re d .

13

Mutually exclusive projects with different lives [LO 3] H e rm e s Pty Ltd o p e ra te s a c o u r ie r s e rv ic e . A n e w v a n is r e q u ire d to m e e t th e in c re a s e d d e m a n d fo r the c o m p a n y ’s s e rv ic e s . T he c h o ic e h a s b e e n n a r r o w e d d o w n to th re e v a n s , A , B a n d C , e a c h c o s tin g $ 1 0 0 0 0 0 . N e t c a s h f lo w e s tim a te s a r e as fo llo w s :

N e t c a sh f lo w e stim a te s ($) Year

Van A

VanB

Van C

1

$47000

$48000

$47000

2

$50000

$40000

$48000

3

$50000

$40000

$48000

4

$58000

$52000

$55000

5

0

$42000

0

20%

20%

20%

$30795

$32881

$26801

Required rate o f re tu rn NPV

By d is c o u n tin g e a c h n e t c a s h flo w , s h o w th a t th e n e t p re s e n t v a lu e o f V a n A h a s b e e n c a lc u la te d p ro p e rly . W h ic h v a n s h o u ld b e p u rc h a s e d ? G iv e re a so n s.

16 5

14

Mutually exclusive projects with different lives [LO 3] The m a n a g e m e n t o f H u n te r A ir Ltd is c o n s id e rin g th e re p la c e m e n t o f its e x is tin g fle e t o f seve n A 6 1 6 a ir c r a ft w ith th re e B 7 2 7 a ir c r a ft. T he fo llo w in g e s tim a te s fo r e a c h a ir c r a ft h a v e b e e n c a lc u la te d :

A 6 1 6 a ir c r a ft

E stim ate d re m a in in g

E stim ates

5 years

B 7 2 7 a e ro p la n e s

Estim ates

Cost

$ 5 00 m illio n

E stim ated life

10 years

life E stim ated scrap value N ow

$50 m illio n

E stim ate d disposal value

In 5 years’ tim e

A n n u a l n e t cash flow s

$10 m illio n

$100 m illio n

In 5 years’ tim e

$200 m illio n

In 10 years’ tim e

$100 m illio n

A n n u a l n e t cash flow s

$200 m illio n

M a n a g e m e n t is a ls o a w a r e o f th e d e v e lo p m e n t o f th e C 8 9 8 , w h ic h th e m a n u fa c tu re r e s tim a te s w ill b e a v a ila b le in 5 y e a rs 7 tim e . T h e fo llo w in g e s tim a te s fo r a C 8 9 8 a ir c r a ft h a v e b e e n p r o v id e d b y th e m a n u fa c tu re r. I C 8 9 8 a ir c r a ft

E stim ates

Cost

$600 m illio n

E stim a te d life

15 years

E stim ate d disposal value A fte r 5 years’ op e ra tio n

$200 m illio n

A fte r 15 years’ op e ra tio n

$50 m illio n

A n n u a l n e t cash flow s

$250 m illio n

It is c o n s id e re d th a t t w o o f th e n e w C 8 9 8 a ir c r a f t w ill b e a d e q u a te to c a r r y th e e s tim a te d n u m b e r o f p a s s e n g e rs . O th e r in fo rm a tio n is a s fo llo w s : i)

M a n a g e m e n t c a n n o t fo re s e e a n y fu rth e r d e v e lo p m e n ts b e y o n d th e C 8 9 8 a ir c r a ft.

ii)

T he a n n u a l n e t c a sh flo w s a re re c e iv e d a t th e e n d o f e a c h y e a r.

iii) T he c o m p a n y 's a fte r-ta x c o s t o f c a p ita l is 1 0 p e r c e n t p e r a n n u m . iv) T he c o m p a n y 's ta x ra te is 3 0 cen ts. v)

T he A 6 1 6 a ir c r a f t a re a s s u m e d to b e fu lly d e p re c ia te d .

vi) S tra ig h t-lin e d e p r e c ia tio n m a y b e a ss u m e d . You a re re q u ire d to a d v is e m a n a g e m e n t w h e th e r it s h o u ld : a)

re p la c e th e A 6 1 6 a ir c r a ft w ith B 7 2 7 a ir c r a ft n o w , a n d re p la c e th e la tte r w ith C 8 9 8 a ir c r a f t in 5 y e a r s ' tim e

b)

re ta in th e A 6 1 6 a ir c r a ft fo r 5 y e a rs , a n d th e n re p la c e th e m w ith C 8 9 8 a ir c r a ft

c)

re p la c e th e A 6 1 6 a ir c r a ft w ith B 7 2 7 a ir c r a ft n o w , a n d re p la c e th e la tte r w ith C 8 9 8 a ir c r a f t in 1 0 y e a r s ' tim e .

O th e r a lte rn a tiv e s a r e n o t to b e c o n s id e re d .

15

Mutually exclusive projects with different lives [LO 3] S p e e d y Pty Ltd o p e ra te s a s u b u rb a n d o c u m e n t d e liv e r y bu sin e ss. It is c o n s id e rin g th e r e p la c e m e n t o f a 2 -to n n e tru c k w ith a 3 -to n n e tru c k . D e ta ils o f th e re s p e c tiv e v e h ic le s a re a s fo llo w s :

C hapter six T he

Rem aining life

5 years

Residual value: N ow

$6000

In 4 years

$0

C H A P T E R SIX R E V I E W

3 -to n n e tru c k

E stim ates

2 -to n n e tru c k

application of project evaluation methods

E stim ates

E stim ate d life

6 years

Cost

$25 000

Residual value a fte r 6 years’ op e ra tio n

$2000

D e pre ciatio n (allow able fo r tax

$4000 p.a.

purposes) W ritte n -d o w n value (fo r ta x

$7500 (before

purposes)

ta xa tio n )

D e pre ciatio n (fo r ta x purposes)

$1200 p.a.

N et cash flo w (before ta x a tio n )

$ 1 2 0 0 0 p.a.

N e t cash flo w

$ 2 0 0 0 0 p.a.

O th e r in fo rm a tio n is a s fo llo w s : i)

N e t c a s h flo w s a re to b e r e g a r d e d a s re c e iv e d a t th e e n d o f e a c h y e a r.

ii)

T he e ffe c tiv e a fte r-ta x c o s t o f c a p ita l is 1 0 p e r c e n t p e r a n n u m .

iii) T he c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r. M a n a g e m e n t is c o n s id e rin g th e fo llo w in g a lte rn a tiv e s : a)

R e p la c e th e 2 -to n n e tru c k w ith th e 3 -to n n e tru c k n o w .

b)

R e p la c e th e 2 -to n n e tru c k w ith th e 3 -to n n e tru c k in 5 y e a r s ' tim e .

A ll o th e r a lte rn a tiv e s m a y b e ig n o r e d . A d v is e m a n a g e m e n t as to w h ic h a lte rn a tiv e it s h o u ld a d o p t, a n d ju s tify y o u r a n a ly s is .

16

Replacement decision [LO 4] A c o m p a n y is c o n s id e r in g th e in s ta lla tio n o f a n e w m a c h in e a t a c o s t o f $ 6 0 0 0 0 to re p la c e a m a c h in e p u rc h a s e d 7 y e a rs a g o f o r $ 1 0 0 0 0 0 . T he d is p o s a l v a lu e o f th e o ld m a c h in e is $ 1 5 0 0 0 . B oth m a c h in e s w ill h a v e s im ila r o u tp u ts a n d w ill p ro d u c e w o r k o f id e n tic a l q u a lity . T he e s tim a te d y e a r ly costs o f o p e r a tin g e a c h m a c h in e a re as fo llo w s : O ld m a c h in e ($ )

Wages

N e w m a c h in e ($ ) 1

15000

5 000

Supplies, repairs, pow er

5000

3 000

Insurance and m iscellaneous

2000

3000

22000

11000

T otal

Both m a c h in e s h a v e a n e s tim a te d re m a in in g life o f 3 y e a rs , a t w h ic h tim e b o th m a c h in e s w ill h a v e a n e s tim a te d d is p o s a l v a lu e o f $ 5 0 0 0 . A s s u m e th a t: a)

th e re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m

b) th e o p e r a tin g costs o f th e o ld m a c h in e a n d th e n e w m a c h in e a r e in c u rre d a t th e e n d o f e a c h y e a r. S h o u ld th e c o m p a n y p u rc h a s e th e n e w m a c h in e , o r c o n tin u e to o p e r a te th e o ld o n e ?

17

Replacement decision [LO 4] T he m a n a g e m e n t o f N e w W o r ld A irlin e s is c o n s id e rin g th e re p la c e m e n t o f its p re s e n t fle e t o f 1 0 p is to n e n g in e p la n e s w ith fiv e tu rb o p ro p s . A s u rv e y ha s re v e a le d th e f o llo w in g e s tim a te s o f costs, a n d so o n , p e r p la n e : Piston e n g in e

R em aining life Residual value:

E stim ates

5 years

T u rb o p ro p

E stim ate s

Life

5 years

Cost

$3430000

j

167

I P iston e n g in e

E stim ates

T u rb o p ro p

E stim ate s

A t p resent tim e

$10000

In 2 years’ tim e

$5 000

In 5 years’ tim e

$0

A fte r 2 years’ o p e ra tio n

30% o f purchase price

$100000

A fte r 5 years’ o p e ra tio n

5% o f purchase price

A n n u a l n e t cash flow s a)

A n n u a l n e t cash flow s

$1000000

Residual value:

S h o u ld re p la c e m e n t b e u n d e rta k e n n o w o r in 5 y e a r s 7 tim e ?

Im m e d ia te ly a fte r th e d e c is io n ha s b e e n re a c h e d , m a n a g e m e n t is in fo rm e d o f a s u p e rje t th a t w ill b e c o m e a v a ila b le in 2 y e a r s ' tim e . T he e stim a te s fo r th e n e w p la n e a re : S u p e rje t

Estim ates

Cost

$4500000

A n n u a l n e t cash in flo w s

$1200000

Life

5 years

Residual value a fte r

3% o f purchase price

5 years’ o p e ra tio n It is c o n s id e re d th a t fo u r o f th e n e w s u p e rje ts w ill b e a d e q u a te to c o v e r th e e s tim a te d p a s s e n g e r lo a d . O th e r in fo r m a tio n is as fo llo w s : •

M a n a g e m e n t c a n n o t fo re s e e a n y fu rth e r d e v e lo p m e n ts b e y o n d th e s u p e rje t.

•

A n n u a l n e t c a s h flo w s a r e a s s u m e d to b e re c e iv e d a t th e e n d o f e a c h y e a r.

•

T he r e q u ir e d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m ,

b)

S h o u ld m a n a g e m e n t: i) re ta in th e p is to n e n g in e p la n e s fo r 5 y e a rs a n d re p la c e th e m w ith su p e rje ts ii) re p la c e th e m im m e d ia te ly w ith tu rb o p ro p s , o p e ra te th e m fo r 5 y e a rs , a n d th e n re p la c e th e m w ith s u p e rje ts iii) re p la c e th e m n o w w ith tu rb o p ro p s , o p e ra te th e m fo r 2 y e a rs , a n d th e n re p la c e th e m w ith su p e rje ts iv) re ta in th e p is to n e n g in e p la n e s fo r 2 y e a rs a n d th e n re p la c e th e m w ith s u p e rje ts?

O th e r re p la c e m e n t d a te s a re n o t to b e c o n s id e re d .

18

Replacement decision [LO 4] A .B . Pty Ltd is c u rre n tly o p e r a tin g a s u b u rb a n ta x i-tru c k b u sin e ss. It is c o n s id e rin g th e re p la c e m e n t o f a 1 .5

to n n e v e h ic le w ith a 2 to n n e v e h ic le . D e ta ils o f th e re s p e c tiv e v e h ic le s a re a s fo llo w s :

I 1 .5 -to n n e v e h ic le

R em aining life

Estim ates

4 years

Residual value: N ow

$4000

2 -to n n e v e h ic le

Estim ates

E stim ate d life

7 years

Cost

$15000

Residual value a fte r

$1000

7 years’ op e ra tio n In fo u r years A n n u a l n e t cash flo w

$0 $6000

N e t cash flo w

$10000

C hapter SIX T he APPLICATION 〇F PROJECT EVALUATION METHODS

•

N e t ca sh flo w s a r e to b e re g a r d e d as re c e iv e d a t th e e n d o f e a c h y e a r.

•

T he re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m .

M a n a g e m e n t is c o n s id e rin g th e f o llo w in g a lte rn a tiv e s : a)

re p la c e th e 1 .5 to n n e v e h ic le w ith th e 2 to n n e v e h ic le n o w

b)

re p la c e th e 1 .5 to n n e v e h ic le w ith th e 2 to n n e v e h ic le in 4 y e a r s 7 tim e .

A ll o th e r a lte rn a tiv e s m a y b e ig n o r e d . A d v is e m a n a g e m e n t a s to w h ic h a lte r n a tiv e it s h o u ld a d o p t, a n d ju s tify y o u r a n a ly s is .

19

Retirement decision [LO 4 】 P ulp a n d P a p e r Ltd h a s ju st p la n te d p in e tre e s a t a c o s t o f $ 1 2 0 0 0 p e r h e c ta re o n 5 0 0 h e c ta re s o f la n d , w h ic h it p u rc h a s e d fo r $ 4 0 0 0 0 0 . T he tre e s a r e e x p e c te d to g r o w r a p id ly a n d th e c o m p a n y 's e s tim a te s o f th e n e t fu tu re v a lu e o f th e c u t tim b e r a re :

T im e o f h a rv e s t e n d

N e t fu tu re v a lu e ($ p e r

o f year

h e c ta re )

2

17320

3

20000

4

22360

5

24495

6

26450

C H A P T E R SIX R E V I E W

O th e r in fo rm a tio n is as fo llo w s :

T he re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m a n d ta x e s c a n b e ig n o r e d . a)

C a lc u la te th e o p tim u m tim e to h a rv e s t th e c r o p o f tre e s. A s s u m e th a t th e v a lu e o f th e c le a re d la n d in c re a s e s a t a ra te o f 1 0 p e r c e n t p e r a n n u m .

b)

E stim a te th e n e t p re s e n t v a lu e o f th e p ro je c t, a s s u m in g s a le o f th e la n d a fte r th e tre e s a re h a rv e s te d . N o te a n y a s s u m p tio n s y o u m a k e .

20

Replacement decision [LO 4] A c o m p a n y is c o n s id e r in g th e re p la c e m e n t o f a n o ld m a c h in e w ith a n e w m a c h in e . T he o ld m a c h in e w a s p u rc h a s e d a y e a r a g o f o r $ 1 2 5 0 0 . A d d it io n a l in fo r m a tio n re la tin g to th e se m a c h in e s (cash flo w s a re in n o m in a l term s) is a s fo llo w s :

E stim ates O ld m a c h in e ($)

Item

N e w m a c h in e ($)

M a rk e t value (now )

$7000

$5000

Service life (w hen

6 years

5 years

$0

$1000

purchased) Residual value in 5 years’ tim e Cash op e ra tin g receipts

-

$500 p.a. in excess o f o ld m achine

T he re a l re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m , a n d th e a n tic ip a te d in fla tio n ra te is 1 0 p e r c e n t p e r a n n u m . C a lc u la te th e n e t p re s e n t v a lu e o f r e p la c in g th e o ld m a c h in e w ith th e n e w m a c h in e .

169

21

Sensitivity analysis [LO 5] M a n a g e m e n t o f R id e Ltd is c o n s id e rin g th e p o s s ib ility o f m a n u fa c tu rin g a n e w m o to ris e d g o lf b u g g y . The in itia l o u tla y f o r th e n e w p la n t to m a n u fa c tu re th e v e h ic le is $1 m illio n . T h e s ta ff o f R id e Ltd h a v e p r o v id e d th e f o llo w in g e s tim a te s fo r th e p ro je c t:

Estim ates Item

P essim istic

Sales (u n its ) S elling price ($) Fixed o p e ra tin g costs p e r a n n u m ($)

M o s t lik e ly

O p tim is tic

3000

3500

4000

750

800

850

100000

90000

80000

25

24

23

4

5

6

Variable o p e ra tin g costs pe r a n nu m per u n it o f sales ($) Life o f the p la n t (years)

A s s u m in g a re q u ire d ra te o f re tu rn o f 1 0 p e r c e n t, c o n d u c t a s e n s itiv ity a n a ly s is . W h a t a re th e m a jo r u n c e rta in tie s if th e p r o je c t is u n d e rta k e n ?

22

Break-even analysis [LO 5] T he m a n a g e r o f A ls p o rts Ltd is c o n s id e rin g a p la n to m a n u fa c tu re a lu m in iu m b a s e b a ll b a ts. E q u ip m e n t to m a n u fa c tu re th e b a ts w ill c o s t $ 8 5 0 0 0 0 a n d is e x p e c te d to h a v e a use ful life o f 3 y e a rs . F ix e d costs a re e s tim a te d to b e $ 8 0 0 0 0 p e r a n n u m a n d th e b a ts a r e e x p e c te d to sell fo r $ 4 0 e a c h , w h ile v a r ia b le costs w ill b e $ 2 8 p e r b a t. A b o u t 5 0 0 0 0 0 b a s e b a ll b a ts a re s o ld e a c h y e a r a n d A ls p o rts h a s a re q u ire d ra te o f re tu rn o f 1 0 p e r c e n t. C a lc u la te th e b re a k -e v e n sales v o lu m e .

23

Decision-tree analysis [LO 6] P asha B u lk e r Ltd is c o n s id e rin g p r o d u c in g a n e w p ro d u c t. It e x p e c ts th a t th e p r o d u c t w ill h a v e a life o f 1 0 y e a rs , b y w h ic h tim e th e m a rk e t f o r th e p r o d u c t w ill b e s a tu ra te d a n d fh e assets n e c e s s a ry to p ro d u c e it w ill b e s o ld . T h e c o m p a n y is u n c e rta in a s to w h e th e r th e p r o d u c t s h o u ld b e m a n u fa c tu re d o n a la r g e s c a le in a la r g e p la n t, o r o n a s m a ll s c a le in a s m a ll p la n t. If th e c o m p a n y c h o o s e s a s m a ll p la n t, it w o u ld c o n s id e r e x p a n d in g th e p la n t a fte r 3 y e a rs . T he c o m p a n y e s tim a te s th a t th e re is a 5 0 p e r c e n t p r o b a b ilit y th a t a h ig h le ve l o f d e m a n d w ill b e a tta in e d o v e r th e 1 0 y e a rs d u r in g w h ic h th e p r o d u c t w ill b e m a rk e te d , a 2 5 p e r c e n t p r o b a b ilit y th a t d e m a n d w ill b e h ig h d u rin g th e firs t 3 y e a rs a n d th e n d r o p to a lo w le ve l o v e r th e s u c c e e d in g 7 y e a rs , a n d a 2 5 p e r c e n t p r o b a b ilit y th a t a lo w le ve l o f d e m a n d w ill p e rs is t o v e r th e e n tire 1 0 y e a rs . T he f o llo w in g ta b le in d ic a te s th e e x p e c te d a n n u a l n e t c a s h flo w s a n d re s id u a l v a lu e s a s s o c ia te d w ith e a c h s c a le o f p ro d u c tio n a n d le ve l o f d e m a n d :

I P o s s ib ilitie s

A n n u a l n e t c a sh f lo w ($ )

R e sid u a l v a lu e ($ ) 1

Large p la n t, h ig h dem and

500000

500000

Large p la n t, lo w dem and

150000

200000

Sm all p la n t, h ig h dem and

200000

200000

Sm all p la n t, lo w dem and

150000

100000

Expanded p la n t, h ig h dem and

300000

400000

Expanded p la n t, lo w dem and

100000

150000

T he in itia l c o s t a s s o c ia te d w ith th e c o n s tru c tio n o f a la r g e p la n t is $ 2 m illio n , a n d th a t a s s o c ia te d w ith a sm a ll p la n t is $1 m illio n . T he e x p e c te d c o s t o f e x p a n d in g fro m a s m a ll p la n t to a la r g e p la n t a fte r 3 y e a rs is $1 m illio n . T h e c o m p a n y 's re q u ire d ra te o f re tu rn o f 1 2 p e r c e n t p e r a n n u m is re le v a n t fo r a ll a lte rn a tiv e s . a)

W h ic h p o lic y s h o u ld th e c o m p a n y p u rsu e ?

b)

Is it lik e ly th a t th e s a m e d is c o u n t ra te w ill b e a p p r o p r ia te fo r a ll a lte rn a tiv e s ? G iv e re a so n s.

C hapter six T he

application of project evaluation methods

Brown, C. & Davis, K., 'O ptions in mutually exclusive projects of unequal lives', Quarterly Review of Economics and Finance, Special Issue 1998, pp. 5 6 9 -7 7 .

Levin, R.I., Kirkpatrick, C.A. & Rubin, D.S., Quantitative Approaches to Management, 8th edn, M cG raw-Hill, N ew York, 1992, pp. 2 3 1 -7 .

Faff, R. & Brailsford, T., 'The constant chain of replacement model and inflation', Pacific Accounting Review, December 1992, pp. 4 5 -5 8 .

Pike, R.J., The capital budgeting behaviour and corporate characteristics of capital-constrained firms', Journal of Business Finance and Accounting, W inter 1983, pp. 6 6 3 -7 .

C H A P T E R SIX R E V I E W

REFERENCES

171

CHAPTER CONTENTS m

R e tu rn a n d ris k

EB

T h e in v e s to r 's u t ilit y fu n c tio n

m

T h e ris k o f a s s e ts

3 7

I n t r o d u c t io n

6 7 9 7

m g g

3 7

ED

EB

P o r t f o lio t h e o r y a n d d iv e r s if ic a t io n

179

T h e p r ic in g o f r is k y a s s e ts

190

A d d it io n a l f a c t o r s t h a t e x p la in re tu rn s

19 7

P o r t f o lio p e r f o r m a n c e a p p r a is a l

19 8

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

u n d e r s ta n d h o w r e tu r n a n d r is k a r e d e f in e d a n d m e a s u r e d

2

u n d e r s ta n d th e c o n c e p t o f r is k a v e r s io n b y in v e s to rs

3

e x p la in h o w d iv e r s if ic a t io n r e d u c e s ris k

4

e x p la in th e c o n c e p t o f e f f ic ie n t p o r t f o lio s

5

u n d e r s ta n d th e im p o r t a n c e o f c o v a r ia n c e b e t w e e n re tu rn s o n r is k y a s s e ts in d e t e r m in in g th e r is k o f a p o r t f o lio

6

e x p la in th e d is tin c t io n b e t w e e n s y s te m a tic a n d u n s y s te m a tic r is k

7

e x p la in w h y s y s te m a tic ris k is im p o r t a n t to in v e s to rs

8

e x p la in th e r e la t io n s h ip b e t w e e n re tu rn s a n d ris k p r o p o s e d b y th e c a p it a l a s s e t p r ic in g m o d e l

9

u n d e r s ta n d th e r e la t io n s h ip b e t w e e n th e c a p it a l a s s e t p r ic in g m o d e l a n d m o d e ls t h a t in c lu d e a d d i t i o n a l fa c to r s

1 0 e x p la in th e d e v e lo p m e n t o f m o d e ls t h a t in c lu d e a d d i t i o n a l f a c to r s 11

d is tin g u is h b e t w e e n a lt e r n a t iv e m e th o d s o f a p p r a is in g th e p e r f o r m a n c e o f a n in v e s tm e n t p o r t f o lio .

C hapter seven Risk

a n d return

Introduction A fin a n c ia l d e c is io n ty p ic a lly in v o lv e s r isk . F o r e x a m p le , a c o m p a n y t h a t b o r r o w s m o n e y f a c e s th e r is k th a t in t e r e s t r a t e s m a y c h a n g e , a n d a c o m p a n y t h a t b u ild s a n e w f a c t o r y f a c e s th e r i s k t h a t p r o d u c t s a l e s m a y b e lo w e r th a n e x p e c te d . T h e se a n d m a n y o t h e r d e c is io n s in v o lv e fu t u r e c a s h flo w s t h a t a r e risk y . In v e s t o r s g e n e r a lly d is lik e r i s k , b u t th e y a re a ls o u n a b le to a v o id it. Th e v a lu a t io n f o r m u la e fo r s h a r e s a n d d e b t s e c u r itie s o u tlin e d in C h a p t e r 4 sh o w e d t h a t th e p ric e o f a r is k y a s s e t d e p e n d s o n i t s e x p e c t e d fu tu r e c a s h flo w s, th e tim e v a lu e o f m o n e y , a n d r isk . H o w ev e r, little a t t e n t i o n w a s p a id to th e c a u s e s o f r i s k o r to h o w r is k s h o u ld b e d e fin e d a n d m e a s u r e d . T o m a k e e ffe c tiv e fin a n c ia l d e c is io n s , m a n a g e r s n e e d to u n d e r s t a n d w h a t c a u s e s r is k , h o w i t s h o u ld b e m e a s u r e d a n d th e e ffe c t o f r is k o n th e r a te o f r e t u r n r e q u ir e d b y in v e s t o r s . T h e se i s s u e s a r e d is c u s s e d in t h is c h a p te r u s in g th e fr a m e w o r k o f p o r t f o lio th e o r y , w h ic h s h o w s h o w in v e s t o r s c a n m a x im is e th e e x p e c te d r e tu r n o n a p o r t f o lio o f r is k y a s s e t s fo r a g iv e n le v e l o f r isk . Th e r e la t io n s h ip b e t w e e n r is k a n d e x p e c te d r e tu r n is fir s t d e s c r ib e d b y th e c a p it a l a s s e t p r ic in g m o d e l (C A P M ), w h ic h lin k s e x p e c t e d r e t u r n to a sin g le so u r c e o f r is k , a n d s e c o n d , b y m o d e ls t h a t in c lu d e a d d it io n a l f a c t o r s to e x p la in r e t u r n s . To u n d e r s ta n d th e m a t e r ia l in t h is c h a p t e r i t i s n e c e s s a r y to u n d e r s t a n d w h a t is m e a n t b y re tu rn a n d risk. T h e re fo re , w e b e g in b y d i s c u s s i n g t h e s e c o n c e p ts .

7.2

Return and risk

The re tu r n o n a n in v e s t m e n t a n d th e r i s k o f a n i n v e s t m e n t a r e b a s ic c o n c e p t s in fin a n c e . R e tu r n o n a n in v e s t m e n t is th e fin a n c ia l o u t c o m e f o r th e in v e sto r . F o r e x a m p le , i f s o m e o n e i n v e s t s $ 1 0 0 in a n a s s e t a n d s u b s e q u e n t ly s e lls t h a t a s s e t f o r $ 1 1 1 , th e d o lla r retu rn is $ 1 1 . U su a lly a n i n v e s t m e n t s d o lla r r e t u r n is

L E A R N IN G O B JEC TIVE 1 U nde rstand h o w return

c o n v e r te d to a ra te o f retu rn b y c a lc u la tin g th e p r o p o r t io n o r p e r c e n ta g e r e p r e s e n t e d b y th e d o lla r r e tu r n .

a n d risk are defined

F o r e x a m p le , a d o lla r r e t u r n o f $ 1 1 o n a n in v e s t m e n t o f $ 1 0 0 is a r a t e o f r e t u r n o f $ 1 1 / $ 1 0 0 , w h ic h is

a n d m easured

0 .1 1 , o r 1 1 p e r c e n t. In th e r e m a in d e r o f t h is c h a p t e r th e w o rd re tu rn is u s e d to m e a n ra te o f re tu rn . R isk is p r e s e n t w h e n e v e r i n v e s t o r s a r e n o t c e r ta in a b o u t th e o u t c o m e s a n in v e s t m e n t w ill p r o d u c e . S u p p o s e , h o w e v e r, t h a t in v e s t o r s c a n a t ta c h a p r o b a b ility t o e a c h p o s s ib le d o lla r r e t u r n t h a t m a y o ccu r. In v e sto r s c a n t h e n d r a w u p a p r o b a b ility d is tr ib u t io n f o r th e d o lla r r e t u r n s fr o m th e in v e s t m e n t . A p ro b ab ility d istrib u tio n is a l is t o f th e p o s s ib le d o lla r r e t u r n s f r o m th e in v e s t m e n t t o g e t h e r w ith th e p r o b a b ility o f e a c h r e tu r n . F o r e x a m p le , a s s u m e t h a t th e p r o b a b ilit y d is t r ib u t io n in T a b le 7 .1 i s a n i n v e s t o r s a s s e s s m e n t o f th e d o lla r r e t u r n s

t h a t m a y b e re c e iv e d f r o m h o ld in g a s h a r e in a c o m p a n y fo r

1 year.

TABLE 7.1 D o lla r re tu rn , Rt ($ )

P ro b a b ility , P,

9

0.1

10

0 .2

11

0 .4

12

0 .2

13

0 .1

S u p p o s e th e in v e s t o r w is h e s to s u m m a r is e t h is d is t r ib u t io n b y c a lc u la tin g tw o m e a s u r e s , o n e to r e p r e s e n t th e s iz e o f th e d o lla r r e t u r n s a n d th e o t h e r to r e p r e s e n t th e r i s k in v o lv e d . Th e s iz e o f th e d o lla r r e t u r n s m a y b e m e a s u r e d b y th e e x p e c t e d v a lu e o f th e d is t r ib u t io n . Th e e x p e c t e d v a lu e E (R ) o f th e d o lla r r e t u r n s is g iv e n b y th e w e ig h te d a v e r a g e o f all th e p o s s ib le d o lla r r e t u r n s , u s i n g th e p r o b a b ilit ie s a s w e ig h t s — t h a t is: E (R ) = ($ 9 ) (0 .1 ) + ( $ 1 0 ) ( 0 .2 ) + ($ 1 1 ) (0 .4 ) + ($ 1 2 ) (0 .2 ) + ( $ 1 3 ) (0 .1 ) =

$11

In general, the expected return on an investment can be calculated as:

w h ic h c a n b e w r it t e n a s fo llo w s:

n E{R) = Y ^ R iP i i= l The c h o ic e o f a m e a s u r e f o r r is k is l e s s o b v io u s . In t h is e x a m p le , r i s k is p r e s e n t b e c a u s e a n y o n e o f fiv e o u t c o m e s ($ 9 , $ 1 0 , $ 1 1 , $ 1 2 o r $ 1 3 ) m ig h t r e s u lt fr o m th e i n v e s t m e n t . I f th e i n v e s t o r h a d p e r fe c t fo r e s ig h t , th e n o n ly o n e p o s s ib l e o u tc o m e w o u ld b e in v o lv e d , a n d th e r e w o u ld n o t b e a p r o b a b ility d i s t r ib u t io n t o b e c o n s id e r e d . T h is s u g g e s t s t h a t r i s k is r e la t e d to th e d is p e r s io n o f th e d is tr ib u t io n . The VARIANCE

m easure of variability; the m ean of the squared deviations from the m ean or expected value

m o r e d i s p e r s e d o r w id e s p r e a d th e d is tr ib u t io n , th e g r e a t e r th e r is k in v o lv e d . S t a t i s t i c i a n s h a v e d e v e lo p e d a n u m b e r o f m e a s u r e s to r e p r e s e n t d is p e r s io n . T h e se m e a s u r e s in c lu d e th e r a n g e , th e m e a n a b s o lu t e d e v ia tio n a n d th e v a r ia n c e . H o w e v e r, it is g e n e r a lly a c c e p te d t h a t in m o s t in s t a n c e s t h e i t s s q u a r e r o o t, th e

stan d ard deviation,

a) is

variance

(o r

th e m o s t u s e f u l m e a s u r e . A c c o rd in g ly , t h is m e a s u r e o f

d i s p e r s io n is th e o n e w e w ill u s e to r e p r e s e n t th e r is k o f a s in g le in v e s t m e n t . T h e v a r ia n c e o f a d is tr ib u t io n

STANDARD DEVIATION

o f d o lla r r e t u r n s is th e w e ig h te d a v e r a g e o f th e s q u a r e o f e a c h d o lla r r e t u r n s d e v ia tio n f r o m th e e x p e c te d

square root of the

d o lla r r e t u r n , a g a in u s i n g th e p r o b a b ilit ie s a s th e w e ig h ts . F o r th e s h a r e c o n s id e r e d in T a b le 7 .1 , th e

varian ce

v a r ia n c e is:

cr2 = (9-11)2(0.1) + (10-11)2(0.2) + (11-11)2(0.4) + (12-11)2(0.2) + (13 - 11)2(0.1) = 1.2 In g e n e r a l th e v a r ia n c e c a n b e c a lc u la te d a s: 〇2 -

[/?, -£(/?)]2p, + [R2 - E ( R ) Y P 2 + ... + [/?„-£(/?)]2p„

w h ic h c a n b e w r it t e n a s fo llo w s:

n o2 = J 2 ^ R' ~ E(R^ 2pi i= l In t h is c a s e th e v a r ia n c e is 1 .2 s o th e s t a n d a r d d e v ia tio n is:

a = \/L 2 = $ 1 .0 9 5 In t h e s e c a lc u la tio n s w e h a v e u s e d d o lla r r e t u r n s r a t h e r t h a n r e t u r n s m e a s u r e d in th e fo r m o f a ra te . T h is is b e c a u s e i t is g e n e r a lly e a s ie r to v is u a lis e d o lla r s t h a n r a t e s , a n d b e c a u s e i t a v o id s c a lc u la tio n s w ith a la r g e n u m b e r o f z e r o s fo llo w in g th e d e c im a l p o in t . H o w e v e r, th e r e is n o d iffe r e n c e in s u b s t a n c e , a s m a y b e s e e n f r o m r e w o r k in g th e e x a m p le u s i n g r e t u r n s in r a te fo r m . I f th e s u m in v e s t e d is $ 1 0 0 , th e n a d o lla r r e tu r n o f $ 9 , f o r e x a m p le , is a r e t u r n o f 0 .0 9 w h e n e x p r e s s e d a s a ra te . T a b le 7 .2 sh o w s r a t e s o f r e t u r n t h a t c o r r e s p o n d to th e d o lla r r e t u r n s in T a b le 7 .1 .

TABLE 7.2 R etu rn,

P ro b a b ility , P,

0 .0 9

0 .1

0 .1 0

0 .2

0 .1 1

0 .4

0 .1 2

0 .2

0 .1 3

0 .1

U s i n g r a t e s , th e e x p e c t e d r e t u r n E (R ) is: E (R ) = (0 .0 9 ) (0 .1 ) + (0 .1 0 ) (0 .2 ) + ( 0 .1 1 ) ( 0 .4 ) + (0 .1 2 ) (0 .2 ) + (0 .1 3 ) (0 .1 ) =

0.11

= 11%

C hapter seven Risk

The v a r ia n c e o f r e t u r n s is:

a 2 = (0.09-0 .1 1 )2(0.1) + (0 .1 0 -0 .1 1 )2(0.2) + (0.11-0 .1 1 )2(0.4) + (0 .1 2 -0 .1 1 )2(0.2) + ( 0 . 1 3 - 0 . 1 1 ) 2( 0 . 1 )

= 0 .0 0 0 12 The s t a n d a r d d e v ia tio n o f r e t u r n s is t h e r e fo r e : ct=

v/0.00012

= 0 .0 1 0 9 5 = 1 .0 9 5 % It is o ft e n a s s u m e d t h a t a n i n v e s t m e n t s d is t r ib u t io n o f r e t u r n s fo llo w s a n o r m a l d is tr ib u t io n . T h is is a c o n v e n ie n t a s s u m p t i o n b e c a u s e a n o r m a l d is t r ib u t io n c a n b e fu lly d e s c r ib e d b y i t s e x p e c t e d v a lu e a n d s t a n d a r d d e v ia tio n . T h e r e fo re , a n i n v e s t m e n t s d is t r ib u t io n o f r e t u r n s c a n b e fu lly d e s c r ib e d b y i t s e x p e c te d r e t u r n a n d r is k . A s s u m i n g t h a t r e t u r n s fo llo w a n o r m a l p r o b a b ility d is tr ib u t io n , th e t a b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u rv e (s e e T a b le 5 o f A p p e n d ix A ) c a n b e u s e d t o c a lc u la te th e p r o b a b ility th a t th e in v e s t m e n t w ill g e n e r a t e a r e tu r n g r e a t e r t h a n o r l e s s t h a n a n y s p e c ifie d r e tu r n . F o r e x a m p le , s u p p o s e t h a t th e r e t u r n s o n a n in v e s t m e n t in C o m p a n y A a r e n o r m a lly d is tr ib u t e d , w ith a n e x p e c t e d r e tu r n o f 1 3 p e r c e n t p e r a n n u m a n d a s t a n d a r d d e v ia tio n o f 1 0 p e r c e n t p e r a n n u m . S u p p o s e a n in v e s t o r in th e c o m p a n y w ish e s to c a lc u la te th e p r o b a b ilit y o f a l o s s — t h a t is , th e in v e s t o r w is h e s to c a lc u la te th e p r o b a b ility o f a r e tu r n o f l e s s th a n z e r o p e r c e n t. A r e t u r n o f z e r o p e r c e n t is 1 .3 s t a n d a r d d e v ia t io n s b e lo w th e e x p e c te d r e t u r n (b e c a u s e 0 .1 3 / 0 .1 0 = 1 .3 ). F ig u r e 7 .1 illu s t r a t e s t h is c a s e . Th e s h a d e d a r e a r e p r e s e n t s th e p r o b a b ility o f a lo s s . Th e ta b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u r v e (T a b le 5, A p p e n d ix A o r th e N O R M S D IS T f u n c tio n in M ic r o s o ft E x c e l*) in d ic a t e s t h a t th e p r o b a b ility o f a l o s s o c c u r r in g is 0 .0 9 6 8 o r a lm o s t 9 .7 p e r c e n t.

T o h ig h lig h t th e i m p o r t a n c e o f th e s t a n d a r d d e v ia tio n o f th e r e t u r n d is tr ib u t io n , a s s u m e t h a t th e s a m e in v e s t o r a ls o h a s th e o p p o r t u n it y o f in v e s t in g in C o m p a n y B w ith a n e x p e c t e d r e t u r n o f 1 3 p e r c e n t a n d a s t a n d a r d d e v ia tio n o f 6 .9 1 p e r c e n t. Th e p r o b a b ility d i s t r ib u t io n s o f th e r e t u r n s o n in v e s t m e n t s in c o m p a n ie s A a n d B a re s h o w n in F ig u r e 7 .2 . B o th in v e s t m e n t s h a v e t h e s a m e e x p e c t e d r e tu r n b u t, o n th e b a s i s o f th e d is p e r s io n o f th e r e t u r n s , a n in v e s t m e n t in C o m p a n y A (w ith a s t a n d a r d d e v ia tio n o f 1 0 p e r c e n t) is r is k ie r t h a n a n in v e s t m e n t in C o m p a n y B (w ith a s t a n d a r d d e v ia tio n o f 6 .9 1 p e r c e n t). S u p p o s e t h a t th e in v e s t o r d e c id e s t h a t a r e t u r n o f z e r o p e r c e n t o r l e s s i s u n s a t is f a c t o r y . A r e tu r n o f z e r o p e r c e n t o n a n in v e s t m e n t in C o m p a n y B is 1 .8 8 s t a n d a r d d e v ia tio n s b e lo w th e e x p e c t e d r e tu r n (b e c a u se 0 . 1 3 / 0 .0 6 9 1 = 1 .8 8 ). Th e p r o b a b ilit y o f t h is o c c u r r in g is 0 .0 3 . T h e r e fo re , th e p r o b a b ilit y t h a t a n in v e s t m e n t in o n e o f t h e s e c o m p a n ie s w ill g e n e r a t e a n e g a tiv e r e t u r n is 3 p e r c e n t fo r C o m p a n y B c o m p a r e d w ith 9 .7 p e r c e n t f o r C o m p a n y A . H o w e v e r, w h e n th e i n v e s t o r c o n s id e r s r e t u r n s a t th e u p p e r e n d o f th e d i s t r ib u t io n s i t i s fo u n d t h a t a n i n v e s t m e n t in C o m p a n y A o f f e r s a 9 .7 p e r c e n t c h a n c e o f a

a n d return

B usiness finance

Figure 7.2

RISK-AVERSE INVESTOR

an investor who dislikes risk and who will only choose a risky investment if the expected return is high enough to compensate for bearing the risk

retu rn in excess o f 26 per cent, compared w ith only a 3 per cent chance fo r an investm ent in Company B. In summ ary the p robability o f both very low returns and very high returns is much greater in the case o f Company A. The fact th a t the investor is more uncertain about the retu rn from an investm ent in Company A does n o t mean th a t the investor w ill necessarily prefer to invest in Company B. The choice depends on the investors a ttitude to risk. A lternative attitudes to risk and the effects o f risk are considered in the next section, which can safely be o m itte d by readers who are prepared to accept th a t investors are generally risk averse. Risk aversion does not mean th a t an investor w ill refuse to bear any risk at all. Rather i t means th a t an investor regards risk as something undesirable, b ut which may be w o rth tolerating i f the expected retu rn is sufficient to compensate fo r the risk. Therefore, a ris k -a v e rs e in v e s to r would prefer to invest in Company B because A and B offer the same expected return, b u t B is less risky.

7.3 LEARNING OBJECTIVE 2 Understand the concept of risk aversion by investors RISK-NEUTRAL INVESTOR

an investor who neither likes nor dislikes risk RISK-SEEKING INVESTOR

an investor who likes risk and who will choose a risky investment even if the expected return is less than the expected return on a less risky investment

The investor’s utility function

Consider the decision to invest in either Company A or Company B. As discussed in Section 7.2, both companies offer the same expected return, b ut differ in risk. A preference fo r investing in either Company A or Company B w ill depend on the investors a ttitude to risk. An investor may be risk averse, risk neutral o r risk seeking. A risk-averse investor attaches decreasing u tility to each increm ent in wealth; a risk -n eu tral in vestor attaches equal u tility to each increm ent in wealth; while a risk -seek in g investor attaches increasing u tility to each increm ent in wealth. Typical u tility -to -w e a lth functions fo r each type o f investor are illustrated in Figure 7.3. The characteristics o f a risk-averse investor w arrant closer examination, as risk aversion is the standard assumption in finance theory. Assume th a t a risk-averse investor has wealth o f $ W* and has the o p p o rtu n ity o f p articipating in the follow ing game: a fa ir coin is tossed and i f it falls tails (probability 0.5), then $1000 is won; i f i t falls heads (probability 0.5), then $1000 is lost. The expected value o f the game is $0 and it is, therefore, described as a *fair game*. Would a risk-averse investor participate in such a game? I f he or she participates and wins, wealth w ill increase to $(PV* + 1000), b ut i f he or she loses, wealth w ill fall to $(PV* - 1000). The results o f this game are shown in Figure 7.4. The investors current level o f u tility is U2. The investors u tility w ill increase to U3 i f he or she wins the game and w ill decrease to [7Xin the event o f a loss. W hat is the expected u tility i f the investor decides to participate in the game? There is a 50 per cent chance th a t his or her u tility w ill increase to U3, and a 50 per cent chance th a t i t w ill decrease to Uv Therefore, the expected u tility is 0 . 5 ^ + 0.5U3. As shown in Figure 7.4, the investors expected u tility w ith the gamble (0.5U1 + 0.5U3) is lower than the u tility obtained w ith o u t the gamble (U2). As it is assumed th a t investors maximise th e ir expected u tility , a riskaverse investor would refuse to participate in this game. In fact, a risk-averse investor may be defined as

C hapter seven Risk

a n d return

ure 7.3 Utility-to-wealth functions for different types of investors Risk seeking

Risk neutral IM ln ir un

Wealth (W )

1

someone who would n ot participate in a fa ir game. Similarly, it can be shown th a t a risk-neutral investor would be indifferent to participation, and a risk-seeking investor would be prepared to pay fo r the rig h t to participate in a fa ir game. Now consider the preferences o f a risk-averse investor w ith respect to an investm ent in either Company A or Company B. As we have seen, the expected retu rn from each investm ent is the same but the investment in A is riskier. An investm ent in A offers the possibility o f making either higher returns or lower returns, compared w ith an investm ent in B. However, from Figure 7.2, the increased spread o f returns above the expected retu rn tends to increase expected u tility . But this increase w ill be outweighed by the decrease in expected u tility resulting from the greater spread o f returns below the expected return. Therefore, the risk-averse investors expected u tility would be greater i f he or she invests in B. As both investments offer the same expected return, the risk-averse investors choice implies th a t the increased dispersion o f returns makes an investm ent riskier. This suggests th a t the standard deviation o f the return distribu tio n may be a useful measure o f risk fo r a risk-averse investor. Similarly, it can be argued th a t the risk-neutral investor would be ind iffe re nt between these tw o investments. For any given amount to be invested, such an investor w ill always choose the investm ent th a t offers the higher return,

命

B usiness finance

irrespective o f the relative risk o f other investm ents— th a t is, the standard deviation is ignored. The risk­ seeking investor would choose to invest in A. I f a given am ount is to be invested, and the investor has the choice o f two investments th a t offer the same expected return, the risk-seeking investor w ill always choose the investm ent w ith the higher risk. An investors preferences regarding expected retu rn and risk can be illustrated using indifference curves. For a given am ount invested, an indifference curve traces out all those combinations o f expected return and risk th a t provide a particular investor w ith the same level o f u tility . Because the level o f u tility is the same, the investor is indifferent between all points on the curve. A risk-averse investor has a positive attitude towards expected retu rn and a negative a ttitude towards risk. By this, we mean th a t a risk-averse investor w ill prefer an investm ent to have a higher expected retu rn (for a given risk level) and lower risk (for a given expected return). Risk aversion does not mean th a t an investor w ill refuse to bear any risk at all. Rather it means th a t an investor regards risk as something undesirable, b u t which may be w o rth tolerating i f the expected return is sufficient to compensate fo r the risk. In graphical terms, indifference curves fo r a risk-averse investor m ust be upward sloping as shown in Figure 7.5. The risk-re tu rn coordinates fo r a risk-averse investor are shown in Figure 7.5 fo r three investments— A, B and C. I t is apparent that this investor would prefer Investment B to Investment A, and would also prefer Investment B to Investment C. This investor prefers a higher expected return at any given level o f risk (compare investments B and A) and a lower level o f risk at any given expected return (compare investments B and C). However, this investor would be indifferent between investments A and C. The higher expected return on investm ent C compensates this investor exactly fo r the higher risk. In addition, fo r a given expected return the expected u tility o f a risk-averse investor falls at an increasing rate as the dispersion o f the distribution o f returns increases. As a result, the rate o f increase in expected return required to compensate for every increment in the standard deviation increases faster as the risk becomes larger. Note that indifference curves for a risk-averse investor are n ot only upward sloping, but also convex, as shown in Figure 7.5. So far we have concentrated on the characteristics and behaviour o f a risk-averse investor. However, there are instances where individuals behave in a way contrary to risk aversion. For example, a risk-averse person w ill never purchase a lo tte ry ticket, as the expected value o f the gamble is less than the price o f the ticket. However, many individuals whose current level o f wealth is quite low relative to the lo tte ry prize are prepared to purchase lo tte ry tickets because, w hile only a small outlay is required, there is the small chance o f achieving a relatively large increase in wealth. In decisions th a t involve larger outlays, risk aversion is much more likely. As the financial decisions considered in this book generally involve

Figure 7.5 Increasing utility

| 0)

EIRB) = EIRC)

J I

肌

)

°C

aA = aB

Risk (o)

C hapter seven Risk

a n d return

large investments and small rates o f retu rn (at least relative to w inning a lo tte ry prize), i t is assumed throughout that investors behave as i f they are risk averse.

7.4

The risk of assets

I f investors, expectations o f the returns from an investm ent can be represented by a norm al probability distribution, then the standard deviation is a relevant measure o f risk fo r a risk-averse investor. I f two investments offer the same expected return, b ut differ in risk, then a risk-averse investor w ill prefer the less risky investm ent. Further, it has been shown th a t a risk-averse investor is prepared to accept higher risk fo r higher expected return, w ith the result th a t the required retu rn on a particular investm ent increases w ith the investors perception o f its risk. The standard deviation o f the retu rn from a single investm ent is a relevant measure o f its riskiness in cases where an individual is considering the investm ent o f all available funds in one asset. However, it is exceptional to lim it investm ents in this way. M ost people invest in a num ber o f assets; they may invest in a house, a car, th e ir human capital and numerous other assets. In addition, where they invest in shares, i t is likely th a t they w ill hold shares in a num ber o f companies. In other words, people typically invest th e ir wealth in a p o rtfolio o f assets and w ill be concerned about the risk o f th e ir overall p ortfo lio . This risk can be measured by the standard deviation o f the returns on the p o rtfo lio . Therefore, when an individual asset is considered, an investor w ill be concerned about the risk o f th a t asset as a component o f a p o rtfo lio o f assets. W hat we need to know is how individual p o rtfo lio components (assets) contribute to the risk o f the p o rtfo lio as a whole. An apparently plausible guess would be th a t the co ntribu tion o f each asset is p ro p o rtio n a l to the assets standard deviation. However, p o rtfo lio theory, w hich is discussed in the next section, shows th a t this guess turns o ut to be alm ost always incorrect.

7.5

PORTFOLIO

combined holding of more than one asset

Portfolio theory and diversification m

Portfolio theory was in itia lly developed by M arkow itz (1952) as a norm ative approach to investm ent choice under uncertainty.1 Two im p o rta n t assumptions o f p o rtfo lio theory have already been discussed. These are: a

The returns from investments are norm ally distributed. Therefore, two parameters, the expected return and the standard deviation, are sufficient to describe the d istrib u tio n o f returns.2 b Investors are risk averse. Therefore, investors prefer the highest expected retu rn fo r a given standard deviation and the lowest standard deviation fo r a given expected return.

Given these assumptions, it can be shown th a t i t is rational fo r a utility-m axim isin g investor to hold a well-diversified p o rtfo lio o f investments. Suppose th a t an investor holds a p o rtfo lio o f securities. This investor w ill be concerned about the expected retu rn and risk o f the p ortfolio. The expected retu rn on a portfolio is a weighted average o f the expected returns on the securities in the p ortfolio. Let E(Rt) be the expected return on the zth security and E(Rp) the expected retu rn on a p o rtfo lio o f securities. Then, using the n otation introduced earlier: n E(R„) = ^ 2 w iE(Ri) i= \

where

= the proportion o f the to ta l current m arket value o f the p o rtfo lio constituted by the current m arket value o f the zth security— th a t is, it is the ‘w eight’ attached to the security n = the number o f securities in the p ortfo lio Calculation o f the expected return on a p o rtfo lio is illustrated in Example 7.1.

1 2

For a more extensive treatment, see Markowitz (1959). Other parameters may exist if the distribution is non-normal. In this case it is assumed that investors base decisions on expected return and standard deviation and ignore other features such as skewness.

LEARNING OBJECTIVE 3 Explain how diversification reduces risk

Example 7.1 A s s u m e th a t th e re a r e o n ly t w o s e c u ritie s (1 a n d 2 ) in a p o r tf o lio a n d E(R}) = 0 . 0 8 a n d E(/?2) =

〇• 1 2 .

A ls o a s s u m e th a t th e c u r r e n t m a rk e t v a lu e o f S e c u rity 1 is 6 0 p e r c e n t o f th e to ta l c u rre n t m a rk e t v a lu e o f th e p o r tf o lio (th a t is, w 1 = 0 . 6 a n d w 2 = 0 . 4 ) . T h e n : E(/?p) = ( 0 . 6 ) ( 0 .0 8 ) + ( 0 . 4 ) ( 0 .1 2 ) = 0 . 0 9 6 o r 9 .6 %

Example 7.1 illustrates the fact th a t the expected retu rn on a p o rtfo lio is sim ply the weighted average o f the expected returns on the securities in the p ortfo lio . However, the standard deviation o f the return on the p o rtfo lio (c p) is not sim ply a weighted average o f the standard deviations o f the securities in the p ortfo lio . This is because the riskiness o f a p o rtfo lio depends n ot only on the riskiness o f the individual securities b ut also on the relationship between the returns on those securities. The variance o f the return on a p o rtfo lio o f two securities is given by: #

=

4 cr| + 2

Cov(/?卜 i?2)

where Cov(Rv R2) = the covariance between the returns on securities 1 and 2 The covariance between the returns on any pair o f securities is a measure o f the extent to which the returns on those securities tend to move together or covary*. This tendency is more commonly measured using the correlation coefficient p, which is found by dividing the covariance between the returns on the tw o securities by the standard deviations o f th e ir returns. Therefore, the correlation coefficient for securities 1 and 2 is: Pi,2 =

Cov(/?i,/?2)

7.3

The correlation coefficient is essentially a scaled measure o f covariance and it is a very convenient measure because it can only have values between +1 and -1 . I f the correlation coefficient between the returns on two securities is +1, the returns are said to be perfectly positively correlated. This means th a t i f the retu rn on security z is ^ ig h 1(compared w ith its expected level), then the retu rn on se curity; w ill, unfailingly, also be ‘high’ （ compared w ith fts expected level) to precisely the same degree. I f the correlation coefficient is -1 , the returns are perfectly negatively correlated; high (low) returns on security i w ill always be paired w ith low (high) returns on security A correlation coefficient o f zero indicates the absence of a systematic relationship between the returns on the tw o securities. Using Equation 7.3 to substitute for the covariance, Equation 7.2 can be expressed as: =

w \ 〇\ -f- W2 O 2 + 2 W \W 2 P \ 2 (J \ (T2

7.4

As may be seen from Equation 7.4, the variance o f a p o rtfo lio depends on: a b

c

the com position o f the p o rtfo lio — th a t is, the p roportion o f the current m arket value o f the p o rtfo lio constituted by each security the standard deviation o f the returns fo r each security the correlation between the returns on the securities held in the p ortfo lio . The effect o f changing the composition o f a p o rtfo lio o f tw o securities is illustrated in Example 7.2.

7.5.1 I Gains from diversification Example 7.2 shows th a t some portfolios enable an investor to achieve simultaneously higher expected retu rn and lower risk; fo r example, compare portfolios (d) and (f) in Figure 7.6. It should be noted th a t Portfolio (d) consists o f both securities, whereas Portfolio (f) consists o f only Security 1— th a t is, Portfolio (d) is diversified, whereas Portfolio (f) is not. This illustrates the general principle th a t investors can gain from diversification.

C hapter seven Risk

a n d return

E xample 7.2 A n in v e s to r w is h e s to c o n s tru c t a p o r tf o lio c o n s is tin g o f S e c u rity 1 a n d S e c u rity 2 . T h e e x p e c te d re tu rn s o n th e tw o s e c u ritie s a r e E(R}) = 8 % p .a . a n d E(R2) = 1 2 % p .a . a n d th e s ta n d a r d d e v ia tio n s a re

= 2 0 % p .a . a n d a 2 = 3 0 % p .a . T he c o r r e la tio n c o e ffic ie n t b e tw e e n th e ir re tu rn s is p ] 2 = - 〇.5. The in v e s to r is fre e to c h o o s e th e in v e s tm e n t p r o p o r tio n s w ] a n d w 2/ s u b je c t o n ly to th e re q u ire m e n ts th a t + w 2 = 1 a n d th a t b o th

a n d vv2 a r e p o s itiv e .3 T h e re is n o lim it to th e n u m b e r o f p o r tfo lio s th a t

m e e t th e se re q u ire m e n ts , s in c e th e re is n o lim it to th e n u m b e r o f p r o p o r tio n s th a t sum to 1. T h e re fo re , a re p re s e n ta tiv e s e le c tio n o f v a lu e s is c o n s id e r e d fo r W ]： 0 , 0 . 2 , 0 . 4 , 0 . 6 , 0 . 8 a n d 1. U s in g E q u a tio n 7 . 1 , th e e x p e c te d re tu rn o n a tw o -s e c u rity p o r tf o lio is: E(/?p) = w .E iR ,) + w 2E(R2)

= w ^ O .0 8 ) +

w

2( 0 . 1 2 )

U s in g E q u a tio n 7 . 4 , th e v a r ia n c e o f th e re tu rn o n a tw o -s e c u rity p o r tf o lio is:

ap = =

+ w^ + 2w 1vv2Pir2a l °2 w2(〇.20)2

+ w2(0.30)2 + 2Wl w2(-0.5)(0.20)(0.30)

= 0.04w^ + 0.09w^ - 0.06W] vv2 T he s ta n d a rd d e v ia tio n o f th e p o r tf o lio re tu rn s is fo u n d b y ta k in g th e s q u a re r o o t o f a . E a ch p a ir o f p r o p o r tio n s is n o w c o n s id e r e d in tu rn : a)

w 1 = 0 and w 2 = 1 q /y

= (o .〇 8 i( o ) + ( o .i

2 )⑴

= 0 . 1 2 o r 1 2 % p .a . 〇

p = (〇.〇4)(0)2 + (0.09)(1)2 -(0.06)(0)(1)

o2 p = 0.09 〇

b)

p - 0.30 or 30% p.a.

W! = 0 . 2 a n d w 2 = 0 . 8 E(Rp) = ( 0 . 0 8 ) ( 0 . 2 ) + ( 0 . 1 2 ) ( 0 . 8 ) = 0 . 1 1 2 o r 1 1 . 2 % p .a .

o2 p = (0.04)(0.2)2 + (0.09)(0.8)2 -(0.06)(0.2)(0.8) o2 p = 0.0496 .-.〇 p = 0.2227 or 22.27% p.a. c)

d)

W l = 0 . 4 a n d w 2 = 0 . 6 E[Rp) = ( 0 . 0 8 ) ( 0 . 4 ) + ( 0 . 1 2 ) ( 0 . 6 ) = 0 . 1 0 4 o r 1 0 . 4 % p .a . 〇

p = (〇.〇4)(0.2)2 + (0.09)(0.6)2 -(0.06)(0.4)(0.6)

〇

p = 0.0244

〇

p = 0.1562 or 15.62% p.a.

W l = 0 . 6 a n d w 2 = 0 . 4 E(/?p) = ( 0 . 0 8 ) ( 0 . 6 ) + ( 0 . 1 2 ) ( 0 . 4 ) = 0 . 0 9 6 o r 9 . 6 % p .a . 〇

l = (0.04)(0.6)2 + (0.09)(0.4)2 -(0.06)(0.6)(0.4) =0.0144 = 0.12 or 12% p.a.

e)

vvt

= 0 . 8 a n d w 2 = 0 . 2 E(/?p) = ( 0 . 0 8 ) ( 0 . 8 ) + ( 0 . 1 2 ) ( 0 . 2 ) = 0 . 0 8 8 o r 8 .8 % p .a .

a2 p = (0.04)(0.8)2 + (0.09)(0.2)2 - (0.06)(0.8)(0.2) =0.0196 〇

p = 0.14 or 14% p.a. continued

3

Negative investment proportions would indicate a short sale', which means that the asset is first sold and later purchased. Therefore, a short-seller benefits from price decreases.

^0^

B usiness finance

continued f)

vvt

= 1 . 0 a n d w 2 = 0 E(/?p) = ( 0 . 0 8 ) ( 1 ) + ( 0 .1 2 ) ( 0 ) = 0 . 0 8 o r 8 % p .a .

〇l = (〇 .〇 4 ) ( l) 2

+ (0 .0 9 )(0 )2 - ( 0 . 0 6 ) ( l) ( 0 )

〇

p = 0.04

〇

p = 0.20 or 20% p.a.

T h e se re su lts a r e s u m m a ris e d in T a b le 7 . 3 .

TA B LE 7 .3 P o rtfo lio (a)

(b)

(Cl

(d)

(e)

(f)

Proportion in Security 1 (Wj)

0.0000

0.2000

0.4000

0.6000

0.8000

1.0000

Proportion in Security 2 (w2)

1.0000

0.8000

0.6000

0.4000

0.2000

0.0000

Expected return E (Rp)

0.1200

0.1120

0.1040

0.0960

0.0880

0.0800

Standard deviation a

0.3000

0.2227

0.1562

0.1200

0.1400

0.2000

R e a d in g a c ro s s T a b le 7 .3 , th e in v e s to r p la c e s m o re w e a lth in th e lo w -re tu rn S e c u rity 1 a n d less in th e h ig h -re tu rn S e c u rity 2 . C o n s e q u e n tly , th e e x p e c te d re tu rn o n th e p o r tfo lio d e c lin e s w ith e a c h step. T he b e h a v io u r o f th e s ta n d a rd d e v ia tio n is m o re c o m p lic a te d . It d e c lin e s o v e r th e firs t fo u r p o rtfo lio s , re a c h in g a m in im u m v a lu e o f 0 . 1 2 0 0 w h e n Nv! = 0 . 6 , b u t th e n rises to 0 . 2 0 0 0 a t th e sixth p o r tfo lio , w h ic h co n sists e n tire ly o f S e c u rity 1 .4 T his is a n im p o rta n t fin d in g a s it im p lie s th a t so m e p o rtfo lio s

LEARNING OBJECTIVE 4 Explain the concept of efficient portfolios

w o u ld n e v e r b e h e ld b y risk-a ve rse in ve sto rs. F or e x a m p le , n o risk-a ve rse in v e s to r w o u ld c h o o s e P o rtfo lio (e) b e c a u s e P o rtfo lio (d) o ffe rs b o th a h ig h e r e x p e c te d re tu rn a n d a lo w e r ris k th a n P o rtfo lio (e). P o rtfo lio s th a t o ffe r th e h ig h e s t e x p e c te d re tu rn a t a g iv e n le ve l o f risk a re re fe rre d to a s 'e ffic ie n t’ p o rtfo lio s . T he d a ta in T a b le 7 . 3 a re p lo tte d in F ig u re 7 . 6 . A s c a n b e se e n fro m F ig u re 7 .6 , p o r tfo lio s (e) a n d (f) a r e n o t e ffic ie n t.

■

E n J P9p9dx ai

uj

4

me minimum value of the standard deviation actually occurs slightly beyond Portfolio (d) at proportions Wj = 0.6333, and = 0.3667. The standard deviation for this portfolio is 0.11.92% p.a. and its expected return is 9.48% p.a.

w2

C h apter

The magnitude o f the gain from diversification is closely related to the value coefficient, p12- To show the importance o f the correlation coefficient, securities considered. This tim e, however, the investm ent proportions are held constant at and different values o f the correlation coefficient are considered. Portfolio variance is =

o f the correlation 1 and 2 are again = 0.6 and w2 = 0.4 given by:

o ^ C T j - f 1〇2 〇 2 + 2 W \ W 2 p \ , 2 ^ \ ^ 2

= (0.6)2(0.20)2 + (0.4)2(0.30)2 + 2(0.6)(0.4)pi,2(0.20)(0.30) =0.0144 + 0.0144 + 0.0288pi,2 (Tp = ^/0.0288 + 0.0288^! 2

a

Pi,2 = +1.00 (Tp = x/0.0288 4-0.0288pi,2 CTp = 0.2400

b

Pi,2 = +0.50 CTp = ^/0.0288 + 0.0288/), i2 (Tp = 0.2079

c

Pi,2 = 0.00 〇

"p = ^0.0288 + 0.0288^1^

CTp = 0.1697 d

Pi,2 = -0.50 (Tp = ^ 0 .0 2 8 8 + 0.0288p1<2 (Tp = 0.1200

e

Pi,2 = -1.00 (Tp = ^0.0288 + 0.0288/?,,2 (Tp = 0 These results are summarised in Table 7.4.

TABLE 7.4 Effect of correlation coefficient on portfolio standard deviation C o r r e la tio n c o e ffic ie n t P i

S ta n d a rd d e v ia tio n

2= + l. 〇 〇

Pi 2 = +0.50 P i 2

=

p i 2

=

〇 .〇 〇

0 .2 4 0 0 0.2 0 7 9 0 .1 6 9 7

-0 .5 0

0.1 2 0 0

P i 2 = - 1 .0 0

0 .0 0 0 0

Table 7.4 shows three im p o rta n t facts about p o rtfo lio construction: a

b

Combining two securities whose returns are perfectly positively correlated (that is, the correlation coefficient is +1) results only in risk averaging, and does n ot provide any risk reduction. In th is case the p ortfo lio standard deviation is the weighted average o f the two standard deviations, which is (0.6)(0.20) + (0.4)(0.30) = 0.2400. The real advantages o f diversification result from the risk reduction caused by com bining securities whose returns are less than perfectly positively correlated.

s e ven

Risk

a n d return

B usiness finance

C

The degree o f risk reduction increases as the correlation coefficient between the returns on the two securities decreases. The largest risk reduction available is where the returns are perfectly negatively correlated, so the tw o risky securities can be combined to form a p o rtfo lio th a t has zero risk (<Jp = 0).

By considering different investm ent proportions w 1 and w 2, a curve sim ilar to th a t shown in Figure 7.6 can be plo tte d fo r each assumed value o f the correlation coefficient. These curves are shown together in Figure 7.7.

Figure 7.7

I t can be seen th a t the lower the correlation coefficient, the higher the expected re tu rn fo r any given level o f risk (or the lower the level o f risk fo r any given expected return). This shows th a t the benefits o f diversification increase as the correlation coefficient decreases, and when the correlation coefficient is -1 , risk can be elim inated completely. The significance o f the dotted lines in Figure 7.7 is th a t a risk-averse investor would never hold combinations o f the two securities represented by points on the dotted lines. A t any given level o f correlation these combinations o f the tw o securities are always dom inated by other com binations th a t offer a higher expected retu rn fo r the same level o f risk.

7 .5 .2 1 Diversification with multiple assets LEARNING OBJECTIVE 5 Understand the importance of covariance between returns on risky assets in determining the risk of a portfolio

^0^

W hile the above discussion relates to the tw o-security case, even stronger conclusions can be drawn fo r larger portfolios. To examine the relationship between the risk o f a large p o rtfo lio and the riskiness o f the individual assets in the p ortfo lio , we sta rt by considering tw o assets. Using Equation 7.2, the p ortfo lio variance is: ojj = W y〇 i

+ U/2〇2 + ^ w l W 2C 〇v (R \ , R 2 )

C hapter seven Risk

a n d return

The variances and covariances on the right-hand side of this equation can be arranged in a matrix as follows: 1 1

2 C ov(R

C〇v(i?2,i?1)

2

v

R 2)

°2

W ith two assets the variances and covariances form a 2 x 2 m atrix; three assets w ill result in a 3 x 3 m atrix; and in general w ith n assets there w ill be ann x n m atrix. Regardless o f the num ber o f assets involved, the variance-covariance m a trix w ill always have the follow ing properties: The m atrix w ill contain a total o f n2 terms. O f these terms, n are the variances o f the individual assets and the remaining (n2 - n) terms are the covariances between the various pairs o f assets in the portfolio, b The two covariance terms fo r each pair o f assets are identical. For example, in the 2 x 2 m a trix above,

a

C o v (R v R 2) = C o v (R 2>^ i )-

c

Since the covariance term s fo rm identical pairs, the m atrix is sym metrical about the m ain diagonal, which contains the n variance terms.

Remember th a t the significance o f the variance-covariance m atrix is th a t it can be used to calculate the p ortfo lio variance. The p o rtfo lio variance is a weighted sum o f the terms in the m atrix, where the weights depend on the proportions o f the various assets in the p ortfolio. The firs t property o f the m a trix listed above shows th a t as the number o f assets increases, the number o f covariance terms increases much more rapidly than the number o f variance terms. For a p o rtfo lio o f n assets there are n variances and {n2 - n) covariances in the m atrix. This suggests th a t as a p o rtfo lio becomes larger, the effect o f the covariance terms on the risk o f the p o rtfo lio w ill be greater than the effect o f the variance terms. To illustrate the effects o f diversification and the significance o f the covariance between assets, consider a portfolio o f n assets. Assume th a t each o f these assets has the same variance {cr\). Also assume, initially, that the returns on these assets are independent— that is, the correlation between the returns on the assets is assumed to be zero in all cases. I f we form an equally weighted p o rtfo lio o f these assets, the proportion invested in each asset w ill be (1/n). Given the assumption o f zero correlation between all the asset returns, the covariance terms w ill all be zero, so the variance o f the p ortfo lio w ill depend only on the variance terms. Since there are n variance term s and each such term is

the variance o f the p o rtfo lio w ill be:

7.5

aP

Equation 7.5 shows that as n increases, the p o rtfo lio variance w ill decrease and as n becomes large, the variance o f the p o rtfo lio w ill approach zero; th a t is, i f the returns between all risky assets were independent, then i t would be possible to elim inate all risk by diversification. However, in practice, the returns between risky assets are not independent and the covariance between returns on most risky assets is positive. For example, the correlation coefficients between the returns on company shares are m ostly in the range 0.5 to 0.7. This positive correlation reflects the fact that the returns on m ost risky assets are related to each other. For example, i f the economy were growing strongly we would expect sales o f new cars and construction o f houses and other buildings to be increasing strongly. In turn, the demand fo r steel and other b uilding materials would also increase. Therefore, the profits and share prices o f steel and b uilding m aterial manufacturers should have a tendency to increase at the same tim e as the p ro fits and share prices o f car manufacturers and construction companies. To reflect the relationships among the returns on individual assets, we relax the assumption th a t the returns between assets are independent. Instead, we now assume th a t the correlation between the returns on all assets in the p o rtfo lio is p*. I f the p o rtfo lio is again equally weighted, the p o rtfo lio variance w ill now be equal to the sum o f the variance terms shown in Equation 7.5, plus (n2 - n) covariance terms 2

where each such term w ill be

T

+ ( 1 ~ n )p^

p*a^- Therefore, the variance o f the p o rtfo lio w ill be:

7.6

40V

B usiness finance

Equation 7.6 illustrates an im p o rta n t result: w ith identical positively correlated assets, risk cannot be completely eliminated, no m atter how many such assets are included in a p ortfolio. As n becomes large, (1/n) w ill approach zero so the firs t term in Equation 7.6 w ill approach zero, b ut the second term w ill approach p*G^; th a t is, the variance o f the p o rtfo lio w ill approach which is the covariance between the returns on the assets in the p ortfolio. Thus, the positive correlation between the assets in a p ortfolio imposes a lim it on the extent to which risk can be reduced by diversification. In practice, the assets in a p o rtfo lio w ill n ot be identical and the correlations between the assets w ill d iffer rather than being equal as we have assumed. However, the essential results illustrated in Equation 7.6 remain the same— th a t is, in a diversified p o rtfo lio the variances o f the individual assets w ill contribute little to the risk o f the p ortfo lio . Rather, the risk o f a diversified p o rtfo lio w ill depend largely on the covariances between the returns on the assets. For example, Fama (1976, pp. 245-52) found that in an equally weighted p o rtfo lio o f 50 random ly selected securities, 90 per cent o f the p o rtfo lio standard deviation was due to the covariance terms.

7 .5 .3 1 Systematic and unsystematic risk

LEARNING OBJECTIVE 6 Explain the distinction between systematic and unsystematic risk UNSYSTEMATIC ( d iv e r s if ia b l e ) RISK

that component of total risk that is unique to the company and may be eliminated by diversification SYSTEMATIC (MARKETRELATED OR N O N DIVERSIFIABLE) RISK

that component of total risk that is due to economy-wide factors

As discussed in Section 7.5.2, i f we diversify by combining risky assets in a p o rtfo lio , the risk o f the p o rtfo lio returns w ill decrease. Diversification is most effective i f the returns on the individual assets are negatively correlated, b u t i t s till works w ith positive correlation, provided th a t the correlation coefficient is less than +1. We have noted that, in practice, the correlation coefficients between the returns on company shares are m ostly in the range 0.5 to 0.7. We also noted th a t this positive correlation reflects the fact th a t the returns on the shares o f m ost companies are economically related to each other. However, the correlation is less than perfect, which reflects the fact th a t much o f the va riab ility in the returns on shares is due to factors th a t are specific to each company. For example, the price o f a company’s shares may change due to an exploration success, an im p o rta n t research discovery or a change o f chief executive. Over any given period, the effects o f these company-specific factors w ill be positive fo r some companies and negative fo r others. Therefore, when shares o f different companies are combined in a p ortfo lio , the effects o f the company-specific factors w ill tend to offset each other, which w ill, o f course, be reflected in reduced risk fo r the p ortfolio. In other words, p a rt o f the risk o f an individual security can be eliminated by diversification and is referred to as unsystem atic risk or diversifiable risk. However, no m atter how much we diversify, there is always some risk th a t cannot be elim inated because the returns on all risky assets are related to each other. This p art o f the risk is referred to as sy stem atic risk or nondiversifiable risk. These tw o types o f risk are illustrated in Figure 7.8.

igure 7.8

C hapter seven Risk

a n d return

Figure 7.8 shows th a t m ost unsystematic risk is removed by holding a p o rtfo lio o f about 25 to 30 securities. In other words, the returns on a well-diversified p o rtfo lio w ill n ot be significantly affected by the events that are specific to individual companies. Rather, the returns on a well-diversified p o rtfo lio w ill vary due to the effects o f market-wide or economy-wide factors such as changes in interest rates, changes in tax laws and variations in com m odity prices. The systematic risk o f a security or p o rtfo lio w ill depend on its sensitivity to the effects o f these market-wide factors. The d istin ction between systematic and unsystematic risk is im p o rta n t when we consider the risk o f individual assets in a p o rtfo lio context, which is discussed in Section 7.5.4, and the pricing o f risky assets, which is discussed in Section 7.6.

7 .5 .4 | The risk of an individual asset The reasoning used above can be extended to explain the factors th a t w ill determine the risk o f an individual asset as a component o f a diversified portfolio. Suppose th a t an investor holds a p o rtfo lio o f 50 assets and is considering the addition o f an extra asset to the p ortfolio. The investor is concerned w ith the effect that this extra asset w ill have on the standard d e la tio n o f the p ortfo lio . The effect is determined by the p o rtfo lio proportions, the extra assets variance and the 50 covariances between the extra asset and the assets already in the portfolio. As discussed above, the covariance terms are the dom inant influence— th a t is, to the holder o f a large p o rtfo lio the risk o f an asset is largely determined by the covariance between the retu rn on th a t asset and the retu rn on the holders existing p ortfolio. The variance o f the return on the extra asset is o f little importance. Therefore, the risk o f an asset when it is held in a large p o rtfo lio is determ ined by the covariance between the return on the asset and the return on the portfolio. The covariance o f a security z w ith a p o rtfo lio P is given by:

The holders o f large p ortfo lio s o f securities can s till achieve risk reduction by adding a new security to their portfolios, provided th a t the returns on the new security are n o t perfectly positively correlated w ith the returns on the existing p ortfo lio . However, the increm ental risk reduction due to adding a new security to a p o rtfo lio decreases as the size o f the p o rtfo lio increases and, as shown in Figure 7.8, the additional benefits from diversification are very small fo r portfolios th a t include more than 30 securities (Statman 1987). I f investors are well diversified, th e ir portfolios w ill be representative o f the m arket as a whole. Therefore, the relevant measure o f risk is the covariance between the retu rn on the asset and the return on the m arket or Cov(Ri}RM). The covariance can then be scaled by dividing it by the variance o f the return on the m arket th a t gives a convenient measure o f risk, the b e ta factor, j3{) o f the asset— th a t is, fo r any asset z, the beta is: Cov(i?/, Rm)

Beta is a very useful measure o f the risk o f an asset and i t w ill be shown in Section 7.6.2 th a t the capital asset pricing model proposes th a t the expected rates o f retu rn on risky assets are directly related to th e ir betas. Value Line (w w w .valueline.com ) is a US website based on the Value Line Investm ent Survey and contains inform a tion to help determine a share s level o f risk.

LEARNING OBJECTIVE 7 Explain why systematic risk is important to investors

BETA

measure of a security’s systematic risk, describing the amount of risk contributed by the security to the market portfolio

^w w ^J

VALUE AT RISK (VaR)-AN O TH ER WAY OF LOOKING AT RISK

Finance

Since the m id -1990s, a new measure o f risk exposure has become popular. This measure was developed by the investment bank J.P. M organ and is known as value at risk (VaR).5 It is defined as the worst loss that is possible under normal market conditions during a given time period. It is therefore determined by w hat are estimated to be normal market conditions and by the time period under consideration. For a given set o f market conditions, the longer the

IN A C T IO N

continued 5

*

7.7

Cov{Ri,Rp) = pip(Tiap

。

*

A detailed examination of value at risk is provided by Jorion (2006), while an excellent online resource for those interested in the topic is provided at www.gloria-mundi.com.

B usiness finance

continued VALUE AT RISK

tim e h o r iz o n th e g r e a t e r is th e v a lu e a t ris k . T h is m e a s u re o f r is k is b e in g in c r e a s in g ly u s e d b y

worst loss possible under normal market conditions for a given time horizon

c o r p o r a t e tr e a s u r e r s , fu n d m a n a g e r s a n d f in a n c ia l in s titu tio n s a s a s u m m a r y m e a s u r e o f th e to ta l r is k o f a p o r t f o lio . To illu s tra te h o w v a lu e a t ris k is m e a s u re d , s u p p o s e th a t $ 1 5 m illio n is in v e s te d in s h a re s in G r a d s t a r ts Ltd. S h a re s in G r a d s ta r ts h a v e a n e s tim a te d re tu rn o f z e r o a n d a s ta n d a r d d e v ia tio n o f 3 0 p e r c e n t p e r a n n u m . 6 T h e s ta n d a r d d e v ia tio n o n th e in v e s tm e n t o f $ 1 5 m illio n is th e re fo r e $ 4 . 5 m illio n . S u p p o s e a ls o t h a t re tu rn s f o llo w a n o r m a l p r o b a b ilit y d is tr ib u tio n . T h is m e a n s th a t th e t a b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u r v e (see T a b le 5 o f A p p e n d ix A , o r th e N O R M S D IS T fu n c tio n in M ic r o s o f t E xcel® ) c a n b e u s e d to c a lc u la te th e p r o b a b ilit y th a t th e re tu rn w ill b e g r e a t e r th a n a s p e c ifie d n u m b e r. S u p p o s e a ls o th a t a b n o r m a lly b a d m a r k e t c o n d itio n s a r e e x p e c te d 5 p e r c e n t o f th e tim e . T h e t a b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u r v e in d ic a te s t h a t th e re is a 5 p e r c e n t c h a n c e o f a lo ss o f g r e a t e r th a n $ 7 . 4 0 2 5 m illio n p e r a n n u m . T h is f ig u r e is e q u a l to 1 . 6 4 5 m u ltip lie d b y th e s t a n d a r d d e v ia tio n o f $ 4 . 5 m illio n . A s s h o w n in F ig u re 7 . 9 , th e v a lu e a t ris k o f th e in v e s tm e n t in G r a d s t a r ts is th e re fo r e $ 7 . 4 0 2 5 m illio n p e r a n n u m .

Figure 7.9 Value of Gradstarts Ltd

!l!

2 >

OJd

-e _Q

S u p p o s e t h a t $ 1 0 m illio n is a ls o in v e s te d in s h a re s in C u r z o n C r e a t iv e Id e a s Ltd . T h e s e C u r z o n C r e a t iv e Id e a s s h a re s h a v e a n e s tim a te d re tu rn o f z e r o a n d h a v e a s t a n d a r d d e v ia t io n o f 2 0 p e r c e n t p e r a n n u m . T h e s t a n d a r d d e v ia t io n o n th e in v e s tm e n t o f $ 1 0 m illio n is th e r e f o r e $ 2 m illio n p e r a n n u m . It is a g a in a s s u m e d t h a t re tu rn s f o ll o w a n o r m a l p r o b a b il it y d is t r ib u t io n a n d t h a t a b n o r m a lly b a d m a r k e t c o n d it io n s a r e e x p e c t e d 5 p e r c e n t o f th e tim e . A s im ila r c a lc u la t io n to t h a t f o r G r a d s t a r ts p r o v id e s a v a lu e a t r is k o f th e in v e s tm e n t in C u r z o n C r e a t iv e Id e a s o f $ 2 m illio n m u lt ip lie d b y 1 . 6 4 5 o r $ 3 . 2 9 m illio n p e r a n n u m . T h e b e n e fits o f d iv e r s if ic a t io n m a y b e d e m o n s tr a te d b y c a lc u la t in g th e v a lu e a t r is k o f a p o r t f o lio c o m p r is in g a $ 1 5 m illio n in v e s tm e n t in G r a d s t a r t s a n d a $ 1 0 m illio n in v e s tm e n t in C u r z o n C r e a t iv e Id e a s . T h e w e ig h t o f th e in v e s tm e n t in G r a d s t a r t s is $ 1 5 m illio n o f $ 2 5 m illio n o r 0 . 6 o f t h e p o r t f o lio . T h e w e ig h t o f th e in v e s tm e n t in C u r z o n C r e a t iv e Id e a s is 0 . 4 . S u p p o s e t h a t th e c o r r e la t io n b e tw e e n th e re tu rn s o n th e s h a re s is 0 . 6 5 . U s in g E q u a t io n 7 .4 , th e v a r ia n c e o f th e re tu r n s o n th e p o r t f o lio is: a 2= ( 0 . 6 ) 2 ( 0 . 3 ) 2 + ( 0 .4 ) 2 ( 0 . 2 ) 2 + 2 ( 0 . 6 ) ( 0 . 4 ) ( 0 . 3 ) ( 0 . 2 ) ( 0 . 6 5 ) = 0 .0 5 7 5 2 T h e s ta n d a r d d e v ia tio n o f p o r t f o lio re tu rn s , a , is th e r e fo r e 0 . 2 3 9 8 3 3 o r 2 3 . 9 8 3 3 p e r c e n t a n d th e s ta n d a r d d e v ia tio n o n th e in v e s tm e n t is $ 2 5 m illio n x 0 . 2 3 9 8 3 3 = $ 5 . 9 9 5 8 m illio n . T h e v a lu e a t ris k o f th e p o r t f o lio is $ 5 . 9 9 5 8 m u ltip lie d b y 1 . 6 4 5 o r $ 9 . 8 6 3 1

6

m illio n p e r a n n u m .

It is usual in calculating value at risk to assume an expected return of zero. This is a reasonable assumption where the expected return is small compared with the standard deviation of the expected return.

C hapter seven Risk

T h e t o t a l v a lu e a t r is k o f t h e in d iv id u a l in v e s tm e n ts in G r a d s t a r t s a n d C u r z o n C r e a t iv e Id e a s w a s $ 7 . 4 0 2 5 m illio n p lu s $ 3 . 2 9 m illio n o r $ 1 0 . 6 9 2 5 m illio n p e r a n n u m . T h e d if f e r e n c e b e tw e e n t h a t a m o u n t a n d th e v a lu e a t r is k o f th e p o r t f o lio o f $ 9 . 8 6 3 1

m illio n is d u e to th e

b e n e fits o f d iv e r s if ic a t io n . If, h o w e v e r , th e re tu rn s o n th e s h a re s o f th e t w o c o m p a n ie s w e r e p e r fe c t ly c o r r e la t e d , th e v a lu e a t r is k o f th e p o r t f o lio w o u ld e q u a l th e v a lu e a t r is k f o r th e in v e s tm e n t in G r a d s t a r t s p lu s th e v a lu e a t r is k o f th e in v e s tm e n t in C u r z o n C r e a t iv e Id e a s . V a R is a t e c h n iq u e t h a t is c o m m o n ly u s e d b y f in a n c ia l in s titu tio n s t o m o n it o r t h e ir e x p o s u r e to lo s s e s t h r o u g h a d v e r s e c h a n g e s in m a r k e t c o n d it io n s . A p e r t in e n t e x a m p le o f th e u s e o f V a R is p r o v id e d b y th e J a n u a r y 2 0 0 4 a n n o u n c e m e n t o f a $ 3 6 0 m illio n f o r e ig n e x c h a n g e lo s s b y th e N a t io n a l A u s t r a lia B a n k . W h i l e a n in d e p e n d e n t in v e s t ig a t io n b y P r ic e w a t e r h o u s e C o o p e r s a ttr ib u t e d m o s t o f th e b la m e f o r th e lo s s to d is h o n e s t y o n th e p a r t o f th e c u r r e n c y t r a d e r s in v o lv e d a n d th e la c k o f s u it a b le c o n t r o l m e c h a n is m s in p la c e to u n c o v e r s u c h b e h a v io u r , th e r e p o r t a ls o m a d e s o m e in te r e s t in g c o m m e n ts o n th e b a n k ’s u s e o f V a R . T h e N a t i o n a l A u s t r a lia B a n k 's b o a r d o f d ir e c t o r s h a d a u t h o r is e d a V a R m a r k e t r is k e x p o s u r e lim it o f $ 8 0 m illio n p e r d a y f o r th e b a n k in g g r o u p a s a w h o le . T h is lim it w a s d i v id e d b e t w e e n t h e v a r io u s d iv is io n s o f th e b a n k . T h e c u r r e n c y o p t io n s d e s k h a d a V a R lim it o f $ 3 . 2 5 m illio n p e r d a y . T h is lim it w a s p e r s is te n tly b r e a c h e d o v e r th e 1 2 -m o n th p e r io d p r i o r to th e a n n o u n c e m e n t o f th e $ 3 6 0 m illio n lo s s . In r e la t io n to th e im p le m e n t a t io n o f a f la w e d V a R s y s te m th e P r ic e w a t e r h o u s e C o o p e r s r e p o r t c o m m e n te d th a t: ... m a n a g e m e n t h a d little c o n fid e n c e in the VaR num bers d u e to systems a n d d a ta issues, a n d e ffe ctive ly ig n o re d VaR a n d o th e r lim it breaches. There w a s n o sense o f u rg e n c y in resolving the VoR c a lc u la tio n issues w h ic h h o d been a p ro b le m fo r a p e rio d o f tw o o r

m ore ye a rs.7

7 .5 .5 1 The efficient frontier When all risky assets are considered, there is no lim it to the num ber o f portfolios th a t can be formed, and the expected return and standard deviation o f the retu rn can be calculated fo r each p ortfo lio . The coordinates fo r all possible p ortfo lio s are represented by the shaded area in Figure 7.10.

Figure 7.10

j E n

s '

UJ

J

Qj

p a p a d x LIJ

Risk (a)

7

See PricewaterhouseCoopers (2004, p. 4).

a n d return

B usiness finance

Only portfolios on the curve between points A and B are relevant since all portfolios below this curve yield lower expected return and/or greater risk. The curve AB is referred to as the efficient frontier and it includes those portfolios that are efficient in that they offer the m aximum expected return for a given level o f risk. For example, Portfolio 1 is preferred to an internal p oint such as Portfolio 3 because Portfolio 1 offers a higher expected return fo r the same level o f risk. Similarly, Portfolio 2 is preferred to Portfolio 3 because it offers the same expected return for a lower level o f risk. No such <dominance, relationship exists between efficient portfolios— that is, between portfolios whose risk-re tu rn coordinates plot on the efficient frontier. Given risk aversion, each investor w ill want to hold a p ortfo lio somewhere on the efficient frontier. Risk-averse investors w ill choose the p o rtfo lio th a t suits th e ir preference fo r risk. As investors are a diverse group there is no reason to believe th a t they w ill have identical risk preferences. Each investor may therefore prefer a different p oint (portfolio) along the efficient frontier. For example, a conservative investor would choose a p ortfo lio near p o in t A while a more risk-tolerant investor would choose a p ortfo lio near p oint B. In summary, the m ain points established in this section are that: diversification reduces risk the effectiveness o f diversification depends on the correlation or covariance between returns on the individual assets combined into a p o rtfo lio C the positive correlation th a t exists between the returns on m ost risky assets imposes a lim it on the degree o f risk reduction th a t can be achieved by diversification d the to ta l risk o f an asset can be divided in to two parts: systematic risk th a t cannot be elim inated by diversification and unsystematic risk th a t can be elim inated by diversification e the only risk th a t remains in a well-diversified p o rtfo lio is systematic risk f fo r investors who diversify, the relevant measure o f the risk o f an individual asset is its systematic risk, which is usually measured by the beta o f the asset g risk-averse investors w ill aim to hold p ortfolios th a t are efficient in th a t they provide the highest expected retu rn fo r a given level o f risk. a

b

The concepts discussed in this section can be extended to model the relationship between risk and expected return fo r individual risky assets. This extension o f p o rtfo lio theory is discussed in Section 7.6 and we discuss below an alternative technique to measuring risk th a t focuses on the maximum dollar losses th a t would be expected during norm al trading conditions.

7.6

The pricing of risky assets

Section 7.5 focused on investm ent decision making by individuals. We now s h ift the focus from the behaviour o f individuals to the pricing o f risky assets and we introduce the assumption th a t investors can also invest in an asset th a t has no default risk. The return on this risk-free asset is the risk-free interest rate, R^. Typically, this is regarded as the interest rate on a government security, such as Treasury notes. We continue to assume th a t all investors in a particular m arket behave according to p o rtfo lio theory, and ask: How would prices o f individual securities in th a t m arket be determined? In tu itive ly, we would expect risky assets to provide a higher expected rate o f retu rn than the risk-free asset. In other words, the expected retu rn on a risky asset could be viewed as consisting o f the risk-free rate plus a premium fo r risk, and this prem ium should be related to the risk o f the asset. However, as discussed in Section 7.5.3, part o f the risk o f any risky asset— unsystematic risk — can be eliminated by diversification. It seems reasonable to suggest that in a competitive market, assets should be priced so that investors are not rewarded fo r bearing risk that could easily be eliminated by diversification. On the other hand, some risk — systematic risk— cannot be eliminated by diversification so it is reasonable to suggest that investors w ill expect to be compensated fo r bearing that type o f risk. In summary, in tu itio n suggests that risky assets w ill be priced such that there is a relationship between returns and systematic risk. The remaining question is: W hat sort o f relationship w ill there be between returns and systematic risk? The work o f Sharpe (1964), Lintner (1965), Fama (1968) and Mossin (1969) provides an answer to this question.8 8

Although we have referred to the pricing5of assets, much of this work deals with expected returns, rather than asset prices. However, there is a simple relationship between expected return and price in that the expected rate of return can be used to discount an assets expected net cash flows to obtain an estimate of its current price.

7 .6 .1 1 The capital market line W ith the opp ortu nity to borrow and lend at the risk-free rate, an investor is no longer restricted to holding a p o rtfo lio th a t is on the efficient fro n tie r AB. Investors can now invest in combinations o f risky assets and the risk-free asset in accordance w ith th e ir risk preferences. This is illustrated in Figure 7.11.

N

%

◦s C J n oJ

L U

p a p a d x L U

Risk [a)

The line R^T represents p o rtfo lio s th a t consist o f an investm ent in a p o rtfo lio o f ris k y assets T and an investm ent in the risk-free asset. Investors can achieve any com bination o f ris k and re tu rn on the line RrT by investing in the risk-free asset and P o rtfo lio T. Each p o in t on the line corresponds to different p ro po rtio ns o f the to ta l funds being invested in the risk-free asset and P o rtfo lio T. However, it would n o t be ratio na l fo r investors to hold p o rtfo lio s th a t p lo t on the line RjT, because they can achieve higher returns fo r any given level o f risk by com bining the risk-free asset w ith o the r p o rtfo lio s th a t p lo t above T on the efficient fro n tie r (AB). This approach suggests th a t investors w ill achieve the best possible re tu rn fo r any level o f ris k by holding P o rtfo lio M rather th an any other p o rtfo lio o f risky assets. The line R^MN is tangential at the p o in t M to the efficient fro n tie r (AB) o f portfolios o f risky assets. This line represents p ortfo lio s that consist o f an investm ent in Portfolio M and an investm ent in the risk-free asset. Points on the line to the le ft o f M require a positive am ount to be invested in the risk-free asset— that is, they require the investor to lend at the risk-free rate. Points on the line to the rig h t o f M require a negative am ount to be invested in the risk-free asset— th a t is, they require the investor to borrow at the risk-free rate. It is apparent th a t the line R^MN dominates the efficient fro n tie r AB since at any given level o f risk a portfolio on the line offers an expected return at least as great as th a t available from the efficient fro n tie r (curve AB). Risk-averse investors w ill therefore choose a p o rtfo lio on the line R^MN— th a t is, some combination o f the risk-free asset and Portfolio M. This is true fo r all risk-averse investors who conform to the assumptions o f p o rtfo lio theory. The portfolios th a t m ig ht be chosen by three investors are shown in Figure 7.11. Having chosen to invest in Portfolio M, each investor combines this risky investm ent w ith a position in the risk-free asset. In Figure 7.11, Investor 1 w ill invest p a rtly in Portfolio M and p a rtly in the risk-free asset. Investor 2 w ill invest all funds in Portfolio M , while Investor 3 w ill borrow at the risk­ free rate and invest his or her own funds, plus the borrowed funds, in Portfolio M . A fo u rth strategy, n o t shown in Figure 7.11, is to invest only in the risk-free asset. This is the least risky strategy, whereas the strategy pursued by Investor 3 is the riskiest.

B usiness finance

MARKET PORTFOLIO

portfolio of all risky assets, weighted according to their market capitalisation CAPITAL MARKET LINE

efficient set of all portfolios that provides the investor with the best possible investment opportunities when a risk-free asset is available. It describes the equilibrium riskreturn relationship for efficient portfolios, where the expected return is a function of the risk-free interest rate, the expected market risk premium and the proportionate risk of the efficient portfolio to the risk of the market portfolio

I f all investors in a particular m arket behave according to p o rtfo lio theory, all investors hold Portfolio M as at least a p art o f th e ir to ta l p o rtfo lio .9 In turn, this implies th a t Portfolio M m ust consist o f all risky assets. In other words, under these assumptions, a given risky asset, X, is either held by all investors as part o f Portfolio M or it is n o t held by any investor. In the la tte r case, Asset X does n o t exist. Therefore, Portfolio M is often called the m arket portfolio because it comprises all risky assets available in the m arket. For example, i f the to ta l m arket value o f all shares in Company X represents 1 per cent o f the to ta l m arket value o f all assets, then shares in Company X w ill represent 1 per cent o f every investors to ta l investm ent in risky assets. The line R^MN is called the capital m arket line because i t shows all the to ta l portfolios in which investors in the capital m arket m ight choose to invest. Since investors w ill choose only efficient portfolios, it follows th a t the m arket p o rtfo lio is predicted to be efficient* in the sense th a t it w ill provide the m axim um expected retu rn fo r th a t particular level o f risk. The capital m arket line, therefore, shows the trade-off between expected return and risk fo r all efficient portfolios. The equation o f the capital m arket line is given b y:10 ' E(Rm ) - R f 、

E(Rp) = Rf +

where

〇

7.8

M is the standard deviation o f the retu rn on the m arket Portfolio M

The slope o f this line is 丑( 只以)—

and this measures the m arket price o f risk. It represents the

additional expected retu rn th a t investors would require to compensate them fo r in cu rring additional risk, as measured by the standard deviation o f the p ortfolio.

7 .6 .2 |T h e Capital Asset Pricing Model (CAPM) and the security market line LEARNING OBJECTIVE 8 Explain the relationship between returns and risk proposed by the capital asset pricing model

A lthough the capital m arket line holds fo r efficient portfolios, it does n o t describe the relationship between expected return and risk fo r individual assets or inefficient portfolios. In equilibrium , the expected return on a risky asset (or inefficient p ortfo lio ), z, can be shown to be:11 f E(R M) - R f \ E(R i) = Rf + f ^ f j Cow(Rh RM)

where

7.9

= the expected retu rn on the zth risky asset

C ov(R j} Rm) = the covariance between the returns on the zth risky asset and the m arket p o rtfo lio

9 This ignores the extreme case of investors who hold only the risk-free asset. 10 The fact that Equation 7.8 is the equation for the capital market line can be shown as follows: let Portfolio p consist of an investment in the risk-free asset and the market portfolio. The investment proportions are w f in the risk-free asset and w M = 1 - W fin the market portfolio. Therefore, Portfolio p is, in effect, a two-security portfolio and its expected return is given by: £(Kp) = w R f + (1 -

w f ) E (RM)

and the variance of its return is:

+ By definition, a2P

_ w)2〇 2m + 2My(! -

= 0 so the variance reduces to:

= ^ ~ wf)Z〇 2M

Therefore:

(Tp = ( l - Wf)crM Since the expected return and standard deviation of Portfolio p are linear functions of w^, it follows that R f M in Figure 7.11 is a straight line. This result is not specific to portfolios consisting of the risk-free asset and Portfolio M: rather it applies to a ll portfolios that include the risk-free asset. The equation for a straight line can be expressed as y = m x + c where m is the slope of the line and c is the intercept on the y axis. Referring to Figure 7.11, it can be seen that: n c = Rr

」

and

m =

E (R M - R f )

--------- — O 'M

Therefore, the equation for the line rf M N is Equation 7.8. 11 This is a purely mathematical problem. For a derivation see Levy and Sarnat (1990) or Brailsford and Faff (1993).

C hapter seven Risk

a n d return

Equation 7.9 is often called the CAPM equation. An equivalent version is given in Equation 7.11. The CAPM equation shows th a t the expected return demanded by investors on a risky asset depends on the risk-free rate o f interest, the expected retu rn on the m arket p ortfo lio , the variance o f the retu rn on the m arket p ortfolio, and the covariance o f the return on the risky asset w ith the retu rn on the market portfolio. The covariance term Cov(Rj} RM) is the only explanatory factor in the CAPM equation specific to asset z. The other explanatory factors (R厂，£(RM) and c r^) are the same, regardless o f which asset z. is being considered. Therefore, according to the CAPM equation, i f tw o assets have different expected returns, this is because they have different covariances w ith the m arket p ortfo lio . In other words, the measure o f risk relevant to pricing a risky asset is Cov(Rif RM)t the covariance o f its returns w ith returns on the m arket portfolio, as this measures the contribution o f the risky asset to the riskiness o f an efficient p ortfolio. In contrast, fo r the efficient p o rtfo lio itse lf the standard deviation o f the p o rtfo lio s return is the relevant measure o f risk (see Figure 7.11). As discussed in Section 7.5.4, the measure o f risk fo r an investm ent in a risky asset i is often referred to as its beta factor, where: Cov(i?/, Rm) Pi

7.10

Because Cov(Rj} RM) is the risk o f an asset held as part o f the m arket p ortfo lio , while crM is the risk (in terms o f variance) o f the m arket p ortfolio, it follows th a t J3f measures the risk o f i relative to the risk o f the market as a whole. Using beta as the measure o f risk, the CAPM equation can be rew ritten: £( r ) = v

z p (r m)

-

〜 ]

HD

When graphed, Equation 7.11 is called the security m arket line and is illustrated in Figure 7.12.

■

graphical representation of the capital asset pricing model

ure 7.12 Security market line Security market line

b / )CJ n 4J

UJ

a}

p a p a d x LU

0.5

SECURITY MARKET LINE

1.0

1.5

Risk (A)

The significance o f the security m arket line is that in equilibrium each risky asset should be priced so that it plots exactly on the line. Equation 7.11 shows that according to the capital asset pricing model, the expected return on a risky asset consists o f two components: the risk-free rate o f interest plus a premium for risk. The risk premium for each asset depends on the assets beta and on the market risk premium [E(RM) - Rr].

B usiness finance

The betas o f individual assets w ill be distributed around the beta value o f the market portfolio, which is l . 12 A risky asset w ith a beta value greater than 1 (that is, higher risk) w ill have an expected return greater than E(Rm), while the expected return on a risky asset w ith a beta value o f less than 1 (that is, lower risk) w ill be less than E(RM). Assuming that the risk-free rate o f interest is 10 per cent and the m arket risk premium [E(Rm) is 5 per cent, the expected return on risky Asset 1 w ith a beta value o f 0.5 w ill be 12.5 per cent. The expected return on risky Asset 2 w ith a beta value o f 1.5 w ill be 17.5 per cent. The capital asset pricing model applies to individual assets and to portfolios. The beta factor fo r a p o rtfo lio p is simply: ^

_

Cov (Rp ,R m)

Pp

一

Z2^

7.12

where Cov(R yRM) = the covariance between the returns on p o rtfo lio p and the m arket p ortfo lio . Equation 7.12 is sim ply Equation 7.10 rew ritten in term s o f a p o rtfo lio pt instead o f a particular asset i. Fortunately there is a simple relationship between a p o rtfo lio s beta (J3p) and the betas o f the individual assets th a t make up the p ortfo lio . This relationship is: n 0p = Y l

7.13

i= \

where n = the num ber o f assets in the p ortfo lio = the proportion o f the current m arket value o f p o rtfo lio p constituted by the zth asset Equation 7.13 states th a t the beta factor fo r a p o rtfo lio is sim ply a weighted average o f the betas o f the assets in the p o rtfo lio .13 One useful application o f Equation 7.13 is to guide investors in choosing the investm ent proportions to achieve some target p ortfo lio beta, /3p. An im p o rta n t special case is to construct such a p o rtfo lio using only the m arket p o rtfo lio (J3 = 1) and a position in the risk-free asset (J3 = 0). In this case, investors place a pro po rtio n wM o f th e ir to ta l funds in the m arket p ortfolio, and a p roportion Wr = (1 - wM) in the risk-free asset. Using Equation 7.13, the target beta is given by: P p

=

wf 0 f

+

w m

P m

Substituting /3f= 0 and j3 m = 1 gives: wM=^*p and W f r = l- J3* For example, if / ^ = 0.75, investors should invest 75 per cent o f their funds in the m arket portfolio and lend 25 per cent o f their funds at the risk-free rate. I f = 1.3, investors should borrow an amount equal to 30 per cent o f their own investment funds and invest the total amount (130 per cent) in the market portfolio. 12 Since Cov (/?,, R m) P i = ----------5-------we have _ C o v (/?a/ ,/? a/)

13 Our discussion has omitted the steps between Equations 7.12 and 7.13. For the interested reader, these steps are as follows. Since: R P = ^ 2 WjRj

/=i

it follows that: C o v (R r , R m ) =

Cov

5 3 ^/C 〇v(/?„ R m)

/=i Substituting in Equation 7.12:

(^i = =

i=i

i=l

WiCov (/?,, Rm)

Wi(3i

C hapter seven Risk

a n d return

7 .6 .3 1 Implementation of the CAPM Use o f the CAPM requires estim ation o f the risk-free interest rate, the systematic risk o f equity, fie and the m arket risk premium, E(RM) - Rf： . Each o f these variables is discussed in turn.

The risk-free interest rate (Rfj The assets closest to being risk free are government debt securities, so interest rates on these securities are norm ally used as a measure o f the risk-free rate. However, as discussed in Section 4.6.1, unless the term structure o f interest rates is flat, the various government securities w ill offer different interest rates. The appropriate risk-free rate is the current yield on a government security whose term to m a tu rity matches the life o f the proposed projects to be undertaken by the company. Since these activities undertaken by the company typically provide returns over many years, the rate on long-term securities is generally used.

The share's systematic risk [jSJ The betas o f securities are usually estimated by applying regression analysis to estimate the follow ing equation from tim e series data: Ri t = a i + ^ iRM + eit where ^ = a constant, specific to asset z eit = an error term Equation 7.14 is generally called the m arket model. Its relationship to the security m arket line can

MARKET MODEL

time series regression of an asset's returns

be readily seen by rew riting Equation 7.11 as follows:

E (R )= R f + ^ E (R M) - A R f

7.15 Therefore, the m arket m odel is a counterpart (or analogue) o f Equation 7.15. The magnitude o f the betas th a t result from using this model when i t is applied to returns on shares is illustrated in Table 7.5, which contains a sample o f betas fo r the shares o f selected listed companies. The values are calculated using ordinary least squares (OLS) regression.

TABLE 7.5 Betas of selected Australian listed companies calculated using daily share price and index data for the period January 2009 - December 2013 N am e o f com pany

M a in in d u s tria l a c tiv ity

Beta

ANZ Banking Group

Banking

1.16

Amcor

Packaging

0.75

BHP Billiton

Minerals exploration, production and processing

1.32

Coca-Cola Amatil

Food, beverage and tobacco

0.41

Fairfax Media

Media

1.16

Harvey Norman

Retailing

1.03

QBE Insurance

Insurance

0.95

Woolworths

Food and staples retailing

0.46

The m arket model, as specified in Equation 7.14, is often used to obtain an estimate o f ex-post systematic risk. To use the m arket model, it is necessary to obtain tim e series data on the rates o f return on the share and on the m arket p o rtfo lio — th a t is, a series o f observations fo r both Rit and RMt is needed. However, when using the m arket model, choices m ust be made about two factors. First, the model may be

estimated over periods o f different length. For example, data fo r the past 1, 2 ,3 or more years may be used. Five years o f data are commonly used, but the choice is somewhat arbitrary. Second, the returns used in the m arket model may be calculated over periods o f different length. For example, daily, weekly, monthly, quarterly or yearly returns may be used. Again this choice is subject to a considerable degree o f judgment. From a statistical perspective, it is generally better to have more rather than fewer observations, because using more observations generally leads to greater statistical confidence. However, the greater the num ber o f years o f data th a t are used, the more likely i t is th a t the company s riskiness w ill have changed. This fact highlights a fundam ental problem o f using the m arket model. The m arket model provides a measure o f how risky a company s equity was in the past. W hat we are seeking to obtain is an estimate of future risk. Therefore, the choice o f both the number o f years o f data and the length o f the period over which returns are calculated involves a trade-off between the desire to have many observations and the need to have recent and consequently more relevant data.14

The market risk premium [E{RM] - Rf] The m arket p o rtfo lio specified in the CAPM consists o f every risky asset in existence. Consequently, it is impossible in practice to calculate its expected rate o f retu rn and hence impossible to also calculate the m arket risk premium. Instead, a share m arket index is generally used as a substitute fo r the m arket p ortfolio. As the rate o f retu rn on a share m arket index is highly variable from year to year, it is usual to calculate the average retu rn on the index over a relatively long period. Suppose th a t the average rate o f return on a share m arket index such as the All-Ordinaries Accum ulation Index over the past 10 years was 18.5 per cent per annum. I f this rate were used as the estimate o f E(RM) and today s risk-free rate is 8.5 per cent, the m arket risk prem ium [E(RM) - R^\ would be 10 per cent. A problem w ith using this approach is th a t the estimate o f ^ re fle c ts the m arkets current expectations o f the future, whereas E(RM) is an average o f past returns. In other words, the two values may n ot match, and some unacceptable estimates may result. For example, [E(RM) - RJ estimated in this way may be negative i f the rate o f in fla tio n expected now, which should be reflected in is greater than the realised rate o f in fla tio n during the period used to estimate E(RM). A better approach is to estimate the market risk prem ium directly, over a relatively long period. For example, Ibbotson and Goetzmann (2005) compare the returns on equities w ith the returns on bonds in the US between 1792 and 1925 and report an average difference o f approximately 3.8 per cent per annum. The Credit Suisse Global Investment Returns Yearbook provides an annual update o f m arket risk premiums across 20 countries. The 2013 yearbook authored by Dimson et al. (2013) reports that over the 113 years from 1900 to 2012 the average prem ium in the US was 5.3 per cent per annum. Over the same period, the country w ith the lowest premium was Denmark, at 2.7 per cent per annum, and the country w ith the highest premium was Australia, at 6.4 per cent per annum. Brailsford, Handley and Maheswaran (2012) provide sim ilar estimates fo r Australia. They report that, over the 128 years from 1883 to 2010, the premium was approximately 6.1 per cent per annum. Using a shorter tim e period during which the quality o f the data is higher, they estimate th a t the premium from 1958 to 2010 was also 6.1 per cent per annum. However, estim ating the m arket risk premium directly also has some problems. R itte r (2002) uses the example o f Japan at the end o f 1989 to illustrate th a t historical estimates can result in nonsensical numbers. He notes th a t estim ating the m arket risk prem ium at the end o f 1989 using historical data starting when the Japanese stock m arket reopened after W orld War II would have provided a m arket risk premium o f over 10 per cent per annum. The Japanese economy was booming, corporate profits were high and average price-earnings (P-E) ratios were over 60. I t was considered th a t the cost o f equity for Japanese companies was low. However, it is n ot possible fo r the cost o f equity to be low and the market risk premium to be high. O f course, it is possible fo r the historical m arket risk premium to be high and the expected m arket risk prem ium (and therefore the expected cost o f equity capital) to be low. In an im p o rta n t theoretical paper, Mehra and Prescott (1985) showed th a t a long-term risk premium such as th a t found in the US, Canada, the UK and Australia cannot be explained by standard models o f risk and return. This fin ding has led to arguments th a t historical measures o f the risk prem ium are subject to errors in th e ir measurement. For example, Jorion and Goetzmann (1999) argue th a t estimates o f the m arket risk premium based solely on data obtained from the US w ill be biased upwards sim ply as a result 14 For a discussion of the issues associated with calculating systematic risk from historical data, see Brailsford, Faff and Oliver ( 1997) .

C hapter seven Risk

of the outperformance o f the US m arket relative to other equity markets over the tw e ntie th century. Others, such as Heaton and Lucas (2000), argue th a t increased opportunities fo r p o rtfo lio diversification mean th a t the m arket risk prem ium has fallen. These concerns have led to new techniques being employed to estimate the m arket ris k prem ium . Fama and French (2002), among others, use the dividend g ro w th m odel and conclude th a t the m arket risk prem ium is now o f the order o f 1 per cent per annum . Claus and Thomas (2001) use forecasts by security analysts and conclude th a t the m arket risk prem ium is approxim ately 3 per cent per annum. Duke U niversity and CFO magazine have conducted a qua rte rly survey o f chief financial officers since 1996 (see w w w .cfosurvey.org). The average estimated ris k prem ium fo r the US over th a t tim e has been approxim ately 4 per cent per annum . For the fo u rth quarter o f 2013, when asked how much they expect returns in the equity m arket in the US to exceed the returns on governm ent bonds over the next 10 years, the average response was 3.6 per cent per annum . In summary, the d isp a rity o f estimates o f the m arket risk prem ium is considerable, ranging from 1 to in excess o f 6 per cent per annum.

a n d return

卜， |

7 .6 .4 | Risk, return and the CAPM The d istin ction between systematic and unsystematic ris k is im p o rta n t in explaining why the CAPM should represent the ris k -re tu rn relationship fo r assets such as shares. This issue was discussed in Section 7.5.3 b ut is reiterated here because o f its importance in understanding the CAPM. The returns on a company s shares may vary fo r many reasons: fo r example, interest rates may change, or the company may develop a new product, attract im p o rta n t new customers or change its chief executive. These factors can be divided in to tw o categories: those related only to an individual company (companyspecific factors) and those th a t affect all companies (m arket-wide factors). As the shares o f different companies are combined in a p o rtfo lio , the effects o f the company-specific factors w ill tend to cancel each other out; this is how diversification reduces risk. However, the effects o f the m arket-wide factors w ill remain, no m atter how many d ifferent shares are included in the p o rtfo lio . Therefore, systematic risk reflects the influence o f m arket-wide factors, w hile unsystematic risk reflects the influence o f company-specific factors. Because unsystematic risk can be elim inated by diversification, the capital m arket w ill n o t reward investors fo r bearing this type o f risk. The capital m arket w ill only reward investors fo r bearing risk that cannot be elim inated by diversification— th a t is, the risk inherent in the m arket p ortfo lio . There are cases when, w ith hindsight, we can id e n tify investors who have reaped large rewards from taking on unsystematic risk. These cases do n ot im p ly th a t the CAPM is invalid: the model sim ply says th a t such rewards cannot be expected in a competitive market. The reward fo r bearing systematic risk is a higher expected retu rn and, according to the CAPM, there is a simple linear relationship between expected return and systematic risk as measured by beta.

A d d itio n a l factors that explain returns In 1977 Richard Roll published an im p o rta n t article th a t pointed out th a t while the CAPM has strong theoretical foundations, there is a range o f difficulties th a t researchers face in testing i t empirically. For example, in testing fo r a positive relationship between an assets beta and realised returns, a researcher first needs to measure the correlation between the assets returns and the returns on the m arket p ortfolio. The m arket p o rtfo lio theoretically consists o f all assets in existence and is therefore unobservable in practice— im plying th a t ultim ately the CAPM itse lf is untestable. Aside from the problems associated w ith testing fo r a relationship between estimates o f beta and realised returns, voluminous empirical research has shown th a t there are other factors th a t also explain returns. These factors include a company s dividend yield, its price-earnings (P-R) ratio, its size (as measured by the m arket value o f its shares), and the ratio o f the book value o f its equity to the m arket value o f its equity. This last ratio is often called the company s book-to-m arket ratio. In a detailed study, Fama and French (1992) show th a t the size and book-to-m arket ratio were dom inant and th a t dividend yield and the price-earnings ratio were n o t useful in explaining returns after allowing fo r these more dom inant factors.

LEARNING OBJECTIVE 9 Understand the relationship between the capital asset pricing model and models that include additional factors

B usiness finance

In another im p o rta n t paper, Fama and French (1993) tested the follow ing three-factor model of expected returns: £(Rit) - Rf, = Pm [E{Rm ) - Rf,} + j3 iS £(SMBt) + J3m £(H M Lt) LEARNING OBJECTIVE 10 Explain the development of models that include additional factors

B

In Equation 7.16, the firs t factor is the m arket risk premium, which is the basis o f the CAPM discussed earlier in this chapter. The next factor, SMB, refers to the difference between the returns o f a diversified p o rtfo lio o f small and large companies, while H M L reflects the differences between the returns o f a diversified p o rtfo lio o f companies w ith high versus low book-to-m arket values. j3iM, j3jS and j3jH are the risk parameters reflecting the sensitivity o f the asset to the three sources o f risk. A ll three factors were found to have strong explanatory power. Brailsford, Gaunt and O b rie n (2012) found th a t in Australia, over the period 1982 to 2006, all three factors provided strong explanatory power. I t is possible th a t both the size and book-to-m arket ratio factors m ig ht be explicable by risk. For example, Fama and French (1996) argue th a t smaller companies are more likely to default than larger companies. Further, they argue th a t this risk is likely to be systematic in th a t small companies as a group are more exposed to default during economic downturns. As a result, investors in small companies w ill require a risk premium. Similarly, Zhang (2005) argues th a t companies w ith high book-to-m arket ratios w ill on average have higher levels o f physical capacity. Much o f this physical capacity w ill represent excess capacity during economic dow nturns and therefore expose such companies to increased risk. However, as discussed in detail in Chapter 16, the relationship between these additional factors and returns may n o t be due to risk. Further, Carhart (1997) added a fo u rth factor to the three described in Equation 7.16 to explain returns earned by m utual funds. In an earlier paper, Jegadeesh and Titm an (1993), using US data from 1963 to 1989, identified better perform ing shares (the winners) and poorer perform ing shares (the losers) over a period o f 6 months. They then tracked the performance o f these shares over the follow ing 6 months. On average, the biggest winners outperform ed the biggest losers by 10 per cent per annum. When Carhart added this m om entum effect to the three-factor model, he found th a t it too explained returns. Unlike the size and book-to-m arket ratio factors, it is d iffic u lt to construct a simple risk-based explanation fo r this factor. W hile the CAPM is clearly an incomplete explanation o f the relationship between risk and returns, it is im p o rta n t to note th a t it is s till widely applied. This p o in t is perhaps best demonstrated by the Coleman, Maheswaran and Pinder (2010) survey o f the financial practices adopted by senior financial managers in Australia. Financial managers employ asset pricing models to estimate the discount rate used in project evaluation techniques such as the net present value approach. Coleman, Maheswaran and Pinder reported that more than twice as many respondents used the trad ition al single-factor CAPM compared w ith models th a t used additional factors.

7.8 LEARNING OBJECTIVE 11 Distinguish between alternative methods of appraising the performance of an investment portfolio

S

Portfolio perform ance appraisal

A fundam ental issue th a t faces investors is how to measure the performance o f th e ir investm ent p ortfolio. To illustrate the problem, assume th a t an investor observes th a t during the past 12 m onths, his or her p o rtfo lio has generated a return o f 15 per cent. Is this a good, bad or indifferent result? The answer to that question depends, o f course, on the expected return o f the p o rtfo lio given the p o rtfo lio s risk. That is, in order to answer the question, we need a measure o f the risk o f the investors p o rtfo lio , and then compare its performance w ith the performance o f a benchmark p o rtfo lio o f sim ilar risk. However, even after accounting fo r the specific risk o f the p ortfo lio , the performance o f a p o rtfo lio may d iffer from that o f the benchmark fo r four reasons: •

•

Asset allocation. Investors m ust decide how much o f th e ir wealth should be allocated between alternative categories o f assets such as corporate bonds, government bonds, domestic shares, international shares and property. This decision w ill ultim ately affect the performance o f the p o rtfo lio because in any given period a particular asset class may outperform other asset classes on a risk-adjusted basis. M arket timing. In establishing and adm inistering a p ortfo lio , investors need to make decisions about when to buy and sell the assets held in a p ortfo lio . For example, investors m ig h t choose to

C hapter seven Risk

•

•

move out o f domestic shares and in to corporate bonds or alternatively sell the shares o f companies that operate in the telecomm unication ind ustry and invest these funds in the shares o f companies operating in the retail industry. Clearly, the performance o f a p o rtfo lio w ill be affected by an investors success in selling assets before th e ir prices fall and buying assets before th e ir prices rise. Security selection. Having made a decision about the desired m ix o f different asset classes w ith in a portfolio, and when that desired m ix should be implemented, investors m ust then choose between many different individual assets w ith in each class. For example, having determined th a t they wish to hold half o f th e ir p o rtfo lio in domestic shares, investors m ust then decide which o f the more than 2000 shares listed on the Australian Securities Exchange they should buy. The a rt o f security selection requires the investors to id e n tify those individual assets th a t they believe are currently underpriced by the m arket and hence whose values are expected to rise over the holding period. Similarly, if investors believe th a t any o f the assets held in the p o rtfo lio are currently overpriced, they would sell these assets so as to avoid any future losses associated w ith a reduction in th e ir m arket value. Random influences. Ultim ately, investing is an uncertain a ctivity and in any given period the performance o f a p o rtfo lio may n o t reflect the skills o f the investor who makes the investm ent decisions. That is, good decisions m ig ht yield poor outcomes and poor decisions m ight yield good outcomes in what we would label as ‘bad luck’ or ‘good luck’, respectively. Over enough time, though, we would expect the influence o f good luck and bad luck to average out.

We now consider four comm only used ways o f measuring the performance o f a p ortfo lio . Each o f these measures has a different approach to try in g to determine the ‘expected’ performance o f the benchmark portfolio in order to determ ine whether the p ortfo lio has met, exceeded or failed to meet expectations.

Simple benchmark index This is probably the m ost comm only used approach to appraising the performance o f a p o rtfo lio and involves a simple comparison between the p o rtfo lio s retu rn and the retu rn on a benchmark index that has (or is assumed to have) sim ilar risk to the p o rtfo lio being measured. For example, a well-diversified portfolio o f domestic shares m ig h t be benchmarked against the S&P/ASX 200 Index, which measures the performance o f the shares in the 200 largest companies listed on the Australian Securities Exchange. The advantages associated w ith using this approach to performance appraisal are th a t it is easy to implement and to understand. The main problem w ith this approach is th a t i t implies th a t the risk o f the portfolio is identical to the risk o f the benchmark index, whereas, w ith the exception o f so-called passive funds, which are specifically established to m im ic (or track) the performance o f benchmark indices, this w ill rarely be the case.

The Sharpe ratio The Sharpe ratio, developed by W illiam Sharpe15, is a measure o f the excess retu rn o f the p o rtfo lio per u n it o f total risk and is calculated using the follow ing formula:

where fp is the average re tu rn achieved on the p o rtfo lio over the tim e period, 7y is the average risk-free rate o f return over the same tim e period and crp is the standard deviation o f the returns on the p ortfo lio over the tim e period and is a measure o f the to ta l risk o f the p ortfo lio . I f the Sharpe ratio o f the investors p ortfo lio exceeds the Sharpe ratio o f the m arket p ortfolio, then the investors p o rtfo lio has generated a greater excess return per u n it o f to ta l risk and hence is regarded as exhibiting superior performance to the m arket p ortfolio. Conversely, i f the p o rtfo lio s Sharpe ratio is less than th a t o f the m arket p ortfo lio then the p o rtfo lio has generated less excess return per u n it o f to ta l risk than the m arket p o rtfo lio and the p ortfo lio can be seen as having underperform ed th a t benchmark. 15 See Sharpe (1966).

a n d return

B usiness finance

The rationale behind the use o f the Sharpe ratio is best demonstrated by considering the ratios links w ith the ris k -re tu rn trade-off described by the capital m arket line discussed in section 7.6.1. Consider Figure 7.13, which illustrates the risk and retu rn profile fo r a superannuation fu nd s p o rtfo lio relative to the m arket p ortfolio.

Note from Figure 7.13 that the superannuation fu nd s p ortfo lio has generated a lower rate o f return than the m arket p o rtfo lio but has also generated a lower level o f to ta l risk. That is, while fp is less than is also less than The key point, however, is th a t the realised excess retu rn per unit o f risk is higher fo r the fu nd s p o rtfo lio compared w ith the m arket p o rtfo lio and hence the fu n d s p ortfo lio is regarded as having exhibited superior performance. This is illustrated in Figure 7.13 by the fu nd s p ortfolio p lo ttin g above the capital m arket line. I f the fu nd s p o rtfo lio had generated a lower excess retu rn per u n it o f risk than the m arket p ortfo lio , then i t would have plotted below the capital m arket line and this would have im plied th a t the p o rtfo lio had underperformed the benchmark on a to ta l risk-adjusted basis. Note th a t the Sharpe ratio assumes th a t in determ ining the risk-adjusted performance o f a p ortfo lio the appropriate measure o f risk is to ta l risk. Following on from our discussion earlier in the chapter, it is clear th a t to ta l risk is an appropriate measure only when we are dealing w ith well-diversified portfolios rather than individual assets or undiversified portfolios.

The Treynor ratio The Treynor ratio, named after Jack T re yn o r16, is a measure th a t is related to the Sharpe ratio of performance measurement, in th a t it measures excess returns per u n it o f risk, b ut differs in th a t it defines risk as non-diversifiable (or systematic) risk instead o f to ta l risk. I t can be calculated using the follow ing form ula:

P

p

where Op and fr are the returns on the p o rtfo lio and the risk-free asset as defined earlier, and f3P is slu estimate o f the systematic risk o f the p o rtfo lio over the period in which the returns were generated, as measured by beta and defined in Section 7.6.2. As w ith the Sharpe ratio, insights in to the rationale behind the use o f the Treynor ratio are provided by considering the lin k between ris k and expected retu rn — b u t this tim e, instead o f considering the trade-off fo r efficient portfolios im plied by the capital 16 See Treynor (1966).

C hapter seven Risk

market line, we tu rn instead to the security m arket line, which applies to individual assets and inefficient portfolios. In Figure 7.14 we compare the ex-post systematic risk and excess returns o f a superannuation fund relative to the m arket p o rtfo lio over the same period o f time.

Recall th a t the security m arket line is sim ply the graphical representation o f the CAPM. The slope o f the security m arket line describes the extra return, in excess o f the risk-free rate, th a t is expected for each additional u n it o f systematic risk (as measured by beta) and is w hat we have previously defined as the m arket risk premium The slope o f the line th a t intersects the realised systematic risk and return o f the funds p o rtfo lio is in tu rn the Treynor ratio. Hence, the decision rule used in assessing the performance o f a p o rtfo lio using this technique requires a comparison o f the Treynor ratio calculated fo r the p ortfolio over a specified interval w ith the market risk prem ium generated over th a t same interval. Example 7.3 illustrates the three approaches to p o rtfo lio appraisal discussed above.

E xample

7.3

An investor holds a portfolio that consists of shares in 15 companies and wants to assess the performance using a simple benchmark index as well as calculating the portfolio's Sharpe and Treynor ratios. She estimates the parameters shown in Table 7.6 for the financial year ended 30 June 2014.

TABLE 7.6 Realised return (% p.a.)

Standard deviation of returns (a) (% p.a.)

Systematic risk estimate (p)

Portfolio

13

30

1.2

S&P/ASX 200 share price index

11

20

1.0

Government bonds

5

0

0

Based solely on the benchmark index approach, the portfolio appears to have performed well in that it has generated an additional 2 per cent return above the proxy for the market (S&P/ASX 200).

a n d return

A s d is c u s s e d e a r lie r , h o w e v e r, th is a s s e s s m e n t fa ils to a c c o u n t fo r d iffe re n c e s in th e ris k p ro file s o f th e tw o p o r tfo lio s . T h e S h a r p e r a t io is e s tim a te d u s in g E q u a tio n 7 . 1 7 f o r b o th th e in v e s to r's p o r tf o lio a n d th e A S X 2 0 0 a s fo llo w s :

5 = ^ (7 P

1 3 -5 SPortfolio

•

30

~

1 1 -5 ^ASX 200

20

0.27

= 0.30

A s th e S h a r p e r a t io f o r th e p o r tf o lio is less th a n th a t o f th e S & P /A S X 2 0 0 , th e in v e s to r c o n c lu d e s th a t th e p o r tf o lio h a s u n d e r p e r fo rm e d th e m a rk e t o n a ris k -a d ju s te d b a s is . A p o s s ib le p r o b le m w ith th is c o n c lu s io n is th a t, a s d e s c r ib e d a b o v e , th e S h a rp e r a t io a ssu m e s th a t th e r e le v a n t m e a s u re o f ris k fo r th e in v e s to r is to ta l ris k , a s m e a s u re d b y th e s ta n d a r d d e v ia tio n o f re tu rn s . T h is is n o t th e c a s e w h e r e , f o r e x a m p le , th e p o r tf o lio o f s h a re s re p re s e n ts o n ly o n e c o m p o n e n t o f th e in v e s to r’s o v e r a ll set o f assets. T h e T re y n o r ra tio s f o r th e p o r tf o lio a n d f o r th e A S X 2 0 0 a r e m e a s u re d a s fo llo w s :

rp -'rf Pp

1 3 -5 1.2

1Portfolio

T 'A S X 200

•

6.67

1 1 -5 1.0

6

N o te th a t th e T re y n o r r a t io f o r th e S & P /A S X 2 0 0 is s im p ly e q u a l to th e m a rk e t ris k p re m iu m o f 6 p e r c e n t. A s th e T re y n o r r a tio o f th e p o r tf o lio e x c e e d s th is a m o u n t th e in v e s to r c o n c lu d e s th a t th e p o r tf o lio h a s o u tp e r fo r m e d th e m a rk e t o n a s y s te m a tic ris k -a d ju s te d b a s is . W e c a n r e c o n c ile th is re s u lt w ith th e s e e m in g ly c o n t r a r y re su lts p r o v id e d b y th e S h a rp e r a t io b y a c k n o w le d g in g th a t s o m e o f th e p o r tf o lio ris k th a t is a c c o u n te d fo r in th e S h a rp e r a tio m a y a c tu a lly b e d iv e r s ifie d a w a y o n c e w e a c c o u n t fo r th e o th e r asse ts in th e in v e s to r's p o r tf o lio . T h e re fo re , in th is c a s e , th e T re y n o r r a t io p r o v id e s th e m o re s u ita b le a s s e s s m e n t o f th e p e r fo r m a n c e o f th e p o r tf o lio re la tiv e to th e m a rk e t g e n e r a lly , as it c o n s id e rs o n ly th a t ris k th a t c a n n o t b e e lim in a te d b y d iv e r s ific a tio n .

Jensen’s alpha Jensens alpha is a measure pioneered by Michael Jensen17 and relies on a m ulti-pe rio d analysis o f the performance o f an investm ent p o rtfo lio relative to some proxy fo r the m arket generally. Recall that the CAPM suggests th a t the relationship between systematic risk and retu rn is fu lly described by the follow ing equation:

E iR ^ R f+ m R ^ -R f) The CAPM is an ex-ante single-period model, in the sense th a t it is concerned w ith the returns that m ig ht be expected over the next tim e period. Its conclusion is relatively simple: the retu rn in excess o f the risk-free rate th a t we expect any asset i to generate is determ ined only by the level o f systematic risk reflected in the assets fi. We compute Jensens alpha by im plem enting an ex-post m ulti-period regression analysis o f the returns on the p o rtfo lio and the returns on the m arket and ask the question: Is there any evidence o f systematic abnormal retu rn performance th a t cannot be explained by the p o rtfo lio s systematic risk? The regression equation estimated is as follows: rP ，t _ r f ， t= a P +

[rM,r_ rfA + e t

where t and are the returns from the p ortfo lio , the risk-free asset and the proxy fo r the m arket p o rtfo lio th a t have been observed in period t. /3P is an estimate o f the p o rtfo lio s beta over the entire period in which returns were collected. Qp is an estimate o f Jensens alpha and reflects the incremental 17 See Jensen (1968 & 1969).

C hapter seven Risk

a n d return

performance o f the p o rtfo lio after accounting fo r the variation in p o rtfo lio returns th a t can be explained by market-wide returns. I f 〇 tp is positive, and statistically significant, then this is an indication th a t the p o rtfo lio has outperformed the market, on a risk-adjusted basis, and may be interpreted as evidence o f a p o rtfo lio managers skill in managing the p ortfolio. Conversely, a statistically significant negative estimate o f Qp m ight be interpreted as evidence th a t the p o rtfo lio managers actions in managing the p o rtfo lio are actually destroying value! There are many other techniques th a t have been developed by academics and practitioners to try to assess the performance o f investm ent portfolios and each technique brings w ith it both advantages and disadvantages over the alternative approaches.18 W hile much o f the preceding discussion has been concerned w ith measuring the relative performance o f a p ortfolio, another issue facing managers and investors is how much o f the performance o f a p o rtfo lio may be a ttributed to the different decisions made by the investment manager. Specifically, as described at the beginning o f Section 7.8, an investor may be concerned w ith how the performance has been affected by the managers decisions w ith respect to asset allocation, market tim in g and security selection as well as the possible interactions between each o f these decisions.

This

c h a p te r

d is c u s s e d

tw o

m a in

issues.

The

•

firs t,

S y s te m a tic

ris k

depends

on

th e

c o v a r ia n c e

b e tw e e n th e re tu rn s o n th e a sse t a n d re tu rn s o n th e

p o r tfo lio th e o ry , c o n c e rn s th e a p p r o a c h th a t c a n b e use d b y ris k -a v e rs e in v e s to rs to s e c u re th e b e s t tr a d e ­

m a rk e t p o r tf o lio , w h ic h c o n ta in s a ll ris k y assets.

o ff b e tw e e n risk a n d re tu rn . S e c o n d , th e c h a p te r d e a lt

T he s y s te m a tic ris k o f a n a s s e t is u s u a lly m e a s u re d

in v o lv e s th e

b y th e a s se t's b e ta fa c to r, w h ic h m e a s u re s th e risk

r e la tio n s h ip b e tw e e n ris k a n d re tu rn in th e m a r k e t fo r

o f th e a s s e t re la tiv e to th e ris k o f th e m a rk e t as

ris k y assets.

a w h o le . R isk-a ve rse in v e s to rs w ill a im

w ith th e p r ic in g

•

o f ris k y a sse ts, w h ic h

T he e s s e n tia l m e s s a g e o f p o r tf o lio d iv e r s ific a tio n

re d u c e s

ris k .

th e o ry

It is a ls o

is th a t

show n

h ig h e s t e x p e c te d re tu rn fo r a g iv e n le ve l o f risk.

th a t

T he set o f e ffic ie n t p o r tfo lio s fo rm s th e e ffic ie n t

th e e ffe c tiv e n e s s o f d iv e r s ific a tio n d e p e n d s o n th e c o r r e la tio n o r c o v a r ia n c e in d iv id u a l

b e tw e e n

assets c o m b in e d

in to

a

fro n tie r, a n d in a m a rk e t w h e r e o n ly ris k y assets

re tu rn s o n th e p o r tf o lio .

a r e a v a ila b le , e a c h in v e s to r w ill a im to h o ld a

T he

g a in s fro m d iv e r s ific a tio n a r e la rg e s t w h e n th e re is n e g a tiv e c o r r e la tio n b e tw e e n a s s e t re tu rn s , b u t th e y

p o r tf o lio s o m e w h e re o n th e e ffic ie n t fro n tie r. •

th a n

p e rfe c t.

In p r a c tic e ,

th e

p o s itiv e

a n d e x p e c te d re tu rn f o r in d iv id u a l ris k y a sse ts. T he

is less

m a in re s u lt is th e C A P M , w h ic h p ro p o s e s th a t th e re

c o r r e la tio n

is a lin e a r r e la tio n s h ip b e tw e e n th e e x p e c te d ra te

th a t e xis ts b e tw e e n th e re tu rn s o n m o st ris k y assets

o f re tu rn o n a n a s s e t a n d its ris k a s m e a s u re d b y its

im p o s e s a lim it o n th e d e g r e e o f ris k r e d u c tio n th a t c a n b e a c h ie v e d b y d iv e r s ific a tio n . •

T he to ta l ris k o f a n a s s e t c a n b e d iv id e d in to tw o

b e ta fa c to r. •

u n s y s te m a tic

ris k th a t re m a in s in a w e ll- d iv e rs ifie d

p o r tf o lio

is

s y s te m a tic ris k . •

T he ris k o f a w e ll- d iv e rs ifie d

p o r tf o lio

can

be

m e a s u re d b y th e s ta n d a r d d e v ia tio n o f p o r tf o lio re tu rn s .

H o w e v e r,

a n a ly s is

o f th e

fa c to rs

th a t

c o n trib u te to th is s ta n d a r d d e v ia tio n s h o w s th a t,

asset re tu rn s

p r ic in g a re

m o d e ls

lin e a r ly

p ro p o s e

re la te d

to

th a t

m u ltip le

fa c to rs ra th e r th a n th e s in g le m a rk e t fa c to r p ro p o s e d

ris k th a t can b e

e lim in a te d b y d iv e r s ific a tio n . It f o llo w s th a t th e o n ly

A lte r n a tiv e e x p e c te d

p a rts : s y s te m a tic ris k th a t ca n n o t b e e lim in a te d b y d iv e r s ific a tio n , a n d

In tro d u c tio n o f a ris k -fre e a s s e t a llo w s th e a n a ly s is to b e e x te n d e d to m o d e l th e r e la tio n s h ip b e tw e e n ris k

still e x is t w h e n th e re is p o s itiv e c o r r e la tio n b e tw e e n a s s e t re tu rn s , p r o v id e d th a t th e c o r r e la tio n

to h o ld

p o r tfo lio s th a t a r e e ffic ie n t in th a t th e y p r o v id e th e

b y th e C A P M . •

A s s e s s m e n t o f th e

p e r fo r m a n c e

o f an

in v e s tm e n t

p o r tf o lio re q u ire s th e s p e c ific a tio n o f th e 'e x p e c t e d ' p e r fo r m a n c e o f a b e n c h m a r k p o r tfo lio . An

e x c e lle n t s ite

w ith

r e la tin g to th is t o p ic is

a

w e a lth

of

in fo r m a tio n

vsww.wsharpe.com.

P ro fe s s o r

W illia m S h a rp e 's w o r k w a s r e c o g n is e d w ith a N o b e l

fo r in v e s to rs w h o d iv e rs ify , th e re le v a n t m e a s u re

P riz e in 1 9 9 0 . F in a n c ia l a d v is o r y in fo r m a tio n c a n a ls o

o f ris k f o r a n in d iv id u a l a s s e t is its s y s te m a tic risk.

b e fo u n d a t

www.moneysmart.gov.au.

18 See Chapter 24 of Bodie, Kane and Marcus (2013) for an excellent review of some of these alternative techniques, and a comprehensive description of other issues faced when assessing portfolio performance.

CHAPTER SEVEN REVIEW

SUMMARY

B usiness finance

KEY TERMS b e ta

187

c a p ita l m a rk e t lin e m a rk e t m o d e l

s e c u rity m a rk e t lin e

193

s ta n d a rd d e v ia tio n

174

s y s te m a tic (m a rk e 卜 re la te d o r n o n -d iv e rs ifia b le )

195

m a rk e t p o r tfo lio p o r tfo lio

192 192

ris k

179

186

u n s y s te m a tic (d iv e rs ifia b le ) ris k

ris k -a v e rs e in v e s to r

176

v a lu e a t ris k

ris k -n e u tra l in v e s to r

176

v a r ia n c e

ris k -s e e k in g in v e s to r

186

187

174

176

SELF-TEST PROBLEMS 1

A n in v e s to r p la c e s 3 0 p e r c e n t o f h is fu n d s in S e c u rity X a n d th e b a la n c e in S e c u rity Y. T he e x p e c te d re tu rn s o n X a n d Y a r e 1 2 a n d 1 8 p e r c e n t, re s p e c tiv e ly . T he s ta n d a rd d e v ia tio n s o f re tu rn s o n X a n d Y a r e 2 0 a n d 1 5 p e r c e n t, re s p e c tiv e ly . a)

C a lc u la te th e e x p e c te d re tu rn o n th e p o r tfo lio .

b)

C a lc u la te th e v a r ia n c e o f re tu rn s o n th e p o r tfo lio a s s u m in g th a t th e c o r r e la tio n b e tw e e n th e re tu rn s o n th e tw o s e c u ritie s is: i) + 1 . 0 ii) + 0 . 7 iii) 0 iv) - 0 . 7

2

A n in v e s to r h o ld s a p o r tf o lio th a t c o m p ris e s 2 0 p e r c e n t X, 3 0 p e r c e n t Y a n d 5 0 p e r c e n t Z . T h e s ta n d a rd d e v ia tio n s o f re tu rn s o n X, Y a n d Z a re 2 2 , 1 5 a n d 1 0 p e r ce n t, re s p e c tiv e ly , a n d th e c o r r e la tio n b e tw e e n re tu rn s o n e a c h p a ir o f s e c u ritie s is 0 . 6 . P re p a re a v a r ia n c e - c o v a r ia n c e m a tr ix f o r th e se th re e s e c u ritie s a n d use th e m a tr ix to c a lc u la te th e v a r ia n c e a n d s ta n d a rd d e v ia tio n o f re tu rn s f o r th e p o r tfo lio .

3

T he ris k -fre e r a te o f re tu rn is c u r r e n tly 8 p e r c e n t a n d th e m a rk e t ris k p re m iu m is e s tim a te d to b e 6 p e r c e n t. T h e e x p e c te d re tu rn s a n d b e ta s o f fo u r s h a re s a r e a s fo llo w s :

Expected return [%)

Beta

Carltown

13.0

0.7

Pivot

17.6

Forresters

14.0

i.i

Brunswick

10.4

0.4

I S h a re

丨

W h ic h sh a re s a re u n d e rv a lu e d , o v e r v a lu e d o r c o rre c tly v a lu e d b a s e d o n th e C A P M ?

Solutions to self-test problems are available in Appendix B.

t y 1

[LO 1]

QUESTIONS F a rm e rs c a n in s u re th e ir c r o p s a g a in s t d a m a g e b y h a ils to rm s a t r e a s o n a b le ra te s . H o w e v e r , th e s a m e

in s u ra n c e c o m p a n ie s re fu s e to p r o v id e f lo o d in s u ra n c e a t a n y p r ic e . E x p la in w h y th is s itu a tio n e xists.

2

[LO 2]

Is ris k a v e rs io n a r e a s o n a b le a s s u m p tio n ? W h a t is th e re le v a n t m e a s u re o f ris k f o r a ris k -a v e rs e

in v e s to r?

204

C hapter seven Risk

[L O 3 i W h a t a r e th e b e n e fits o f d iv e r s ific a tio n to a n in v e s to r? W h a t is th e k e y fa c to r d e te r m in in g th e e x te n t o f th e se b e n e fits ?

4

[LO 4 ] E x p la in e a c h o f th e f o llo w in g : a)

th e e 仟 ic ie n t fro n tie r

b)

th e c a p ita l m a rk e t lin e

c)

th e s e c u rity m a rk e t lin e .

Risky assets con be combined to form a riskless asset. D iscuss.

5

[L O 5 ]

6

[L O 5 】Whenever

7

[L O 6 ]

an asset is added to a portfolio, the total risk o f the portfolio w ill be reduced p rovided the returns o f the asset and the portfolio ore less than perfectly correlated. D iscuss. Total risk can be decomposed into systematic and unsystematic risk. E x p la in e a c h c o m p o n e n t o f ris k ,

a n d h o w e a c h is a ffe c te d b y in c re a s in g th e n u m b e r o f s e c u ritie s in a p o r tfo lio . 8

[L O 7 】Diversification is certainly good for investors. Therefore, investors should be prepared to p ay a premium for the shores o f companies that operate in several lines o f business. E x p la in w h y th is s ta te m e n t is tru e o r fa ls e .

9

[L O 7 】M in c o Ltd, a la r g e m in in g c o m p a n y , p r o v id e s a s u p e r a n n u a tio n fu n d fo r its e m p lo y e e s . T he fu n d 's m a n a g e r s a y s : 'W e k n o w th e m in in g in d u s try w e ll, so w e fe e l c o m fo r ta b le in v e s tin g m o s t o f th e fu n d in a p o r tf o lio o f m in in g c o m p a n y s h a re s ’ . A d v is e M in c o ’s e m p lo y e e s o n w h e th e r to e n d o rs e th e fu n d ’s in v e s tm e n t p o lic y .

C H A P T E R SEVEN! R E V I E W

3

a n d return

An important conclusion o f the CAPM is that the relevant measure o f an asset's risk is its systematic risk. O u tlin e th e s ig n ific a n c e o f th is c o n c lu s io n fo r a m a n a g e r m a k in g f in a n c ia l d e c is io n s .

10

[L O 8 ]

11

[L O 8 】F o r in v e s to rs w h o a im to d iv e rs ify , s h a re s w ith n e g a tiv e b e ta s w o u ld b e v e r y u se fu l in v e s tm e n ts , b u t such s h a re s a r e v e r y ra re . E x p la in w h y f e w s h a re s h a v e n e g a tiv e b e ta s .

12

[LO 8 ] C o m p a r e a n d c o n tra s t th e c a p it a l a s s e t p r ic in g m o d e l a n d m o d e ls th a t in c lu d e a d d itio n a l fa c to rs .

13

[L O 1 1 ] In w h a t s itu a tio n s w o u ld it b e a p p r o p r ia t e to use a s im p le b e n c h m a r k in d e x , such a s th e S & P /A S X

14

[L O ll]

2 0 0 s h a re p r ic e in d e x , to assess th e p e r fo r m a n c e o f a p o r tfo lio ?

When assessing the performance o f o set o f portfolios it does not really matter if you choose the Shorpe ratio or the Treynor ratio to do so os both approaches account for the risk inherent in the portfolios. D iscuss.

PROBLEMS 1

V a lu e a t r is k [L O 1 ] C o n s id e r a p o r tfo lio c o m p ris in g a $ 3 m illio n in v e s tm e n t in O u tlo o k P u b lis h in g a n d a $ 5 m illio n in v e s tm e n t in Russell C o m p u tin g . A s s u m e th a t th e s ta n d a rd d e v ia tio n s o f th e re tu rn s fo r sh a re s in the se c o m p a n ie s a r e 0 . 4 a n d 0 . 2 5 p e r c e n t p e r a n n u m re s p e c tiv e ly . A s s u m e a ls o th a t th e c o r r e la tio n b e tw e e n th e re tu rn s o n th e sh a re s in these c o m p a n ie s is 0 . 7 . A s s u m in g a 1 p e r c e n t c h a n c e o f a b n o r m a lly b a d m a rk e t c o n d itio n s , c a lc u la te th e v a lu e a t risk o f th is p o r tfo lio . S tate a n y a s s u m p tio n s th a t y o u m a k e in y o u r c a lc u la tio n s .

2

In v e s tm e n t a n d r is k [L O 2 ] M r B o b N e il is c o n s id e r in g a 1 -y e a r in v e s tm e n t in sh a re s in o n e o f th e f o llo w in g th re e c o m p a n ie s . •

C o m p a n y X: e x p e c te d re tu rn

= 1 5% w ith a s ta n d a rd d e v ia tio n o f 1 5%

•

C o m p a n y Y: e x p e c te d re tu rn

= 1 5 % w ith a s ta n d a rd d e v ia tio n o f 2 0 %

•

C o m p a n y Z : e x p e c te d re tu rn

= 2 0 % w ith a s ta n d a rd d e v ia tio n o f 2 0 %

R a n k th e in ve s tm e n ts in o r d e r o f p re fe re n c e fo r e a c h o f th e ca s e s w h e r e it is a s s u m e d th a t M r B o b N e il is: a)

risk a v e rs e

b)

risk n e u tra l

c)

risk s e e k in g .

G iv e re a s o n s .

205

Portfolio standard deviation and diversification [LO 3] The s ta n d a rd d e v ia tio n s o f re tu rn s o n assets A a n d B a r e 8 p e r c e n t a n d 1 2 p e r c e n t, re s p e c tiv e ly . A p o r tfo lio is c o n s tru c te d c o n s is tin g o f 4 0 p e r c e n t in A s s e t A a n d 6 0 p e r c e n t in A sse t B. C a lc u la te th e p o r tfo lio s ta n d a rd d e v ia tio n if th e c o r r e la tio n o f re tu rn s b e tw e e n th e tw o assets is: a)

1

b)

0 .4

c)

0

d)

-1

G om m ^nt on y o u 「 a n s w e rs .

Expected return, variance and risk [LO 3] You b e lie v e th a t th e re is a 5 0 p e r c e n t c h a n c e th a t th e s h a re p r ic e o f C o m p a n y L w ill d e c re a s e b y 1 2 p e r c e n t a n d a 5 0 p e r c e n t c h a n c e th a t it w ill in c re a s e b y 2 4 p e r ce n t. F urther, th e re is a 4 0 p e r c e n t c h a n c e th a t th e s h a re p r ic e o f C o m p a n y M w ill d e c re a s e b y 1 2 p e r c e n t a n d a 6 0 p e r c e n t c h a n c e th a t it w ill in c re a s e b y 2 4 p e r ce n t. T h e c o rre la tio n c o e ffic ie n t o f th e re tu rn s o n sh a re s in th e tw o c o m p a n ie s is 0 . 7 5 . C a lc u la te : a)

th e e x p e c te d re tu rn , v a r ia n c e a n d s ta n d a rd d e v ia tio n fo r e a c h c o m p a n y 's sh a re s

b)

th e c o v a r ia n c e b e tw e e n th e ir return s.

Variance of return [LO 5] A n in v e s to r p la c e s 4 0 p e r c e n t o f h e r fu n d s in C o m p a n y A 's sh a re s a n d th e r e m a in d e r in C o m p a n y B7s sha res. T he s ta n d a rd d e v ia tio n o f th e re tu rn s o n A is 2 0 p e r c e n t a n d o n B is 1 0 p e r c e n t. C a lc u la te th e v a r ia n c e o f re tu rn o n th e p o r tfo lio , a s s u m in g th a t th e c o r r e la tio n b e tw e e n th e re tu rn s o n th e tw o se c u ritie s is: a)

+ 1 .0

b)

+ 0 .5

c) 〇 d)

-0 .5

Expected return, risk and diversification [LO 5 】 H a r r y Jo n e s h a s in v e s te d o n e -th ird o f his fu n d s in S h a re 1 a n d tw o -th ird s o f his fu n d s in S h a re 2 . H is asse ssm en t o f e a c h in v e s tm e n t is as fo llo w s :

Item

S h a re

1

S h a re 2

Expected return (%)

15.0

21.0

Standard deviation (%)

18.0

25.0

Correlation between the returns

0.5

a) b)

W h a t a re th e e x p e c te d re tu rn a n d th e s ta n d a rd d e v ia tio n o f re tu rn o n H a r r y 's p o rtfo lio ? R e c a lc u la te th e e x p e c te d re tu rn a n d th e s ta n d a rd d e v ia tio n w h e r e th e c o r r e la tio n b e tw e e n th e re tu rn s is 0 a n d 1 .0 , re s p e c tiv e ly .

c)

Is H a r r y b e tte r o r w o r s e o ff as a re su lt o f in v e s tin g in tw o s e c u ritie s ra th e r th a n in o n e se c u rity ?

Expected return, risk and diversification [LO 5]

A

12.5

40

1.00

0.20

0.35

B

16.0

45

0.20

1.00

0.10

C

20.0

60

0.35

0.10

1.00

C hapter seven Risk

a n d return

a)

P o rtfo lio 1 co n sists o f 4 0 p e r c e n t A s s e t A a n d 6 0 p e r c e n t A sse t B. C a lc u la te its e x p e c te d re tu rn a n d s ta n d ­ a r d d e v ia tio n .

b)

P o rtfo lio 2 co n sists o f 6 0 p e r c e n t A sse t A , 2 2 . 5 p e r c e n t A s s e t B a n d 1 7 .5 p e r c e n t A s s e t C . C a lc u la te its e x p e c te d re tu rn a n d s ta n d a rd d e v ia tio n . C o m p a re y o u r a n s w e rs to (a) a n d c o m m e n t.

c)

P o rtfo lio 3 co n sists o f 4 . 8 p e r c e n t A s s e t A , 7 5 p e r c e n t A s s e t B a n d 2 0 . 2 p e r c e n t in th e risk-fre e asset. C a lc u la te its e x p e c te d re tu rn a n d s ta n d a rd d e v ia tio n . C o m p a re y o u r a n s w e rs to (a) a n d (b) a n d c o m m e n t.

d)

P o rtfo lio 4 is a n e q u a lly w e ig h te d p o r tfo lio o f th e th re e ris k y assets A , B a n d C . C a lc u la te its e x p e c te d re tu rn a n d s ta n d a rd d e v ia tio n a n d c o m m e n t o n the se results.

e)

P o rtfo lio 5 is a n e q u a lly w e ig h te d p o r tfo lio o f a ll fo u r assets. C a lc u la te its e x p e c te d re tu rn a n d s ta n d a r d d e v ia tio n a n d c o m m e n t o n th e se results.

8

Expected return and systematic risk [LO 7 】 The e x p e c te d re tu rn o n th e /th a sse t is g iv e n b y:

E L R f+_ R a)

M]-R

f 、

W h a t is th e e x p e c te d re tu rn o n th e /th a sse t w h e r e Rf = 0 . 0 8 , fi- = 1 . 2 5 a n d f(/?yvi) = 0 . 1 4 ?

b) W h a t is th e e x p e c te d re tu rn o n th e m a rk e t p o r tf o lio w h e r e E(Rj) = 0 . 1 1 , c)

9

= 0 . 0 8 a n d p y= 0 . 7 5 ?

W h a t is th e s y s te m a tic ris k o f th e /th a sse t w h e re E(Rt ) = 0 . 1 4 , ^ = 0 . 1 0 a n d E(RM) = 0 . 1 5 ?

Assessing diversification benefits [LO 7 】

CHAPTER SEVEN REVIEW

T h e re is a ls o a risk-fre e A s s e t F w h o s e e x p e c te d re tu rn is 9 . 9 p e r ce n t.

You a re a s h a re a n a ly s t e m p lo y e d b y a la r g e m u ltin a tio n a l in v e s tm e n t fu n d a n d h a v e b e e n s u p p lie d w ith th e fo llo w in g in fo rm a tio n : S ta n d a rd d e v ia tio n (%)

E x p e c te d re tu rn (%)

A sse t

BHZ Ltd

9

8

ANB Ltd

13

48

1

You a re a ls o to ld th a t th e c o r r e la tio n c o e ffic ie n t b e tw e e n th e re tu rn s o f th e tw o c o m p a n ie s is 0 . 8 . A c lie n t c u rre n tly h a s a ll o f h e r w e a lth in v e s te d in B H Z s h a re s. S he w is h e s to d iv e r s ify h e r p o r tf o lio b y re d is trib u tin g h e r w e a lth such th a t 3 0 p e r c e n t is in v e s te d in B H Z sh a re s a n d 7 0 p e r c e n t in A N B sh a re s. a)

W h a t w ill b e th e e x p e c te d re tu rn o f th e n e w p o r tfo lio ?

b)

W h a t w ill b e th e s ta n d a rd d e v ia tio n o f re tu rn s fo r th e n e w p o rtfo lio ? A fte r c o n s tru c tin g th e p o r tfo lio a n d r e p o r tin g th e results to y o u r c lie n t, she is q u ite u p se t, s a y in g , 7I th o u g h t th e w h o le p u rp o s e o f d iv e r s ific a tio n w a s to re d u c e risk? Yet y o u h a v e ju st to ld m e th a t th e v a r ia b ility o f m y p o r tfo lio h a s a c tu a lly b e e n in c re a s e d fro m w h a t it w a s w h e n I in v e s te d o n ly in B H Z ’ .

c)

P ro v id e a re s p o n s e to y o u r c lie n t th a t d e m o n s tra te s th a t th e n e w p o r tfo lio d o e s o r d o e s n o t re fle c t th e b e n e ­ fits o f d iv e rs ific a tio n . S h o w a ll n e c e s s a ry c a lc u la tio n s .

10

Portfolio weights systematic risk and unsystematic risk [LO 8 】 T he ta b le p ro v id e s d a ta o n tw o ris k y assets, A a n d B, th e m a rk e t p o r tf o lio M a n d th e ris k-fre e a sse t F. Asset

E x p e c te d re tu rn (%)

A

A

10.8

324

60

48

0

B

15.6

60

289

96

0

M

14.0

48

96

80

0

F

6.0

0

0

0

0

A n in v e s to r w is h e s to a c h ie v e a n e x p e c te d re tu rn o f 1 2 p e r c e n t a n d is c o n s id e rin g th re e w a y s this m a y b e done: a)

in v e s t in A a n d B

b)

in v e s t in B a n d F

c)

in v e s t in M a n d F.

207

B usiness finance

F or e a c h o f th e se o p tio n s , c a lc u la te th e p o r tfo lio w e ig h ts r e q u ire d a n d th e p o r tfo lio s ta n d a rd d e v ia tio n . S h o w th a t assets A a n d B a re p r ic e d a c c o r d in g to th e c a p ita l a sse t p r ic in g m o d e l a n d , in th e lig h t o f th is result, c o m m e n t o n y o u r fin d in g s .

11

Portfolio performance appraisal [LO 11 ] In 2 0 1 4 th e re tu rn o n th e F o rt K n o x Fund w a s 1 0 p e r ce n t, w h ile th e re tu rn o n th e m a rk e t p o r tfo lio w a s 1 2 p e r c e n t a n d th e risk-fre e re tu rn w a s 3 p e r ce n t. C o m p a ra tiv e sta tistics a r e s h o w n in th e ta b le b e lo w . S ta tis tic

F o rt K n o x fu n d

S & P /A S X 2 0 0 sh a re p r ic e in d e x

Standard deviation of return

15%

30%

Beta

0.75

1.00

C a lc u la te a n d c o m m e n t o n th e p e rfo rm a n c e o f th e fu n d u s in g th e fo llo w in g th re e a p p ro a c h e s : a)

th e s im p le b e n c h m a rk in d e x

b)

th e S h a rp e ra tio

c)

th e T re y n o r ra tio .

REFERENCES Bodie, Z., Kane, A. & Marcus, A.J., /nvesfmenfs, 1 1th edn, M cG raw-H ill, N e w York, 20 1 3 .

------ , ------- 7 'The equity premium,/ Journal o f Finance, April 2 0 0 2 , pp. 6 3 7 -5 9 .

Brailsford, T. & Faff, R., 'A derivation o f the CAPM for pedagogical use', Accounting a n d Finance, M a y 1993, pp. 5 3 -6 0 .

Heaton, J. & Lucas, P ortfolio choice and asset prices: the importance of entrepreneurial risk', Journal of Finance, June 2 0 0 0 , pp. 1 1 6 3 -9 8 .

-------, ------- & Oliver, B.; Research Design Issues in the Estimation of Beta, M cG raw -H ill, Sydney, 1997.

Ibbotson, R.G. & Goetzmann, W . N ., 'History and the equity risk premium', A pril 2 0 0 5 , Yale ICF W orking Paper No. 0 5 -0 4 . Available at h ttp ://s s rn .c o m /a b s tra c t-7 0 2 3 4 1 .

------ , Gaunt, C. & O 'Brien, M ., 'Size and book-tomarket factors in Australia7, Australian Journal of Management, August 2 0 1 2 , pp. 2 6 1 -8 1 . ------ , Handley, J. & M aheswaran, K., The historical equity risk premium in Australia: post-GFC and 128 years of data7, Accounting and Finance, M arch 2 0 1 2 , pp. 2 3 7 -4 7 . Carhart, M . M w 'O n persistence in mutual fund performance', Journal of Finance, March 1997, pp. 5 7 -8 2 . Claus, J. & Thomas, J., 'Equity premia as low as three per cent? Evidence from analysts' earnings forecasts for domestic and international stock markets7, Journal of Finance, O ctober 2 0 0 1 , pp. 1 6 2 9 -6 6 . Coleman, L, M aheswaran, K. & Pinder, S., 'Narratives in managers, corporate finance decisions', Accounting and Finance, September 2 0 1 0 ; pp. 6 0 5 -3 3 . Dimson, E., Marsh, P.R., Staunton, M . & G arthwaite, A., Credit Suisse G lobal Investment Returns Yearbook, Credit Suisse A G Research Institute, Zurich, 20 1 3 . Fama, E.F., 'Risk, return and equilibrium : some clarifying comments', J o u rn o /o f F/nonce, M arch 1968, pp. 2 9 -4 0 . -------, Foundations of Finance, Basic Books, N ew York, 1976. ------ & French, K.R., 'The cross-section of expected stock returns', Journal of Finance, June 1 9 9 2 ; pp. 4 2 7 -6 5 . ------ , ------- , 'Common risk factors in the returns on stocks and bonds', Journal of Financial Economics, February 1993, pp. 3 -5 6 . ------ , ------- , 'M ultifactor explanations o f asset pricing anomalies', Journal of Finance, March 1996, pp. 5 5 -8 4 .

208

Jegadeesh, N . & Titman, S., 'Returns to buying winners and selling losers: implications for market efficiency7, Journal of Finance, 1993, pp. 6 5 -9 1 . Jensen, M ., The performance of mutual funds in the period 1 9 4 5 -1 9 6 4 ', Jo u rn o /o f F/nonce, M a y 1 9 6 8 ; pp. 3 8 9 -4 1 6 . ------ , 'Risk, the pricing of capital assets, and the evaluation of investment portfolios', Journal of Business, April 1969, pp. 1 6 7 -2 4 7 . -------, 'C apital markets: theory and evidence7, Bell Journal of Economics a n d M anagem ent Science, Autumn 1972, pp. 3 5 7 -9 8 . Jorion, Value at Risk: The N e w Benchmark for Controlling Market Risk, 3rd edn, M cG raw -H ill, Chicago, 2 0 0 6 . -------& Goetzmann, W .N ., ’G lobal stock markets in the twentieth century,/ Journal of Finance, June 1999, pp. 9 5 3 -8 0 . Levy, H. & Sarnat, M ., Capitol Investment a n d Financial Decisions, 4th edn; Prentice-Hall, N ew Jersey, 1990, pp. 3 1 9 -2 2 . Lintner, J., ;The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets', Review of Economics and Statistics, February 1965, pp. 1 3 -3 7 . M arkow itz, H .M ., 'Portfolio selection', Journal of Finance, M arch 19 52 , pp. 7 7 -9 1 . -------, Portfolio Selection: Efficient Diversification of Investments, John W ile y & Sons, N ew York, 1959.

C hapter seven Risk

Sharpe, W.F., 'C apital asset prices: a theory of market equilibrium under conditions of risk', Journal of Finance, September 1964, pp. 4 2 5 -4 2 .

Mossin, Jw 'Security pricing and investment criteria in competitive markets’，Amencan Econom/’c /?eWew, December 1969, pp. 7 4 9 -5 6 .

-------, 'Mutual fund performance', Journal of Business, January 1966, pp. 1 1 9 -3 8

PricewaterhouseCoopers, Investigation into Foreign Exchange Losses at the National Australia Bank, Melbourne, 2004.

Statman, M ., 'H ow many stocks make a diversified portfolio?', Joumcr/ o f F/ncmaa/ anc/ Gt/cmf/faf/Ve September 1987, pp. 3 5 3 -6 3 .

Ritter, J.R., The biggest mistakes we teach7, Journal of Financial Research, Summer 2 0 0 2 , pp. 1 5 9 -6 8 .

Treynor, J.L, 'H ow to rate management investment funds', January 1966, Harvard Business Review, pp. 6 3 -7 5 .

Roll, R., 'A critique of the asset pricing theory's tests; Part 1: On the past and potential testability of the theory', Journal of Financial Economics, March 19 77 , pp. 1 2 6 -7 6 .

Zhang, L., The value premium', Journal of Finance, February 2 0 0 5 , pp. 6 7 -1 0 3 .

CHAPTER SEVEM REVIEW

Mehra, R. (& Prescott, E.C., 'The equity premium: a puzzle',

Journal of Monetary Economics, M arch 1985, pp. 1 4 5 -6 1 .

a n d return

209

CHAPTER CONTENTS ED

I n t r o d u c t io n

21 1

EB

F in a n c ia l in t e r m e d ia r ie s

220

EQ

F in a n c ia l a g e n c y in s titu tio n s

215

ESI

In v e s tin g in s titu tio n s

224

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

u n d e r s ta n d th e f u n c tio n s o f a c a p it a l m a r k e t

2

d is tin g u is h b e t w e e n f in a n c ia l a g e n c y in s titu tio n s , f in a n c ia l in t e r m e d ia r ie s a n d in v e s tin g in s titu tio n s

3 4 5

id e n t if y a n d e x p la in th e r o le o f f in a n c ia l a g e n c y in s titu tio n s

o u t lin e th e r o le o f s e c u r it is a tio n

6

id e n t if y a n d e x p la in th e r o le o f in v e s tin g in s titu tio n s .

id e n t if y a n d e x p la in th e r o le o f f in a n c ia l in t e r m e d ia r ie s

Z

C hapter eight T he

capital market

■ jjJ ~ l^ tr o d u c tio n In Chapters 5 and 6 we discussed the methods used to select a company s assets. The company also has to decide how to finance those assets. Where w ill the money come from? Is the money needed fo r a long time, or only a short time? Depending on the answers to these and related questions, the company w ill enter in to different arrangements and different types o f financial assets w ill be created. Financial a sse ts are legally enforceable claims to future cash flows. Bank deposits, trade creditors, debt securities and shares are different types o f financial assets. The markets in which financial assets are bought and sold are commonly referred to as financial markets and include the equity (share) market, the bond m arket and the foreign exchange m arket. The financial markets in which companies raise long-term funds are referred to collectively as the capital m arket. In this chapter we discuss the benefits o f having a capital m arket and the m ajor features o f the Australian capital m arket, paying p articular attention to the characteristics o f the im p o rta n t in stitu tio n s th a t participate in the market.

Over a given period an economic e n tity such as an individual, a company or an unincorporated business w ill be either a ‘deficit u n it’ or a ‘surplus u n it’. A deficit u n it is one whose expenditure exceeds its income for a particular period, whereas a surplus u n it is one whose income exceeds its expenditure fo r a particular period. The financing process involves a flow o f funds from the surplus units to the deficit units. I f a company wishes to grow, b ut does n o t generate sufficient funds interna lly to finance an increase in its assets— th a t is, the company is a deficit u n it— it w ill need to finance the difference by drawing on the funds held by surplus u nits.1 Surplus units may be households, businesses, governments or the overseas sector. The flow o f funds from surplus units to deficit units may be direct or indirect. A direct flow o f funds may result solely from negotiation between the parties, or a financial in s titu tio n may be involved as an adviser or underw riter.2 For example, when a company issues (that is, creates and sells) debt securities, an investm ent bank may advise on and/or underw rite the issue.3 However, the funds w ill flow directly from the purchasers o f the debt securities to the issuing company. D irect funding is more commonly used where the borrower has a recognised credit rating and wishes to raise relatively large amounts. Alternatively, the flow o f funds may be indirect— th a t is, i t occurs through financial interm e­ diaries, such as banks and finance companies. In this case the deficit u n it obtains funds from a financial interm ediary th a t has borrowed the funds from surplus units. Interm ediated funding is more commonly used where the credit risk o f the deficit u n it (the borrower) needs to be assessed, and where the amounts fo r both borrowers and lenders are relatively small. Financial intermediaries have an im portant role in facilitating the flow o f funds from surplus units to deficit units. The number o f financial assets th a t are created in the overall financing process is an im p o rta n t difference between direct and indirect financing. I f a company raises funds directly by, fo r example, issuing a bond to an investor (lender), only one financial asset has been created. The bond is a financial asset held by the investor and it is a lia b ility o f the company. In contrast, i f the investor deposits funds in a bank, which then makes a loan to a company, two financial assets are created. The bank deposit is an asset owned by the investor and the bank loan is an asset owned by the bank. Corresponding to these tw o assets are two liabilities. The deposit is a lia b ility o f the bank and the bank loan is a lia b ility o f the borrower.

FINANCIAL ASSETS

assets such as shares, bonds and bank deposits, as distinct from real assets CAPITAL MARKET

market in which long­ term funds are raised and long-term debt and equity securities are traded

FINANCIAL INTERMEDIARY

institution that acts as a principal in accepting funds from depositors or investors and lending them to borrowers

m The capital m arket enables the suppliers o f funds (the surplus units) and the users o f funds (the deficit units) to negotiate the conditions on which the funds w ill be transferred. Equity or share markets involve

1 2 3

Internally generated funds are discussed in Section 9.8. Underwriting is discussed further in Section 8.2.2. The activities of investment banks are discussed in Section 8.2.2. These institutions were generally referred to as merchant banks until the early 1990s when the US term investment bank' was widely adopted in Australia. In this chapter we use the latter term, except in cases where the historical context makes the earlier term appropriate.

LEARNING OBJECTIVE 1 Understand the functions of a capital market

B usiness finance

ownership and usually a permanent transfer o f funds, w ith returns to shareholders contingent on the future p ro fita b ility o f the company raising the funds. Debt markets usually involve a transfer o f funds fo r a fin ite period, w ith predetermined promised returns to lenders. In the finance literature, equity and debt markets together form the capital m arket.4

PRIMARY MARKET

market for new issues of securities where the sale proceeds go to the issuer of the securities SECONDARY MARKET

market where previously issued securities are traded

EXCHANGE-TRADED MARKET

market in which trading takes place by competitive bidding on an organised exchange OVER-THE-COUNTER MARKET

there is no organised exchange and the market consists of financial institutions that are willing to trade with a counterparty

Financial markets may be classified in several ways. For example, the d istinction between debt markets and equity markets is based on the type o f financial asset th a t is traded in the market. Similarly, markets fo r financial assets may be either prim ary m arkets, where financial assets are firs t sold by th e ir originators, or secondary m arkets, where pre-existing financial assets are traded. Prim ary markets are im p o rta n t because it is in these markets th a t a deficit u n it— fo r example, a company— raises new funds to finance its investments. For example, a company may make a new share issue or a new bond issue to finance the development o f a new m ine or the acquisition o f another business. A transaction in the secondary m arket does n ot raise any new funds fo r the issuer o f the securities th a t are traded. A ll th a t happens is a change o f ownership; the seller o f the security transfers, fo r a price, ownership o f the security to the buyer. However, secondary markets are im p o rta n t because they provide a way in which securities can be exchanged fo r cash— th a t is, they provide liquidity. The existence o f a secondary m arket enables companies to raise long-term funds, even though individual suppliers o f funds may be w illin g to provide funds only fo r much shorter terms. For example, a company may issue a 7-year bond to an investor who wishes to invest fo r only 3 years. The investor is w illin g to buy the bond because she knows that, after 3 years have passed, she w ill be able to sell the bond in the secondary m arket. In this way, the existence o f an active secondary m arket facilitates capital raising in the p rim ary market. W ith o u t an active secondary m arket, many investors would n o t participate in prim ary markets because they require the fle xib ility to redeploy th e ir funds. The secondary m arket provides this flexibility. A nother im p o rta n t d istin ction between different financial markets is based on the organisational structure o f the markets. Indirect financing takes place through financial intermediaries, which raise funds by issuing financial claims against themselves and use those funds to purchase financial assets, most o f which cannot be traded in a secondary m arket. For example, a loan provided by a bank is often retained as an asset o f th a t bank u n til it has been repaid. In contrast, the financial assets created through direct financing are usually marketable securities. These securities may be traded through an organised exchange or they may be traded in an over-the-counter market. In an exchange-traded m arket, securities are traded through an organised exchange such as a stock exchange, where brokers carry out d ie nts, instructions to buy or sell nom inated securities. In an over-the-counter m arket there is no organised exchange and the m arket consists o f financial in s titu tio n s (dealers) who trade w ith clients and w ith each other. The Australian capital m arket includes financial intermediaries and markets o f both these types. Exchange-traded securities include shares, options on shares and futures contracts. Debt securities, swaps and currency options are usually traded in over-the-counter markets.

Some features o f the financial system remain essentially constant over tim e while other features are subject to change, which may be gradual or, in some cases, very rapid. For example, banks have had a very im p o rta n t role in Australia since the firs t bank was established in 1817. However, the relative importance o f banks has varied over tim e — many new banks have entered the market, a few banks have failed and several have been acquired by other banks. The factors th a t can trigger significant changes in the financial system include changes in regulation and technology, changes in the demand fo r different form s o f funding and the effects o f financial crises. The evolution and expansion o f the Australian financial markets in the last three decades were largely an outcome o f the deregulation o f those markets in the 1980s. W hile the Australian financial markets have been largely deregulated, this deregulation has n o t extended to the removal o f controls th a t serve a prudential purpose. The p rim ary regulator o f Australia’s banks, insurance companies, superannuation 4

In practice, participants in the financial markets usually refer to the direct short-term debt market—that is, where loans are for 12 months or less—as the m on ey m ark e t. The term c a p ita l m a r k e t is used to describe the direct long-term debt market.

C hapter eight T he

funds, credit unions and b uilding societies is the Australian Prudential Regulation A u th o rity (APRA, www.apra.gov.au). In 1998, APRA took over prudential supervision functions from Australia’s central ban k — the Reserve Bank o f Australia (RBA, www.rba.gov.au). Arguably, the m ost im p o rta n t role fu lfille d by banking regulatory authorities is ensuring that depositors* funds are adequately protected. One way o f protecting the interests o f depositors is to require banks to m aintain an adequate level o f ‘capital’ （ fo r example, shareholders’ funds): the more capital a bank has, the more it relies on its shareholders fo r funding and hence the less it relies on its depositors. Therefore, the depositors are safer than they otherwise would be. I f a bank is judged by the regulator to be carrying too much risk, it can be required to increase its capital, thus sh ifting more o f the cost o f risk­ bearing from the banks depositors to the banks shareholders. In 1988, the Basel Committee on Banking Supervision established a set o f recommendations known as the 1988 Capital Accord (or sim ply the Basel Accord). The Basel Committee was established by the Bank fo r International Settlements (BIS, w w w .bis.org), which its e lf can be thought o f as a bank fo r central banks. To illustrate one simple consequence o f the Basel Accord, a banks loan to a company would be judged to be twice as risky as a loan secured by a firs t mortgage over fam ily-held real estate. Hence, twice as much capital m ust be m aintained by the bank to protect the depositors. Gup (2004) notes that during the period from 1980 to 1996, 133 o f the 181 member countries o f the International M onetary Fund experienced serious banking sector problems, including those countries that adopted the 1988 accord. Some o f the deficiencies o f the first set o f recommendations have been addressed in a second accord, commonly referred to as Basel II, which provides a more comprehensive method by which banks account for risk.5 The Basel II framework has applied in Australia from 1 January 2008. The adequacy o f m any aspects o f bank regulation was called in to question by the global financial crisis th a t began in m id-2007 when problems th a t o riginated in credit m arkets in the US became widespread th ro ug h ou t the developed nations. This crisis saw tu rm o il in m any financial m arkets during 2008 and 2009 and the failure or near-failure o f many financial in s titu tio n s in the US, the UK and Europe. I t also involved unprecedented actions by central banks, financial regulators and governments to restore confidence and s ta b ility in the financial system and to lim it the effects o f the crisis on economic activity. In several stages beginning in December 2009 the Basel Com m ittee has proposed fu rth e r refinem ents, inclu ding more detailed regulations aimed at increasing the q u a n tity and q ua lity o f bank capital and strengthening bank liq u id ity . Together, these proposals have been referred to as Basel III. In September 2012, APRA announced th a t the capital reform s w ould be im plem ented on 1 January 2013 (APRA, 2012b). In May 2013 APRA stated th a t i t w ould introduce changes to liq u id ity regulation based on Basel III in three stages on 1 January 2014, 1 January 2015 and 1 January 2018 (APRA, 2013b). When the structure o f the financial system is viewed in terms o f the in s titu tio n s th a t operate w ith in it, four main developments can be identified over the post-deregulation period— th a t is, from 1985 to 2005 (RBA March 2006). These developments are: • • • •

a significant increase in the importance o f banks a decrease in the relative importance o f b uilding societies, credit unions, finance companies and money m arket corporations a significant increase in the share o f assets held through managed funds, particularly superannuation funds rapid growth in securitisation.

These developments, which typically occurred gradually, were followed by some much more rapid changes associated w ith the global financial crisis. In Australia, the effects o f the financial crisis were less severe than in the US, the U K and Europe b u t the effect on equity prices was comparable to the changes experienced in other countries: from its peak in November 2007, the Australian stock m arket fell by more than 50 per cent to a low in March 2009. O ther effects included a fu rth e r strengthening o f the dom inant position held by banks and a significant reversal o f the previous grow th in securitisation. These, and other developments, are discussed in Sections 8.2 to 8.4.

5

See Gup (2004) for a detailed discussion of the background to the introduction of Basel II and a critical analysis of its recommendations •

capital market

CENTRAL BANK

a bank that controls the issue of currency, acts as banker to the government and the banking system and sets the interest rate for overnight cash

B usiness finance

Business funding

LEARNING OBJECTIVE 2 Distinguish between financial agency institutions, financial intermediaries and investing institutions

FINANCIAL AGENCY INSTITUTION

arranges or facilitates the direct transfer of funds from lenders to borrowers

INVESTING INSTITUTION

accepts funds from the public and invests them in assets; includes superannuation funds, life insurance companies and unit trusts

AUTHORISED DEPOSIT­ TAKING INSTITUTION

a corporation that is authorised under the Banking Act 1959 to accept deposits from the public

Sections 8.2 to 8.4 outline the m ajor financial in s titu tio n s in the Australian capital m arket involved in providing funds to companies. In stitu tio n s such as b uilding societies and credit unions, whose main function is consumer lending, are n o t discussed. The financial in s titu tio n s we discuss can be divided into three broad categories: financial agency institutio ns, financial intermediaries and investing institutions. A financial agency in stitu tio n arranges or facilitates the direct transfer o f funds from lenders to borrowers; typically, the funds are transferred from investors to companies. Companies usually obtain the assistance o f a stockbroker or investm ent bank when they wish to raise capital externally. For example, a broker or an investm ent bank may place a company s newly issued shares w ith in stitu tio n a l clients. Stockbroking firm s and investm ent banks fu nctio n as agency in stitu tio n s and w ill receive a fee or commission fo r arranging a transaction. Financial agency in s titu tio n s are discussed in Section 8.2. A financial intermediary, such as a bank, provides funds as a principal— th a t is, a company that borrows from a bank has an obligation to repay the bank, b u t it has no obligation to the banks depositors. Similarly, a bank acts as a principal in its relationship w ith depositors who have claims against the bank; depositors do n ot have claims against those who have borrowed from the bank. In contrast to agents, whose earnings consist m ostly o f fees and commissions, financial intermediaries obtain a significant part o f th e ir income from the in te re s t m argin,, which is the difference between the interest rates they charge for loans and the rates they pay to depositors. M ost financial interm ediaries also charge various fees. Companies w ith large funding requirements and high credit ratings are well placed to access debt funds directly. Such companies can therefore raise m ost or all o f th e ir funding requirements w ith o u t the services o f an interm ediary. However, m ost companies would fin d it either impossible or very expensive to access debt funds directly, so these companies typically borrow from financial intermediaries. The funds provided are sourced m ainly from depositors, so financial intermediaries have to provide services th a t depositors find attractive. Financial intermediaries are discussed in Section 8.3. Investing in stitu tio n s are sim ilar to financial intermediaries in th a t they accept funds from the public and invest the funds in assets. However, there are im p o rta n t differences between them. Essentially, financial intermediaries, such as banks, accept deposits and make loans. The m ajor roles o f investing in s titu tio n s — which include superannuation funds, life insurance companies and u n it tru sts— are to provide insurance and funds management. Funds placed w ith these in s titu tio n s are generally n ot in the form o f deposits and, while some o f these in s titu tio n s do make loans, they also invest in shares, debt securities, infrastructure assets and real estate, giving them a w ider spread o f assets than financial intermediaries. Another difference is th a t the returns provided by investing in s titu tio n s usually depend directly on the performance o f the assets held by them, whereas intermediaries have ‘fixed’ commitments to depositors th a t m ust be m et even i f an unexpectedly high pro po rtio n o f borrowers fa il to repay th eir loans. Investing in stitu tio n s are discussed in Section 8.4. W hile Sections 8.2 to 8.4 discuss financial agency institutio ns, financial intermediaries and investing in stitu tio n s, tw o qualifications should be noted. First, there are some entities th a t do n ot fit neatly in to any one o f these three categories. In particular, despite the fact th a t securitisation vehicles do not conform to our d e fin itio n o f ‘financial interm ediary’，we discuss securitisation in Section 8.3 because it is a process widely used by financial intermediaries. Second, some o f the differences between these three types o f in stitu tio n s have become less d istin ct in recent years. Many investing in s titu tio n s now offer products, such as housing loans, th a t were previously provided almost exclusively by intermediaries. In addition, there has been a considerable grow th in financial conglomerates th a t provide a wide range of financial services. For example, many banks have funds management, stockbroking and life insurance subsidiaries, while some life insurance companies have banking subsidiaries. These developments are likely to continue. However, there are s till fundam ental differences between financial interm ediation, the life insurance business and funds management. For example, the assets and liabilities o f a bank and the risks involved in banking are quite different from those o f a life insurance company. Therefore, while customers see a b lu rrin g o f previous distinctions, the differences between, say, banking and insurance continue to be im p o rta n t to those involved in managing and regulating financial institutio ns. A nother d ifficu lty arises from the terms used to refer to some institutio ns. In particular, the term inve stm en t bank* is used despite the fact th a t these in s titu tio n s may n ot be au th orised deposit-taking in stitu tio n s (ADIs) and are therefore n o t p erm itted to use the word ‘bank’ in th e ir title . On the other

C hapter eight T he

capital market

hand, many investm ent banks in Australia are the local wholesale m arket operations o f foreign banks. In summary, activities described as ‘investm ent banking’ may be carried out by a bank or by a non-bank. The to ta l assets o f the main types o f financial in s titu tio n s are shown in Table 8.1, which shows that banks are by far the largest group o f in stitu tio n s in the Australian market, followed by life insurance companies and superannuation funds. The grow th o f banks, life insurance companies and superannuation funds, other managed funds and p articularly securitisation vehicles was relatively high in the period from 1990 to 2007, while the assets o f other ADIs and registered financial corporations grew more slowly. Table 8.1 also shows th a t fo r some institutio ns, such as life insurance companies and superannuation funds, the rate o f asset grow th has slowed since 2007, while fo r registered financial corporations, other managed funds and securitisation vehicles, the value o f assets has fallen since 2007. Generally, these differences between pre- and post-2007 conditions reflect the effects o f the global financial crisis.

TABLE 8.1 Assets of Australian financial institutions, $ billi on r Life in s u ra n c e

3 0 Ju n e |

A u th o ris e d

R e g iste re d

c o m p a n ie s a n d

O th e r

d e p o s it-ta k in g

fin a n c ia l

s u p e ra n n u a tio n

m anaged

in s titu tio n s

c o rp o ra tio n s

fu n d s

fu n d s

___

B a n ks (o th e r

O th e r

th a n RBA)

A D Is

.

G e n e ra l

in s u ra n c e

S e c u ritis a tio n

c o m p a n ie s

v e h ic le s

Total

1990

325.8

31.4

109.0

158.9

43.3

21.7

5.7

695.9

1995

437.9

27.4

95.6

241.1

57.7

38.9

9.8

908.3

2000

731.0

34.2

134.6

455.1

151.7

61.4

65.0

1633.0

2005

1363.5

49.2

166.7

662.9

243.0

105.1

184.5

2774.8

2006

1581.1

53.6

176.3

787.1

300.6

113.8

216.5

3228.9

2007

1876.9

59.3

222.8

1024.9

378.3

143.7

274.0

3980.0

2008

2324.1

64.6

251.4

997.0

352.7

137.2

239.2

4366.2

2009

2590.2

67.5

215.6

936.5

313.8

134.2

192.7

4450.5

2010

2613.2

73.0

168.6

1050.6

312.6

133.4

146.1

4497.6

2011

2733.2

82.2

171.2

1172.1

287.8

152.9

136.1

4735.6

2012

2964.9

68.7

154.0

1233.7

272.5

163.4

126.8

4984.0

2013

3103.0

66.8

155.5

1421.0

278.0

175.2

127.5

5327.0

Note: The figures for life insurance companies, superannuation funds and other managed funds have been consolidated by the Australian Bureau of Statistics. They should not be compared with the figures in Tables 8.5, 8.6 and 8.7, which are unconsolidated. Source: Table B1, Reserve Bank of Australia website, www.rba.gov.au.

8.2

Financial agency institutions

Financial agency in stitu tio n s are those th a t facilitate direct funding b u t do n o t themselves provide the funds. These in stitu tio n s operate in the p rim ary markets to b ring together surplus units and deficit units, and assist w ith the design o f appropriate contracts. They also operate in the secondary markets. The m ain financial agency in stitu tio n s in Australia are stockbrokers and investm ent banks.

LEARNING OBJECTIVE 3 Identify and explain the role of financial agency institutions

8.2.1 I Brokers and the stock exchange The trad ition al function o f the stock exchange (and o f stockbrokers) is to provide facilities fo r the trading o f shares, bonds and other securities such as convertible notes, options and preference shares. As a result, a stock exchange perform s three functions. First, i t mobilises savings. Because there are large numbers of investors, issues o f securities can be fo r large sums. The presence o f a stock exchange allows companies to issue debt or equity securities in relatively small units, and each surplus u n it can then invest its desired amount. Second, it allocates resources. A stock exchange facilitates the allocation o f resources (savings) among a large num ber o f competing investm ent opportunities. Third, it allows investments to be realised through the sale o f securities— th a t is, i t provides investors w ith liquidity, and therefore the o pp ortu nity to adjust th e ir portfolios. As explained earlier, the existence o f a liq u id secondary m arket encourages investm ent in the p rim ary market.

Development of the Australian Stock Exchange In 1987 the Australian Stock Exchange Ltd (ASX, www.asx.com.au) commenced business as a national stock exchange form ed by amalgamating the six independent exchanges th a t previously operated in the state capital cities. U n til 1998, the ASX was a company lim ite d by guarantee. However, follow ing dem utualisation in 1998, i t became a company lim ite d by shares. In 2006 the ASX merged w ith the SFE Corporation, the owner o f the Sydney Futures Exchange, resulting in an exchange group th a t operated as the Australian Securities Exchange (ASX) u n til 1 August 2010 when it adopted the name ASX Group. The ASX is a large and sophisticated m arket. A t the end o f 2012, more than 2000 companies had equities listed on the exchange, w ith a to ta l m arket capitalisation o f $1335 billion. In th a t year, the average daily value o f share trading was about $4 b illio n and more than $41 b illio n o f new equity capital was raised during the year. By market capitalisation o f its listed entities, the ASX ranks te n th in the world; by the value o f share trading, i t ranks tw e lfth .6

Other equity markets in Australia There are two smaller stock exchanges in Australia: the Asia Pacific Stock Exchange and the National Stock Exchange o f Australia. •

•

The Asia Pacific Stock Exchange (www.apx.com .au), usually referred to as the APX, was started in 1997 and targets grow th-oriented companies based in Australia or elsewhere in the Asia-Pacific region, including China. I t is owned by AIMS Financial Group. The N ational Stock Exchange o f Australia (www.nsxa.com .au), usually referred to as the NSX, is located in Newcastle and in 2013 had over 100 securities listed. I t is owned by its shareholders and is its e lf listed on the ASX. It generally attracts smaller companies than the ASX because its listing requirements are less demanding. For example, to lis t on the ASX a company m ust have at least 300 shareholders and a m arket capitalisation o f at least $10 m illion , whereas the NSX requires only 50 shareholders and a m arket capitalisation o f at least $500 000.

Australia also has other equity markets designed to meet the needs o f small and medium-sized enterprises. These include the Australian Small Scale Offerings Board (www.assob.com.au) and the CAPstart Private Equity M arket (w w w.capstart.com .au), which facilitate capital raising by small unlisted companies.

Automation of trading Since 1990, all shares have been traded electronically through systems th a t enable stockbrokers to trade from term inals in th e ir offices; clients can place orders w ith online brokers using the internet. Visitors to the stock exchanges can now view share prices and other inform ation, such as local and overseas m arket indices, on video screens in the visitors* gallery. The ju n io r exchanges also use electronic trading and the prices o f listed securities can be obtained from th e ir websites. Table 8.2 provides some ASX m arket statistics fo r the period 1990 to 2012.

6

Ranks refer to the 53 members of the World Federation of Exchanges (www.world-exchanges.org).

C hapter eight T he

capital market

TABLE 8.2 ASX market statistics as at December, 1990-2012 Year

V a lu e o f A ll O r d in a r ie s s h a re , M a r k e t c a p ita lis a tio n d o m e s tic p r ic e in d e x

e q u itie s ($ m illio n )

N u m b e r o f c o m p a n ie s w ith e q u itie s liste d

1990

1280

139572

1136

1995

2203

329647

1178

2000

3155

670918

1406

2005

4709

1109596

1807

2006

5644

1390315

1908

2007

6421

1478651

2077

2008

3659

969046

2086

2009

4883

1403117

2043

2010

4847

1419001

2072

2011

4111

1168712

2079

2012

4665

1335 837

2056

Source: Compiled from Australian Stock Exchange Ltd, Fact Book 2001, 2001 and www.asx.com.au/research/market— info/index.htm.

The role of the stockbroker Traditionally, stockbrokers have played a leading role in the new-issues market. In the year to 31 December 2012, ASX-listed entities raised $41.2 b illio n in new equity capital compared w ith the 2010 and 2011 totals o f $56.5 b illio n and $47.8 b illio n respectively. The 2012 to ta l comprised $7.2 b illio n raised in in itia l public offerings by newly listed entities and $34.0 b illio n raised by entities th a t were already listed (see w w w .asx.co m .au /a bo ut/m a rke t-sta tistics.htm ). A company may m aintain a continuing relationship w ith a stockbroking firm th a t advises it on the m ost appropriate means o f raising funds and the terms o f a new issue o f securities. The same broker or an associated company may underw rite the issue, which means th a t the broker or associated company agrees to subscribe to any p o rtio n o f the issue th a t is not subscribed to by other investors during a given period. In addition, a broker may undertake to sell the issue, mainly to the brokers clients and in s titu tio n a l investors. The larger stockbroking firm s also frequently advise companies th a t are considering a merger or acquisition, and may assist w ith negotiations if the merger or acquisition proceeds. Many stockbroking firm s have extended th e ir services beyond those trad ition ally offered. O ther services offered by brokers include advice on financial planning and superannuation, research and trading of derivative securities (such as options), access to stock markets outside Australia and investments in commercial bills and other money m arket assets.7 Although a stockbroking firm may provide these services directly, they are usually provided through associated investm ent banks.

8 .2 .2 1 Investment banks The role of investment banks The term investm ent bank* has no official defin itio n in Australia. Rather, investm ent banks are identified by the range o f financial services th a t they provide. Their m ain activities involve wholesale banking and trading in the financial markets. The range o f activities is broad and includes financial interm ediation (borrowing and lending), trading in securities, foreign exchange and derivatives, investm ent management,

7

Derivatives are discussed in Chapters 17 and 18 and commercial bills in Chapter 10.

Jw w ^J

provision o f corporate advisory services, u nd erw riting and stockbroking. Thus, unlike most banks and other authorised deposit-taking in s titu tio n s (ADIs), investm ent banks have little involvem ent in retail banking. Accordingly, they usually have m inim al dealings w ith individuals except perhaps as managers o f funds such as cash management trusts or as advisers to a small number o f very wealthy individuals. There is no
The wholesale banking operation provides a service to companies th a t wish to deposit tem porarily idle cash balances, or to borrow funds fo r a short to m edium period, b The investment management function involves managing the p ortfolios o f in s titu tio n a l investors and an investm ent banks own u n it trusts. Part o f this fu nctio n is to direct funds to the new issues o f Australian companies. c The corporate financial advisory function involves providing advice to companies about raising additional capital, or a merger or takeover, and the provision o f und erw riting facilities and m arketing services fo r new issues. The u n d erw rite rs skills, contacts and knowledge o f the capital m arket are expected to result in a higher price than i f the issuer attempted to m arket the securities itself. In addition, the m arketing risk is assumed by the underw riter. I f the issue is priced appropriately, the supply o f securities w ill match the demand. I f the issue is over-priced, the u nderw riter w ill be le ft holding the unsold securities, d Making a market in foreign exchange and derivative securities involves being w illin g to quote b oth a price to buy and a price to sell in these m arkets— th a t is, this fu nctio n requires the investm ent bank to be w illin g to deal on both sides o f the m arket at all times. a

Regulation of investment banks The regulatory provisions th a t apply to an investm ent bank w ill depend, at least in p art, on its structure and the range o f services th a t it provides. An investm ent bank operating in Australia w ill be structured either as an AD I or as a money m arket corporation. Those th a t are ADIs w ill be subject to the provisions o f the Banking Act 1959 and to prudential supervision by APRA (w w w .a p ra .g o v .a u ). Investm ent banks th a t are structured as money m arket corporations are n o t subject to prudential supervision, b ut are required to register w ith, and provide statistical data to, APRA in accordance w ith the Financial Sector (Collection of Data) Act 2001. Their name may n ot include the word ^ank*, but guidelines issued by APRA in January 2006 allow registered money m arket corporations to use expressions such as 'merchant bank* in relation to th e ir business. Because they are corporations, they are also regulated by the Australian Securities and Investments Commission (ASIC, w w w .a s ic .g o v .a u ) and are subject to the same conduct and disclosure regulations as other corporations. As a provider o f financial advice or as a dealer in financial markets, an investm ent bank m ust have an Australian Financial Services Licence issued by ASIC. In addition, m ost o f those th a t trade in the financial markets are members o f the Australian Financial M arkets Association (AFMA, w w w .a fm a . c o m .a u ). AFM A is an ind ustry association th a t represents the in s titu tio n s th a t operate in Australia’s over-the-counter financial markets. It imposes a degree o f self-regulation through measures such as its code o f conduct, codification o f m arket conventions and standardisation o f documentation.

Developments in Australian investment banking A fte r the deregulation o f the banks in the 1980s, lending became a much less im p o rta n t activity o f money m arket corporations, while other investm ent banking activities have grown considerably. Therefore, the value o f th e ir assets and the associated m arket shares shown in Table 8.3 (see Section 8.3) are n o t good measures o f the sectors importance. O ther measures, such as the value o f equity capital raised and fees earned, are better indicators o f the importance o f investm ent banking. As noted above, investm ent banks th a t engage in securities trading and u n d erw riting w ill usually be members o f AFM A. In 2013, AFM A had more than 130 members and there are many investm ent banks th a t are n ot members o f AFMA. These non-members do n o t trade in the financial markets and focus instead on activities such as advisory services, investm ent and funds management. Investm ent banking can involve inherent conflicts o f interest th a t m ust be managed i f they cannot be avoided. These conflicts are m ost likely to arise in cases where the firm has a wide range o f activities

C hapter eight T he

including stockbroking, securities trading and u nderw riting. In such cases, investors and regulators may be concerned th a t the broking analysts* recommendations on which shares to buy or sell may be influenced by th e ir colleagues who are seeking to attract or retain business in u nd erw riting or corporate advisory activities. Further, i f share trading undertaken by one section o f an investm ent bank is m otivated by confidential inform a tion gathered by another section o f the bank, then the bank may be subject to a charge o f insider trading. The standard approach to managing such conflicts o f interest is to employ internal barriers— know n as inform a tion barriers or, more frequently, Chinese walls_ to lim it the flow o f confidential client inform a tion between departments. Concerns about the effectiveness o f Chinese walls were widely publicised in the US in 2001. One outcome was that M errill Lynch agreed to pay a fine o f US$100 m illion because o f allegations th a t its broking analysts issued overly optim istic reports on the shares o f companies that were clients o f its investment banking operation. In Australia, ASIC took civil action against Citigroup in 2006 in the only recorded Australian case to consider Chinese walls as a defence against insider trading (Overland and Li, 2012). Citigroup was successful in defending the charges but the outcome o f the case highlights the importance o f m aintaining adequate Chinese wall arrangements. In particular, the policies and procedures underpinning such arrangements should be documented extensively, and understood and applied by employees. Some investment banks avoid any exposure to inherent conflicts o f interest by restricting the scope o f th e ir activities. Firms that take this approach focus on advisory services and do n ot engage in securities trading or underwriting.

Investment banks and the global financial crisis The global financial crisis saw m ajor investm ent banks in the US experience severe stress. Bear Stearns suffered a severe liq u id ity shortage in March 2008 and failure was avoided only when J. P. Morgan Chase agreed to purchase Bear Stearns in a takeover facilitated by government authorities. By the end o f August 2008, the losses th a t had been recognised by financial in stitu tio n s w ritin g down the values o f assets had accumulated to a global to ta l o f around US$500 billion. Pressure on the equity prices o f financial institutions made it more d iffic u lt fo r banks to replenish th e ir depleted capital bases or to raise loan funds from markets where lenders were unw illing to accept anything other than the lowest credit risks. W ith th e ir higher leverage and exposures to impaired assets, investm ent banks experienced the greatest pressure. O f the m ajor US investm ent banks, Lehman Brothers, w ith assets o f about $639 billion, faced the m ost severe problems and when it was unable to raise urgently needed funding the company filed for bankruptcy protection in September 2008— the largest ‘bank’ failure in US history. The failure o f Lehman Brothers and the planned takeover o f M e rrill Lynch by the Bank o f America would leave just two big investm ent banks: Goldman Sachs Group Inc. and Morgan Stanley. A week after Lehman Brothers failed, the US central bank, the Federal Reserve, announced that, at a 9 pm meeting, its Board o f Governors had approved applications delivered earlier th a t day by b oth firm s to become bank holding companies— th a t is, firm s th a t own or control banks. The im plications o f this change o f status included regulation by the Federal Reserve instead o f the Securities and Exchange Commission, lower financial leverage, greater reliance on deposits from retail customers rather than borrow ing by issuing bonds and probably less risk taking. A report by Bloomberg began:

The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.8 W hile the effects in Australia were less severe than in the US, the global financial crisis had significant effects on investm ent banks in Australia. The Sydney-based investm ent bank Babcock & Brown (B&B), which listed on the ASX in 2004 and had at its peak 28 offices worldwide and a m arket capitalisation in excess o f $9 billion , became a victim o f the crisis when it failed in 2009. B&B had a leading role as an adviser on structured finance including leases and securitisation, invested in real estate and infrastructure as a principal and managed several satellite* funds th a t i t established. B&B relied heavily on short-term debt to finance its holdings o f m ostly illiq u id assets, such as real estate and shareholdings in unlisted related businesses. W ith financial markets disrupted and concerns about the high debt levels o f B&B and its satellite funds, the company was unable to refinance its debt and was placed in voluntary adm inistration in March 2009 and then in to liqu id atio n in August 2009. The Australian subsidiaries o f US and European

8

See Harper and Torres (2008).

capital market

B usiness finance

investm ent banks such as M e rrill Lynch and UBS reduced th e ir workforces to offset lower revenues. As financial markets stabilised in 2009 and 2010, these and other investm ent banks were able to earn substantial fees by arranging and u nd erw riting share issues fo r companies whose managers recognised the need to reduce th e ir financial leverage.

8.3 LEARNING OBJECTIVE 4 Identify and explain the role of financial intermediaries

Financial interm ediaries

Financial intermediaries borrow funds on th e ir own behalf and then lend the funds to another party. The types o f financial intermediaries in the Australian capital m arket include banks, money m arket corporations, finance companies, building societies and credit unions. Recent statistics on the assets o f the financial interm ediaries th a t are im p o rta n t as lenders to businesses are shown in Table 8.3.

TABLE 8.3 Total assets of selected financial intermediaries ($ billion) and market shares (percentage of total)

r

3 0 June

M o n e y m a rk e t

$ b illio n

F in a n c e c o m p a n ie s

c o rp o ra tio n s

B a n ks %

$ b illio n

%

$ b illio n

,

Total

%

$ b illio n

1990

325.8

74.9

53.6

12.3

55.4

12.7

434.8

1995

437.9

82.1

51.2

9.6

44.4

8.3

533.5

2000

731.0

84.5

63.7

7.4

70.9

8.2

865.6

2005

1363.5

89.1

80.1

5.2

86.5

5.7

1530.1

2006

1581.1

90.0

79.0

4.5

97.3

5.5

1757.4

2007

1876.9

89.4

106.7

5.1

116.1

5.5

2099.7

2008

2324.1

90.3

121.9

4.7

129.5

5.0

2575.6

2009

2590.2

92.3

94.5

3.4

121.1

4.3

2805.8

2010

2613.2

93.9

64.8

2.3

103.9

3.7

2781.8

2011

2733.2

94.1

66.7

2.3

104.5

3.6

2904.5

2012

2964.9

95.1

49.1

1.6

104.9

3.4

3118.8

2013

3103.0

95.2

43.6

1.3

111.8

3.4

3258.5

Source: Table B1, Reserve Bank of Australia website, www.rba.gov.au.

8.3.1 | Banks The to ta l assets o f financial in stitu tio n s in Australia are shown in Table 8.1. As can be seen from the table, banks are the largest group o f financial in stitu tio n s in Australia. As at June 2013, th e ir assets accounted directly fo r more than 58 per cent o f the assets held by all financial in stitu tio n s. However, this understates the overall importance o f banks because many o f them also have interests in other financial institutio ns, such as investm ent banks, finance companies, insurance companies, fund managers and stockbrokers. Accordingly, banks— p articularly the larger ones— provide a wide range o f products and financial services including funds management, insurance, und erw riting , security dealing and stockbroking. In many cases, these activities are carried out through subsidiaries and affiliated businesses. A m ajor part o f banking business is borrow ing from depositors and other investors and lending to a wide range o f borrowers, including governments, businesses and consumers. Therefore, banks need to offer services th a t attract both borrowers and depositors. The m ain attraction to borrowers is obvious: access to debt capital. Banks are large lenders to the business sector, and in the 12-m onth period ended

C hapter eight T he

capital market

June 2013 accounted fo r more than 90 per cent o f commercial lending by interm ediaries.9 But banks offer more than mere access to debt capital— they offer a wide range o f loans w ith different characteristics. For example, there are short-term loans and long-term loans, secured loans and unsecured loans, fixedinterest rate loans and variable-interest rate loans, and domestic-currency loans and foreign-currency loans. The most distinctive fo rm o f bank lending is the overdraft facility, which involves an arrangement whereby borrowers may draw funds, at th e ir discretion, up to a specified lim it. How do banks attract depositors? A n obvious answer is: by paying interest. But why would someone deposit money in a bank, which then lends the money to a borrower, when the banks deposit interest rate is almost certainly less than the interest rate charged to the borrower? In other words, why n o t lend directly, instead o f going through the bank? The answer is that, in addition to paying interest, banks provide valuable services to th e ir depositors, including: • • • •

•

Credit assessment. Banks typically have much greater expertise than depositors in assessing the quality o f loan applicants, thus reducing default risk. Credit enhancement. Partly by applying th e ir credit assessment skills, banks are able to offer low -risk investments to depositors, even i f some o f the loans made by the bank are high risk. Diversification. Banks reduce risk by lending to a much w ider variety o f borrowers than an individual depositor could.10 Maturity transformation. Depositors often wish to lend fo r short periods (such as a few m onths or a few years) whereas borrowers often wish to borrow fo r term s o f many years; banks make this transform ation possible. Transaction services. Banks assist depositors to receive and pay funds by (for example) cheques and electronic transfers.11

In addition to m aking loans and meeting the needs o f depositors, banks also provide many other services. These services include assisting clients to borrow from sources o ther than the bank by providing guarantees, letters o f credit and b ill acceptances. O ther services assist clients in risk management and involve market-related activities such as entering in to forw ard rate agreements, transacting in various foreign-currency contracts and dealing in derivatives. As at 11 October 2013, 69 banks were authorised to operate in Australia. O f these, 21 were predominantly Australian owned, eight were subsidiaries o f foreign banks and 40 were branches o f foreign banks. A foreign bank subsidiary is incorporated in Australia and m ust hold capital w ith in Australia, whereas a foreign bank branch is essentially just a p art o f the parent bank th a t is authorised to conduct banking business w ith in Australia. As discussed below, foreign bank branches are subject to some restrictions th a t do n o t apply to subsidiaries o f foreign banks. Some foreign banks have both a branch and a subsidiary in Australia. As from 1 July 1998, the responsibility fo r bank supervision was transferred from the RBA to APRA. The RBA retains responsibility fo r m onetary policy and the maintenance o f financial stability, including th a t o f the payments system— which is the cash, cheque and electronic means by which payments are effected. As a result, the current regulatory structure requires close cooperation between the RBA and APRA. An a uth ority from APRA is required before a bank is perm itted to operate in Australia. APRA also imposes a number o f other controls over banks, including m inim um capital requirements and asset requirements. Banks are also required to provide APRA w ith extensive data on th e ir activities and management systems. W hile subsidiaries o f foreign banks are subject to the same requirements as locally owned banks, branches o f foreign banks are n ot subject to m inim um capital requirements in Australia. However, such branches are effectively confined to operating in the wholesale m arket because they are n ot perm itted to accept in itia l deposits o f less than $250000 from Australian residents and non-corporate institutio ns. Therefore, a foreign bank th a t wishes to operate in the retail m arket m ust establish a subsidiary in Australia. Before the global financial crisis, the Australian government did n o t explicitly guarantee deposits in Australian banks. As p art o f its response to the crisis, the government introduced an explicit guarantee

9

This percentage is derived from the Australian Bureau of Statistics publication L e n d in g F in an ce, A u str a lia , cat. no. 5671.0, Table 3. 10 See Chapter 7 for a discussion of how diversification of a portfolio can reduce risk. 11 Banks are the major participants in the payments system in the settlement of cheques, which is conducted through exchange settlement accounts at the RBA.

DEFAULT RISK

the chance that a borrower will fail to meet obligations to pay interest and principal as promised

B usiness finance

Finance in

ACTION

GOVERNMENT GUARANTEE EXTENDED O N BANK DEPOSITS P r io r to th e g lo b a l f in a n c ia l c ris is , b a n k d e p o s its in A u s t r a lia w e r e n o t g u a r a n t e e d , a lth o u g h d e p o s it in s u r a n c e s c h e m e s w e r e c o m m o n in o t h e r c o u n tr ie s . F a c e d w ith a c ris is o f c o n fid e n c e in la te S e p t e m b e r / e a r ly O c t o b e r 2 0 0 8 , m a n y g o v e r n m e n ts in c r e a s e d th e lim it o n th e a m o u n t o f d e p o s its g u a r a n t e e d u n d e r th e s e s c h e m e s w h ile o th e rs w e n t fu r t h e r b y p r o v id in g a g u a r a n t e e o v e r a ll d e p o s its , t y p ic a lly f o r a s e t p e r io d o f a r o u n d 2 y e a r s . S o m e g o v e r n m e n ts a ls o m o v e d to p r o v id e a g u a r a n t e e o n w h o le s a le b o r r o w in g b y d e p o s it - ta k in g in s titu tio n s . W h il e m o s t A u s t r a lia n in s titu tio n s r e m a in e d s o u n d a n d p r o f it a b le , th e A u s t r a lia n g o v e r n m e n t to o k s im ila r m e a s u re s so t h a t A u s t r a lia n b a n k s a n d o fh e r d e p o s it - ta k in g in s titu tio n s w o u ld n o t b e d is a d v a n t a g e d in te r n a tio n a lly . A n a r t ic le in T /ie A g e o u t lin e d th e g o v e r n m e n t's in itia tiv e s . T h e G o v e r n m e n t w i l l g u a r a n t e e t h e $ 6 0 0 —$ 7 0 0 b i l l i o n d e p o s it s in A u s t r a lia n f i n a n c i a l in s t it u t io n s in a m o v e t o s h o r e u p lo c a l c o n f id e n c e a n d p r o t e c t t h e n a t i o n ’ s in t e r n a t i o n a l c o m p e t it iv e n e s s . D e c la r i n g t h a t t h e c o u n t r y is in 't h e e c o n o m ic e q u i v a le n t o f a r o l lin g n a t io n a l s e c u r it y c r is is 7, [ P r im e M in is t e r ] K e v in R u d d h a s a ls o a n n o u n c e d t h a t a l l b o r r o w i n g b y A u s t r a lia n b a n k s a n d o t h e r d e p o s it - t a k in g in s t it u t io n s f r o m o v e r s e a s w i l l b e g u a r a n t e e d . T h e d e p o s it a n d le n d in g g u a r a n t e e s a r e u n p r e c e d e n t e d in A u s t r a lia n b a n k i n g h is t o r y a n d a r e a n im m e d ia t e r e s p o n s e t o t h e d r a m a t i c m o v e s b y o t h e r c o u n t r ie s t o p r o p u p t h e ir f a i l i n g f i n a n c i a l s y s te m s . . . . A u s t r a lia n b a n k s w e lc o m e d t h e G o v e r n m e n t 's m o v e s . A u s t r a lia n B a n k e r s A s s o c i a t io n c h i e f e x e c u t iv e D a v id B e ll s a id A u s t r a lia n b a n k s w e r e w e ll c a p it a l is e d b u t w e r e s till a f f e c t e d b y t h e s e iz u r e o f i n t e r n a t i o n a l f i n a n c i a l m a r k e ts . 'T h is le v e ls t h e p l a y i n g f ie l d a n d a l lo w s A u s t r a lia n b a n k s t o c o m p e t e e q u a l l y a n d f a i r l y 7, h e s a id .

Source: 'Rudd's $700 billion bank guarantee,/ Michelle Grattan and Vanessa O'Shaughnessy, The Age, 13 October 2008.

|w w w j

on deposits in banks and other AD Is.12 (See Finance in Action.) Some o f these guarantees were temporary b u t the government continued to guarantee deposits o f up to $250 000 per person per ADI. The Australian banking sector is dominated by fo ur m ajor banks, the AN Z Banking Group (www. anz.com.au), the Commonwealth Bank o f Australia (w w w.com m bank.com .au), the N ational Australia Bank (w w w .national.com .au) and Westpac Banking Corporation (www.westpac.com .au). These banks accounted fo r 79 per cent o f the to ta l assets o f the Australian banking sector as at October 2013 (APRA 2013c). Each has a nationwide branch netw ork and provides a fu ll range o f banking services for individuals as well as business customers b oth locally and overseas. O ther Australian-owned banks are smaller and many are referred to as Regional banks’ because they originally had a regional base in one state. M any o f these smaller banks, including the Bendigo and Adelaide Bank, Suncorp Bank and the Bank o f Queensland, have since expanded to compete w ith the m ajor banks by achieving broader coverage of the Australian market. Historically, foreign-owned banks played only a m in o r role in the Australian financial system. However, in recent years they have attracted increased a tte ntio n through measures such as attractive interest rates paid on internet-based savings accounts. Foreign banks have also begun to compete more aggressively in lending in Australia and at the end o f 2008 they held around 16 per cent o f overall Australian bank assets. However, by the end o f October 2013, th e ir share o f bank assets had declined to 11.5 per cent (APRA 2013c). Following the collapse o f the m ajor US firm Lehman Brothers in September 2008 and the failure or near-failure o f many other financial institutio ns, there was a widespread loss o f confidence in the solvency o f financial in stitu tio n s and the sta bility o f the global financial system. Governments in several countries, including Australia, moved to restore confidence through measures th a t were in some cases unprecedented. As m entioned above, in Australia one o f the m ajor changes was the announcement o f an explicit government guarantee o f bank deposits.

12 For discussion of the guarantee measures, see Schwartz (2010).

C hapter eight T he

capital market

8 .3 .2 1 Money market corporations The activities o f money m arket corporations (MMCs) were discussed in Section 8.2.2. Table 8.3 shows that the assets o f these in stitu tio n s have declined from around 10 per cent o f the to ta l assets o f banks, MMCs and finance companies in the mid-1990s to around 5 per cent from 2004 to 2008; they then fell fu rth e r to only 1.3 per cent in 2013. As discussed in Section 8.2.2, the long-term decline reflects the ongoing effects o f the deregulation o f the Australian financial system, whereby restrictions th a t applied to banks were removed, allowing them to strengthen th e ir com petitive position at the expense o f non-bank financial intermediaries. The more rapid decline over the 2008 to 2013 period coincides w ith the global financial crisis and its afterm ath. Since MMCs are n o t authorised deposit-taking in s titu tio n s (ADIs) th eir borrowings were not covered by the government guarantee announced in October 2008.

8 .3 .3 | Finance companies Initially, finance companies were p rim a rily concerned w ith lending to individuals by providing instalm ent credit for retail sales. In 1954 this accounted fo r 85 per cent o f finance company lending b ut by June 2010, lending to individuals accounted fo r only 27 per cent o f the to ta l assets o f finance companies.13 Finance companies grew rapidly during the period in which the Australian financial markets were highly regulated. They offered a wide range o f financial services fo r companies, including instalm ent credit, lease financing, inventory financing, discounting o f accounts receivable, mortgages and other commercial loans. Their success was due largely to the regulatory constraints on th e ir natural competitors, the banks. In fact, each o f the m ajor banks acquired a finance company subsidiary in order to gain access to markets denied them by bank regulations. The deregulation o f the banking sector in the 1980s removed much o f the competitive advantage h itherto enjoyed by finance companies. As can be seen from Table 8.3, the assets o f finance companies have grown at a much lower average rate than the assets o f banks over the period from 1995 to 2013 and declined in dollar terms from 2008 to 2013. Many finance companies have become specialised in stitu tio n s focusing on specific areas such as m otor vehicle finance or the financing o f machinery and equipment.

8 .3 .4 | Securitisation14 S e c u ritis a tio n is the process o f converting illiq u id assets such as bank loans in to tradable securities. In a typical case, an originator o f financial assets— such as a bank th a t has provided a significant number o f housing loans— sells a p o rtfo lio o f these loans to a specially created company or trust. This entity, generally referred to as a securitisation vehicle or special purpose vehicle (SPV), finances its purchase o f the loans by issuing tradable securities to investors using the underlying assets (the housing loans) as collateral. I f these securities are long term they are generally referred to as asset-backed bonds, or i f the loans involved are all mortgage loans over residential property, the securities may be referred to as residential mortgage-backed securities (RMBS). I f the securities are short term — th a t is, th e ir term to m aturity is less than a year— they may be referred to as asset-backed commercial paper (ABCP). The end result is th a t securitisation allows a financial in s titu tio n to fund its lending indirectly through the capital market instead o f by the trad ition al m ethod o f gathering deposits or borrow ing directly in its own name. A traditional interm ediary assesses loan applications and provides funds to approved loan applicants. One advantage claimed fo r securitisation is th a t it enables the credit assessment fu nctio n to be separated from the funding function. That is, the lending in s titu tio n continues to assess loan applicants but, through securitisation, the funds are provided by investors. One view is th a t this process enables in stitu tio n s to specialise in either credit assessment or funding, depending on where th e ir expertise lies. A nother view is that this separation may incur agency costs: the credit assessor may n o t bear the fu ll costs o f making poor assessments. The securitisation m arket in Australia has been dominated by securitisation o f residential mortgages but the range o f assets that can be securitised also includes commercial mortgages, leases, trade receivables 13 See Reserve Bank of Australia, Table B10, www.rba.gov.au. 14 Facts related to the Australian securitisation market mentioned in this section are mostly drawn from Reserve Bank of Australia (2004) pp. 48-56 and Debelle (2009).

LEARNING OBJECTIVE 5 Outline the role of securitisation SECURITISATION

the process of making assets marketable by aggregating incomeproducing assets in a pool and issuing new securities backed by the pool

B usiness finance

a n d m o to r v e h icle lo an s. A s s h o w n in Table 8.1, th e assets o f A u s tra lia n s e c u ritis a tio n ve h icle s g re w fro m a ro u n d $ 1 0 b illio n in J u n e 1 9 9 5 to a p e a k o f $ 2 7 4 b illio n in J u n e 2 0 0 7 b u t th e n fe ll to $ 1 2 8 b illio n in Ju n e 2 0 1 3 . D u rin g th e p e rio d o f ra p id g ro w th t h a t co m m e n ce d in th e 19 90 s, th e share o f re s id e n tia l

[ wwn^]

m o rtg a g e lo a n s fu n d e d th ro u g h s e c u ritis a tio n in cre a se d fr o m less th a n 10 p e r c e n t in th e la te 1990s to a lm o s t 25 p e r c e n t in J u n e 2 0 0 7 (see D e b e lle 2 0 0 9 , p. 4 3 ). C u rre n t in fo r m a tio n a b o u t s e c u ritis a tio n is p ro v id e d b y th e A u s tra lia n S e c u ritis a tio n F o ru m (ASF,

w w w .securitisation.com .au). The assets o f

A u s tra lia n s e c u ritis a tio n ve h icle s are s h o w n in Table 8.4.

TABLE 8.4 Assets of securitisation vehicles, $ million O th e r 3 0 Ju n e

I

M o r tg a g e s

lo a n s a n d

Asse 卜 backed

O th e r

A ll o th e r

p la c e m e n ts

bonds

se cu ritie s

assets

Total assets

1990

4794

845

5734

1995

5358

1456

928

1229

894

9845

2000

41306

7905

8072

2515

5 216

65014

2005

146984

11293

12286

3972

9970

184505

2006

176288

11162

13738

2946

12327

216461

2007

215201

17319

18907

3025

19525

273977

2008

179669

19106

20997

2753

16715

239240

2009

142885

15346

15858

525

18104

192718

2010

115 794

11922

9229

0

8835

146073

2011

110666

13353

6983

255

4813

136070

2012

106495

13747

1556

0

5 024

12 6 8 2 2

2013

106156

14175

1374

0

5554

127259

Source: Table B19, Reserve Bank of Australia website, www.rba.gov.au.

The ra p id g ro w th in s e c u ritis a tio n u p to 2 0 0 7 can be a ttr ib u te d to tw o m a in fa c to rs . F irs t, th e d e m a n d f o r h o u s in g fin a n c e in A u s tra lia re m a in e d s tro n g . Second, th e c o m p o s itio n o f le n d e rs in th e m o rtg a g e m a rk e t changed, w it h m o rtg a g e o rig in a to rs t h a t s e c u ritis e a lm o s t a ll o f t h e ir lo a n s g a in in g a g ro w in g share a fte r e n te rin g th e m a rk e t in th e 19 90 s (D e b e lle 2 0 0 9 , p p . 4 3 - 4 ) . The fa ll in th e assets o f s e c u ritis a tio n vehicles a fte r 2 0 0 7 is a n o th e r o u tc o m e o f th e g lo b a l fin a n c ia l c ris is . A t tim e s d u r in g th is crisis, m a rk e ts f o r asset-backed s e c u ritie s w e re e ffe c tiv e ly fro z e n , w ith m a n y sellers b u t n o b u ye rs, so th e re was li t t le i f a n y tra d in g in s e c o n d a ry m a rk e ts . Issuance o f n e w s e c u ritie s d e c lin e d m a rk e d ly a n d in som e cases ceased a lto g e th e r. W it h re p a y m e n ts o n th e u n d e rly in g lo a n s b e in g a p p lie d to a m o rtis e th e p r in c ip a l o f e x is tin g s e c u ritie s a n d m in im a l issuance o f n e w s e c u ritie s , th e assets o f s e c u ritis a tio n veh icle s in e v ita b ly fe ll.

8.4 LEARNING OBJECTIVE 6 Identify and explain the role of investing institutions

Investing institutions

The m a in in v e s tin g in s titu t io n s in A u s tra lia are life in s u ra n c e com p an ies, s u p e ra n n u a tio n fu n d s , p u b lic u n it tr u s ts a n d ge n e ra l in s u ra n c e co m p a n ie s. A s n o te d e a rlie r, m a n y o f the se in s titu t io n s are o w n e d b y b a n ks o r are m e m b e rs o f fin a n c ia l c o n g lo m e ra te s . There is also s ig n ific a n t o v e rla p b e tw e e n th e categories. In p a rtic u la r, m a n a g e m e n t o f s u p e ra n n u a tio n fu n d s is a m a jo r a c tiv ity o f life in s u ra n c e com p an ies, so m o s t o f th e assets h e ld b y the se co m p a n ie s are w it h in s u p e ra n n u a tio n fu n d s .

C hapter eight T he

8.4.1 | Insurance companies and superannuation funds As s h o w n in Table 8.1, th e t o ta l assets o f ge ne ral in s u ra n c e co m p a n ie s are a ro u n d $ 1 7 5 b illio n , w h ic h is a b o u t 3 p e r ce n t o f th e assets o f a ll A u s tra lia n fin a n c ia l in s titu tio n s . In A u s tra lia , m o s t o f th e g e ne ral in su ra n ce b u sin ess in vo lve s p r o v id in g in s u ra n c e c o ve r f o r assets such as m o to r veh icle s a n d b u ild in g s w h ere a n y losses are g e n e ra lly in c u rre d w it h in 12 m o n th s o f re c e iv in g th e p re m iu m . In s u ra n c e com p an ies u s u a lly m a tc h th e d u ra tio n o f t h e ir assets w ith th e d u ra tio n o f t h e ir lia b ilitie s . T h e re fo re , w h ile g e ne ral in su ra n ce com panies do m a k e som e lo n g -te rm in v e s tm e n ts , th e m a jo r ity o f t h e ir assets are s h o rt te rm . This fa c to r, to g e th e r w it h t h e ir re la tiv e ly s m a ll size, m ea ns t h a t ge n e ra l in s u ra n c e co m p a n ie s are n o t a m a jo r source o f c o m p a n y fin a n ce . Hence, in th is s e c tio n w e fo cu s o n life in s u ra n c e com p an ies a n d s u p e ra n n u a tio n fu n d s , w h ic h m ake lo n g e r te r m in v e s tm e n ts . In s u ra n c e co m p a n ie s a n d m o s t s u p e ra n n u a tio n fu n d s are re g u la te d b y A P R A , th e o n ly e x c e p tio n b e in g se lf-m a n a g e d s u p e ra n n u a tio n fu n d s (SMSFs) w h ic h are re g u la te d b y th e A u s tra lia n T a x a tio n O ffice . L ife in su ra n ce co m p a n ie s a n d s u p e ra n n u a tio n fu n d s are m a jo r sources o f co m p a n y fin a n ce . These in s titu tio n s raise la rg e a m o u n ts as p re m iu m s a n d c o n trib u tio n s , w h ic h are la rg e ly lo n g -te rm c o m m itm e n ts and, a cco rd in g ly, such in s titu t io n s te n d to a cq u ire lo n g -te rm assets such as shares issu e d b y p u b lic com p an ies, an d b o n d s a n d o th e r fo rm s o f d e b t issu e d b y g o v e rn m e n ts a n d com p an ies. A u s tra lia s s u p e ra n n u a tio n in d u s tr y has g ro w n ra p id ly since th e e a rly 19 90 s in resp on se to th e C o m m o n w e a lth G o v e rn m e n t s s u p e ra n n u a tio n g u a ra n te e charge p o lic y , w h ic h a im s to p ro m o te u n iv e rs a l s u p e ra n n u a tio n coverage. The g ro w th o f assets w it h in th e s u p e ra n n u a tio n s yste m is e xp e cte d to c o n tin u e , a lth o u g h th e ra te o f g ro w th w ill be in flu e n c e d b y changes in g o v e rn m e n t p o lic y a n d flu c tu a tio n s in in v e s tm e n t re tu rn s . Table 8.5 show s th e re c e n t g r o w th in b o th th e assets h e ld b y s u p e ra n n u a tio n fu n d s a n d th e to t a l n u m b e r o f fu n d s .

TABLE 8.5 Assets and number of funds—superannuation funds N u m b e r o f s u p e ra n n u a tio n e n titie s c la s s ifie d b y ty p e P o o le d s u p e r­

P u b li 7 _

A s s e ts ~ 3 0 Jun e ; ($ b illio n ) j C o r p o ra te

In d u s try

se cto r

R e ta il

S m a ll

a n n u a tio n trusts

Total

____ ： _____________ ____： ___ ： ______ j

2000

484.2

3389

155

81

293

212538

164

216620

2005

751.4

962

90

43

228

296813

130

298266

2006

904.2

555

80

45

192

315924

123

316919

2007

1172.8

287

72

40

176

356309

101

356985

2008

1131.0

226

70

40

169

381413

90

382008

2009

1067.4

190

67

40

166

404131

82

404676

2010

1198.5

168

65

39

154

418928

79

419433

2011

1350.9

143

61

39

143

446597

77

447060

2012

1400.5

122

56

39

135

481538

67

481957

Source: Australian Prudential Regulation Authority, www.apra.gov.au, Annual Superannuation Bulletin, June 2006, June 2010 and June 2013a.

The la rge increase in to t a l s u p e ra n n u a tio n assets o v e r th e 7 years to J u n e 2 0 0 7 re fle c ts th e c o m b in e d effects o f p o s itiv e n e t c o n tr ib u tio n flo w s — t h a t is, c o n trib u tio n s exceeded b e n e fits p a id — a n d s tro n g in v e s tm e n t re tu rn s o n som e asset classes, p a r tic u la r ly A u s tra lia n e q u itie s , a fte r 2 0 0 2 . In th e years im m e d ia te ly a fte r 2 0 0 7 , n e t c o n trib u tio n s re m a in e d p o s itiv e b u t fa lls in th e value s o f m a n y fin a n c ia l assets, p a rtic u la rly e q u itie s , m e a n t t h a t t o ta l s u p e ra n n u a tio n assets d e c lin e d in 2 0 0 8 a n d 20 09 . Since 20 09 , th e assets h e ld b y s u p e ra n n u a tio n fu n d s have re su m e d t h e ir lo n g -te rm tre n d , g ro w in g b y 31 p e r ce n t in th e 2 0 0 9 to 2 0 1 2 p e rio d .

capital market

The s ig n ific a n t increase in th e n u m b e r o f fu n d s o v e r th e p e rio d covered b y Table 8 .5 is due e n tire ly to g r o w th in th e n u m b e r o f s m a ll fu n d s , m o s t o f w h ic h are SMSFs. The n u m b e r o f s m a ll fu n d s is d is p ro p o rtio n a te ly h ig h re la tiv e to th e v a lu e o f t h e ir assets. To illu s tra te , a t 30 J u n e 2 0 1 2 s m a ll fu n d s a cco u n te d f o r 9 9 .9 p e r c e n t o f th e to t a l n u m b e r o f fu n d s b u t o n ly 31 .5 p e r c e n t o f th e to t a l assets h e ld b y s u p e ra n n u a tio n fu n d s (A P R A 2 0 1 3 c, Tables 1 a n d 9). W h ile th e n u m b e r o f s m a ll fu n d s has g ro w n stro n g ly, Table 8.5 shows th a t th e n u m b e r o f fu n d s in o th e r categories, p a rtic u la rly c o rp o ra te fu n d s , has d e clin e d d ra m a tic a lly in rece nt years. In la rge p a rt, th is decline refle cts th e effects o f lic e n s in g re q u ire m e n ts th a t w ere phased in d u rin g a tra n s itio n a l p e rio d th a t ended on 30 J u n e 2 0 06 . The tru ste e s o f m a n y sta n d -a lo n e c o rp o ra te fu n d s chose n o t to seek a licence a n d th e m em bers an d assets o f these fu n d s w ere tra n s fe rre d to o th e r fu n d s , p a rtic u la rly in d u s try fu n d s and re ta il fun ds. The v a lu e o f assets h e ld b y s u p e ra n n u a tio n fu n d s o u ts id e life in su ra n ce co m p a n ie s is s h o w n in Table 8.6. I t show s t h a t s u p e ra n n u a tio n fu n d s are la rge , a n d g ro w in g , in v e s to rs in th e shares o f A u s tra lia n co m p a n ie s a n d in u n its in tru s ts . These assets ty p ic a lly a cco u n te d f o r a b o u t 45 p e r c e n t o f t o ta l fu n d assets in th e la s t fe w years, co m p a re d w it h less th a n 3 0 p e r c e n t in 1 9 9 0 . These fig u re s , in c o n ju n c tio n w it h tho se in Table 8.1, s h o w t h a t s u p e ra n n u a tio n fu n d s are p o te n tia lly th e la rg e s t in s titu t io n a l source o f e q u ity c a p ita l f o r A u s tra lia n co m p a n ie s. O verseas assets m ad e u p 19 p e r c e n t o f to t a l assets in 2 0 1 3 com p are d w ith 1 1 .4 p e r c e n t in 19 90 . S im ila rly , cash a n d d e p o s its m ade u p 1 6 .4 p e r c e n t o f t o t a l assets in 20 1 3 , co m p a re d w it h o n ly 1 0 .7 p e r c e n t in 19 90 . In c o n tra s t, th e d e b t-ty p e in v e s tm e n ts — lo a n s, p la ce m e n ts a n d s h o r t- te rm s e c u ritie s — decreased fr o m a lm o s t 15 p e r c e n t o f t o ta l assets in 1 9 9 0 to 6 .7 p e r c e n t in 2 0 1 3 , w h ile in v e s tm e n ts in lo n g -te rm g o v e rn m e n t s e c u ritie s d e c lin e d fr o m 10 .1 p e r ce n t o f assets in 1 9 9 0 to o n ly 1.7 p e r c e n t in 2 0 1 3 . W h ile d e b t-ty p e in v e s tm e n ts have d e c lin e d as a pe rce n ta g e o f fu n d assets, th e a b s o lu te size o f t h e ir asset p o o l is such t h a t s u p e ra n n u a tio n fu n d s re m a in a s ig n ific a n t source o f d e b t fin a n c e , e ith e r d ire c tly o r in d ire c tly , f o r businesses. F o r exa m ple, th e in v e s tm e n t o f $7 9 b illio n in s h o r t- te rm s e c u ritie s a t J u n e 2 0 1 3 w o u ld in c lu d e b ills o f exchange issu e d b y c o rp o ra te b o rro w e rs . A lso , th e cash a n d d e p o s its o f $ 2 2 7 b illio n h e ld in 2 0 1 3 w o u ld c o n s is t m o s tly o f d e p o s its in b a n ks, w h ic h co u ld use the se d e p o sits to fu n d lo a n s, in c lu d in g lo a n s to com p an ies. M a n a g e m e n t o f s u p e ra n n u a tio n fu n d s is a v e ry im p o r ta n t a c tiv ity o f life in s u ra n c e com p an ies: as a t J u n e 2 0 1 2 , assets h e ld in s u p e ra n n u a tio n fu n d s a cco u n te d f o r o ve r 90 p e r c e n t o f th e assets o f these c o m p a n ie s, c o m p a re d to a b o u t 65 p e r c e n t in 1 9 9 2 . D e s p ite th is h ig h p r o p o r tio n , th e re has been

TABLE 8.6 Assets held by superannuation funds outside life nsurancec:ompanies, $ million

3 0 June

L o n g -te rm

E q u itie s

C ash a n d

i Loans a n d

S h o rt-te rm

g o v e rn m e n t

a n d u n its in

Land a n d

O th e r

A ssets

d e p o s its

1 p la c e m e n ts

se cu ritie s

se c u ritie s

trusts

b u ild in g s

assets

o v e rs e a s

Total assets

1990

8629

4234

7703

8191

23 770

12668

6399

9226

80820

1995

11143

5375

8794

20632

56 715

11006

8 513

21094

143272

2000

23469

16138

19376

19877

144266

17294

21239

68065

329724

2005

57443

5 292

25134

21579

281691

32157

29159

114419

566874

2006

70102

5 756

27261

28032

352674

36602

33 499

147312

701236

2007

114270

7220

36197

29755

476461

48408

49917

184930

947 157

2008

1 1 5 561

7981

40124

27253

453015

56986

52829

179601

933 351

2009

137118

9035

46467

22819

401814

61589

53281

148678

880803

2010

13 8 2 2 0

10272

55 206

25885

463862

66687

61191

171437

992 760

2011

16 8 9 5 0

11148

50200

21254

542262

76685

64796

187637

1122934

2012

208998

11963

60872

20661

525960

86089

66136

201064

1181742

2013

227003

13 232

78924

22857

621688

96450

60984

262926

1384066

Source: Table B15, Reserve Bank of Australia website, wvsrw.rba.gov.au.

C hapter eight T he

capital market

TABLE 8.7 Assets held by life insurance companies—statutory funds, $ million L o n g -te rm 3 0 Ju n e

(

C a sh a n d

Loan s a n d

S h o rt-te rm

d e p o s its

p la c e m e n ts

se cu ritie s

E q u itie s

g o v e rn m e n t a n d u n its in ; L a n d a n d se cu ritie s

trusts

b u ild in g s

,

O th e r

A ssets

|

assets

o ve rse a s

Total assets

1990

2 680

10 701

5 347

14 265

24 415

13 397

6 217

8 401

85 422

1995

4 912

5 817

9 927

23 779

38 076

9 486

9 321

17 214

118 532

2000

7 015

8 819

14 040

24 093

78 477

7 474

17 608

32 953

190 478

2005

4 429

2 577

12 757

13 441

156 021

n.a.

n.a.

15 828

231 444

2006

4 777

4 396

11261

9 784

172 418

3105

21903

14 299

241 943

2007

5146

3 945

10 772

9 296

200 656

3 367

21 738

12 070

266 990

2008

4 643

3 975

8 771

9 405

173 943

2 710

20 814

11839

236 099

2009

7 816

3 594

10 349

7 091

149 238

1722

21 027

10 057

210 895

2010

7 261

2 337

9 821

7 066

165 534

1719

18 846

10 896

223 481

2011

8 464

2 284

6136

7 324

178 697

1829

18 765

11196

234 695

2012

11348

2 696

6 521

8 614

167 968

1871

21148

14 979

235 146

2013

12 034

1953

5 847

9 667

189 896

1520

19 303

14 986

255 206

Source: Table B1 4,

Reserve Bank of Australia website, www.rba.gov.au.

a s ig n ific a n t d e clin e in th e share o f t o ta l s u p e ra n n u a tio n assets h e ld b y life in s u ra n c e co m p a n ie s. T h e ir share o f th e t o ta l s u p e ra n n u a tio n p o o l p eaked a t 4 4 p e r c e n t in 1 9 9 2 b u t d e c lin e d to less th a n 15 p e r ce n t b y J u n e 2 0 1 2 (APR A, 2 0 1 2 a ). The assets o f life in s u ra n c e co m p a n ie s are s h o w n in Table 8.7. W h ile th e d a ta in Table 8 .7 w ill la rg e ly re fle c t th e assets h e ld in s u p e ra n n u a tio n fu n d s m a n a g e d b y life in su ra n ce com p an ies, th e re are som e n o tic e a b le d iffe re n ce s b e tw e e n th e d is tr ib u tio n s o f assets in Tables 8.6 an d 8.7. C o m p a re d w it h th e s u p e ra n n u a tio n fu n d s o u ts id e life in s u ra n c e co m p a n ie s, based on th e 2 0 1 3 fig u re s, th e life in s u ra n c e com p an ies have in v e s te d a h ig h e r p r o p o r tio n o f t h e ir assets in d o m e s tic e q u itie s a n d tr u s ts (7 4 .4 p e r c e n t versu s 4 4 .9 p e r c e n t), a lo w e r p r o p o r tio n in cash an d d e po sits (4 .7 p e r c e n t versu s 1 6 .4 p e r c e n t) a n d a lo w e r p r o p o r tio n in overseas assets (5 .9 p e r c e n t versus 19.0 p e r ce n t). Table 8 .7 sho w s t h a t life in s u ra n c e c o m p a n ie s are n o t la rg e le n d e rs to th e c o rp o ra te sector. H is to ric a lly , m o s t o f t h e ir in v e s tm e n t in d e b t to o k th e fo r m o f g o v e rn m e n t d e b t se c u ritie s . H o w eve r, h o ld in g s o f ‘o th e r assets’，w h ic h in c lu d e s d e b t s e c u ritie s issu ed b y n o n -g o v e rn m e n t b o rro w e rs , have te n d e d to increase as t h e ir h o ld in g s o f lo n g -te rm g o v e rn m e n t s e c u ritie s have de clin e d . In c o n tra s t, lik e s u p e ra n n u a tio n fu n d s o u ts id e life in s u ra n c e com p an ies, th e y are s ig n ific a n t s u p p lie rs o f e q u ity , w ith shares a n d u n its in tru s ts g e n e ra lly c o n s titu tin g b e tw e e n 70 a n d 75 p e r c e n t o f t h e ir to t a l assets a t th e end o f J u n e each ye a r fro m 2 0 0 6 to 2 0 1 3 . W h e n assessing th e asset d is tr ib u tio n s s h o w n in Tables 8 .6 a n d 8.7, tw o q u a lific a tio n s s h o u ld be n o te d . F irs t, th e in v e s tm e n t b y s u p e ra n n u a tio n fu n d s a n d life in s u ra n c e com p an ies in p r o p e r ty is c o n s id e ra b ly g re a te r th a n suggested b y th e fig u re s s h o w n f o r 4la n d a n d b u ild in g s 1. M a n y o f the se in s titu t io n s in v e s t in p ro p e rty b y p u rc h a s in g u n its in re a l esta te in v e s tm e n t tru s ts (R E IT s)15 m a in ly because th e y p re fe r th e liq u id ity t h a t these tru s ts p ro v id e , p a r tic u la r ly i f th e t r u s t is lis te d o n a s to c k exchange. These in v e s tm e n ts are in c lu d e d in th e fig u re s f o r ‘E q u itie s a n d u n its in tr u s t s ’. Second, th e ‘s to c k ，fig u re s s h o w n in these ta b le s do n o t n e ce ssa rily p ro v id e an accu rate in d ic a tio n o f th e w a y in w h ic h

new m o n e y

flo w in g

in to s u p e ra n n u a tio n is in ve ste d . F o r exa m ple, as n o te d above, th e ta b le s s h o w t h a t e q u itie s a n d u n its

15 Real estate investment trusts (REITs) were traditionally referred to as property trusts, which could be listed or unlisted. The term REIT was adopted in Australia in 2008. Where such trusts are listed on the ASX, they are referred to as A-REITs.

in tru s ts m a ke u p a la rg e a n d ty p ic a lly g ro w in g p r o p o r tio n o f th e assets o f s u p e ra n n u a tio n fu n d s and life in s u ra n c e co m p a n ie s. In th e case o f s u p e ra n n u a tio n fu n d s o u ts id e life in s u ra n c e com p an ies, th is asset class in cre a se d fr o m less th a n 30 p e r c e n t o f to t a l assets in 1 9 9 0 to ju s t o v e r 5 0 p e r c e n t o f to ta l assets in 2 0 0 7 a n d has since s ta b ilis e d a t a b o u t 4 5 p e r ce n t. Thus, i t m ig h t seem t h a t th e p r o p o r tio n o f s u p e ra n n u a tio n c o n trib u tio n s d ire c te d in to d o m e s tic e q u itie s pe ake d a ro u n d 2 0 0 6 -0 7 a n d th e n declin ed . H o w eve r, th e values o f th e v a rio u s assets h e ld a t a n y tim e w ill re fle c t p a s t re tu rn s as w e ll as th e p a tte r n o f n e w in v e s tm e n t. The r e tu rn s o n A u s tra lia n shares w e re u n u s u a lly h ig h fr o m 2 0 0 2 to 2 0 0 7 b u t n e g a tiv e in 2 0 0 8 a n d 20 0 9 . S pe cifica lly, th e S & P /A S X A ll O rd in a rie s share p ric e in d e x , w h ic h w as 3 1 6 3 .2 a t th e e n d o f J u n e 2 0 0 2 , a lm o s t d o u b le d to reach 6 3 1 0 .6 a t th e e n d o f J u n e 2 0 0 7 a n d th e n fe ll to 3 9 4 7 .8 a t th e e n d o f J u n e 2 0 0 9 . T h e re fo re , o v e r th e 2 0 0 2 to 2 0 0 9 p e rio d , a ty p ic a l fu n d c o u ld e x h ib it an in crea se in th e value o f e q u itie s as a pe rce n ta g e o f it s to t a l assets u p to 2 0 0 7 , fo llo w e d b y a d e clin e , even i f th e p r o p o r tio n o f n e w c o n trib u tio n s in v e s te d in each asset class re m a in e d c o n s ta n t o v e r tim e . The reverse can also occur: fr o m J u n e 2 0 0 9 to J u n e 2 0 1 3 , th e S & P /A S X A ll O rd in a rie s share p ric e in d e x rose b y 21 p e r c e n t b u t o ve r th e sam e p e rio d th e share o f t o t a l assets h e ld as e q u itie s a n d u n its in tru s ts fe ll m a rg in a lly fr o m 4 5 .6 to 4 4 .9 p e r c e n t.

U n it tr u s ts are a c o m m o n f o r m o f c o lle c tiv e in v e s tm e n t in w h ic h th e fu n d s o f in v e s to rs are p o o le d a n d in v e s te d b y a p ro fe s s io n a l m a n a g e m e n t co m p a n y in a w id e ran ge o f in v e s tm e n ts , u s u a lly o f a specific asset ty p e . F o r e xa m p le , th e re are R EITs, A u s tra lia n e q u ity tr u s ts a n d in te r n a tio n a l e q u ity tru s ts . These a n d a v a r ie ty o f o th e r p o o le d in v e s tm e n ts are cla ssifie d as ‘m a n a g e d in v e s tm e n t sche m es’. The re g u la to ry re g im e f o r the se in v e s tm e n ts is set o u t in th e

Managed Investments Act 1998.

I t spe cifie s t h a t m an ag ed

in v e s tm e n t schem es are to be o p e ra te d b y a sin g le R esponsible e n tity *, w h ic h m u s t be an A u s tra lia n p u b lic c o m p a n y h o ld in g an a p p ro p ria te A u s tra lia n F in a n c ia l Services Licence. M o s t o f th e se re sp o n sib le e n titie s are su b s id ia rie s o f b a n ks, in v e s tm e n t b a n k s o r in s u ra n c e co m p a n ie s. In v e s to rs place t h e ir m o n e y in p o o le d in v e s tm e n ts to o b ta in a spre ad o f r is k a n d to o b ta in re tu rn s fr o m assets t h a t are to o exp en sive f o r in d iv id u a ls to p u rcha se d ire c tly . F o r som e in v e s to rs , tr u s ts m a y also be a ttra c tiv e f o r ta x reasons. In ge n e ra l, a t r u s t is n o t ta xe d p ro v id e d t h a t i t d is trib u te s a ll o f its in c o m e to in v e s to rs . Each in v e s to r is th e n ta x e d o n th e in c o m e th e y re ce ive d fr o m th e t r u s t . 16 T h ere fore, t r u s t in c o m e is a lm o s t in v a ria b ly d is tr ib u te d in f u ll w hereas a co m p a n y can r e ta in a ll o r p a r t o f its p r o f it to fin a n c e exp a n sio n . M a n y tr u s ts are o p e n -e n d fu n d s , w h ic h m ea ns t h a t n e w u n its m a y be cre a te d c o n tin u a lly as in v e s to rs c o n trib u te a d d itio n a l cash. These tru s ts are u n lis te d a n d in v e s to rs p u rch a se a n d re d e e m u n its a t values, c a lc u la te d d a ily b y th e fu n d m an ag er, based o n th e v a lu e o f th e assets h e ld b y th e t r u s t . The t r u s t m a y b u y a d d itio n a l assets a t a n y tim e a n d m a y ne ed to se ll assets a t tim e s in o rd e r to m e e t re d e m p tio n req ue sts fr o m e x is tin g in v e s to rs . In J u n e 2 0 1 3 , p u b lic u n it tr u s t s 17 in A u s tra lia h a d t o ta l assets o f $ 2 3 8 b illio n a n d a f u r t h e r $2 5 b illio n w as h e ld b y cash m a n a g e m e n t tr u s ts (R eserve B a n k o f A u s tra lia , Table B l,

www.

rba.gov.au). A w id e ran ge o f lis te d m a n a g e d in v e s tm e n ts (L M Is ) is also ava ila ble. A t th e e n d o f J u n e 2 0 1 3 , 2 0 4 m an ag ed in v e s tm e n ts w e re lis te d o n th e A S X a n d th e m a rk e t c a p ita lis a tio n o f the se e n titie s to ta lle d $ 1 63 b illio n . Based o n m a rk e t c a p ita lis a tio n a t t h a t tim e , th e la rg e s t c a te g o ry o f L M Is is re a l esta te in v e s tm e n t tru s ts ($ 9 5 b illio n ) , fo llo w e d b y in fr a s tr u c tu r e fu n d s ($ 4 0 b illio n ) a n d lis te d in v e s tm e n t com p an ies a n d tru s ts ($ 2 0 b illio n ) (A u s tra lia n S e cu ritie s E xchange,

w w w .asx.com .au/products/m anaged-funds/

m arket-update.htm .) REITs a llo w in v e s to rs to acq uire an in te re s t in a p ro fe s s io n a lly m a n a g e d p o r tf o lio o f re a l estate. Some R EITs in v e s t o n ly in a p a r tic u la r ty p e o f re a l esta te such as in d u s tr ia l (w a reho use s a n d fa c to rie s ), offices, h o te ls o r re ta il (s h o p p in g ce n tre s, m a lls a n d cin e m a s). O th e rs are m o re d iv e rs ifie d a n d in v e s t in tw o o r m o re o f th e se ty p e s o f re a l estate. There are also in te r n a tio n a l R EITs, w h ic h are lis te d o n th e A S X b u t in v e s t in sp e cific o ffs h o re m a rk e ts such as th e US, E u ro p e o r Japan.

16 In many cases, the distributions from REITs are partly tax deferred, which means that investors do not pay tax on the taxdeferred component of the distribution until their holding in the trust is sold. 17 Public unit trusts are investment funds, excluding property and trading trusts, that are open to the Australian public.

C hapter eight T he

capital market

A R E IT lis te d o n th e A S X w i ll have one o f tw o s tru c tu re s : •

a s ta n d -a lo n e t r u s t t h a t p ro v id e s in v e s to rs w it h e xp o su re o n ly to an u n d e rly in g p o r tf o lio o f real estate assets; o r

•

a g ro u p c o n s is tin g o f a co m p a n y a n d one o r m o re re la te d tru s ts . P a rtly because o f it s ta x a tio n tre a tm e n t, a s ta n d -a lo n e t r u s t is s u ita b le f o r h o ld in g a n d m a n a g in g a

p o r tfo lio o f assets t h a t p ro d u ce passive r e n ta l in c o m e f o r d is tr ib u tio n to in v e s to rs . P ro p e rty d e v e lo p m e n t a n d /o r m a n a g e m e n t are u s u a lly b e tte r u n d e rta k e n b y a c o rp o ra te s tru c tu re r a th e r th a n a tr u s t. In a g ro u p s tru c tu re , in c o m e -p ro d u c in g p ro p e rtie s w ill be h e ld b y th e tru s t(s ) w h ile an a sso cia te d c o m p a n y w i ll c a rry o u t p ro p e rty d e v e lo p m e n t a n d /o r m a n a g e m e n t. The g ro u p w ill issue s t a p le d s e c u r it ie s c o m p ris in g a

STAPLED SECURITIES

share in th e c o m p a n y p lu s a u n it in each o f th e tru s ts . The te r m s ta p le d ' re fe rs to th e re q u ire m e n t t h a t

two or more legally separate instruments, typically an ordinary share plus units in one or more related trusts, which cannot be traded separately

th e tw o se c u ritie s m u s t be tra d e d to g e th e r as i f th e y w e re a s in g le s e cu rity. In fra s tru c tu re fu n d s in v e s t in assets in v o lv e d in th e s u p p ly o f e s s e n tia l goods a n d services such as p o r t fa c ilitie s , ra ilw a ys, t o ll roa ds, a irp o rts , c o m m u n ic a tio n fa c ilitie s , p o w e r lin e s a n d o il/g a s p ip e lin e s . Some in fra s tru c tu re fu n d s in v o lv e a c o m p a n y /tru s t g ro u p th a t issues s ta p le d se c u ritie s . L ike REITs, in fra s tru c tu re fu n d s g e n e ra lly receive a stab le in c o m e s tre a m a n d p a y re g u la r d is tr ib u tio n s to in v e s to rs . In v e s to rs can also choose t o in v e s t b y b u y in g shares in a lis te d in v e s tm e n t co m p a n y (L IC ). T yp ica lly, an LIC w ill in v e s t in a d iv e rs ifie d p o r tf o lio o f in v e s tm e n ts , o fte n c o n s is tin g o f th e shares o f a w id e range o f o th e r com p an ies t h a t are also lis te d o n th e ASX. In v e s to rs th e re fo re achieve a d iv e rs ifie d p o r tf o lio w ith o u t th e need to p e rs o n a lly select, b u y a n d m anage a la rg e n u m b e r o f in v e s tm e n ts . Som e LICs specialise in p a rtic u la r typ e s o f assets such as in te r n a tio n a l shares, s m a ll co m p a n ie s o r g o ld co m p a n ie s, o r th e y m a y focus on p a r tic u la r g e o g ra p h ic a l re g io n s such as E u ro p e o r A sia . In c o n tra s t to u n lis te d m an ag ed in v e s tm e n ts , LICs are e s s e n tia lly clo sed -end , m e a n in g t h a t th e co m p a n y does n o t c o n tin u a lly issue n e w shares o r cancel shares as s h a re h o ld e rs jo in a n d leave th e com pany. R a th e r, th e co m p a n y s shares are tra d e d o n th e A S X in th e sam e w a y as o th e r lis te d shares, a n d th e size a n d t im in g o f a n y share issues o r repurchases w ill be d e te rm in e d b y th e c o m p a n y s m anagers. The m a rk e t p ric e o f th e shares is d e te rm in e d b y m a rk e t forces. The share p ric e w ill o fte n be s im ila r to th e m a rk e t va lu e o f th e L IC s assets b u t can be a t a p re m iu m or, m o re o fte n , a t a d is c o u n t to th e n e t asset value. The fa c t t h a t som e m a n a g e d in v e s tm e n ts are s tru c tu re d as a t r u s t w h ile o th e rs use a c o m p a n y s tru c tu re creates im p o r t a n t ta x a tio n d iffe re n ce s. F o r exa m ple, i f a t r u s t m akes a p r o fit, th e e n tire p r o fit w ill be passed o n to in v e s to rs as a d is tr ib u tio n a n d each in v e s to r w ill be ta x e d a t t h e ir in d iv id u a l rate. I f a lis te d in v e s tm e n t co m p a n y m ake s th e sam e p r o fit, i t w ill p a y ta x a t th e co m p a n y ta x ra te o n t h a t p r o fit. The a fte r-ta x p r o f it can th e n be d is tr ib u te d to sh a re h o ld e rs as a fra n k e d d iv id e n d .18

The A u s tra lia n c a p ita l m a rk e t is p a r t o f th e g lo b a l c a p ita l m a rk e t a n d f o r m a n y years th e re has b e en a sizeable flo w o f fu n d s fro m overseas f o r in v e s tm e n t in A u s tra lia n com p an ies. These flo w s have c o m p ris e d b o th e q u ity a n d d e b t, in c lu d in g e q u ity fu n d in g o f n e w v e n tu re s a n d f o r p o r tf o lio in v e s tm e n t. Some A u s tra lia n com p an ies, p a r tic u la r ly v e ry la rge ones, b o rro w d ire c tly fr o m overseas, a n d b a n ks a n d o th e r in te rm e d ia rie s have been v e ry a ctive in o b ta in in g fu n d s f r o m overseas. Because A u s tra lia n b a n ks ty p ic a lly have h ig h c re d it ra tin g s , th e y are b e tte r p lace d to b o rro w overseas th a n m a n y com p an ies. The fu n d s b o rro w e d b y th e in te r m e d ia ry are th e n le n t to c u sto m e rs. W h ile sizeable fu n d s have flo w e d fr o m overseas f o r in v e s tm e n t in A u s tra lia n co m p a n ie s, A u s tra lia has also been a s ig n ific a n t source o f fu n d s f o r in v e s tm e n t in fo re ig n com p an ies. F o r exa m p le , as s h o w n in Table 8.6, A u s tra lia n s u p e ra n n u a tio n fu n d s have la rg e in v e s tm e n ts in overseas assets a n d the se in v e s tm e n ts have a t tim e s exceeded 20 p e r c e n t o f th e fun ds* assets. The in flo w to , a n d o u tflo w o f c a p ita l fro m , A u s tra lia is c o n s is te n t w it h in v e s to rs re c o g n is in g th e advantages o f d iv e rs ific a tio n , in c lu d in g th e o p p o r tu n ity to in v e s t in in d u s trie s t h a t m a y n o t be p re s e n t in t h e ir d o m e s tic eco no m ies.

18 Franked dividends are discussed in detail in Section 11.4.1.

SUMMARY •

A t a n y g iv e n tim e , s o m e e n titie s w ill h a v e su rp lu s

b y c o m p a n ie s to ra is e e q u ity a n d lo n g -te rm d e b t is

fu n d s (the 's u rp lu s u n its '), w h ile o th e rs w ill b e s e e k in g

c o n s id e re d in m o re d e ta il in C h a p te rs 9 a n d 1 0 .

fu n d s (the 'd e f ic it u n its '). A m a jo r ro le o f th e c a p it a l m a rk e t is to tra n s fe r fu n d s fro m th e s u rp lu s u n its to •

•

S e v e ra l

ty p e s

of

f in a n c ia l

in s titu tio n s

fo rm

an

im p o r ta n t p a r t o f th e c a p it a l m a rk e t. T h e se in c lu d e

th e d e fic it un its.

in s titu tio n s th a t o p e r a te a s a g e n ts (such a s b ro k e rs ),

The A u s tra lia n c a p ita l m a rk e t is la rg e , a c tiv e a n d w e ll

f in a n c ia l in te r m e d ia r ie s (such as b a n k s ) a n d in v e s to rs

re g u la te d a n d o ffe rs a w id e ra n g e o f o p tio n s fo r surp lu s

(such a s in s u ra n c e c o m p a n ie s a n d s u p e ra n n u a tio n

un its a n d d e fic it units. The use o f th e c a p ita l m a rk e t

fu n d s ).

KEY TERMS a u th o ris e d d e p o s i 卜 ta k in g in s titu tio n c a p ita l m a rk e t c e n tra l b a n k d e fa u lt ris k

214

211

in v e s tin g in s titu tio n

213

p r im a r y m a rk e t

e x c h a n g e -tra d e d m a rk e t

212

fin a n c ia l a g e n c y in s titu tio n

214

211

212

212

s e c o n d a ry m a rk e t s e c u ritis a tio n

211

214

o v e r-th e -c o u n te r m a rk e t

22 1

fin a n c ia l assets

fin a n c ia l in te r m e d ia r y

212

223

s ta p le d s e cu ritie s

229

QUESTIONS 1

[L O 1

D is tin g u is h b e tw e e n d ir e c t f in a n c e a n d in te r m e d ia te d fin a n c e . D iscu ss w h y s o m e b o r r o w e r s m ig h t

p re fe r d ir e c t fin a n c e , w h ile o th e rs m ig h t p r e fe r in te r m e d ia te d fin a n c e . 2

[LO 1] W h y is th e e x is te n c e o f a s e c o n d a r y m a rk e t e x p e c te d to in c re a s e th e d e m a n d f o r s e c u ritie s is s u e d in th e c o r r e s p o n d in g p r im a r y m a rk e t?

3 4

[ L O l ] W h a t a r e th e m a in d iffe re n c e s b e tw e e n a n e x c h a n g e -tr a d e d m a rk e t a n d a n o v e r-th e -c o u n te r m a rk e t? [L O 2 ]

D is tin g u is h b e tw e e n f in a n c ia l a g e n c y in s titu tio n s , f in a n c ia l in te r m e d ia r ie s a n d in v e s tin g in s titu tio n s .

W h y is th e re s u ch a r a n g e o f in s titu tio n s in th e c a p it a l m a rk e t? 5

6

[L O 3 ] D iscu ss th e re la tiv e im p o r ta n c e o f th e f o llo w in g in s titu tio n s a s p r o v id e r s o f c o m p a n y fin a n c e : a)

s to c k b ro k e rs

b)

in v e s tm e n t b a n k s

c)

banks

d)

fin a n c e c o m p a n ie s

e)

s u p e ra n n u a tio n fu n d s .

[L O 3 ] O u tlin e th e s e rv ic e s p r o v id e d b y fin a n c ia l in s titu tio n s , su ch a s s to c k b ro k e rs a n d in v e s tm e n t b a n k s , to c o m p a n ie s w is h in g to ra is e fu n d s d ir e c t fro m th e c a p it a l m a rk e t.

7

[L O 3 ] W h a t d is tin c tio n s c a n b e m a d e b e tw e e n th e a c tiv itie s o f la r g e A u s tr a lia n b a n k s a n d in v e s tm e n t banks?

8

[L O 3 ] In v e s tm e n t b a n k s c a n fa c e in h e re n t c o n flic ts o f in te re s t. E x p la in h o w th e se c o n flic ts o f in te re s t u s u a lly a ris e . H o w c a n th e y b e m a n a g e d ?

9

[L O 3 ] D u rin g th e g lo b a l f in a n c ia l c ris is , a t le a s t o n e A u s tr a lia n - b a s e d in v e s tm e n t b a n k c o lla p s e d , w h ile o th e rs , in c lu d in g th e s u b s id ia r ie s o f US a n d E u ro p e a n firm s , c o n tin u e d to o p e r a te b u t o n a s o m e w h a t s m a lle r s c a le . O u tlin e th e m a in d iffe re n c e s th a t c o n trib u te d to th e se v e r y d iffe r e n t o u tc o m e s .

10

[L O 4 ] W h a t s e rv ic e s d o b a n k s o ffe r to d e p o s ito rs ?

11

[ L 0 4 ] W h a t s e rv ic e s d o b a n k s o ffe r to c o r p o r a te c lie n ts ?

C hapter eight T he

[LO 4

】W h a t

a re th e m a in r e g u la to r y d iffe re n c e s b e tw e e n a fo r e ig n b a n k s u b s id ia r y o p e r a tin g in A u s tr a lia

a n d a fo r e ig n b a n k b r a n c h o p e r a tin g in A u s tr a lia ? W h a t a r e th e m a in im p lic a tio n s o f th e se d iffe re n c e s ? 13

[LO 5 】The m a jo r b a n k s in A u s tr a lia s e c u ritis e o n ly a s m a ll p r o p o r tio n o f th e ir m o r tg a g e lo a n s , r e g io n a l b a n k s m a k e g r e a te r use o f th is te c h n iq u e a n d s p e c ia lis t m o r tg a g e o r ig in a t o r s s e c u ritis e m o s t o f th e ir lo a n s . E x p la in w h y th e se d iffe re n c e s e x is t.

14

[LO 6 ] E x p la in p o s s ib le re a s o n s f o r th e r a p id in c re a s e in th e n u m b e r o f s u p e r a n n u a tio n fu n d s in e x is te n c e as w e ll a s th e to ta l assets h e ld b y th o s e fu n d s .

15

[LO 6 ] Institutional investors have a lw ays been m a jo r suppliers o f co m p a n y finance. D iscu ss th is s ta te m e n t a n d e x p la in h o w th is f lo w o f fu n d s o c c u rs .

REFERENCES Australian Bureau of Statistics, Lending Finance, Australia, cat. no. 5 6 7 1 .0 , Table 3. Australian Prudential Regulation Authority, Annual Superannuation Bulletin, wvy^v.apra.gov.au, Commonwealth of Australia, ACT, June 2 0 0 6 , June 2 0 0 9 and June 2 0 1 3 a .

September 2 0 0 8 . Available at w w w .blo om b erg.co m /a pps/ news?pid=2107 00 01 & sid=axaX5i4871 UO, 22 September 20 08 .

-------; li f e insurance industry overview 7, A PRA Insight, Issue 3, 20 12 a, pp. 1 8 -3 9 , w w w .apra.gov.au.

Investing in Australian Real Estate: A Guide for Global Investors, King & W ood Mallesons, 2 0 1 3 . Available at www.mallesons.com/Documents/Real_Estate_Real_ 0pportunities% 20_0ct% 201 1_hyperlinks.pdf.

-------; Regulation Impact Statement: Implementing Basel III Capital Reforms in Australia, September 2 0 1 2 b , w w w .a p ra . gov.au.

O verland , 丄 & Li, K., 'Room for improvement: Insider trading and Chinese w alls', Australian Business Law Review, 2 0 1 2 , pp. 2 2 3 -4 0 .

-------, Discussion Paper: Implementing Basel III Liquidity Reforms in Australia, M a y 2 0 1 3 b , w w w .apra.gov.au.

Reserve Bank of Australia, 'Asset securitisation in Australia', Financial Stability Review, September 2 0 0 4 , pp. 4 8 -5 6 .

-------, Monthly Banking Statistics, O ctober 2 0 1 3c.

Schwartz, C., 'The Australian Government Guarantee Schemed Reserve Bank of Australia, Bulletin, M arch 2 0 1 0 , pp. 1 9 -2 6 .

Carew, E.; Fast M o n e y 4, Allen & Unwin, Sydney, 1998. Debelle, G ., 'W hither securitisation?/, Reserve Bank of Australia, Bulletin, December 2 0 0 9 , pp. 4 3 -5 3 . Gup, B.E., The N e w Basel Capital Accord, Texere, N ew York, 20 04 .

C H A P T E R EIGHT R E V I E W

12

capital market

Viney, C. & Phillips, P., Financial Institutions, Instruments and Markets, 7th edn, M cG raw-H ill, Sydney, 20 12 .

Harper C. & Torres C., 'G oldm an, M organ Stanley bring down curtain on an era' (Update 5), Bloomberg, 22

231

CHAPTER CONTENTS I n t r o d u c t io n T h e c h a r a c t e r is tic s o f o r d in a r y s h a re s ^ 0

P riv a te e q u it y

I^ Q

I n f o r m a tio n d is c lo s u r e

m

F lo a tin g a p u b lic c o m p a n y

g g■ g

m

S u b s e q u e n t is s u e s o f o r d in a r y s h a re s

252

E m p lo y e e s h a r e p la n s

265

In te r n a l fu n d s

266

M a n a g in g a c o m p a n y ’s e q u it y s tru c tu r e

268

LEARNING OBJECTIVES m A f te r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

o u t lin e th e c h a r a c t e r is tic s o f o r d in a r y s h a re s

2

e x p la in th e a d v a n t a g e s a n d d is a d v a n t a g e s o f e q u it y a s a s o u r c e o f f in a n c e

3

o u t lin e th e m a in s o u rc e s o f p r iv a t e e q u it y in th e A u s t r a lia n m a r k e t

4

id e n t it y th e in f o r m a t io n t h a t m u s t b e d is c lo s e d w h e n is s u in g s e c u r itie s

5

o u t lin e th e p ro c e s s o f f lo a t in g a p u b lic c o m p a n y

6

d is c u s s a lte r n a tiv e e x p la n a t io n s f o r th e u n d e r p r ic in g o f in it ia l p u b lic o f f e r in g s

7

o u t lin e e v id e n c e o n th e lo n g - te r m p e r f o r m a n c e o f c o m p a n ie s t h a t a r e f lo a t e d

8

e x p la in h o w c o m p a n ie s r a is e c a p it a l t h r o u g h r ig h ts is s u e s , p la c e m e n ts , s h a r e p u r c h a s e p la n s a n d s h a r e o p t io n s

9

o u t lin e th e d if f e r e n t ty p e s o f e m p lo y e e s h a r e p la n s

10

o u t lin e th e a d v a n t a g e s o f in te r n a l f u n d s a s a s o u r c e o f f in a n c e

11

o u t lin e th e e ffe c ts o f b o n u s is s u e s , s h a r e s p lits a n d s h a r e c o n s o lid a t io n s .

C hapter n in e S ources

of f in a n c e : equity

In th is c h a p te r a n d in C h a p te r 10, w e discuss m e th o d s b y w h ic h a c o m p a n y m a y fin a n c e its assets. In th is c h a p te r we discuss e q u ity , C h a p te r 10 covers d e b t, a n d le a s in g is co n sid e re d in C h a p te r 15. In th is cha pter, several w ays o f ra is in g e q u ity are co n sid e re d . The m a jo r ity o f e q u ity in A u s tra lia is raised b y p u b lic co m p a n ie s a n d u n it tru s ts w it h shares, u n its a n d

stapled secu rities

lis te d o n a s to c k

exchange. I m p o r ta n t sources o f e q u ity f o r lis te d co m p a n ie s in c lu d e in it ia l p u b lic o ffe rin g s (IP O s) o f

primary raising, V ig hts* issues, share pu rcha se o f w h ic h is a secondary raising o f c a p ita l. O th e r,

shares, w h ic h is an e xa m ple o f a

p la n s, p la ce m e n ts a n d

re in v e s tm e n t o f d iv id e n d s , each

less s ig n ific a n t sources

o f e q u ity in c lu d e share issues to em ployees, calls o n c o n tr ib u tin g shares a n d exercise o f c o m p a n y-issu e d o p tio n s . In a d d itio n , th e use o f in te r n a l fu n d s as a source o f fin a n c e is discussed. E q u ity ra ise d b y is s u in g o rd in a ry shares is an im p o r t a n t source o f fin a n c e f o r A u s tra lia n co m p a n ie s. The im p o rta n c e o f e q u ity is illu s tra te d b y th e fa c t t h a t a t th e en d o f D e ce m b e r 2 0 1 3 , th e va lu e o f shares a n d o th e r e q u itie s lis te d on th e A u s tra lia n S e cu ritie s E xchange (ASX) was $ 1 5 2 7 b illio n . 1 As s h o w n in Table 9.1 , e q u ity c a p ita l o f a p p ro x im a te ly $ 3 1 5 b illio n was ra ise d th ro u g h th e issue o f shares a n d o th e r s e c u ritie s b y lis te d e n titie s ove r th e 5 -ye a r p e rio d e n d in g 30 J u n e 20 13 .

TABLE 9.1 Listings and equity raisings by ASX-listed entities, financial year ended 30 June ($ billion) 2010

2011

2012

2013

1.9

11.4

35.6

10.2

9.9

Rights issues

28.5

23.2

7.4

8.1

4.0

Placements and share

42.0

28.6

10.1

12.8

19.2

15.0

10.2

7.8

9.3

6.9

2.1

2.4

2.1

2.4

2.3

0.5

0.7

0.2

0.1

0.1

90.0

76.5

63.2

42.9

42.4

【Type o f c a p ita l ra is in g

2009

Primary raisings IPOs

Secondary raisings

purchase plans R einvestm ent o f dividends Company-issued o p tio n s and employee share schemes O thers

Total capital

Source: Australian Financial Markets Association, 2 0 1 3 Australian Financial Markets Report, February 2014, p. 55.

A m u ch s m a lle r b u t s t ill im p o r t a n t m a rk e t is th e p riv a te e q u ity m a rk e t, w h e re fin a n c e is ra ise d b y is s u in g s e c u ritie s t h a t are n o t p u b lic ly tra d e d . P riv a te e q u ity in c lu d e s v e n tu re c a p ita l, w h ic h re fe rs to th e fin a n c in g o f n e w v e n tu re s o r s ta rt-u p * com p an ies. B efo re d is c u s s in g th e ways in w h ic h co m p a n ie s raise e q u ity, we o u tlin e th e fe a tu re s o f th e m a in ty p e o f e q u ity s e c u ritie s th e y issu e— t h a t is, o rd in a ry shares. P reference shares, w h ic h are le g a lly e q u ity b u t also have som e o f th e c h a ra c te ris tic s o f d e b t, are discussed in C h a p te r 10.

1

Australian Securities Exchange Limited, www.asx.com.au/about/historical-market-statistics.htm#End_of_month_values. The figure quoted does not include the value of overseas-based equities listed on the ASX. There are also many private and unlisted companies, most of which are much smaller than listed companies.

STAPLED SECURITIES

two or more legally separate instruments, typically an ordinary share plus units in one or more related trusts, which cannot be traded separately

B usiness finance

9.2

The characteristics of o rd in a ry shares

E q u ity is th e m o s t fu n d a m e n ta l f o r m o f c o rp o ra te fin a n c e because e v e ry co m p a n y m u s t raise som e e q u ity

LEARNING OBJECTIVE 1 Outline the characteristics of ordinary shares ORDINARY SHARES

securities that represent an ownership interest in a company and provide the owner with voting rights. Holders of ordinary shares have a residual interest in the net assets of the issuing company and are therefore exposed to greater risk than other classes of investors RESIDUAL CLAIM

b y is s u in g

ordinary sh ares.

A n o rd in a ry share gives th e h o ld e r o w n e rs h ip o f a p r o p o r tio n o f th e e q u ity

o f th e com p an y. I f a co m p a n y has 10 0 0 0 0 issu ed shares a n d an in v e s to r h o ld s 1 0 0 0 shares, th e in v e s to r has an o w n e rs h ip in te re s t in 1 p e r c e n t o f th e n e t assets o f th e com pany. T h is does n o t m ea n t h a t th e in v e s to r can exercise o w n e rs h ip rig h ts w it h re sp e ct to sp e cific assets o f th e com p an y. H o w eve r, w h e n d iv id e n d s are p a id , o r i f th e co m p a n y is ta k e n o v e r b y a n o th e r com pany, o r is p lace d in t o liq u id a tio n , th e in v e s to r has th e r ig h t to receive 1 p e r c e n t o f th e p a y m e n ts m ad e to o rd in a ry s h a re h o ld e rs. P e rio d ica lly, a co m p a n y s d ire c to rs m a y decide to p a y d iv id e n d s to s h a re h o ld e rs an d, as discussed in S e c tio n 4 .3 , th e va lu e o f an o rd in a ry share can be v ie w e d as th e p re s e n t va lu e o f exp ected f u tu r e d iv id e n d s . The in te re s t h e ld b y s h a re h o ld e rs is a residual

claim

in th e sense t h a t s h a re h o ld e rs w ill receive d iv id e n d s

o n ly a fte r a co m p a n y has m e t its o b lig a tio n s to a ll o th e r c la im a n ts such as su p p lie rs , em ployees, le n d e rs a n d g o v e rn m e n ts . S im ila rly , i f a c o m p a n y is placed in to liq u id a tio n , o rd in a ry s h a re h o ld e rs have a re s id u a l c la im o n th e proceeds fr o m th e sale o f th e co m p a n y s assets. Because s h a re h o ld e rs are p a id la s t, th e y face g re a te r r is k th a n o th e r in v e s to rs in a com pany. To com p en sate f o r th is ris k , in v e s to rs in o rd in a ry shares exp ect a ra te o f r e tu r n t h a t is g re a te r th a n th e y c o u ld o b ta in b y le n d in g to th e com pany.

9.2.1 | Fully paid and partly paid shares W h e n n e w shares are cre a te d a n d issu ed th e y w ill have a s ta te d issue p rice . T his p ric e m a y be payable in

claim to profit or assets that remain after the entitlements of all other interested parties have been met

has been p a id , shares are re fe rre d to as p a r tly p a id shares o r c o n trib u tin g shares. O nce th e t o ta l issue

CALL

p ric e has been p a id th e shares are f u lly p a id a n d th e h o ld e r c a n n o t be re q u ire d to c o n trib u te a n y m o re

notice given by a company that the holders of partly paid shares must make an additional contribution of equity

LIMITED LIABILITY

legal concept that protects shareholders whose liability to meet a company’s debts is limited to any amount unpaid on the shares they hold

f u ll a t th e tim e th e shares are issu e d o r p a r t o f th e issue p ric e m a y be payable in it ia lly w it h th e balance to be p a id in s u b se q u e n t in s ta lm e n ts , g e n e ra lly k n o v rn as calls. The a m o u n t a n d t im in g o f each

call

m a y be

sp e cifie d in it ia lly o r th e c o m p a n y s d ire c to rs m a y d e te rm in e th e m la te r. W h e re o n ly p a r t o f th e issue p rice

fu n d s to th e com pany, a lth o u g h th e y m a y be g iv e n th e o p p o r tu n it y to do so. A v e ry s im ila r s e c u rity th a t has b e e n issu e d to in v e s to rs is ca lle d an in s ta lm e n t re c e ip t. C o n tr ib u tin g shares a n d in s ta lm e n t re ce ip ts are discussed in d e ta il in S e ctio n 9.6 .3 .

9 .2 .2 ! Limited liability W h ile s h a re h o ld e rs face g re a te r r is k th a n le n d e rs, t h e ir r is k is lim it e d in t h a t th e y e n jo y lim ited

liability.

This m ea ns t h a t a s h a re h o ld e r is n o t p e rs o n a lly lia b le f o r th e co m p a n y s de bts. In th e case o f a co m p a n y lim ite d b y shares, th e lia b ilit y o f sh a re h o ld e rs is lim it e d to a n y a m o u n t u n p a id o n th e shares h e ld .2 F or exa m ple, i f an in v e s to r purchases shares w it h an issue p ric e o f $ 2 .5 0 p e r share, t h a t are p a r tly p a id to $1 .7 5 , th e in v e s to rs lia b ilit y f o r fu tu r e p a y m e n ts is lim it e d to 75 cen ts p e r share. C o n se q u e n tly, i f th e c o m p a n y is placed in to liq u id a tio n a n d has in s u ffic ie n t cash to p a y its c re d ito rs , h o ld e rs o f its p a r tly p a id shares can be re q u ire d to c o n trib u te u p to 75 cen ts p e r share to w a rd s th e p a y m e n t o f c re d ito rs . H o ld e rs o f f u lly p a id shares w o u ld n o t be re q u ire d to m ake a n y c o n tr ib u tio n to w a rd s th e p a y m e n t o f c re d ito rs , so th e m a x im u m a m o u n t th e y can lose is th e a m o u n t a lre a d y p a id to p u rch a se th e shares.

9 .2 .3 | No liability companies The m a jo r ity o f com p an ies lis te d o n th e A S X are lim it e d lia b ilit y com p an ies, b u t th e re are also m a n y m in in g co m p a n ie s th a t are re g is te re d as n o lia b ilit y co m p a n ie s. Such com p an ies m u s t in c lu d e th e w o rd s *No L ia b ility * o r th e a b b re v ia tio n

lNV a t

th e e n d o f th e co m p a n y s na m e. These c o m p a n ie s ty p ic a lly have

p a r tly p a id shares on issue a n d can raise c a p ita l in stages b y c a llin g u p p a r t o f th e u n p a id c a p ita l. N o lia b ilit y co m p a n ie s have tw o m a in fe a tu re s t h a t d is tin g u is h th e m fr o m o th e r ty p e s o f com p an ies. O ne is t h a t th e y are re s tric te d to o p e ra tin g o n ly in th e m in in g in d u s try . The second fe a tu re is t h a t i f th e c o m p a n y fa ils , sh a re h o ld e rs have n o lia b ilit y f o r th e co m p a n y s de bts. A c c o rd in g ly , h o ld e rs o f p a r tly *5 6 1 2

The advantages and disadvantages of limited liability are discussed in Lipton, Herzberg & Welsh (2010, p. 24). See also section 516 of the C o rp o ratio n s A c t 2 0 0 1 .

C hapter n in e S ources

of fin a n c e : equity

p a id shares issued b y a n o lia b ilit y c o m p a n y are n o t o b lig e d to p a y calls m ad e b y th e com pany. H o w eve r, sha reh old ers w h o fa il to pay a ca ll f o r f e it t h e ir shares. N o lia b ilit y co m p a n ie s are ty p ic a lly in v o lv e d in m in e ra l o r o il e x p lo ra tio n . T h e re fo re , th is second fe a tu re a llo w s sh a re h o ld e rs to re v ie w t h e ir in v e s tm e n t in a ris k y v e n tu re w h e n a d d itio n a l fu n d s are b e in g ra ise d a n d gives th e m th e o p p o r tu n ity to a b a n d o n th e in v e s tm e n t i f th e y be lie ve t h a t its p ro sp e cts are u n a ttra c tiv e .3

9.2.4|T he rights of shareholders S hareholders in a lis te d co m p a n y have m a n y rig h ts , such as th e r ig h t to receive an a n n u a l re p o rt, to be n o tifie d o f m e e tin g s a n d to a tte n d th o se m e e tin g s . In p ra ctice , m o s t o f these rig h ts are o f l i t t le im p o rta n c e and, generally, th e re are ju s t th re e rig h ts t h a t are im p o r t a n t to sh a re h o ld e rs in lis te d com p an ies:

a

S ha reh old ers are e n title d to a p ro p o r tio n a l share o f a n y d iv id e n d t h a t is de cla red b y d ire c to rs ,

b

As p a rt ow n e rs o f th e com p an y, o rd in a ry s h a re h o ld e rs e x e rt a degree o f c o n tro l o v e r its m a n a g e m e n t th ro u g h th e v o tin g rig h ts a tta c h e d to t h e ir shares. These rig h ts in c lu d e th e r ig h t to e le ct m e m b e rs o f th e B o a rd o f D ire c to rs . The B oa rd, w h ic h is u s u a lly e lected a t th e A n n u a l G en eral M e e tin g , has u ltim a te c o n tro l o ve r th e o p e ra tio n s o f th e com p an y. U su ally, sh a re h o ld e rs have one v o te f o r each share h e ld .4 The r ig h t o f s h a re h o ld e rs to e le ct th e B o a rd o f D ire c to rs gives th e m som e c o n tro l o ve r th e co m p a n y s o p e ra tio n s . H o w eve r, in p ra c tic e , t h e ir a b ility to exercise c o n tro l is lim it e d because th e B oa rd o f D ire c to rs is g e n e ra lly able to m u s te r s u ffic ie n t vo te s, in c lu d in g p ro x ie s , to e n sure th a t its m e m b e rs are re -e le cte d a t th e A n n u a l G e n e ra l M e e tin g .5

C

S ha reh old ers have th e r ig h t to sell t h e ir shares. This r ig h t can be exercised re a d ily in th e case o f lis te d shares because th e shares can be s o ld th ro u g h th e s to c k exchange.

9 .2 .5 1 Advantages and disadvantages of equity as a source of finance E q u ity raised b y is s u in g o rd in a ry shares has im p o r ta n t advantages as a source o f fin a n ce : •

A c o m p a n y is n o t

required to

pay d iv id e n d s to o rd in a ry sh a re h o ld e rs: p a y m e n t o f d iv id e n d s is a t

th e d is c re tio n o f d ire c to rs . T h ere fore, i f a c o m p a n y s u ffe rs a d e clin e in p r o fita b ilit y o r is s h o rt o f cash, i t can o m it th e p a y m e n t o f d iv id e n d s w ith o u t a n y s e rio u s le g a l consequences. In c o n tra s t, fa ilu re to pay in te re s t o n d e b t, o r delays in p a y in g in te re s t, w ill a lm o s t c e rta in ly have se rio u s legal consequences a n d can u ltim a te ly le a d to a c o m p a n y b e in g p laced in to liq u id a tio n . •

O rd in a ry shares do n o t have a n y m a t u r ity date, w h ic h m ea ns t h a t th e is s u in g c o m p a n y has no o b lig a tio n to red ee m th e m .6 A g a in , in c o n tra s t, d e b t

must be

re p a id (o r *redeem ed,) w h e n

i t m a tu re s. •

The h ig h e r th e p r o p o r tio n o f e q u ity in a co m p a n y s c a p ita l s tru c tu re , th e lo w e r is th e r is k th a t le n d e rs w ill s u ffe r losses as a re s u lt o f th e b o rro w e r e x p e rie n c in g fin a n c ia l d iffic u lty . T h ere fore, ra is in g e q u ity b y is s u in g o rd in a ry shares lo w e rs th e in te re s t ra te t h a t a c o m p a n y w ill have to pay o n de bt. W h ile e q u ity has im p o r t a n t advantages, i t also has som e disad vanta ges.

•

I f a co m p a n y issues m o re o r d in a r y shares to raise n e w c a p ita l, e x is tin g sh a re h o ld e rs w i ll have to e ith e r o u tla y a d d itio n a l cash o r s u ffe r som e d ilu t io n o f t h e ir o w n e rs h ip a n d c o n tro l o f th e com pany.

3

4 5 6

Arguably, another feature of no liability (NL) companies is also important. Historically, NL companies had greater flexibility than other companies to raise capital by issuing shares at a discount to their par value. When the C o rp o ratio n s A c t was amended to abolish the par value concept from 1 July 1998, this advantage no longer existed. Subsequently, some NL companies have converted to limited liability status and the number of new NL companies listing on the ASX has declined. As at February 2014, only 68 of the 2140 companies listed on the ASX were NL companies (see www.asx.com.au/asx/ research/ASXListedCompanies.csv). The voting rights of a company s shareholders must be specified in its constitution. For companies listed on the ASX, the form of the voting rights is specified in Chapter 6 of the Exchange’s Listing Rules. As many shareholders do not attend the Annual General Meeting, the right to vote by proxy is provided. Voting by proxy involves a shareholder assigning to another person the right to vote on resolutions at the Annual General Meeting. While ordinary shares have no maturity date and can, in principle, exist in perpetuity, companies are permitted to repurchase their ovm shares, which leads to cancellation of those shares. Share buybacks are discussed in Chapter 11.

m LEARNING OBJECTIVE 2 Explain the advantages and disadvantages of equity as a source of finance

B usiness finance

B o rro w in g , o n th e o th e r h a n d , a llo w s fu n d s to be ra ise d w ith o u t such d ilu tio n . S m a ll sh a re h o ld e rs m a y n o t be co n ce rn e d i f t h e ir in te re s t in a co m p a n y is d ilu te d , p ro v id e d th e n e w sh a re h o ld e rs pay a f a ir p ric e f o r th e shares th e y o b ta in , b u t in v e s to rs w h o o w n a s ig n ific a n t p r o p o r tio n o f a com p an y's shares m a y be u n w illin g to have t h e ir in te re s t d ilu te d . •

The tra n s a c tio n costs o f ra is in g fu n d s b y is s u in g shares are u s u a lly h ig h e r th a n th e costs o f b o rro w in g a s im ila r a m o u n t. O n e rea son is th a t, as discussed in S e ctio n 9.4, a share issue b y a p u b lic co m p a n y o fte n re q u ire s a p ro s p e c tu s . Because o f th e v o lu m e o f in fo r m a tio n t h a t is u s u a lly p ro v id e d , a p ro s p e c tu s f o r a share issue ty p ic a lly ru n s to m o re th a n 1 0 0 pages a n d is c o s tly to p re pa re. A lso , share issues are o fte n u n d e r w r itte n : th is o fte n in v o lv e s a fee b e in g p a id to th e u n d e r w r ite r w h o gu a ra n te e s to pu rcha se a n y shares n o t ta k e n u p b y in v e s to rs . In o u t lin in g th e advan ta ge s a n d disad vanta ges o f e q u ity , ta x a tio n has n o t been m e n tio n e d because,

u n d e r th e A u s tra lia n ta x syste m , th e o v e ra ll ta x b u rd e n s o n d e b t a n d e q u ity are o fte n th e sam e fo r A u s tra lia n re s id e n t in v e s to rs . A s discussed in S e ctio n 1 2 .5 .2 ，th e s yste m is e ith e r n e u tra l o r biase d to w a rd s e q u ity d e p e n d in g o n th e in v e s to rs m a rg in a l ta x rate. F o r overseas in v e s to rs in A u s tra lia n co m p a n ie s th e ta x b u rd e n o n e q u ity m a y be h ig h e r th a n th e ta x b u rd e n o n d e b t. T h e re fo re , in A u s tra lia , a n y ta x a tio n ad va n ta g e o r d isa d va n ta g e th a t m a y arise in a p a r tic u la r case de pe nd s o n th e circu m sta nce s o f th e s h a re h o ld e r co n ce rn e d a n d is n o t an in h e re n t fe a tu re o f e q u ity as a source o f fin a n ce .

9.3

Private equity

M o s t o f th is c h a p te r covers e q u ity c a p ita l ra is in g b y com p an ies w h o se shares are lis te d a n d tra d e d p u b lic ly LEARNING OBJECTIVE 3 Outline the main sources of private equity in the Australian market

o n a s to c k exchange. There is also a m u c h s m a lle r b u t s t ill v e ry im p o r ta n t p riv a te e q u ity m a rk e t. The te rm p riv a te e q u ity * is o fte n used to de scrib e tw o d is tin c t typ e s o f in v e s tm e n t. The f ir s t ty p e is also k n o w n as V e n tu re capital* a n d re fe rs to fu n d in g f o r s m a lle r a n d r is k ie r co m p a n ie s w it h p o te n tia l f o r s tro n g g ro w th . F o r the se co m p a n ie s, p riv a te e q u ity can be m o re a ttra c tiv e th a n a s to c k exchange lis tin g . F o r exa m ple, th e a m o u n t o f c a p ita l re q u ire d m a y be to o s m a ll to ju s t if y th e cost o f a share m a rk e t flo a t. A ls o , th e fu tu r e o f th e v e n tu re — w h ic h a t th e e a rlie s t stage m a y be n o m o re th a n an id e a — m a y be to o u n c e rta in to a ttra c t fu n d s f r o m a la rge n u m b e r o f in v e s to rs . The second ty p e is th e a c q u is itio n o f a lis te d p u b lic co m p a n y b y a g ro u p o f in v e s to rs w h o p riv a tis e * th e co m p a n y so t h a t i t is d e lis te d fr o m th e s to c k exchange. Such a c q u is itio n s u s u a lly in v o lv e a h ig h p r o p o r tio n o f d e b t fin a n c e a n d are c o m m o n ly k n o w n as leveraged b u y o u ts (LB O s), w h ic h are discussed in S e ctio n 1 9 .7 .3 . The re m a in d e r o f th is s e c tio n focuses o n p riv a te e q u ity fu n d in g f o r v e n tu re s o th e r th a n LBO s.

9.3.1 | W hat is private equity? P riv a te e q u ity re fe rs to e q u ity s e c u ritie s t h a t are n o t p u b lic ly tra d e d . P riv a te e q u ity can be ra ised fr o m v a rio u s sources in c lu d in g fa m ily m e m b e rs, frie n d s a n d ‘bu sin ess angels’，b u t th e m o re fo r m a l p riv a te e q u ity m a rk e t in v o lv e s fu n d s b e in g c h a n n e lle d to businesses b y p riv a te e q u ity fu n d m an ag ers. P riva te e q u ity fu n d in g can be d iv id e d in to fo u r ca te g o rie s:7 a

start-up fin a n c in g

f o r a b u sin ess less th a n 3 0 m o n th s o ld w h e re fu n d s are re q u ire d to de ve lo p th e

c o m p a n y ’s p ro d u c ts b

expansion fin a n c in g

w h e re a d d itio n a l fu n d s are re q u ire d to m a n u fa c tu re a n d sell p ro d u c ts

c o m m e rc ia lly c d

turnaround fin a n c in g f o r a c o m p a n y in fin a n c ia l d iff ic u lt y management buyout (M B O ) fin a n c in g w h e re a b u sin ess is p u rch a se d

b y its m a n a g e m e n t te a m w ith

th e assistance o f a p riv a te e q u ity fu n d . Because p riv a te e q u ity is n o t p u b lic ly tra d e d , th e m a rk e t is illiq u id a n d in v e s to rs m u s t be p re p a re d to c o m m it fu n d s f o r th e lo n g te rm , w ith p e rio d s o f 5 to 10 years b e in g ty p ic a l.

7

This four-category breakdown is provided by Connolly and Tan (2002).

C hapter NINE $ 〇URCES 〇F FINANCE: EQUITY

E n tre p re n e u rs a n d in v e s to rs in n e w v e n tu re s se e kin g s ta rt-u p fin a n c in g face th re e im p o r t a n t in fo r m a tio n p ro b le m s .8

a

Information gaps: in fo r m a t io n

a b o u t th e va lu e o f th e v e n tu re is lik e ly to be in c o m p le te a n d v e ry

u n c e rta in . b

Information asymmetry: im p o r t a n t

in fo r m a tio n is u s u a lly d is tr ib u te d u n e v e n ly b e tw e e n th e

p a rtie s , w h ic h is th e p ro b le m k n o w n as

in form ation asym m etry.

In p a rtic u la r, th e e n tre p re n e u r

w ill a lm o s t c e rta in ly have m o re accurate in fo r m a tio n th a n o u ts id e in v e s to rs a b o u t th e te c h n ic a l o r s c ie n tific m e r it o f an id e a a n d o f th e te c h n o lo g y re q u ire d to e x p lo it th e idea. O n th e o th e r ha n d , o u ts id e in v e s to rs m a y have m o re re a lis tic in fo r m a tio n a b o u t th e e co n o m ic v a lu e o f th e idea. H o w eve r, p o te n tia l in v e s to rs in a n e w v e n tu re are n o t co n ce rn e d o n ly w ith th e va lu e o f th e u n d e rly in g idea o r in v e n tio n . T hey also ne ed to assess th e s k ills a n d c o m m itm e n t o f th e e n tre p re n e u r. Som e e n tre p re n e u rs have an accurate a p p re c ia tio n o f t h e ir o w n s k ills , a b ility an d c o m m itm e n t, w h ile o th e rs te n d to be less re a lis tic . C

Information leakage: th e re

is th e r is k t h a t o th e rs m a y a p p ro p ria te th e e n tre p re n e u r s idea. To

con vin ce p ro s p e c tiv e in v e s to rs t h a t a p ro p o s a l is va lu a b le , th e e n tre p re n e u r w ill have to p ro v id e th e m w it h som e in fo r m a tio n a b o u t th e idea. U n fo rtu n a te ly , d is c lo s in g th is in fo r m a tio n m a y a llo w som eone else to e x p lo it th e o p p o rtu n ity .

INFORMATION ASYMMETRY

situation where all relevant information is not known by all interested parties. Typically, this involves company 'insiders' (managers) having more information about the company’s prospects than 'outsiders' (shareholders and lenders)

The m a rk e t f o r n e w v e n tu re fin a n ce has som e u n iq u e fe a tu re s t h a t have d e velope d to m in im is e th e effects o f these in fo r m a tio n p ro b le m s . The m a in such fe a tu re is t h a t fin a n c e f o r n e w v e n tu re s is n o rm a lly p ro v id e d in stages ra th e r th a n as a sin g le lu m p sum . A lso , th e p ro v is io n o f fin a n c e a t each stage is g e n e ra lly lin k e d to th e a ch ie ve m e n t o f m ile s to n e s , such as c o m p le tio n o f a p ro to ty p e o r successful o p e ra tio n o f a p ilo t p la n t. A c h ie v e m e n t o f the se m ile s to n e s o r o th e r p e rfo rm a n c e b e n c h m a rk s h e lp s to reduce in fo r m a tio n a s y m m e try in tw o ways. F irs t, i t p ro v id e s in v e s to rs w ith ta n g ib le evidence a b o u t th e v ia b ilit y o f th e p ro je ct. Second, i t also p ro v id e s th e m w it h in fo r m a tio n a b o u t th e s k ill a n d a b ility o f th e e n tre p re n e u r. P ro v id in g th e fin a n ce in stages is c le a rly sen sib le fr o m th e v ie w p o in t o f in v e s to rs . I f a p ro je c t is d e s tin e d to fa il due to te c h n ic a l d iffic u ltie s , la c k o f c o n s u m e r d e m a n d o r h ig h m a n u fa c tu rin g costs, i t is b e tte r to discove r these p ro b le m s b e fo re a ll th e fu n d s needed to c o m p le te th e p ro je c t have b e en c o m m itte d to it . Staged fin a n c in g is also in th e in te re s t o f th e e n tre p re n e u r. F o r an e n tre p re n e u r w ith n o tra c k re c o rd o f successful v e n tu re s , i t w ill be d iff ic u lt to co n vin ce o th e rs t h a t fu n d s in v e s te d in a n e w v e n tu re w ill be used p ro fita b ly . F o r th e e n tre p re n e u r, ra is in g m o n e y fr o m o u ts id e in v e s to rs in th e e a rly stages o f a v e n tu re is ge n e ra lly expensive. In th is c o n te x t, expensive* m eans t h a t th e e n tre p re n e u r w ill have to g ive u p a la rge fra c tio n o f o w n e rs h ip to raise a r e la tiv e ly s m a ll a m o u n t o f c a p ita l. A c h ie v e m e n t o f each m ile s to n e reduces u n c e rta in ty an d increases th e va lu e o f a p ro je c t. R a isin g fin a n c e in stages, a fte r m ile s to n e s have been achieved, th e re fo re h e lp s th e e n tre p re n e u r to r e ta in g re a te r o w n e rs h ip th a n w o u ld o th e rw is e be th e case. F in a lly, c o n s id e r th e p o s s ib ility t h a t release o f in fo r m a tio n to p ro s p e c tiv e in v e s to rs m a y le a d to a p p ro p ria tio n o f th e e n tre p re n e u r s idea. The e n tre p re n e u r m a y seek p ro te c tio n b y a s k in g p ro s p e c tiv e in v e s to rs to sig n c o n fid e n tia lity a g re e m e n ts w h e n th e y are g iv e n a co p y o f th e b u sin ess p la n . H o w eve r, m a n y in v e s to rs re fu se to sig n such a g re e m e n ts because a le a k o f in fo r m a tio n fr o m a n y source can re s u lt in c o s tly le ga l d isp u te s. I t is m o re im p o r t a n t to th e e n tre p re n e u r t h a t a p o te n tia l in v e s to r is h o n e s t a n d can be tru s te d n o t to m isu se c o n fid e n tia l in fo r m a tio n . T h e re fo re , p riv a te e q u ity f u n d m an ag ers w ill t r y to e sta b lish an d p ro te c t a re p u ta tio n f o r h o n e s ty a n d in te g rity .

There are m a n y p o te n tia l sources o f fin a n c e f o r a n e w v e n tu re . These sources in c lu d e th e e n tre p re n e u r s p e rso n a l resources, p riv a te e q u ity fu n d s a n d fu n d s ra ise d b y an

in itial public offering

o f shares

associated w ith lis tin g o n a s to c k exchange. The s u ita b ility o f th e se a n d o th e r sources o f fin a n c e depends o n th e v e n tu re s stage o f d e v e lo p m e n t. E v e ry v e n tu re is d iffe re n t a n d i t is im p o s s ib le to id e n tify a *life cycle’ o f d e v e lo p m e n t stages t h a t a p p lie s to a ll n e w v e n tu re s . There are, h o w e ve r, som e id e n tifia b le stages th a t w ill a p p ly in m a n y cases. M a n y v e n tu re s w ill b e g in w it h a research a n d d e v e lo p m e n t phase 8

Our discussion of these information problems is based on Smith and Smith (2000, pp. 27-8).

IN ITIAL PUBLIC OFFERING

a company's first offering of shares to the public

B usiness finance

w h ic h , i f successful, w ill be fo llo w e d b y a s ta rt-u p phase w h e re th e e q u ip m e n t a n d p e rs o n n e l needed fo r p ro d u c tio n are assem bled. I f th e p ro d u c t is accepted b y cu sto m e rs, th e v e n tu re m a y g ro w , p e rha ps v e ry ra p id ly a t fir s t, a fte r w h ic h th e re w ill o fte n be p e rio d s o f s lo w e r g ro w th , m a t u r ity a n d p e rh a p s decline. There m a y be n o cle ar d e m a rc a tio n p o in t b e tw e e n the se stages b u t in m a n y cases th e tr a n s itio n w ill c o rre s p o n d to id e n tifia b le m ile s to n e s . In t u r n , th e re is o fte n a re la tio n s h ip b e tw e e n the se m ile s to n e s and th e a v a ila b ility o f d iffe re n t sources o f fina nce . A t th e research an d d e v e lo p m e n t stage th e e n tre p re n e u r w i ll u s u a lly re ly in it ia lly o n p e rso n a l resources— t h a t is, savings, m o n e y t h a t can be b o rro w e d b y m o rtg a g in g th e fa m ily h o m e a n d p e rha ps lin e s o f c re d it lin k e d to c re d it cards. U nless th e e n tre p re n e u r is v e ry w e a lth y , these resources m a y be e x h a u ste d b e fo re th e v e n tu re is f u lly d e velope d a n d i t w ill u s u a lly be necessary to o b ta in fin a n c e fro m o u ts id e rs such as fa m ily m e m b e rs, frie n d s , in d iv id u a ls k n o w n as ‘b u sin ess an ge ls’ a n d p riv a te e q u ity fu n d s . O u ts id e fin a n c e ra ise d in th e e a rly stages o f a v e n tu re s d e v e lo p m e n t is n o r m a lly in th e fo r m o f e q u ity — t h a t is, th e e n tre p re n e u r tra n s fe rs a share o f o w n e rs h ip to th e n e w in v e s to rs a n d th e re tu rn s to the se in v e s to rs w ill d e p e n d d ire c tly o n th e success o r o th e rw is e o f th e v e n tu re .

9 .3 .4 1 Finance from business angels B usiness angels are w e a lth y in d iv id u a ls p re p a re d to in v e s t in p ro je c ts t h a t are a t a n e a rly stage o f d e v e lo p m e n t.9 The a m o u n ts in v o lv e d ty p ic a lly range fr o m te n s o f th o u s a n d s to h u n d re d s o f th o u s a n d s o f d o lla rs p e r in v e s tm e n t. These in v e s to rs w ill o fte n p ro v id e th e fu n d s ne eded to de ve lo p a v e n tu re to th e stage w h e re i t is p o ssib le to seek o u ts id e fin a n c e fr o m p riv a te e q u ity fu n d s , b a n ks a n d o th e r fin a n c ia l in s titu tio n s . B usiness angels are g e n e ra lly p re p a re d to in v e s t in a v e n tu re f o r 5 to 10 years. M a n y o f th e m have b u sin ess o r te c h n ic a l s k ills a n d a im to add v a lu e to a n e w v e n tu re b y p ro v id in g ad vice a n d e x p e rtis e as w e ll as fin a n ce . T ra d itio n a lly th e m a rk e t has o p e ra te d in fo r m a lly o n th e basis o f c o n ta c ts a n d re fe rra ls. H o w eve r, th e m a rk e t has re c e n tly been fo rm a lis e d b y th e d e v e lo p m e n t o f b u sin ess in tr o d u c tio n services t h a t seek to m a tc h in v e s to rs w it h e n te rp ris e s t h a t need c a p ita l. Som e o f the se services s im p ly p ro v id e in fo r m a tio n , w h ile o th e rs m a in ta in databases o f b o th in v e s to rs a n d c o m p a n ie s a n d a im to a c tiv e ly m a tc h the se p a rtie s . Services o p e ra tin g in A u s tra lia in c lu d e Business A n g e ls P ty L td

(w w w .businessangels.com .

au) a n d th e A u s tra lia n S m a ll Scale O ffe rin g s B o a rd (w ww.assob.com .au). Som e b u sin ess angels w ill in v e s t in p e rh a p s one p ro je c t p e r y e a r w h ile o th e rs w ill in v e s t in several. M o s t r e s tr ic t t h e ir in v e s tm e n ts to in d u s trie s w h e re th e y u n d e rs ta n d th e te c h n o lo g y a n d to p ro je c ts lo c a te d in t h e ir o w n g e o g ra p h ic a l area. A ty p ic a l e xa m p le is <J o h n ,, a 6 3 -y e a r-o ld c h a rte re d a c c o u n ta n t w h o has m a d e 12 in v e s tm e n ts in 8 years as a f u ll- tim e e q u ity in v e s to r.10 H e p o in ts o u t t h a t th e e x p e rtis e t h a t b u sin ess angels can p ro v id e is u s u a lly m o re im p o r t a n t th a n th e m o n e y th e y in v e s t. F in d in g m o n e y is easy i f a bu sin ess is good. A n g e l in v e s to rs lo o k f o r a b u sin ess w it h a w eakness t h a t th e y can h e lp to o ve rco m e so t h a t i t becom es a g o o d business. J o h n lo o k s f o r o p p o rtu n itie s in in d u s trie s w it h h ig h g ro w th p o te n tia l. Because he does n o t w a n t h is m o n e y tie d u p f o r m o re th a n 5 years, he lo o k s f o r a co m p a n y th a t can b e n e fit v e ry q u ic k ly fr o m re o rg a n is a tio n o r a d d itio n a l e x p e rtis e . Such co m p a n ie s are u s u a lly s m a ll a n d have a g o o d idea, b u t la ck e x p e rtis e in m a n a g e m e n t, m a rk e tin g , m a n u fa c tu rin g o r d is tr ib u tio n . J o h n w i ll in v e s t u p to $ 2 0 0 0 0 0 , re q u ire s a seat o n th e B o a rd a n d w ill sp e n d u p to h a lf a d a y each w eek w o rk in g o n th e com p an y. F in a lly , he lo o k s f o r c o m p a n ie s t h a t can p ro v id e h ig h re tu rn s o n h is in v e s tm e n t b y d e v e lo p m e n t to a stage w h e re th e c o m p a n y can be s o ld to o r m erg e w it h a la rg e r com pany, a ttra c t th e in v o lv e m e n t o f a p riv a te e q u ity fu n d o r lis t o n a s to c k exchange.

9 .3 .5 1 Finance from private equity funds The A u s tra lia n B u re a u o f S ta tis tic s (ABS) e s tim a te s t h a t $ 1 9 .8 b illio n was c o m m itte d to th e p riv a te e q u ity m a rk e t a t 30 J u n e 2 0 1 3 , o f w h ic h $ 1 3 .8 b illio n was d ra w n d o w n , le a v in g $6 b illio n u n c a lle d .11 A c c o rd in g to th e ABS, a t J u n e 2 0 1 3 a t o ta l o f 2 3 1 p riv a te e q u ity fu n d s o p e ra te d in A u s tra lia b y 1 2 2 v e n tu re c a p ita l

9 For a detailed discussion of this market in Australia, see Abernethy and Heidtman (1999). 10 This example is cited by Abernethy and Heidtman (1999, pp. 137-40). The remainder of this section relies heavily on that source. 11 Australian Bureau of Statistics (2014).

C hapter n in e S ources

of fin a n c e : equity

m anagers h a d in v e s te d in 7 2 0 com p an ies. V e n tu re c a p ita l m an ag ers have tw o m a in roles: ra is in g m o n e y fro m in v e s to rs a n d s e le c tin g s u ita b le co m p a n ie s in w h ic h to in v e s t th e c a p ita l. In A u s tra lia , in v e s to rs in c lu d e s u p e ra n n u a tio n fu n d s , w h ic h are th e la rg e s t source o f fu n d s , w e a lth y in d iv id u a ls a n d ba nks. W h ile these in v e s to rs have la rg e sum s ava ila ble, p riv a te e q u ity fu n d in g is n o t easy to o b ta in . A c c o rd in g to th e ABS, th e 1 2 2 m anagers re v ie w e d 6 6 0 4 p o te n tia l n e w in v e s tm e n ts in th e fin a n c ia l yea r e n d in g Ju n e 20 13 , f u r t h e r an alysis was c o n d u c te d o n 8 5 0 o f th o se a n d o n ly 76 w e re succe ssful in a ttra c tin g in v e s tm e n t. D u rin g th a t p e rio d the se v e n tu re c a p ita l m an ag ers m ad e n e w a n d fo llo w - o n in v e s tm e n ts to ta llin g $ 1 1 2 4 m illio n . V e n tu re c a p ita l fu n d m a n a g e rs g e n e ra lly in v e s t a m o u n ts in th e o rd e r o f $ 5 0 0 0 0 0 to $2 0 m illio n f o r p e rio d s o f 3 to 7 years. T hey lo o k f o r a bu sin ess w ith g o o d p ro sp e cts f o r g ro w th , m a n a g e d b y p e o p le w h o are capable, h o n e s t a n d c o m m itte d to th e success o f th e bu sin ess. P riv a te e q u ity in v e s tm e n ts ty p ic a lly have a h ig h e r le ve l o f r is k th a n m o s t o th e r in v e s tm e n ts . T h ere fore, fu n d m an ag ers seek a re la tiv e ly h ig h ra te o f r e tu r n t h a t w ill v a ry w it h th e p e rce ive d ris k . F o r e xa m p le , p ro v is io n o f seed a n d s ta rt-u p c a p ita l in vo lve s a h ig h le v e l o f r is k a n d in v e s to rs m a y seek a ra te o f r e tu r n o f a t le a st 30 to 4 0 p e r c e n t p e r a n n u m o ve r th e life o f th e in v e s tm e n t. A t a la te r stage w h e n p r o d u c tio n has co m m e n ce d a n d p ro d u c t is b e in g sold, p ro v is io n o f c a p ita l f o r e x p a n s io n in v o lv e s lo w e r r is k so t h a t th e m in im u m ra te o f r e tu r n s o u g h t m a y be 20 to 30 p e r c e n t p e r a n n u m . To o b ta in p riv a te e q u ity i t is e s s e n tia l to have a w e ll-d o c u m e n te d a n d b e lie v a b le b u sin ess p la n . The p la n s h o u ld p ro v id e in fo r m a t io n on: •

th e s tru c tu re , a c tiv itie s a n d fin a n c ia l h is to r y o f th e bu sin ess

•

analysis o f th e in v e s tm e n t o p p o r tu n ity

•

th e a m o u n t o f c a p ita l s o u g h t

•

h o w th e c a p ita l w ill be used

•

fin a n c ia l p ro je c tio n s

•

th e q u a lific a tio n s a n d e xp e rie n ce o f th e m a n a g e m e n t team . As w e ll as b e c o m in g p a r t o w n e rs o f th e businesses th e y in v e s t in , fu n d m an ag ers ty p ic a lly re q u ire a

seat on th e c o m p a n y s B o a rd o f D ire c to rs . This does n o t m e a n t h a t th e y seek d a y -to -d a y c o n tro l. R a th er, p riv a te e q u ity fu n d s g e n e ra lly ta k e a s ig n ific a n t m in o r it y share in th e c o m p a n y a n d a im to p ro v id e v a lu a b le advice o n b o th te c h n ic a l a n d m a n a g e m e n t issues. A n e n tre p re n e u r m a y be able to o b ta in c a p ita l fr o m a v a rie ty o f sources, b u t a fu n d m a n a g e r can also p ro v id e m a n a g e m e n t in p u t based o n th e e xp erience o f h e lp in g o th e r com p an ies ove rco m e th e p ro b le m s ty p ic a lly e n c o u n te re d b y new , fa s t-g ro w in g businesses. The in v e s tm e n t veh icle s d iffe r c o n s id e ra b ly in size, th e ty p e o f in d u s trie s th e y in v e s t in an d th e typ e s o f m a n a g e m e n t s u p p o rt th e y can p ro v id e . T h e re fo re , i t is im p o r t a n t t h a t an e n tre p re n e u r se e kin g p riv a te e q u ity s h o u ld be aw are o f the se d iffe re n ce s a n d a p p ro a ch th e fin a n c ie rs t h a t are b e s t e q u ip p e d to p ro v id e th e c a p ita l a n d s u p p o rt t h a t th e b u sin e ss is lik e ly to need. M o s t fu n d m an ag ers a im t o achieve th e m a jo r ity o f t h e ir r e tu r n in th e f o r m o f c a p ita l g a in ra th e r th a n d iv id e n d s . A c c o rd in g ly , th e y u s u a lly p la n to d ispo se o f th e in v e s tm e n t, ty p ic a lly w it h in a p e rio d o f 3 to 7 years. D isp o sa l m a y ta k e place in one o f th re e ways:

a

an in it ia l p u b lic o ffe rin g a sso cia te d w it h s to c k exchange lis tin g

b

sale

C voluntary liquidation. W h e re a sale occurs th e b u y e r m a y be a la rg e r co m p a n y (a ‘tra d e sale’) ，th e m a jo r ity o w n e r, th e m a n a g e m e n t o r a n o th e r o u ts id e in v e s to r. W h ile d isp o sa l o f th e in v e s tm e n t can re s u lt in s p e c ta c u la r gains, th e le ve l o f r is k is h ig h a n d i t is to be e xp ected t h a t a s ig n ific a n t p r o p o r tio n o f th e d isp o sa ls th a t occur w ill in v o lv e a loss. In som e cases th e p ro je c t w ill fa il a n d th e in v e s tm e n t w i ll be liq u id a te d . P riva te e q u ity in v e s tm e n t in A u s tra lia has g ro w n ra p id ly since th e e a rly 1 9 9 0 s. F actors t h a t have c o n trib u te d to th is g ro w th in c lu d e : •

g ro w th in th e v o lu m e o f fu n d s flo w in g in to s u p e ra n n u a tio n , to g e th e r w it h in cre a se d re c o g n itio n b y

•

g o v e rn m e n t p ro g ra m s to en cou rage in v e s tm e n t in n e w v e n tu re s , such as th e In n o v a tio n In v e s tm e n t

fu n d m anagers o f th e ro le o f p riv a te e q u ity in v e s tm e n ts as p a r t o f a d iv e rs ifie d p o r tf o lio F u n d p ro g ra m a n d th e E a rly Stage V e n tu re C a p ita l L im ite d P a rtn e rs h ip s p ro g ra m (see w w w .

ausindustry.gov.au). •

re g u la to ry changes t h a t a llo w b a n ks to m a ke e q u ity in v e s tm e n ts .

|www j

9.4

Information disclosure

C h a p te r 6 D o f th e LEARNING OBJECTIVE 4 Identify the information

Corporations Act

co n ta in s p ro v is io n s designed to ensure th a t in v e s to rs in p u b lic

com panies are p ro te c te d b y disclosu re o f in fo rm a tio n . There are p a rtic u la r disclosure re q u ire m e n ts th a t a p p ly to o ffe rs o f secu ritie s so th a t in v e s to rs s h o u ld be able to m ake an in fo rm e d de cisio n on w h e th e r to

that must be disclosed

purchase th e securities. These re q u ire m e n ts are g e n e ra lly sa tisfie d b y p ro v id in g p o te n tia l in ve sto rs w ith a

when issuing securities

disclosure docum ent c o n ta in in g in fo rm a tio n a b o u t th e issu er a nd d e tails o f th e secu ritie s o ffe re d fo r sale. H ow ever, th e re are v a rio u s e x e m p tio n s th a t m ean a disclosu re d o c u m e n t is n o t needed f o r som e o ffe rs o f secu ritie s.

DISCLOSURE DOCUMENT

prospectus, profile statement o r offer

In cases w h e re d is c lo s u re is needed, th e d isclo su re re q u ire m e n ts v a ry d e p e n d in g o n w h e th e r th e s e c u ritie s are a lre a d y lis te d o n th e s to c k exchange. W e n o w discuss th e d isclo su re re q u ire m e n ts f o r o ffe rs o f s e c u ritie s t h a t do n o t fa ll in to a n y o f th e e x e m p t categories.

information statement that must be supplied

9.4.1 | Offers of unlisted securities

to potential investors to provide information about an offer of

O ffe rs o f u n lis te d s e c u ritie s in c lu d e in it ia l p u b lic o ffe rin g s o f o r d in a r y shares a n d issues b y lis te d

securities

co m p a n ie s o f a n e w class o f se c u ritie s . In the se cases, th e s e c u ritie s do n o t have an o b se rva b le m a rk e t p ric e a n d in th e case o f an in it ia l p u b lic o ffe rin g th e re m a y be lit t le , i f any, p u b lic ly a va ila b le in fo r m a tio n a b o u t th e com p an y. T h ere fore, th e disclo su re re q u ire m e n ts t h a t a p p ly to o ffe rs o f u n lis te d se c u ritie s are m o re s tr in g e n t th a n th o se f o r lis te d se cu ritie s. The g e n e ra l ru le is t h a t an o ffe r o f s e c u ritie s to in v e s to rs c a n n o t p ro cee d u n t il a d isclo su re d o c u m e n t has b e e n lo d g e d w it h th e A u s tra lia n S e cu ritie s a n d In v e s tm e n ts C o m m is s io n (A S IC ). D isclo su re d o c u m e n ts m a y be g iv e n to p o te n tia l in v e s to rs as so o n as th e y have b e en lo d g e d w it h A S IC . F o r u n lis te d s e c u ritie s , a w a itin g p e rio d o f a t le a st 7 days is im p o s e d b e fo re a p p lic a tio n s b y in v e s to rs can be accepted. The w a itin g p e rio d a llo w s th e d isclo su re d o c u m e n t to be e x a m in e d b y A S IC a n d o th e r in te re s te d p a rtie s . I f th e d o c u m e n t is fo u n d to be d e fic ie n t, th e issue o f s e c u ritie s can be delayed u n t il an acceptable s u p p le m e n ta ry o r re p la c e m e n t d o c u m e n t is p ro v id e d . The in fo r m a t io n t h a t m u s t be in c lu d e d va rie s w it h th e ty p e o f d is c lo s u re d o c u m e n t. The typ e s m o s t c o m m o n ly used are: •

a p ro s p e c tu s

•

a s h o r t- fo rm p ro sp e ctu s

•

an o ffe r in fo r m a t io n s ta te m e n t.12

Prospectuses PROSPECTUS

a docum ent that,

A p ro sp ectu s is th e m o s t c o m p re h e n sive d o c u m e n t a n d g e n e ra lly c o n ta in s in fo r m a t io n o f fo u r m a in types:

a m o ng other things, provides details of

a

the co m p a n y and

fu n d s w ill be used, a n y u p p e r o r lo w e r lim it s o n th e a m o u n t t h a t each in d iv id u a l can in v e s t a n d any

the terms of the issue of securities, w hich must be pro vided to

in fo r m a t io n a b o u t th e s e c u rity issue— h o w m u c h c a p ita l is s o u g h t, th e s u b s c rip tio n p ric e , h o w th e m in im u m s u b s c rip tio n le ve l th a t m u s t be ach ie ved

b

n o n -fin a n c ia l in fo r m a t io n a b o u t th e issu e r— a d e ta ile d d e s c rip tio n o f it s b u sin ess a n d re p o rts fro m d ire c to rs o r e x p e rts in th e in d u s tr y

potential investors by a co m p a n y seeking to

C

a d e ta ile d d is c u s s io n o f th e ris k s associated w ith th e bu sin ess

issue shares or other

d

fin a n c ia l in fo r m a tio n a b o u t th e is s u e r— th e m o s t re c e n t a u d ite d fin a n c ia l s ta te m e n ts an d, in m a n y

securities

cases, fin a n c ia l fo re ca sts in c lu d in g fo re ca sts o f p r o fits a n d d iv id e n d s . The t e x t o f a ll p ro sp e ctu se s issu ed in A u s tra lia since 2 0 0 1 is a va ila ble a t w w w .s e a rc h .a s ic .g o v .a u / o f f e r li s t / o f f e r l is t 一 is s u e r 一 n a m e .h tm l. A p ro s p e c tu s is th e m o s t exp e n sive o f th e d o c u m e n ts to p re p a re , p r i n t a n d d is trib u te . The fa c to rs th a t c o n trib u te to these costs in c lu d e th e size o f th e d o c u m e n t a n d th e fees payable to e x p e rts w h ose re p o rts

12 These disclosure documents apply in the case of security issues by companies. If funds are being raised for a managed investment, such as a property trust, a different type of disclosure document known as a product disclosure statement (PDS) is required.

C hapter n in e S ources

are in clu d e d . M o re o v e r, d e ficie n cie s in a d isclo su re d o c u m e n t can lead to p e op le w h o w ere in v o lv e d in its p re p a ra tio n o r in th e is s u in g o f s e c u ritie s b e in g lia b le f o r c r im in a l p ro s e c u tio n . T hey m a y also be re q u ire d to com pensate in v e s to rs f o r losses su ffe re d as a re s u lt o f a m is s ta te m e n t in , o r an o m is s io n fro m , th e d o cu m e n t. H o w eve r, th e

Corporations Act p ro v id e s

a *due d ilig e n c e , defence in re la tio n to a p ro s p e c tu s and

o th e r d isclo su re d o cu m e n ts. T his is a defence a g a in s t a c la im o f m is s ta te m e n t o r o m is s io n i f th e p e rso n m ade a ll reasonable e n q u irie s a n d b e lie ve d o n rea son able g ro u n d s t h a t th e s ta te m e n t w as n o t m is le a d in g o r de ceptive, o r th a t th e re w as n o o m is s io n . The p re p a ra tio n o f a p ro s p e c tu s can in v o lv e e x te n s iv e an d c o s tly in v e s tig a tio n s to e n su re t h a t th e in fo r m a tio n p ro v id e d is as accurate as p o ssib le a n d t h a t th e due d ilig e n ce defence w ill be a va ila b le i f a n y d e fic ie n c y is fo u n d . The p ro sp e ctu s d is tr ib u te d to p o te n tia l in v e s to rs can be in a s h o r t f o r m 1, w h ic h m ea ns t h a t i t re fe rs to m a te ria l in d o c u m e n ts lo d g e d w ith A SIC in s te a d o f p ro v id in g t h a t m a te ria l in th e p ro sp e ctu s. A s h o rt fo rm pro sp e ctu s m u s t in fo r m in v e s to rs t h a t th e y are e n title d to a fre e cop y o f th e a d d itio n a l m a te ria l o n request.

O ffer information statements A n o ffe r in fo r m a tio n s ta te m e n t (O IS ) m a y be used in s te a d o f a p ro s p e c tu s i f th e a m o u n t o f m o n e y to be raised is re la tiv e ly sm a ll. S p e cifica lly, an O IS m a y be used o n ly i f th e a m o u n t o f m o n e y to be ra ise d b y th e issuer, w h e n adde d to a ll a m o u n ts p re v io u s ly raised, is less th a n $ 1 0 m illio n . A n O IS is m u c h less c o s tly to p re p a re th a n a p ro s p e c tu s because th e in fo r m a tio n to be disclose d is m in im a l a n d e x te n s iv e *due d ilig e n c e ’ e n q u irie s are n o t needed.

9 .4 .2 1 Offers of listed securities The d isclosu re re q u ire m e n ts are less o n e ro u s f o r o ffe rs o f s e c u ritie s t h a t are a lre a d y lis te d o n a s to c k exchange. A n exa m ple is a rig h ts issue w h e re n e w shares are o ffe re d to e x is tin g sh a re h o ld e rs. As discussed in S e ctio n 9.6 .1 , a p ro s p e c tu s is n o lo n g e r re q u ire d f o r a rig h ts issue, b u t th e re m a y be cases w h ere such issues are a cco m p a n ie d b y a p ro sp e ctu s. A lis te d e n t it y is s u b je c t to c o n tin u o u s d isclo su re re q u ire m e n ts u n d e r s to c k exchange lis tin g ru le s backed b y th e

Corporations Act.

A n y m a te ria l p ric e -

se n sitive in fo r m a tio n has to be d isclo se d to th e s to c k exchange o n a c o n tin u o u s basis. T h e re fo re , m u c h o f th e in fo r m a tio n t h a t w o u ld n o rm a lly have to be in c lu d e d in a p ro s p e c tu s is a lre a d y p u b lic ly ava ila ble, so, i f a rig h ts issue is m ad e u n d e r a p ro sp e ctu s, i t does n o t n e ed to be as d e ta ile d as a p ro s p e c tu s f o r an issue o f u n lis te d se c u ritie s .

9 .4 .3 1 Offers that do not need disclosure There are v a rio u s e x e m p tio n s t h a t m e a n a d isclo su re d o c u m e n t is n o t ne eded f o r som e o ffe rs o f se c u ritie s .13 The m a in e x e m p tio n s are o u tlin e d in Table 9.2.

TABLE 9.2 Main types of offer that do not need disclosure D e s c rip tio n

O ff e r ty p e

Small-scale offerin gs

Personal offers th a t re s u lt in issues to no m ore th a n 20 in vestors in a ro llin g 1 2 -m o n th p e rio d , w ith a m a x im u m o f $2 m illio n raised.

Rights issues

A p ro -ra ta o ffe r made o f a d d itio n a l shares to e x is tin g shareholders. The term s o f the o ffe r to each shareholder m u s t be id e n tic a l and the new shares m u s t be o f the same class as those already held.

S ophisticated investors:

The a m o u n t payable fo r securities m u s t be a t least:

• Large offers

$ 5 0 0 0 0 0 , OR

continued

13 The circumstances where a disclosure document is not required are set out in section 708 of the

C o rp o ratio n s A ct.

of f in a n c e : equity

B usiness finance

Table 9 .2

continued

O f f e r ty p e

D e s c rip tio n

• O ffers to w e a lth y in vestors

th e in v e s to r had a gross incom e over each o f the previous tw o fin a n c ia l years o f a t least $250 000 o r n e t assets o f a t least $2.5 m illio n , OR

• O ffers to experienced in vestors

th e o ffe r is made th ro u g h a licensed securities dealer w h o is satisfied th a t the in v e s to r has s u ffic ie n t previous experience in in v e s tin g in securities to assess m a tte rs such as th e m e rits o f th e o ffe r and th e risks involved.

Executive officers and

O ffers to d irectors and o th e r persons in vo lve d in th e m anagem ent o f the

associates

issu ing e n tity and ce rta in o f th e ir relatives and associated e n titie s .

E x is tin g s e c u rity holders

O ffers o f fu lly pa id o rd in a ry shares u n d e r a d iv id e n d re in v e s tm e n t plan, bonus share pla n o r share purchase plan. O ffers o f debentures to e x is tin g debenture holders.

9.5

Floating a public com pany

W h e n a c o m p a n y f ir s t in v ite s th e p u b lic to su b scrib e f o r shares i t is u s u a l to re fe r to t h is as L E A R N IN G OBJECTIVE 5 Outline the process

floating th e

com pany. A n a lte rn a tiv e te r m is t h a t th e c o m p a n y m akes an in it ia l p u b lic o ffe rin g (IP O ). A co m p a n y m a k in g it s f ir s t issue o f o rd in a ry shares to th e p u b lic w ill u s u a lly a p p ly f o r s to c k exchange lis tin g , w h ic h

of floating a public

m ea ns t h a t sh a re h o ld e rs in th e c o m p a n y can se ll t h e ir shares o n th e s to c k exchange.14 To o b ta in lis tin g ,

co m p a n y

th e d ire c to rs o f th e c o m p a n y m u s t e n sure t h a t it s p ro p o s e d s tru c tu re c o m p lie s w it h th e re q u ire m e n ts o f th e exchange. F o r exa m ple, th e A S X has e xte n sive lis tin g ru le s t h a t are based o n seve ral p rin c ip le s d e sig n e d to p ro te c t th e in te re s ts o f lis te d e n titie s , in v e s to rs a n d th e r e p u ta tio n o f th e m a rk e t. L is te d e n titie s m u s t s a tis fy m in im u m s ta n d a rd s o f q u a lity a n d size, a n d c o m p ly w it h s trin g e n t re q u ire m e n ts o n d isclo su re o f in fo r m a tio n . F o r exa m ple, to achieve lis tin g o n th e ASX, a c o m p a n y m u s t u s u a lly have a t le a s t 3 0 0 sh a re h o ld e rs, each s u b s c rib in g f o r shares w it h a v a lu e o f a t le a s t $ 2 0 0 0 . E n titie s to be lis te d m u s t also s a tis fy e ith e r a p r o f it te s t o r an assets te s t. The p r o f it te s t re q u ire s th e co m p a n y to have g e n e ra te d a m in im u m aggregate p r o f it o f $1 m illio n o v e r th e p re v io u s th re e years a n d a t le ast $ 4 0 0 0 0 0 in th e p re v io u s 12 m o n th s . The re q u ire m e n ts o f th e assets te s t in c lu d e n e t ta n g ib le assets o f a t le a st $3 m illio n (a fte r d e d u c tin g th e costs o f fu n d ra is in g ) o r a m a rk e t c a p ita lis a tio n o f a t le a s t $10 m illio n . 15 The A S X sets the se c o n d itio n s in an e f f o r t to ensure t h a t th e re w ill be an a ctive m a rk e t in th e co m p a n y s shares a fte r th e y are lis te d . C o m pa nie s t h a t are u n a b le to s a tis fy th e re q u ire m e n ts f o r lis tin g o n th e ASX

WWW

m a y o p t f o r lis tin g o n one o f th e m a rk e ts t h a t have d e ve lo p e d to m e e t th e needs o f s m a lle r com panies. These in c lu d e th e A s ia Pacific S to ck Exchange (w w w .a p x .c o m .a u ) a n d th e N a tio n a l S to ck Exchange o f A u s tra lia (w w w .n s x a .c o m .a u ), b o th o f w h ic h a im to p ro v id e a m a rk e t in th e shares o f s m a ll a n d m e d iu m ­ sized e n titie s w it h as fe w as 50 s e c u rity h o ld e rs.

9.5.1 I Public versus private ownership A co m p a n y u n d e rta k in g a flo a t m a y be e ith e r a n e w c o m p a n y o r an e x is tin g p riv a te com pany. In th e la tte r case, th e co m p a n y is said to be g o in g p u b lic 1. There are tw o m a in reasons w h y a p riv a te c o m p a n y m a y go p u b lic . F irs t, lis te d p u b lic com p an ies u s u a lly have b e tte r access to th e c a p ita l m a rk e t th a n p riv a te com p an ies. A s discussed in S e c tio n 9.3, p riv a te e q u ity in v e s to rs are v e ry se le ctive a n d th e te rm s t h a t th e y re q u ire m a y n o t be a ttra c tiv e to th e o w n e rs o f a com p an y. G re a te r access to th e c a p ita l m a rk e t is m o s t v a lu a b le to h ig h -g ro w th co m p a n ie s t h a t re q u ire fu n d s to im p le m e n t a ttra c tiv e n e w p ro je c ts . Second, a

14 While stock exchange listing normally follows a public issue, a company can list without raising any capital at the time of listing provided it complies with the ASX Listing Rules. This approach is referred to as a compliance listing*. An alternative way to become a listed public company is by a 'back-door listing*. This involves an unlisted company taking over a company that is listed on the stock exchange. 15 These and other listing requirements apply to all companies. There are additional requirements that differ depending on whether the company s main activities involve investment, mining exploration or scientific research. They are set out in Chapter 1 of the ASX Listing Rules.

C hapter n in e S ources

p u b lic flo a t a llo w s th e o w n e rs o f a c o m p a n y to cash in o n th e success o f th e bu sin ess th e y have developed. The cash th e y receive b y s e llin g p a r t o f t h e ir in te re s t in th e co m p a n y can be used to d iv e rs ify t h e ir in v e s tm e n t p o rtfo lio . G o in g p u b lic also has several costs t h a t m u s t be co n sid e re d . The m o s t s ig n ific a n t is u s u a lly th e loss o f c o n tro l associated w it h s h a rin g o w n e rs h ip o f th e co m p a n y w it h m a n y o th e r in v e s to rs . The o rig in a l owners* v o tin g p o w e r w ill be red uce d a t th e tim e o f a flo a t a n d t h e ir p ro p o r tio n a l o w n e rs h ip m a y d e clin e ove r tim e as th e y sell som e o f t h e ir shares o r as th e co m p a n y raises c a p ita l b y is s u in g m o re shares to n e w in ve sto rs. A p u b lic lis tin g also in v o lv e s d ire c t costs such as s to c k exchange lis tin g fees a n d s h a re h o ld e r s e rv ic in g costs. In a d d itio n , lis te d c o m p a n ie s in c u r costs associated w it h g re a te r in fo r m a tio n d isclo su re . These costs in c lu d e p ro d u c in g th e re q u ire d in fo r m a tio n a n d th e tim e s p e n t b y m a n a g e m e n t o n in v e s to r re la tio n s . In p a rtic u la r, m anagers m a y n e e d to discuss th e c o m p a n y s p la n s a n d p ro sp e cts w it h a n a lysts e m p lo y e d b y b ro ke rs a n d in s titu t io n s because th e re c o m m e n d a tio n s p ro d u c e d b y a n a lysts can in flu e n c e a co m p a n y s share p ric e a n d its a b ility to raise c a p ita l b y is s u in g m o re shares. F in a lly , th e in fo r m a tio n t h a t a lis te d com p an y is re q u ire d to disclose m a y in c lu d e d e ta ils t h a t are v a lu a b le to c o m p e tito rs .

9 .5 .2 | Initial public offering of ordinary shares As s h o w n in Table 9.3, th e n u m b e r o f IPO s a n d t h e ir v a lu e can v a ry c o n s id e ra b ly fr o m yea r to year. W h e n a c o m p a n y is to go p u b lic ,, its p ro m o te rs u s u a lly seek th e assistance o f a fin a n c ia l in s t it u t io n w ith e xp e rtise in a rra n g in g share issues. T y p ic a lly , th is has b e en th e fu n c tio n o f th e la rg e r s to c k b ro k e rs an d in v e s tm e n t b a n ks. B o th typ e s o f in s t it u t io n can advise o n th e p ric e o f th e issue, u n d e rw rite th e issue a n d h a n d le th e sale o f th e shares.

TABLE 9.3 New listings on the ASX Year en d e d June 3 0

2009

N u m be r o f new lis tin g s

45

In itia l cap ital raised

1.9

2010

93 11.5

2011 160 29.4

2012

99 10.2

2013

82 9.9

($ b illio n ) Source: ASX Limited, 2 0 1 3 Annual Report.

9 .5 .3 | Pricing a new issue D e cid in g o n th e p ric e o f a n e w issue is a d iff ic u lt ta sk. The is s u e r faces p o te n tia l p ro b le m s i f th e o ffe r p ric e is set to o h ig h o r to o lo w . I f th e p ric e is set to o h ig h , fe w in v e s to rs w ill w a n t to sub scrib e a n d th e issue m a y fa il unless i t is u n d e rw ritte n , in w h ic h case th e u n d e r w r ite r w ill have to m e e t th e s h o rtfa ll. In t u r n , th is o u tco m e w ill have a n e g a tive e ffe c t o n th e m a rk e t p ric e o f th e shares a fte r th e y are lis te d . I f th e p ric e is set to o lo w , th e o w n e rs w ill s u ffe r an o p p o r tu n it y loss because th e y w o u ld have received a h ig h e r p a y m e n t i f th e n e w issue h a d been m ad e a t a h ig h e r p rice . The a va ila b le evide nce suggests th a t, o n average, n e w issues in it ia lly tra d e a t a p ric e above th e issue p rice . In t h is sense th e y are u n d e rp ric e d ,. The u n d e rp ric in g o f in it ia l p u b lic o ffe rin g s is discussed in S e c tio n 9.5 .6 . The ta s k o f s e ttin g th e issue p ric e is p a r tic u la r ly d iff ic u lt w h e n th e co m p a n y has ju s t b e e n fo rm e d , as th e re is n o re co rd o f fin a n c ia l p e rfo rm a n c e . W h e re th e co m p a n y has p re v io u s ly o p e ra te d as a p riv a te com pany, th e ta s k is n o t as d iff ic u lt because p a s t p r o fits m a y be a g u id e to f u tu r e p ro fits . The m o s t c o m m o n a p pro ach to p r ic in g used b y advisers is to use h is to ric a l p r o fits as th e basis f o r e s tim a tin g fu tu re e a rn in g s p e r share. The a d vise r w ill also e x a m in e th e p ric e -e a rn in g s (P /E ) ra tio (th e m a rk e t price o f a share, d iv id e d b y th e e a rn in g s p e r share) o f e x is tin g co m p a n ie s in th e sam e o r s im ila r in d u s trie s . Forecasts o f fu tu re e a rn in g s p e r share a n d th e in fo r m a tio n o n p ric e -e a rn in g s ra tio s w ill th e n be used b y th e a d vise r to suggest a p o ssib le range o f issue p rice s f o r th e co m p a n y s shares. F o r exa m ple, i f a c o m p a n y is expected to e a rn 30 cen ts p e r share a n d th e p ric e -e a rn in g s ra tio s o f s im ila r co m p a n ie s are b e tw e e n 9 and 14, th is suggests an issue p ric e o f b e tw e e n $ 2 .7 0 a n d $ 4 .2 0 p e r share. I f in s titu t io n s are e n th u s ia s tic a b o u t th e p ro p o se d issue, th e issue p ric e m a y be set close to $ 4 .2 0 . In c o n tra s t, i f th e re is li t t le in te re s t

of fin a n c e : equity

A

B usiness finance

in th e issue, th e issue p ric e m a y be set clo se r to th e lo w e r e n d o f th e range. As is e v id e n t fr o m th e above d e s c rip tio n , use o f th is a p p ro a ch to set th e issue p ric e in v o lv e s co n sid e ra b le ju d g m e n t. In th e case o f a fix e d -p ric e o ffe r, th e p ric e m u s t be se t b e fo re th e p ro s p e c tu s is p r in te d a n d th e o ffe r is u s u a lly o p e n f o r a t le a s t 2 to 3 w eeks. C o n se q u e n tly, th e success o f th e o ffe r is s u b je c t to general m o v e m e n ts in share p rice s d u rin g a p e rio d o f seve ral w eeks. F o r exa m ple, i f th e g e n e ra l le v e l o f share prices increases s ig n ific a n tly d u rin g t h a t p e rio d , i t is lik e ly t h a t th e fix e d p ric e w ill be to o low . H o w eve r, i f share p rice s decrease s ig n ific a n tly d u r in g t h a t p e rio d , in v e s to rs m a y re g a rd th e fix e d p ric e as b e in g to o h ig h , a n d th e issue w ill close u n d e rs u b s c rib e d . A n a lte rn a tiv e a p p ro a ch w h e n p r ic in g a n e w issue is to use

book-building— a

process t h a t in v o lv e s

c o m p e titiv e b id d in g b y m a rk e t p a rtic ip a n ts , p a r tic u la r ly in s titu t io n a l in v e s to rs . T his a p p ro a ch uses e ith e r

open pricing o r constrained open pricing.

In b o th cases, p o te n tia l in v e s to rs place b id s f o r th e shares

w h e re th e y in d ic a te th e q u a n titie s th e y w is h to p u rcha se a t v a rio u s prices. The fin a l p ric e is d e te rm in e d a t th e e n d o f th e b id d in g process. In th e case o f o p e n p ric in g , shares are u s u a lly a llo c a te d o n ly to b id d e rs w h o o ffe re d p rice s e q u a l to o r h ig h e r th a n th e fin a l p rice . O p e n p r ic in g has b e en used in som e A u s tra lia n flo a ts , b u t c o n s tra in e d o p e n p r ic in g is m o re c o m m o n . In c o n s tra in e d o p e n p ric in g , b o th u p p e r an d lo w e r lim it s are placed o n th e p ric e a n d a ll b id s b e tw e e n th o s e lim it s are co n sid e re d . The p ro s p e c tu s w ill set o u t th e c r ite r ia to be used in a llo c a tin g shares to b id d e rs . U su a lly, th e p ric e ran ge can be re v is e d d u rin g th e b id d in g process i f d e m a n d f o r th e shares is fo u n d to be s u b s ta n tia lly g re a te r o r less th a n expected. O nce th e fin a l p ric e has been d e te rm in e d , a ll successful b id d e rs p a y th e sam e p ric e b u t th o se w h o m ade h ig h e r b id s have a h ig h e r p r o b a b ility o f re c e iv in g an a llo c a tio n o f shares. O ffe rs to in s titu t io n s u n d e r a b o o k -b u ild in g process are o fte n a cco m p a n ie d b y an o ffe r to th e general p u b lic (a 'r e ta il o ffe r*), w h e re a m a x im u m p ric e is sp e cifie d in advance a n d r e ta il in v e s to rs m a y also be o ffe re d a p ric e d is c o u n t. F o r exa m ple, in th e flo a t o f Q R N a tio n a l L td in N o v e m b e r 2 0 1 0 , th e re was an in s titu t io n a l b o o k -b u ild w it h an in d ic a tiv e p ric e ran ge o f $ 2 .5 0 to $3 a n d a re ta il o ffe r, w h ic h was su b je ct to a m a x im u m p ric e o f $ 2 .8 0 p e r share. Successful a p p lic a n ts in th e re ta il o ffe r p a id th e lo w e r o f th e fin a l p ric e p a id b y in s titu t io n s less a d is c o u n t o f 10 cen ts p e r share a n d th e m a x im u m r e ta il p ric e o f $2 .80. B o o k -b u ild in g was f ir s t used in A u s tra lia b y th e N e w S o u th W ales G o v e rn m e n t w h e n i t so ld th e G o v e rn m e n t In s u ra n c e O ffic e (G IO ) in 19 92 . Since th e G IO issue, i t has b e en use d in m a n y la rg e issues, in c lu d in g th e W o o lw o rth s , Q an ta s, T e ls tra a n d N in e E n te rta in m e n t flo a ts , a n d in som e s m a lle r flo a ts such as th o s e o f K a th m a n d u H o ld in g s ($ 3 4 0 m illio n in N o v e m b e r 2 0 0 9 ) a n d th e c re d it-c h e c k in g co m p a n y Veda G ro u p ($ 3 4 1 m illio n in D e cem b er 2 0 1 3 ). The m a in a d va n ta g e o f b o o k -b u ild in g is t h a t i t a llo w s th e is s u e r a n d its ad vise rs to o b ta in fee dba ck fr o m in fo rm e d in s titu t io n a l in v e s to rs o n t h e ir assessm ent o f th e va lu e o f th e shares. The in fo r m a tio n g a th e re d fr o m th e se in v e s to rs can be used in s e ttin g th e issue p rice . W h ile th is a p p ro a ch is e xp ected to re s u lt in a lo w e r le v e l o f u n d e rp ric in g , c o n d u c tin g a b o o k -b u ild is a c o s tly process, so i t is u s u a lly w o r th w h ile o n ly f o r la rg e r flo a ts . H ence, th e m a jo r ity o f flo a ts in A u s tra lia s t ill in v o lv e fix e d -p ric e o ffe rs. W it h a fix e d -p ric e o ffe r, once th e te rm s h a ve b e e n se t, th e a d v is e r u s u a lly e n su re s t h a t th e p ro p o s e d o ffe r s a tis fie s a ll re le v a n t le g a l re q u ire m e n ts a n d a s sists in p r e p a rin g th e o ffe r d o c u m e n t (u s u a lly a p ro s p e c tu s ), e n su re s t h a t s to c k exch an ge lis t in g re q u ire m e n ts are m e t, lo d g e s th e p ro s p e c tu s w it h A S IC a n d m a rk e ts th e shares to in s t it u t io n a l a n d p r iv a te in v e s to rs . The co sts o f p re p a rin g th e p ro s p e c tu s in c lu d e le g a l fees, fees f o r th e p re p a ra tio n o f a n in v e s tig a tin g a c c o u n ta n t's r e p o r t a n d th e co st o f p r in t in g . The t o t a l costs o f th e a d v is o ry se rv ic e s , in c lu d in g th e c o sts o f p re p a rin g a p ro s p e c tu s a n d o b ta in in g s to c k exch a n g e lis tin g , can v a r y w id e ly a n d u s u a lly re p re s e n t b e tw e e n 2 a n d 5 p e r c e n t o f th e a m o u n t ra is e d . A s discu sse d in S e c tio n 9 .5 .6 , th e costs can be less th a n 2 p e r c e n t o f th e a m o u n t ra is e d f o r la rg e r flo a ts . C o n ve rse ly, f o r v e r y s m a ll flo a ts t h a t ra is e $ 1 0 m illio n o r less, th e co sts are u s u a lly m u c h h ig h e r th a n 5 p e r c e n t. I f th e p ro m o te rs agree w i t h th e a d v is e rs re c o m m e n d a tio n s o n th e te rm s o f th e flo a t, th e sam e a d v is e r w i ll u s u a lly be a p p o in te d to u n d e r w r ite a n d h a n d le th e sale o f th e shares.

A s p re v io u s ly in d ic a te d , w ith a fix e d -p ric e o ffe r th e is s u e r is s u b je c t to th e vag aries o f th e m a rk e t fr o m th e tim e w h e n th e p ric e is set u n t il th e issue closes. In m a n y cases th e issu e r w ill pass th is r is k o n to an u n d e rw rite r, w h ic h is ty p ic a lly an in v e s tm e n t b a n k o r a m a jo r s to c k b ro k e r. I f th e b o o k -b u ild in g process is used, o n e o r m o re in v e s tm e n t b a n ks o r b ro k e rs w ill be n e ed ed to receive a n d c o lla te th e in s titu t io n a l bids, advise th e p ro m o te rs o n th e issue p ric e a n d m an ag e th e issue. In th is case, th e in s titu t io n s in v o lv e d are

C hapter n in e S ources

of fin a n c e : equity

ty p ic a lly re fe rre d to as 'lea d m anagers* o f th e issu e .16 N a tu ra lly , w h e n an u n d e r w r ite r acts as b o th a lead m anager as w e ll as f u lf illin g th e m o re t r a d itio n a l u n d e r w r itin g ro le , separate fees are o fte n charged. F o r exam ple, w h e n T en N e tw o rk H o ld in g s ra ise d $ 1 6 1 m illio n v ia th e in s titu t io n a l tra n c h e o f its e n title m e n t o ffe r in Ju n e 20 1 2 , i t p a id its ad vise rs, C itig ro u p , 1.8 5 p e r c e n t o f th e gross pro cee ds as an u n d e r w r itin g fee and a n o th e r 0.5 p e r ce n t as an o ffe r m a n a g e m e n t a n d a rra n g e m e n t fe e ,. I f th e issue is u n d e rw ritte n , th e o b lig a tio n s o f th e co m p a n y a n d th e u n d e rw rite r are c o n ta in e d in an u n d e rw ritin g ag ree m ent. The u n d e r w r ite r co n tra c ts to purchase a ll shares f o r w h ic h a p p lic a tio n s have n o t been received b y th e c lo sin g date o f th e issue. In re tu rn , th e u n d e rw rite r charges a fee, u s u a lly based o n a fix e d percentage o f th e a m o u n t to be raised b y th e issue. The fee is n e g o tia te d an d w ill re fle c t th e u n d e rw rite r s p e rce p tio n o f th e d iffic u lty o f s e llin g th e issue a n d th is in t u r n w ill be d e te rm in e d b y fa c to rs such as th e com pany s sta tu re in th e m a rk e t, th e p ric e o f th e issue an d general m a rk e t c o n d itio n s . The u n d e rw ritin g agreem ent n o rm a lly in clu d e s escape clauses th a t sp e cify th e circum stances in w h ic h th e u n d e rw rite r w ill be released fro m its o b lig a tio n s .17 In som e cases, th e ro le o f th e in s titu tio n s th a t m anage a flo a t m a y in clu d e price s ta b ilis a tio n once th e shares are lis te d . Price s ta b ilis a tio n , also k n o w n as a greenshoe o p tio n (a fte r th e com p an y th a t f ir s t used it ) , re q u ire s a special d is p e n s a tio n fro m ASIC. A d is p e n s a tio n o f th is ty p e was o b ta in e d b y th e in v e s tm e n t b a n ks th a t m anaged th e N o ve m b e r 2 0 1 0 flo a t o f ra il o p e ra to r Q R N a tio n a l, w h ic h was p re v io u s ly w h o lly o w n e d b y th e Q ue enslan d S tate G o v e rn m e n t (see F inance in A c tio n ).

PRICE STABILISATION IN FLOAT OF RAIL OPERATOR____________ T h e Q R N a t io n a l m e d ia re le a s e a n d A S X a n n o u n c e m e n t a b o u t th e p r ic in g a n d a llo c a t io n o f s h a re s in its f lo a t c o n t a in e d th e f o llo w in g s ta te m e n t: 'F o llo w in g th e tr a n s f e r o f Q R N a t i o n a l S h a re s b y th e S ta te to s u c c e s s fu l a p p lic a n t s , th e S ta te w ill in it ia lly r e ta in 8 2 1 4 3 6 7 3 5 Q R N a t i o n a l S h a re s . T h is a m o u n t m a y in c r e a s e b y u p to 1 4 6 4 0 0 0 0 0 Q R N a t io n a l S h a r e s d e p e n d in g o n w h e t h e r th e J o in t L e a d M a n a g e r s e x e r c is e a n o p t io n to p u r c h a s e u p t o 6 p e r c e n t o f Q R N a t i o n a l S h a re s o n is s u e to c o v e r a n y o v e ra llo c a t io n s m a d e a s p a r t o f th e O ff e r , a s d e s c r ib e d in s e c tio n 2 . 4 . 3 o f th e O f f e r D o c u m e n t / T h e m e a n in g o f th is s ta te m e n t w a s e x p la in e d a n d d is c u s s e d in a r tic le s b y f in a n c ia l jo u r n a lis ts . E x c e rp ts fr o m o n e s u ch a r t ic le a p p e a r b e lo w . R e a d th e Q R N a t io n a l m e d ia r e le a s e a b o u t t o d a y ’ s f lo a t c a r e f u lly a n d y o u r e a lis e th o s e c a n n y in v e s tm e n t b a n k e r s s o ld 6 6 p e r c e n t o f th e s h a re s in th e c o m p a n y . W h y s e ttle o n 6 6 p e r c e n t? T h e a n s w e r ta k e s us to th e d a r k a r t o f th e f lo a t 's jo in t le a d m a n a g e r s e n t e r in g th e m a r k e t a n d b u y in g s h a re s to s u p p o r t Q R 7s p r ic e . T h e p r ic e s u p p o r t t o o l k n o w n a s 'th e g r e e n s h o e ' is ( v e r y o p a q u e ly ) d is c lo s e d in th e p r o s p e c tu s . .. T h e t a n g le d t e c h n ic a lit ie s o f th e g r e e n s h o e s p e c if y it is a n o v e r - a llo c a tio n o p t io n . T h e te c h n ic a lit ie s m e a n th e o v e r - a llo c a te d s to c k c a n b e b o u g h t b a c k o n th e m a r k e t b y th e in v e s tm e n t b a n k s , p r o v id in g th e p r ic e s u p p o r t. G u e s s w h a t ? T h e o v e r - a llo c a t io n o p t io n — a n d th e r e f o r e th e p r ic e s u p p o r t — o n ly k ic k s in a f t e r th e Q u e e n s la n d g o v e r n m e n t s e lls 6 0 p e r c e n t o f th e s to c k . A n d th e o v e r - a llo c a tio n o p t io n is lim it e d to 6 p e r c e n t o f th e to ta l s to c k o n is s u e . N o w 6 0 p e r c e n t p lu s 6 p e r c e n t e x p la in s w h y th e o f f e r s o ld a m a g ic 6 6 p e r c e n t o f th e c o m p a n y . N o t 6 1 p e r c e n t. N o t 6 4 p e r c e n t. R ig h t o n th e k n o c k e r o f 6 6 p e r c e n t. A s in a n y f lo a t , it is h a r d to s e e w h e r e t o d a y 's p r ic e la n d s .

continued 16 It is possible for a share issue to be underwritten and priced using book-building. As discussed in Section 9.6.2, this approach is often used for share placements where issuers desire certainty of funding and, given the short time involved, the underwriting risk is low and its cost may be acceptable. In the case of IPOs, vendors are generally prepared to accept the risk that the market clearing price1established in a book-build may be less than they expected. In such cases, the indicative price range may be lowered or the proposed share issue may be withdrawn. 17 The escape clauses in an underwriting agreement relate to factors that would seriously affect demand for shares in general, such as the outbreak of war, a significant reduction in a benchmark market index such as the S&P/ASX 200, as well as company-specific events that could reduce the value of the shares.

F in a n c e in

ACTION

N e w s <W

n 墨.

B usiness finance

continued B e c e r t a in o f th is : if th e s h a r e p r ic e f a lls b e lo w th e o f f e r p r ic e , th e r e is p r ic e s u p p o r t a v a ila b l e in th e fo r m o f f iv e in v e s tm e n t b a n k s w it h a b o u t 9 p e r c e n t o f th e to ta l t r a d e d s h a re s a v a ila b l e to b u y . If th e s h a r e p r ic e is h o v e r in g a b o v e a n d b e lo w th e o f f e r p r ic e , r e a d th e Q u e e n s la n d g o v e r n m e n t 's v ic t o r io u s m e d ia r e le a s e s w it h a d e g r e e o f s c e p tic is m . T h e s h a r e p r ic e is m o r e th a n lik e ly b e in g g a m e d .

Source: 'Greenshoe on cue may be used to keep QR National 0^001', Stuart Washington, Sydney Morning Herald, 22 November 2010.

The la rg e r s to c k b ro k e rs are m a jo r u n d e rw rite rs , p r im a r ily because th e y have an e s ta b lis h e d c lie n te le p re p a re d to su b scrib e f o r th e issues th e y u n d e rw rite . A n u n d e r w r ite r w ill fre q u e n tly a tte m p t to li m it its e xp osu re to th e r is k o f u n d e rs u b s c rip tio n b y in v it in g o th e r in s titu t io n s to a ct as s u b u n d e rw rite rs . These in s titu t io n s m a y in c lu d e life a n d g e n e ra l in s u ra n c e co m p a n ie s, b a n k s a n d s u p e ra n n u a tio n fu n d s . The ro le o f th e s u b u n d e rw rite r is to ta k e u p a p r o p o r tio n o f a n y u n d e rs u b s c rip tio n in r e tu r n f o r a fee, p a id b y th e u n d e rw rite r, w h ic h is based o n a fix e d p r o p o r tio n o f th e issue p ric e .18

I f a s to c k b ro k e r is th e u n d e r w r ite r o r le a d m a n a g e r o f an issue o f shares i t w ill u s u a lly a ct as a s e llin g ag en t f o r th e issue. By p r o m o tin g an issue, a s to c k b ro k e r p ro te c ts its in te re s ts as u n d e r w r ite r a n d also earns b ro k e ra g e fees. D e p e n d in g o n th e size o f th e issue, one o r m o re o th e r b ro k in g fir m s m a y also be a p p o in te d as m a n a g e rs o r co-m a na gers to assist in p u b lic is in g th e issue a n d d is tr ib u tin g th e shares to a w id e range o f c lie n ts . The fees p a id to the se firm s w ill u s u a lly be s tru c tu re d so t h a t b ro k e rs w h o can d is tr ib u te shares to c lie n ts have an in c e n tiv e to co m p e te a g a in s t in s titu t io n a l b id s in a b o o k -b u ild . To th is end, th e fees f o r b ro k e rs m a y be d iv id e d in to a ‘f ir m a llo c a tio n fe e ’ a n d a ‘h a n d lin g fee’. The separate h a n d lin g fee encourages b ro k e rs to place b id s f o r a d d itio n a l shares above t h e ir f ir m a llo c a tio n in th e e x p e c ta tio n th a t th e a d d itio n a l shares can be so ld to t h e ir c lie n ts . G re a te r c o m p e titio n b e tw e e n in s t it u t io n a l in v e s to rs and b ro k e rs ’ c lie n ts (re ta il in v e s to rs ) is, o f course, d e sira b le f o r th e is s u e r a n d th e lead m an ag er. W h e re a fix e d -p ric e issue is n o t u n d e r w r itte n , a b ro k e r w ill s t ill be engaged to a ssist in d is tr ib u tin g th e shares. B roke rag e fees are n e g o tia b le a n d d e p e n d o n fa c to rs such as th e size o f th e issue, th e s ta tu s o f th e is s u in g co m p a n y a n d th e p e rio d f o r w h ic h th e issue is to re m a in open. B roke rag e fees are u s u a lly set b e tw e e n 1 a n d 2 p e r c e n t o f th e issue p rice .

I t was n o te d in S e c tio n 9 .2 .5 t h a t ra is in g c a p ita l b y is s u in g shares can in v o lv e s ig n ific a n t costs. In th e case o f c o m p a n y flo a ts th e costs fa ll in to th re e m a in categories: a

Stock exchange listing fees and the costs ofpreparing and distributing a prospectus. These

costs in c lu d e

le ga l fees, fees f o r th e p re p a ra tio n o f an in v e s tig a tin g a c c o u n ta n ts r e p o rt, fees f o r e x p e rt re p o rts a n d p r in t in g costs. b

Fees paid to underwriters or lead managers and commissions paid to brokers for selling the shares. The t o ta l o f these fees a n d costs can v a ry c o n s id e ra b ly b u t f o r m o s t flo a ts th e costs w o u ld fa ll in th e ran ge fro m 1 to 5 p e r c e n t o f th e fu n d s raised.

C

Underpricing. The

t h ir d c a te g o ry o f costs re la te s to th e fa c t t h a t th e issue p ric e o f shares s o ld in an

IP O is u s u a lly less th a n th e m a rk e t v a lu e o f th e shares once th e y are lis te d . The costs t h a t fa ll in to th e f ir s t tw o cate gories m a y be c o m b in e d to fo r m a t o t a l cost o f lis tin g . U n d e rp ric in g o f IPO s can be s ig n ific a n t a n d is discussed a fte r we discuss th e costs o f lis tin g . The fa c to rs t h a t in flu e n c e th e costs o f lis tin g f o r a flo a t in c lu d e its size, th e ris k in e s s o f th e co m p a n y a n d th e c o m p le x ity o f th e u n d e rly in g bu sin ess. The t o ta l costs w ill g e n e ra lly increase w it h th e size o f th e

18 The subunderwriting fee is usually only slightly less than the underwriting fee. For example, if the underwriting fee was 3 per cent of the issue price, the subunderwriting fee would usually be about 2.5 per cent of the issue price.

C hapter n in e S ources

of f in a n c e : equity

flo a t, b u t because o f th e fix e d n a tu re o f som e c o m p o n e n ts o f th e costs, th e y w ill be la rg e r in p e rcen ta ge te rm s w h e n th e a m o u n t o f fu n d s s o u g h t is sm a ll. F o r exa m ple, w h e n th e a m o u n t s o u g h t is less th a n $ 1 0 m illio n , th e costs can be m o re th a n 15 p e r c e n t o f th e a m o u n t s o u g h t. F o r flo a ts t h a t raise m o re th a n $ 1 0 0 m illio n , th e costs are u s u a lly fr o m 2 to 5 p e r c e n t o f th e a m o u n t s o u g h t a n d can be even lo w e r f o r la rg e r flo a ts . H o w eve r, v e ry la rg e flo a ts m a y be h a rd e r to sell a n d re q u ire a g re a te r m a rk e tin g e ffo r t. F o r exam ple, i f a flo a t is so la rge t h a t i t is necessary to a ttr a c t m a n y in te r n a tio n a l in v e s to rs , th e average cost m a y be h ig h e r th a n f o r a s m a lle r flo a t t h a t is s o ld o n ly in th e A u s tra lia n m a rk e t. I f a co m p a n y has aboveaverage business ris k , i t w i ll g e n e ra lly be m o re d iff ic u lt to d e te rm in e an a p p ro p ria te p ric e f o r th e shares a n d m o re d iffic u lt to se ll th e shares to in v e s to rs . T h ere fore, a m in in g e x p lo ra tio n co m p a n y w ill be m o re c o s tly to flo a t th a n an e s ta b lis h e d in d u s tr ia l co m p a n y w it h sta b le cash flo w s. F in a lly , i f a co m p a n y s o p e ra tio n s are c o m p le x o r d iff ic u lt to u n d e rs ta n d , i t w ill be m o re c o s tly to c a rry o u t ‘due d ilig e n c e ’ in v e s tig a tio n s o f th e com pany, a n d to engage in research a n d m a rk e tin g . F o r exa m ple, a d d itio n a l in d e p e n d e n t experts* re p o rts m a y be re q u ire d a n d a d d itio n a l costs m a y be in c u rre d in p r o m o tin g th e flo a t. W h e re a flo a t is u n d e r w r itte n , th e u n d e r w r itin g fee g e n e ra lly ranges fr o m 1 to 5 p e r c e n t o f th e fu n d s so u g h t. H is to ric a lly , th e m a jo r ity o f A u s tra lia n flo a ts have be en u n d e r w r itte n , b u t in re c e n t years th e p o p u la rity o f u n d e r w r itin g has d e c lin e d as m o re flo a ts have be en p ric e d a n d so ld u s in g th e b o o k ­ b u ild in g process. W h e re b o o k -b u ild in g is used, in v e s tm e n t b a n ks a n d b ro k e rs are s t ill in v o lv e d in th e IPO. H ow ever, in s te a d o f b e in g p a id to g u a ra n te e t h a t a c e rta in su m w ill be raised, th e y are p a id to p ro v id e a range o f services, in c lu d in g p re p a ra tio n o f research re p o rts o n th e com pany, a rra n g in g s e m in a rs an d a n a lyst b rie fin g s , a n d m a n a g in g th e b o o k -b u ild in g process. T h ere fore, b o o k -b u ild in g in v o lv e s s ig n ific a n t costs a n d w ill n o t ne ce ssa rily be che ap er th a n h a v in g a flo a t u n d e r w r itte n . In s u m m a ry , th e costs o f lis tin g are g e n e ra lly lo w e s t f o r la rge , lo w - r is k flo a ts w h e re th e u n d e rly in g b u sin ess is e a sily u n d e rs to o d b y in v e s to rs . F o r exa m ple, in th e 2 0 1 0 flo a t o f Q R N a tio n a l, w h ic h ra ise d $ 4 .0 5 b illio n , issue costs as d e ta ile d in se ctio n 1 0 .1 3 .4 o f th e c o m p a n y s O ffe r D o c u m e n t a m o u n te d to $ 7 5 .5 m illio n , w h ic h is less th a n 1.9 p e r ce n t o f th e fu n d s raised. U n d e rp ric in g o f a n IP O re p re s e n ts a re a l co st to th e o rig in a l sh a re h o ld e rs, w h o are e ffe c tiv e ly s e llin g assets to th e n e w sh a re h o ld e rs f o r less th a n t h e ir f a ir value. T his d iffe re n c e in v a lu e is o fte n re fe rre d to as m o n e y le ft o n th e ta b le 1. M o re pre cise ly, m o n e y le f t o n th e ta b le is u s u a lly d e fin e d as th e r e tu r n o n th e f ir s t day o f tra d in g , an d is ty p ic a lly m e a su re d b y th e n u m b e r o f shares sold, m u ltip lie d b y th e d iffe re n c e b e tw e e n th e firs t-d a y c lo s in g m a rk e t p ric e a n d th e issue p rice . I t has b e e n w e ll d o c u m e n te d t h a t in IPO s th e a m o u n t o f m o n e y le f t o n th e ta b le is ty p ic a lly large. F o r exa m ple, R itte r a n d W e lch fo u n d t h a t th e average firs t-d a y r e tu r n f o r 6 2 4 9 IP O s in th e US b e tw e e n 1 9 8 0 a n d 2 0 0 1 was 1 8 .8 p e r c e n t.19 R itte r a n d W elch also fo u n d t h a t th e average firs t-d a y r e tu r n v a rie d c o n s id e ra b ly o v e r tim e . In th e 19 80 s, th e average firs t-d a y r e tu r n was 7 .4 p e r c e n t a n d i t in crea sed to a lm o s t 1 1 .2 p e r c e n t d u r in g 1 9 9 0 -9 4 a n d 1 8 .1 p e r cent d u rin g 1 9 9 5 -9 8 b e fo re ju m p in g to 65 p e r c e n t d u rin g th e in t e r n e t b u b b le , p e rio d in 1 9 9 9 -2 0 0 0 and th e n re v e rtin g to 14 p e r c e n t in 2 0 0 1 .20 In A u s tra lia , a s tu d y b y Lee, T a y lo r a n d W a lte r (1 9 9 6 ) o f 2 6 6 in d u s tr ia l IP O s b e tw e e n 1 9 7 6 a n d 1 9 8 9 fo u n d an average firs t-d a y a b n o rm a l r e tu r n o f 11 .9 p e r ce n t. D im o v s k i a n d B ro o ks (2 0 0 3 ) s tu d ie d 3 5 8 in d u s tria l a n d resource IP O s in A u s tra lia fr o m 1 9 9 4 to 1 9 9 9 a n d fo u n d t h a t th e average firs t-d a y r e tu r n was 25 .6 p e r c e n t, w h ile th e m e d ia n firs t-d a y r e tu r n was 9.3 p e r ce n t. The IP O s th e y s tu d ie d ra ise d a to ta l o f $ 2 4 ,4 3 9 b illio n in c a p ita l, th e t o ta l a m o u n t o f m o n e y le f t o n th e ta b le was $ 5 ,6 7 8 b illio n a n d t o t a l issue costs w ere $ 5 9 2 m illio n . Da S ilva Rosa, V e la y u th e n a n d W a lte r (2 0 0 3 ) re p o rte d m e d ia n u n d e rp ric in g o f 12 p e r c e n t f o r t h e ir sam p le o f 3 3 3 A u s tra lia n in d u s tr ia l IP O s f r o m 1 9 9 1 to 19 9 9 . G on g a n d S h e kh a r (2 0 0 1 ) s tu d ie d a ll 11 g o v e rn m e n t-s e c to r IPO s in A u s tra lia b e tw e e n 1 9 8 9 a n d 19 99 . T hey fo u n d an average firs t-d a y a b n o rm a l r e tu r n f o r r e ta il in v e s to rs o f a p p ro x im a te ly 11 p e r c e n t a n d c o n c lu d e d t h a t th e re is n o evidence th a t th e u n d e rp ric in g o f the se IPO s d iffe rs fr o m t h a t o f A u s tra lia n p riv a te -s e c to r IPO s o r o f g o v e rn m e n t-s e c to r IP O s in o th e r O EC D c o u n trie s . The u n d e rp ric in g p h e n o m e n o n is n o t re s tric te d to th e US a n d A u s tra lia . P ro fe s s o r Jay R itte r fr o m th e U n iv e rs ity o f F lo rid a is one o f th e w o r ld s fo re m o s t e xp e rts in th e area o f IP O u n d e rp ric in g a n d has c o lle c te d th e e m p iric a l re s u lts fr o m m a n y stu d ie s u n d e rta k e n in d iffe re n t c o u n trie s a ro u n d th e w o rld (see h t t p : / / b e a r . w a r r in g t o n . u f l. e d u / r it t e r / ip o d a t a . h tm ) . F igu re 9.1 d e m o n s tra te s th e in it ia l re tu rn s en jo yed, o n average, b y IP O su b scrib e rs in te r n a tio n a lly an d illu s tra te s ju s t h o w p e rv a s iv e IP O u n d e rp ric in g has been.

19 Ritter and Welch (2002). The equally-weighted average first-day return measured from the offer price to the first closing price listed by CRSP is 18.8 per cent. 20 For an analysis of possible reasons for this variation, see Loughran and Ritter (2004).

|wwwj

B usiness finance

Source: Loughran, T., Ritter, J. and Rydqvist, K., Initial public offerings: International insights: 2014 update', 17 January 2014, http://bear.warrington.ufl.edu/ritter/lnt2014.pdif.

Reasons for underpricing M a n y p o s s ib le e x p la n a tio n s f o r th e u n d e rp ric in g o f IPO s have b e en p ro p o s e d . O n e e x p la n a tio n is based o n in fo r m a t io n a s y m m e try in t h a t som e in v e s to rs are m o re in fo rm e d th a n th e issu er, p e rh a p s a b o u t LEARNING OBJECTIVE 6 Discuss alternative explanations for the underpricing of initial public offerings

th e g e n e ra l d e m a n d f o r shares in th e m a rk e t. I t is also based o n th e c o n ce p t t h a t som e in v e s to rs are w e ll in fo rm e d a b o u t th e value o f th e shares b e in g o ffe re d w h ile o th e rs are u n in fo r m e d a n d th e re fo re have d iff ic u lt y e s tim a tin g th e fu tu r e m a rk e t p ric e o f th e shares. T his a p p ro a ch pro po ses t h a t a degree o f u n d e rp ric in g is necessary to a ttr a c t the se in v e s to rs . U n in fo rm e d in v e s to rs m a y a p p ly f o r a n y IP O b u t in fo r m e d in v e s to rs w ill o n ly s u b scrib e w h e n an issue is u n d e rp ric e d . T h e re fo re , w h e n an issue is o v e rp ric e d , a ll th e shares w ill be a llo c a te d to u n in fo rm e d in v e s to rs . C onversely, w h e n an issue is u n d e rp ric e d , in fo r m e d in v e s to rs w ill c ro w d out* th e u n in fo rm e d , w h o w i ll be a llo c a te d o n ly a fra c tio n o f th e shares. T his e x p la n a tio n m a y be illu s tra te d w it h a s im p le exa m ple. C o n s id e r tw o IPO s, one o f w h ic h records a firs t-d a y r e t u r n o f + 2 0 p e r ce n t, w h ile th e o th e r re co rd s a firs t-d a y r e t u r n o f - 1 0 p e r ce n t. Hence, th e average firs t-d a y r e tu r n is 5 p e r ce n t. Because th is r e tu r n is p o s itiv e , th e re appears to be u n d e rp ric in g . N o w c o n s id e r th e r e tu r n e a rn e d b y an u n in fo rm e d in v e s to r w h o a p p lie s f o r $ 1 0 0 0 0 w o r th o f shares in each o f th e se IP O s a n d is a llo c a te d $ 5 0 0 0 w o r th o f shares in th e f ir s t IP O a n d th e f u ll $ 1 0 0 0 0 w o r th o f shares in th e second. The u n in fo rm e d in v e s to r s r e t u r n is 0 p e r c e n t. T h e re fo re , fr o m th e v ie w p o in t o f th e u n in fo r m e d in v e s to r, th e IPO s are o n average f a ir ly p ric e d . In s u m m a ry , w h ile IPO s in v o lv e la rg e average in it ia l r e tu rn s , th is does n o t n e ce ssa rily m e a n t h a t e v e ry in v e s to r can e xp e ct to e a rn a b n o rm a l r e tu rn s b y s u b s c rib in g f o r co m p a n y flo a ts .

W IN N E R ^ CURSE

problem that arises in bidding because the bidder who ’wins’ is likely to be the one who most overestimates the value of the assets offered for sale

U n in fo rm e d in v e s to rs , th e re fo re , face a

w inn er^ curse.

I f th e y g e t a ll o f th e shares th e y d e m an d,

i t is because th e in fo r m e d in v e s to rs d id n o t w a n t th e m . Faced w it h th is s itu a tio n , u n in fo r m e d in v e s to rs w ill o n ly s u b scrib e to IPO s i f th e y are s u ffic ie n tly u n d e rp ric e d , o n average, to c o m p e n sa te f o r th e bias in th e a llo c a tio n o f shares ( fo r m o re d e ta ils , see R o ck 1 9 8 6 ). In research re la te d to th e ‘w in n e r ’s curse’ e x p la n a tio n i t is c o m m o n to assum e t h a t la rg e r in v e s to rs are b e tte r in fo rm e d th a n s m a ll in v e s to rs . Lee, T a y lo r a n d W a lte r (1 9 9 9 ) e xa m in e th is issue b y s tu d y in g IPO s o n th e S to ck E xchange o f S in ga pore w h e re d e ta ile d d a ta o n a p p lic a tio n s f o r a n d a llo c a tio n s o f shares are ro u tin e ly p ro v id e d . T h e ir re s u lts are c o n s is te n t w it h R o c k s (1 9 8 6 ) m o d e l: la rg e r in v e s to rs are m o re in fo rm e d in t h a t th e y a p p ly f o r re la tiv e ly m o re shares in issues t h a t are u n d e rp ric e d . Thus, s m a ll in v e s to rs are c ro w d e d o u t o f th e m o s t u n d e rp ric e d issues a n d receive la rg e r p r o p o r tio n s o f th e less a ttra c tiv e issues. A seco nd e x p la n a tio n f o r th e u n d e rp ric in g o f IP O s is t h a t p o te n tia l in v e s to rs w i ll a tte m p t to ju dg e th e in te re s t o f o th e r in v e s to rs a n d w ill o n ly s u b scrib e f o r IP O s t h a t th e y b e lie ve w i ll be p o p u la r. I f an in v e s to r perceives t h a t a flo a t is n o t p o p u la r w it h o th e r in v e s to rs , th e n he o r she m a y decide n o t to sub scrib e. I f th e is s u e r sets a p ric e t h a t is p e rce ive d as o n ly a l i t t le to o h ig h , th e re is a s ig n ific a n t p r o b a b ility t h a t th e issue w ill be a fa ilu re , w it h in v e s to rs d e c id in g n o t to s u b scrib e because o th e rs have also de cid e d n o t to sub scrib e. T h ere fore, issu ers m a y have an in c e n tiv e to u n d e rp ric e an issue in o rd e r to in d u c e som e p o te n tia l in v e s to rs to buy. The a c tio n o f the se in v e s to rs m a y th e n se t o f f a cascade in

C hapter n in e S ources

w h ic h o th e r in v e s to rs are w illin g to sub scrib e. R itte r a n d W e lch (2 0 0 2 ) n o te t h a t th is e x p la n a tio n is s u p p o rte d b y evidence t h a t IP O s te n d to be e ith e r u n d e rs u b s c rib e d o r h e a v ily o v e rsu b scrib e d , w it h fe w b e in g m o d e ra te ly o v e rsu b scrib e d . U s in g b o o k -b u ild in g to p ric e an IPO, w h ic h in c re a s in g ly has becom e s ta n d a rd p ra ctice , a llo w s issuers to o b ta in in fo r m a tio n fro m in fo rm e d in v e s to rs . A f te r an in d ic a tiv e p ric e ran ge has been set, th e issu e r a n d th e lead m a n a g e r u s u a lly go o n a ‘ro a d s h o w ’ to p ro m o te th e co m p a n y to p ro s p e c tiv e in v e s to rs . The lead m a n a g e r can th e n gauge d e m a n d f o r th e shares as exp re ssio n s o f in te re s t are rece ive d fr o m p o te n tia l in ve sto rs. I f d e m a n d is h ig h , th e o ffe r p ric e w ill be set a t th e to p o f th e in d ic a tiv e p ric e range o r i t m a y be set above th a t le ve l i f d e m a n d is p a r tic u la r ly s tro n g . H o w e ve r, p o te n tia l in v e s to rs w ill be u n w illin g to reveal t h e ir tru e in te re s t in th e IP O i f th e y k n o w t h a t s h o w in g s tro n g in te re s t is lik e ly to re s u lt in a h ig h e r o ffe r p ric e — un le ss th e y are o ffe re d s o m e th in g in re tu rn . U n d e rp ric in g th e n becom es p a r t o f th e in d u c e m e n t needed to g e t p o te n tia l in v e s to rs to t r u t h f u lly re ve a l t h a t th e y are w illin g to pu rcha se th e shares a t a h ig h price. A n a ly s is o f d a ta o n IPO s p ric e d u s in g b o o k -b u ild in g in th e US is c o n s is te n t w ith th is a rg u m e n t. F o r e xa m p le , R itte r a n d W e lch fo u n d t h a t o v e r th e 1 9 8 0 to 2 0 0 1 p e rio d , f o r IP O s th a t were p ric e d w it h in th e in d ic a tiv e p ric e range, average u n d e rp ric in g was 12 p e r ce n t. H o w e ve r, w h e n th e o ffe r p ric e was above th e in d ic a tiv e p ric e range, average u n d e rp ric in g was 53 p e r ce n t. The a d d itio n a l u n d e rp ric in g is re g ard ed as c o m p e n s a tio n to in d u c e in v e s to rs to reve al t h e ir h ig h in d iv id u a l d e m a n d f o r th e shares— b u t as R itte r a n d W e lch n o te , average u n d e rp ric in g o f 53 p e r c e n t seems to be excessive c o m p e n s a tio n f o r re v e a lin g in fo r m a tio n . Several stu d ie s have fo u n d t h a t g re a te r u n d e rp ric in g is a sso cia te d w it h h ig h e r tra d in g v o lu m e once th e shares becom e lis te d . A c c o rd in g ly , a t h ir d e x p la n a tio n f o r u n d e rp ric in g is t h a t i t p ro v id e s b e n e fits th ro u g h g re a te r liq u id ity . F o r exa m ple, a b ro k e r w h o u n d e rw rite s an IP O can e a rn h ig h e r b ro ke ra g e fees fo r h a n d lin g tra d e s in th e p o s t-lis tin g m a rk e t i f th e issue is u n d e rp ric e d . L iq u id ity can also b e n e fit issuers, p a rtic u la rly i f th e y have re ta in e d a h ig h p r o p o r tio n o f th e c o m p a n y s shares. P ham , K a le v an d Steen (2 0 0 3 ) argue t h a t g re a te r u n d e rp ric in g encourages s m a ll in v e s to rs to su b scrib e f o r an IPO, w h ic h re su lts in a b ro a d e r an d m o re d iffu s e o w n e rs h ip base. U s in g a sam ple o f A u s tra lia n IPO s th e y s h o w t h a t these fa c to rs are s ig n ific a n tly a n d p o s itiv e ly a sso cia te d w it h th e liq u id it y o f th e shares once th e y are lis te d . C onversely, th e y argue t h a t lo w e r u n d e rp ric in g w ill g ive ris e to a m o re c o n c e n tra te d o w n e rs h ip s tru c tu re , w h ic h m a y be p re fe rre d i f la rge sh a re h o ld e rs o b ta in b e n e fits fr o m c o n tro l o r can p ro v id e va lua ble m o n ito r in g o f th e c o m p a n y s m a n a g e m e n t. A f o u r t h e x p la n a tio n is t h a t u n d e rp ric in g o f IPO s is in th e in te re s ts o f th e is s u in g com p an y. O ne aspect o f th is e x p la n a tio n is t h a t u n d e rp ric e d IP O s *leave a g o o d taste* w it h in v e s to rs , ra is in g th e p ric e a t w h ic h sub se q u e n t share issues b y th e c o m p a n y can be s o ld .21 A re la te d a rg u m e n t is t h a t u n d e rp ric in g re fle cts, a t le ast in p a rt, th e co st to th e is s u in g co m p a n y o f p u rc h a s in g research coverage b y a n a lysts. C liff a n d D e nis (2 0 0 4 ) n o te t h a t in a d d itio n to p re -IP O a c tiv itie s re la te d to th e p r ic in g a n d m a rk e tin g o f a share issue, in v e s tm e n t b a n k s p ro v id e a ran ge o f p o s t-is s u e services such as m a rk e t-m a k in g a n d a n a ly s t research coverage. T hey also n o te t h a t is s u in g co m p a n ie s a p p e a r to place a v a lu e o n s e c u rin g research coverage fr o m a n a lysts, p a r tic u la r ly th o s e w it h s tro n g re p u ta tio n s . A c c o rd in g ly , issu ers p la n n in g an IPO m a y seek o u t u n d e rw rite rs w h o th e y e xp e ct w ill p ro v id e research coverage b y a h ig h ly ra te d a n a ly s t a n d issuers w ill be p re p a re d to p a y f o r t h a t a n a ly s t coverage— p e rh a p s d ire c tly b y w a y o f h ig h e r u n d e r w r itin g fees. H o w eve r, C lif f a n d D e n is fo u n d t h a t u n d e r w r itin g fees are la rg e ly u n ifo r m a n d p ro p o se in s te a d t h a t gre a te r u n d e rp ric in g serves to in d ir e c tly com p e n sa te u n d e rw rite rs f o r p ro v id in g a n a ly s t coverage. F o r exam ple, u n d e rw rite rs can b e n e fit fr o m u n d e rp ric in g b y a llo c a tin g shares to fa v o u re d c lie n ts w h o are expected to p ro v id e th e u n d e r w r ite r w it h in v e s tm e n t b a n k in g o r b ro k in g b u sin e ss in th e fu tu re . A f if t h e x p la n a tio n is t h a t issu e rs u n d e rp ric e IP O s to reduce th e r is k o f b e in g sued b y in v e s to rs . W h ile th e p o te n tia l le ga l lia b ilit y o f issu e rs m a y be a fa c to r in som e IPO s, p a r tic u la r ly in th e US, o th e r c o u n trie s , w h ere litig a t io n is m u c h less c o m m o n , e xp erience s im ila r levels o f u n d e rp ric in g . T h e re fo re , i t seems u n lik e ly th a t le ga l lia b ilit y is th e m a in fa c to r t h a t d e te rm in e s th e u n d e rp ric in g o f IPO s. F in a lly , L o u g h ra n a n d R itte r (2 0 0 2 ) n o te t h a t issuers ra re ly ap p e a r to be u p s e t a b o u t le a v in g s u b s ta n tia l a m o u n ts o f m o n e y o n th e ta b le in IPO s. T hey p ro p o se a b e h a v io u ra l e x p la n a tio n f o r th is p u z z lin g p h e n o m e n o n . T h e ir e x p la n a tio n can be illu s tra te d u s in g a h y p o th e tic a l e xa m p le . Suppose th a t M arcus T h o m p s o n o w n s a la rg e successful b u sin ess an d, a fte r d is c u s s io n w ith an in v e s tm e n t b a n k , he plan s to sell 60 p e r c e n t o f th e co m p a n y in an IPO , w h ic h w ill be p ric e d u s in g a b o o k -b u ild . The in d ic a tiv e *1 4 9 21 For an analysis of this explanation, see Welch (1989). The explanations for underpricing of IPOs outlined above are only some of the possible explanations that have been proposed. Further explanations are discussed by Ibbotson, Sindelar and Ritter (1994) and Brau and Fawcett (2006).

of f in a n c e : equity

B usiness finance

p ric e ran ge f o r th e b o o k -b u ild is set a t $ 4 .5 0 to $5 p e r share, b u t, a fte r a successful ro a d s h o w , w h e re th e in v e s tm e n t b a n k reco rds s tro n g in te re s t fr o m in s titu tio n s , i t advises M a rcu s t h a t th e issue p ric e s h o u ld be in cre a se d to $6 p e r share. G iv e n th e g o o d ne w s t h a t h is c o m p a n y is w o r th a t le a st 2 0 p e r c e n t m o re th a n he p re v io u s ly th o u g h t, M a rcu s accepts th e advice a n d does n o t b a rg a in f o r a h ig h e r issue price. W h e n th e shares are lis te d o n th e ASX, th e firs t-d a y c lo s in g m a rk e t p ric e is $1 0. M a rc u s has le f t a large a m o u n t o f m o n e y o n th e ta b le b u t he has also d isco ve re d t h a t th e in te re s t he re ta in e d — 4 0 p e r c e n t o f th e shares— is w o r th tw ic e as m u c h as he expected. G ive n th e p le a s a n t s u rp ris e a b o u t h is n e w -fo u n d w e a lth , M a rcu s m a y fe e l happy, d e sp ite th e o p p o r tu n it y loss o n th e shares t h a t he so ld to o th e r in v e s to rs . I f th e la rge in it ia l re tu rn s o n IPO s re fle c t ra tio n a l b e h a v io u r b y issuers a n d in v e s to rs , th e n these re tu rn s s h o u ld be re la te d to fa c to rs such as th e a m o u n t o f in fo r m a tio n a va ila ble to in v e s to rs a n d th e b e n e fits t h a t issu ers m a y d e riv e f r o m u n d e rp ric in g . E m p iric a l evide nce s u p p o rts th is e x p e c ta tio n . F or exa m ple, Lee, T a y lo r a n d W a lte r (1 9 9 6 ) fo u n d a s tro n g in v e rs e re la tio n s h ip b e tw e e n th e le n g th o f th e de la y b e tw e e n p ro sp e ctu s re g is tra tio n a n d exchange lis tin g a n d th e le v e l o f u n d e rp ric in g . In o th e r w o rd s, IPO s w it h s h o rte r delays in lis tin g are s ig n ific a n tly m o re u n d e rp ric e d . T his fin d in g is c o n s is te n t w it h th e ^w in n e rs curse* e x p la n a tio n in w h ic h in fo rm e d in v e s to rs w ill q u ic k ly s u b scrib e f o r u n d e rp ric e d issues th e re b y e n s u rin g t h a t th e issue w ill be fille d in a s h o rt p e rio d . H o w , Iz a n a n d M o n ro e (1 9 9 5 ) also fo u n d a s tro n g re la tio n s h ip b e tw e e n de la y in lis tin g a n d th e le ve l o f u n d e rp ric in g . F u rth e r, th e y fo u n d th a t u n d e rp ric in g is re la te d to m easures o f b o th th e q u a lity a n d q u a n tity o f in fo r m a t io n a va ila b le a b o u t th e com pany. S pe cifica lly, u n d e rp ric in g was lo w e r w h e n th e u n d e r w r ite r h a d a g o o d re p u ta tio n a n d i t was also lo w e r f o r co m p a n ie s w it h m o re in fo r m a t io n a va ila b le .22 C am p, C o m e r a n d H o w (2 0 0 6 ) s tu d ie d 4 9 N e w Z e a la n d IPO s t h a t lis te d b e tw e e n 1 9 8 9 a n d 2 0 0 2 . They fo u n d t h a t u n d e rp ric in g was s ig n ific a n tly lo w e r f o r issues t h a t used b o o k -b u ild in g ra th e r th a n a fix e d p ric e o ffe r. T his re s u lt is c o n s is te n t w it h th e a rg u m e n t t h a t b o o k -b u ild in g p ro v id e s issuers w ith feedback fr o m in fo rm e d in v e s to rs , w h ic h a llo w s m o re accurate p r ic in g o f th e IPO. T hey also fo u n d t h a t g re a te r u n d e rp ric in g is associated w it h h ig h e r tra d in g v o lu m e in th e p o s t-lis tin g m a rk e t, su g g e s tin g a tra d e -o ff b e tw e e n th e cost (u n d e rp ric in g ) o f g o in g p u b lic a n d th e b e n e fit (g re a te r liq u id ity ) o f d o in g so. C am p e t al. also fo u n d t h a t u n d e rp ric in g is p o s itiv e ly re la te d to th e p r o p o r tio n o f shares re ta in e d b y th e p re -IP O sh a re h o ld e rs. C o n s is te n t w it h L o u g h ra n a n d R itt e r s e x p la n a tio n , issu ers w h o re ta in m o re shares in th e c o m p a n y a p pe ar to be less co n ce rn e d a b o u t u n d e rp ric in g because a n y loss o f w e a lth o n th e shares sold in th e IP O w i ll be o ffs e t b y a g a in o n th e shares th e y re ta in . U n d e rp ric in g o f IPO s is a p e rs is te n t p h e n o m e n o n t h a t is y e t to be f u lly e x p la in e d . In e v a lu a tin g th e p ro p o s e d e x p la n a tio n s o u tlin e d p re v io u s ly , th e q u e s tio n s h o u ld n o t be: ‘W h ic h m o d e l is co rre c t? ’ R a th er, w e s h o u ld ask q u e s tio n s such as: ‘W h ic h m o d e l is m o re u s e fu l in th is case?’ A lso , w e s h o u ld re m e m b e r t h a t th e reasons f o r u n d e rp ric in g can change o v e r tim e . F o r exa m ple, th e re is evidence t h a t u n d e rp ric in g is g e n e ra lly lo w e r f o r com p an ies t h a t engage h ig h e r-q u a lity u n d e rw rite rs a n d h ig h e r-q u a lity a u d ito rs . These p a rtie s have been v ie w e d as p ro v id in g a c e rtific a tio n role; in v e s to rs are c o n fid e n t t h a t a h ig h q u a lity u n d e r w r ite r w ill n o t o v e rp ric e an IP O because d o in g so w o u ld h a rm its r e p u ta tio n w it h in v e s to rs . H o w e ve r, th e u s u a l re la tio n s h ip b e tw e e n u n d e rp ric in g a n d u n d e r w r ite r q u a lity re ve rse d d u rin g th e 1 9 9 9 -2 0 0 0 in t e r n e t b u b b le \ A s discussed p re v io u s ly , one e x p la n a tio n f o r th is re v e rs a l is t h a t th e o b je c tiv e s o f issu ers cha ng ed in t h a t th e y becam e less co n ce rn e d a b o u t u n d e rp ric in g a n d w e re p re p a re d to p a y f o r research coverage b y le a d in g an alysts.

The c o n s is te n t fin d in g t h a t IPO s are o n average u n d e rp ric e d does n o t ne ce ssa rily m e a n t h a t issue prices are ‘to o lo w ’ 一 i t is also p o ssib le t h a t firs t-d a y m a rk e t p rice s are 'to o h ig h ,. T his p o s s ib ility is c o n s is te n t LEARNING OBJECTIVE 7 Outline evidence on the long-term performance of companies that are floated

w it h evide nce t h a t th e p o s itiv e firs t-d a y re tu rn s o n IP O s are o fte n reve rsed o v e r tim e — t h a t is, several stu d ie s have fo u n d t h a t th e shares o f n e w ly lis te d co m p a n ie s te n d to u n d e rp e rfo rm d u r in g th e f ir s t fe w years a fte r lis tin g . U n fo rtu n a te ly , i t is v e ry d iff ic u lt to a c c u ra te ly assess th e lo n g -ru n p e rfo rm a n c e o f c o m p a n ie s t h a t go p u b lic . O n e rea son is t h a t th e m a rk e t m o d e l, w h ic h was in tro d u c e d in S e ctio n 7.6.3, c a n n o t be used to e s tim a te th e be tas o f th e s e c u ritie s because p re -lis tin g r e tu r n d a ta does n o t e x is t f o r IPO s. T h ere fore, researchers have used a v a r ie ty o f o th e r approaches to assess w h e th e r p o s t-lis tin g re tu rn s are a b n o rm a l. O ne a p p ro a ch is to com p are p o s t-lis tin g r e tu rn s o n IP O co m p a n ie s to one o r m o re 22 The underwriting fee as a percentage of the issue proceeds was used as a measure of the underwriters reputation and the size of the company was used as a measure of the quantity of information.

C hapter n in e S ources

of fin a n c e : equity

m a rk e t in d ice s, w ith o u t a n y a d ju s tm e n t f o r ris k . A n o th e r a p p ro a ch is to co m p a re th e re tu rn s o n th e IPO com panies w ith a c o n tro l sam ple o f o th e r lis te d co m p a n ie s m a tc h e d o n th e basis o f one o r m o re ch a ra cte ristics such as size (m a rk e t c a p ita lis a tio n ) a n d in d u s try . R itte r (1 9 9 1 ) s tu d ie d co m p a n ie s t h a t w e n t p u b lic in th e US in th e p e rio d 1 9 7 5 to 1 9 8 4 .23 H e fo u n d t h a t an in v e s to r w h o p u rc h a s e d shares in IP O co m p a n ie s a t th e c lo s in g p ric e o n th e f ir s t d a y o f p u b lic tra d in g an d th e n h e ld th e shares f o r 3 years w o u ld have e a rn e d an average t o ta l r e tu r n o f 3 4 .4 7 p e r cen t. F o r a c o n tro l sam ple o f n o n -IP O com p an ies m a tc h e d b y size a n d in d u s try , th e average t o ta l r e tu r n o ve r th e same p e rio d was 6 1 .8 6 p e r cen t. The u n d e rp e rfo rm a n c e b y IP O co m p a n ie s v a rie d s ig n ific a n tly fr o m yea r to yea r a n d across in d u s trie s b u t i t was c o n c e n tra te d a m o n g re la tiv e ly y o u n g , g ro w th com p an ies, p a rtic u la rly th o s e t h a t w e n t p u b lic in years w h e n th e re was a h ig h v o lu m e o f IPO s. L o u g h ra n a n d R itte r (1 9 9 5 ) fo u n d t h a t th e p o o r lo n g -te rm p e rfo rm a n c e o f IP O s c o n tin u e d b e y o n d 3 years a n d was sha red b y com p an ies m a k in g su b s e q u e n t e q u ity issues— k n o w n as s e a s o n e d e q u i t y

SEASONED EQUITY

o f f e r in g s (SEOs) in th e US. U s in g la rge sam ples o f co m p a n ie s t h a t issu ed e q u ity in th e p e rio d 1 9 7 0 to

OFFERING

19 9 0 , th e y re p o rte d average a n n u a l re tu rn s o v e r th e 5 years a fte r th e is s u in g o f o n ly 5 p e r c e n t f o r IPO s a n d 7 p e r c e n t f o r com p an ies m a k in g SEOs. In c o n tra s t, in v e s tin g in n o n -is s u in g com p an ies o f th e same size an d h o ld in g th e in v e s tm e n t f o r th e sam e p e rio d w o u ld have p ro d u c e d an average a n n u a l re tu r n o f 12 p e r ce n t f o r IPO s a n d 15 p e r c e n t f o r SEOs. L o u g h ra n a n d R itte r p ro p o se t h a t t h e ir evide nce is c o n s is te n t w ith a m a rk e t w h e re shares are p e rio d ic a lly o v e rv a lu e d a n d t h a t com p an ies ta ke ad van ta ge o f these E n d o w s o f o p p o r tu n it y 1 b y is s u in g e q u ity a t th o s e tim e s . T h a t idea, a n d th e re la te d p ro p o s itio n th a t in v e s to rs w ill re s p o n d b y c u ttin g share p rice s w h e n an issue is a n n o u n ce d , are n o t new . F o r e xa m ple, S m ith (1 9 8 6 ) re p o rte d t h a t w h e n a US co m p a n y a n n o u n ce s an SEO, its share p ric e fa lls b y a b o u t 3 p e r cen t o n average. L o u g h ra n a n d R itte r p o in t o u t t h a t i f in v e s to rs are to receive th e sam e lo n g -te rm re tu rn s on issuers as o n n o n -is s u e rs o f th e sam e size, th e fa ll in p ric e w h e n an issue is a n n o u n c e d s h o u ld be m u c h larger. T h e ir n u m b e rs *im p ly t h a t i f th e m a rk e t re a cte d f u lly to th e in fo r m a tio n im p lie d b y a n e q u ity issue a n n o u n c e m e n t, th e average a n n o u n c e m e n t e ffe c t w o u ld be - 3 3 p e r c e n t, n o t - 3 p e r cent* (L o u g h ra n an d R itte r 19 9 5 , p. 4 8 ). L o u g h ra n a n d R itte r r e fe r to th e u n e x p la in e d lo w lo n g -te rm re tu rn s fo llo w in g e q u ity issues as ‘th e n e w issues p u z z le ’. The sig n ifica n ce o f th e n e w issues p u z z le is c o n tro v e rs ia l. B rav a n d G o m p e rs (1 9 9 7 ) s h o w t h a t lo w p o s t-lis tin g re tu rn s te n d to be c o n c e n tra te d a m o n g s m a ll com p an ies, w h ic h m ea ns t h a t m ea sure d u n d e rp e rfo rm a n c e is m u c h s m a lle r w h e n re tu rn s are v a lu e w e ig h te d ra th e r th a n e q u a lly w e ig h te d . They also fin d t h a t u n d e rp e rfo rm a n c e is a c h a ra c te ris tic o f s m a ll com p an ies w it h lo w b o o k -to -m a rk e t ra tio s regardless o f w h e th e r th e y are n e w ly lis te d o r n o t. I n o th e r w o rd s , B ra v a n d G o m p e rs f in d t h a t c om p an ies th a t go p u b lic do n o t e x h ib it lo n g -te rm u n d e rp e rfo rm a n c e w h e n r e tu rn s are m e a su re d re la tiv e to c o n tro l com panies m a tc h e d o n b o th size a n d b o o k -to -m a rk e t ra tio . Eckbo, M a s u lis a n d N o r li (2 0 0 0 ) arg ue t h a t th e *new issues puzzle* id e n tifie d b y L o u g h ra n a n d R itte r can be reso lve d w ith o u t re s o rtin g to e x p la n a tio n s based o n m a rk e t u n d e rre a c tio n to th e in fo r m a tio n in a n n o u n c e m e n ts o f s e c u rity issues. E ckbo e t al. analyse re tu rn s fo llo w in g a la rg e sam p le o f seasoned issues o f b o th e q u ity a n d d e b t fr o m 1 9 6 4 to 1 9 9 5 . T hey argue t h a t th e m a tc h e d -firm te c h n iq u e does n o t p ro v id e a p ro p e r c o n tro l f o r r is k f o r tw o reasons. F irs t, an e q u ity issue lo w e rs th e fin a n c ia l leverage o f th e is s u in g c o m p a n y so issu ers also lo w e r t h e ir ris k , a n d th e re fo re t h e ir e xp e cte d r e tu rn , re la tiv e to th e m a tch e d firm s . Second, th e y f in d t h a t share t u r n o v e r increases s ig n ific a n tly a fte r SEOs, b u t tu r n o v e r does n o t change f o r th e m a tc h e d firm s . In o th e r w o rd s , liq u id it y increases a fte r SEOs so th e shares o f is s u in g com panies c o u ld re q u ire lo w e r liq u id it y p re m iu m s a fte r an issue. In sum , th e y con clu de t h a t evidence o f lo n g -ru n u n d e rp e rfo rm a n c e p ro d u c e d b y th e m a tc h e d -firm te c h n iq u e is an a r tifa c t o f th e te c h n iq u e its e lf* (Eckbo, M a s u lis & N o r li 2 0 0 0 , p. 2 5 3 ). G om pe rs a n d L e rn e r (2 0 0 3 ) p o in t o u t t h a t m o s t stu d ie s th a t re p o rt u n d e rp e rfo rm a n c e b y IP O s have e xa m in e d d a ta fr o m th e tim e p e rio d a fte r fo r m a tio n o f th e N asdaq syste m w h e re m o s t US IPO s are tra d e d . The N asdaq is th e la rg e s t e le c tro n ic e q u ity s e c u ritie s tra d in g m a rk e t in th e US. W h e n e sta b lish e d in th e e a rly 19 70 s b y th e N a tio n a l A s s o c ia tio n o f S e cu ritie s D ealers, i t was th e w o r ld s f ir s t e le c tro n ic sto c k m a rk e t. To te s t w h e th e r th e re is a ‘N a sda q e ffe c t’，G o m p e rs a n d L e rn e r c o n d u c te d an o u t-o f-s a m p le in v e s tig a tio n u s in g d a ta o n 3 6 6 1 IPO s fr o m 1 9 3 5 to 1 9 7 2 — a p e rio d p r io r to th e c re a tio n o f N asdaq. They fo u n d t h a t th e re la tiv e p e rfo rm a n c e o f a n IP O sam p le depends c r itic a lly o n th e m e th o d used to assess p e rfo rm a n c e . O ne m e th o d re ve aled som e u n d e rp e rfo rm a n c e , b u t th is m e a su re d u n d e rp e rfo rm a n c e

23 Updated evidence on the long-term performance of US IPOs from 1970 to 2013 is available at http://bear.w arrington.ufl. edu/ritter/ipodata.htm.

offer to sell equity securities of a class that is already traded

B usiness finance

d isa p p e a re d w h e n th e sam e sam p le was s tu d ie d u s in g o th e r m e th o d s , in c lu d in g re g re ssio n s based o n th e C A P M (see S e c tio n 7 .6 .2 ) a n d th e Fam a a n d F re n c h th re e -fa c to r m o d e l (see S e ctio n 7 .7 ). G om pe rs and L e rn e r co n clu d e t h a t th e evide nce f o r u n d e rp e rfo rm a n c e b y IP O s is w eak. M ix e d evide nce o n th e lo n g -te rm p e rfo rm a n c e o f c o m p a n ie s t h a t go p u b lic is n o t c o n fin e d to th e US. F o r A u s tra lia n IPO s, lo n g -te rm u n d e rp e rfo rm a n c e , re la tiv e to th e m a rk e t in d e x , has b e en re p o rte d by Lee, T a y lo r a n d W a lte r (1 9 9 6 ) o v e r 3 years, a n d D im o v s k i a n d B ro o ks (2 0 0 3 ) o v e r 1 year, a fte r lis tin g . F o r t h e ir sam p le o f 2 6 6 IPO s, Lee e t al. re p o rte d a m a rk e t-a d ju s te d r e t u r n o f - 5 1 p e r c e n t o v e r 3 years. D im o v s k i a n d B ro o ks re p o rte d a n average m a rk e t-a d ju s te d r e tu r n o f - 4 . 0 p e r ce n t o v e r 1 ye a r f o r a sam p le o f 2 5 1 IP O s fr o m 1 9 9 4 to 19 9 8 . H o w e ve r, th e re s u lts w e re n o t u n if o r m ly n e g a tiv e w h e n th e sam p le w as d iv id e d in to su b g ro u p s. F o r exa m ple, th e average m a rk e t-a d ju s te d r e tu r n f o r 7 8 n o lia b ilit y co m p a n ie s w as - 3 0 p e r c e n t a fte r 1 ye a r b u t f o r th e 1 7 3 lim it e d lia b ilit y co m p a n ie s th e c o rre s p o n d in g average r e t u r n w as +7.7 p e r ce n t. The m e d ia n m a rk e t-a d ju s te d r e t u r n a fte r 1 y e a r w as n e g a tiv e f o r th e sam p le as a w h o le a n d f o r e ve ry su b g ro u p . In c o n tra s t, da S ilva Rosa, V e la y u th e n a n d W a lte r (2 0 0 3 ) used several b e n c h m a rk s a n d co n clu d e d t h a t th e sam p le th e y s tu d ie d d id n o t u n d e rp e rfo rm in th e 2 years fo llo w in g lis tin g . In s u m m a ry , th e evidence o n lo n g -ru n p e rfo rm a n c e fo llo w in g IP O s re m a in s c o n tro v e rs ia l. M a n y stu d ie s have re p o rte d u n d e rp e rfo rm a n c e b y IP O co m p a n ie s o v e r p e rio d s o f 1 to 5 years a fte r lis tin g . There is evide nce t h a t co m p a n ie s t h a t issue e q u ity , w h e th e r th r o u g h an IP O o r a seasoned o ffe rin g , te n d to be p o o r lo n g -te rm in v e s tm e n ts . H o w e ve r, several a u th o rs have q u e s tio n e d w h e th e r th e *new issues puzzle* is re a l a n d p ro v id e evide nce t h a t suggests t h a t i t m a y be n o m o re th a n a n illu s io n .

9.6 LEARNING OBJECTIVE 8 Explain how companies raise capital through rights issues, placements, share purchase plans and share options

Subsequent issues of o rd in a ry shares

A f te r a c o m p a n y has been flo a te d , a d d itio n a l e x te rn a l fin a n c e w i ll u s u a lly be re q u ire d a t som e tim e to fin a n c e e x p a n s io n . M a n a g e m e n t has th e choice o f is s u in g m o re shares a n d /o r b o rro w in g . I f i t is de cid e d to issue m o re shares, th e re are several choices ava ila ble. I f th e fu n d s are to be ra is e d f r o m e x is tin g sh a re h o ld e rs, th e c o m p a n y can m ake a p ro -ra ta share issue (e n title m e n t o ffe r) o r set u p a share p u rch a se p la n (SPP). A p ro -ra ta sha re issue m a y in t u r n be e ith e r a tr a d itio n a l r ig h ts issue o r a n a ccelerated e n title m e n t o ffe r an d in e ith e r case th e o ffe r m a y be re n o u n ce a b le o r n o n -re n o u n c e a b le . I f m a n a g e m e n t decides to raise fu n d s fr o m selected in v e s to rs , w h o m a y o r m a y n o t be e x is tin g s h a re h o ld e rs in th e co m p a n y, i t m u s t choose a p la c e m e n t. Share issues o f the se typ e s m a y be c a rrie d o u t in d iv id u a lly o r in c o m b in a tio n . F o r exa m ple, a co m p a n y m a y raise c a p ita l th ro u g h a p la c e m e n t a n d an SPP t h a t are a n n o u n c e d s im u lta n e o u s ly . The re g u la to ry re g im e t h a t g o ve rn s c a p ita l ra is in g s b y lis te d co m p a n ie s is o u tlin e d in Table 9.4.

TABLE 9.4 The Australian capital-raising regime for listed companies R e g u la to ry re q u ire m e n ts

M a in c h a ra c te ris tic s

T yp e o f c a p ita l ra is in g

Renounceable

P a rtic ip a tio n is based on each

The tim e ta b le fo r e n title m e n t offers is

e n title m e n t o ffe r

shareholder s e x is tin g in te re s t in the

specified in th e ASX L is tin g Rules. The

company. A prospectus m ay be needed.

disclosure req uire m en ts are set o u t in

Shareholders are able to sell th e ir rig h t

th e

Corporations Act.

to p a rtic ip a te in th e e n title m e n t offer. N on-renounceable

P a rtic ip a tio n is based o n each

The tim e ta b le fo r e n title m e n t offers

e n title m e n t o ffe r

shareh old er’s e x is tin g in te re s t in the

is specified in th e ASX L is tin g Rules.

company. A prospectus m ay be needed.

The L is tin g Rules lim it th e size o f the

Shareholders are n o t able to sell th e ir rig h t to p a rtic ip a te in th e offer. A n y

o ffe r to a m a x im u m o f one new share fo r each e x is tin g share. The disclosure

rig h ts n o t take n up m ay be placed a t the

re q u ire m e n ts are set o u t in the

d iscre tio n o f th e com pany s Board o f

Corporations Act.

D irectors.

C hapter n in e S ources

of fin a n c e : equity

Table 9 .4 continued

— T ype o f c a p ita l ra is in g

R e g u la to ry re q u ire m e n ts

M a in c h a ra c te ris tic s

Placement

P a rtic ip a tio n b y in vestors is at the

ASX L is tin g Rules re s tric t placem ents

d is c re tio n o f th e com pany’s Board o f

to no m ore th a n 15 p e r cent o f issued

D ire cto rs and m anagem ent. O pen

cap ital over a 1 2 -m o n th p e rio d w ith o u t

to ‘s o p h istica te d ’ o r ‘p ro fe ssio nal’

appro val by shareholders. U n de r certain

investors. A prospectus is n o t required.

circum stances, th is lim it increases to 25 p e r cent o f issued cap ital fo r sm aller firm s w ith m a rk e t cap ita lisa tio n s o f less th a n $300 m illio n . The

Corporations Act

p e rm its placem ents w ith o u t a disclosure d o cu m e n t p ro vid e d a cleansing notice* is issued. The SPP m echanism is stip u la te d in the

Share purchase plan

P a rtic ip a tio n is open to e x is tin g

(SPP)

shareholders. There is no re q u ire m e n t

L is tin g Rules. The disclosure regim e has

fo r a prospectus p ro v id e d a cleansing

been p ro vid e d by ASIC in a series o f

n o tice is issued, offers are lim ite d

R e gu latory Guides and Class Orders.

to $15 000 p e r shareholder over a 1 2 -m o n th p e rio d , and th e shares are fu lly p a id a nd issued a t a d isco u n t to th e m a rk e t price d u rin g the 30 days o f tra d in g p rio r to e ith e r th e o ffe r date o r th e issue date.

9 .6 .1 1 Rights issues A rig h ts issue— also k n o w n as an e n title m e n t o ffe r— is a n issue o f n e w shares to e x is tin g sh a re h o ld e rs. U n d e r th e te rm s o f a rig h ts issue, sh a re h o ld e rs receive th e r ig h t to s u b scrib e f o r a d d itio n a l shares in a fix e d ra tio to th e n u m b e r o f shares a lre a d y h e ld . P ro v id e d each s h a re h o ld e r accepts th e o ffe r, th e re is no d ilu tio n o f a n y s h a re h o ld e rs pe rce n ta g e o w n e rs h ip in th e com pany. To illu s tra te th e e le m e n ts o f a r ig h ts issue: assum e t h a t an in v e s to r h o ld s 1 0 0 0 shares, w h ic h re p re s e n t 1 p e r ce n t o f a c o m p a n y s issu e d c a p ita l o f 1 0 0 0 0 0 shares. I f th e c o m p a n y m akes a rig h ts issue th a t e n title s each s h a re h o ld e r to p u rch a se one a d d itio n a l share f o r e v e ry fo u r shares h e ld , th e s h a re h o ld e r is

SUBSCRIPTION PRICE

e n title d to b u y an e x tra 2 5 0 shares, th u s in c re a s in g th e s h a re h o ld in g to 1 2 5 0 . In to ta l, th e c o m p a n y w ill

the price that must be paid to obtain a new share

issue 25 0 0 0 n e w shares. T h e re fo re , th e p e rcen ta ge o w n e rs h ip o f th e s h a re h o ld e r in th e c o m p a n y re m a in s un cha ng ed a t 1 p e r ce n t because 1 2 5 0 /1 2 5 0 0 0 = 1 p e r ce n t. W ith a rig h ts issue, s h a re h o ld e rs b u y a d d itio n a l shares. The com p an y, th e re fo re , has to se t a

subscription price.

U su a lly, th e s u b s c rip tio n p ric e is less th a n th e c u rre n t m a rk e t p ric e o f th e shares,

because o th e rw is e n o -o n e w o u ld w a n t to s u b scrib e f o r th e n e w shares. G ive n t h a t th e s u b s c rip tio n p ric e is b e lo w th e c u rre n t m a rk e t p ric e , th e r ig h t to b u y a n e w share has a value . I f th e rig h ts are re n o u n ce a b le , a s h a re h o ld e r is able to se ll th e rig h ts to a n o th e r in v e s to r i f th e y w is h to . A fo rm u la k n o w n as th e

theoretical rights price can

be used to e s tim a te th e v a lu e o f a r ig h t. To de ve lo p

th is fo rm u la suppose t h a t a c o m p a n y m akes a 1 - fo r - N re n o u n ce a b le rig h ts issue a t a s u b s c rip tio n p ric e of

S d o lla rs

p e r sha re— t h a t is, each s h a re h o ld e r o b ta in s th e r ig h t to pu rcha se o n e n e w share f o r e v e ry

shares th a t th e y c u rre n tly h o ld an d w ill p a y

S d o lla rs

N

f o r each n e w share. A ll re n o u n ce a b le rig h ts issues

ex-rights date. I f an in v e s to r pu rcha ses shares in th e c o m p a n y b e fo re th e pu rcha se is said to be cum righ ts a n d th e in v e s to r w ill receive rig h ts to purcha se n e w

sp e cify a date, called th e e x -rig h ts date, th e

shares. The rig h ts th e m s e lv e s m a y be tra d e d s e p a ra te ly f r o m th e shares o n o r a fte r th e e x -rig h ts date. I f an in v e s to r purchases shares o n o r a fte r th e e x -rig h ts da te th e p u rcha se is sa id to be in v e s to r

will not receive

a n y rig h ts .

ex-rights a n d

th e

EX-RIGHTS DATE

date on which a share begins trading ex-rights. After fhis date a share does not have attached to it the right to purchase any additional share(s) on the subscription date CUM RIGHTS

when shares are traded cum rights the buyer is entitled to participate in the forthcoming rights issue

A ssu m e t h a t a n in v e s to r purchases is

NM w h e re M is

N shares

ju s t b e fo re th e e x -rig h ts date. The co st o f th is purchase

th e m a rk e t p ric e o f a share cu m rig h ts . T his in v e s to r is e n title d to th e r ig h t to purchase

one n e w share. E x a c tly th e sam e in v e s tm e n t can be a ch ie ved b y e n te rin g th e m a rk e t ju s t a fte r th e shares b e g in tra d in g e x -rig h ts a n d p u rc h a s in g T his w ill c o st

NX + R} w h e re X is

N shares e x -rig h ts

a n d also p u rc h a s in g th e r ig h t to one n e w share.

th e m a rk e t p ric e o f a share e x -rig h ts a n d

R is

th e m a rk e t p ric e o f th e r ig h t

to p u rcha se one n e w share. In th e absence o f a n y n e w in fo r m a tio n t h a t causes p ric e s to change, b o th in v e s tm e n t stra te g ie s s h o u ld co st th e same. T h a t is:

9.1

N M =N X +R

I f th e s u b s c rip tio n p ric e is pa yab le im m e d ia te ly , th e n th e r ig h t to one n e w share can be im m e d ia te ly c o n v e rte d to a n e w share b y p a y m e n t o f th e s u b s c rip tio n p ric e . T h e re fo re , w h e n th e shares b e g in tra d in g

R and X. To p re v e n t a rb itra g e ,

e x -rig h ts , an in v e s to r c o u ld o b ta in a share e ith e r b y b u y in g th e r ig h t to one n e w share a t a cost o f th e n p a y in g th e s u b s c rip tio n p ric e o f

S, o r b y b u y in g

a share d ir e c tly a t a p ric e o f

b o th in v e s tm e n t s tra te g ie s m u s t co st th e same. T h a t is:

_______

R+ S= X THEORETICAL RIGHTS

S u b s titu tin g E q u a tio n 9.2 in to E q u a tio n 9.1, a n d re a rra n g in g , gives:

PRICE

N+

1

S u b s titu tin g E q u a tio n 9.3 in to E q u a tio n 9.2, a n d re a rra n g in g , gives:

NM+S

X

THEORETICAL EX-RIGHTS SHARE PRICE

the expected price of one share when shares begin to be traded ex-rights

N(M -S)

R.

the expected price of one right calculated on the basis of the cum-rights share price

The p ric e s t h a t r e s u lt fr o m u s in g E q u a tio n s 9.3 a n d 9 .4 are o fte n re fe rre d to as th e

price

a n d th e

theoretical ex-righ ts sh are price,

theoretical righ ts

resp ective ly.

W h a t is th e e ffe c t o f a rig h ts issue o n th e va lu e o f an in v e s tm e n t in shares? To a n s w e r th is q u e s tio n , c o n s id e r E xam p le 9.1.

E x a m p l e 9 .1 A th o l o w n s 1 0 0 0 s h a re s in R a ven E n te rp ris e s Ltd (REL), w h o s e c u rre n t s h a re p r ic e (cu m rig h ts ) is $ 2 p e r s h a re . REL m a k e s a l- f o r - 4 rig h ts issu e w ith a s u b s c rip tio n p r ic e o f $ 1 . 4 0 p e r s h a re . A th o l w is h e s to c a lc u la te : a)

th e v a lu e , R, o f th e r ig h t to b u y 1 n e w s h a re

b)

th e e x -rig h ts s h a re p r ic e , X

c)

th e v a lu e o f h is in v e s tm e n t c u m rig h ts a n d e x -rig h ts .

In th is c a s e , N = 4 , M = $ 2 . 0 0 a n d S = $ 1 . 4 0 .

SOLUTION a)

U s in g E q u a tio n 9 . 3 , th e v a lu e o f th e r ig h t to b u y 1 n e w s h a re is:

R _ N IM - S ) N+ 1

4($2.00-$1.40)

471

—

= 4 8 cents b)

U s in g E q u a tio n 9 . 4 , th e e x -rig h ts s h a re p r ic e is:

v

NM + S

A =

-----------------

N+ 1

4($2.00)-$1.40 — = $

4^1 1.88

C hapter n in e S ources

c)

of f in a n c e : equity

C u m rig h ts , th e in v e s tm e n t is w o r th :

( 1000)($2) =$2000 E x -rig h ts , th e in v e s tm e n t is w o r th : (1 0 0 0 )($ 1 .8 8 ) + (2 5 0 )($ 0 .4 8 )

=$2000 A c c o r d in g to th is a n a ly s is th e to ta l v a lu e o f th e in v e s tm e n t is u n a ffe c te d . B e fo re th e issu e A th o l o w n e d 1 0 0 0 s h a re s w o r th $ 2 e a c h — a to ta l o f $ 2 0 0 0 . A fte r th e issu e h e o w n s 1 0 0 0 s h a re s w o r th $ 1 . 8 8 e a c h ( $ 1 8 8 0 ) p lu s 2 5 0 rig h ts w o r th 4 8 c e n ts e a c h ( $ 1 2 0 ) , w h ic h in to ta l is a ls o w o r th $ 2 0 0 0 . C le a rly , th e v a lu e o f th e rig h ts ju st o ffs e ts th e d e c lin e in th e v a lu e o f th e s h a re s . If A th o l d e c id e s to sell his rig h ts he c a n e x p e c t to r e c e iv e $ 1 2 0 , w h ic h s h o u ld b e r e g a r d e d a s a p a r tia l re tu rn o f c a p it a l as d is tin c t fro m a p r o fit o r re tu rn on c a p it a l. F in a lly , s u p p o s e th a t in s te a d o f a l- f o r - 4 rig h ts issu e w ith a s u b s c rip tio n p r ic e o f $ 1 . 4 0 p e r s h a re , REL m a k e s a l- f o r - 2 issu e w ith a s u b s c rip tio n p r ic e o f 7 0 ce n ts p e r s h a re . C le a rly , b o th issues w o u ld ra is e e x a c tly th e s a m e fu n d s f o r REL a n d r e w o r k in g th e a b o v e c a lc u la tio n s w o u ld s h o w th a t th e e x -rig h ts v a lu e o f A t h o l’s in v e s tm e n t w o u ld a g a in b e $ 2 0 0 0 .

This a n alysis relates to th e v a lu e o f a n in v e s tm e n t m ad e a t th e tim e o f th e e x -rig h ts da te a n d i t suggests th re e im p o r t a n t c o n c lu s io n s . F irs t, sha reh old ers* w e a lth is n o t a ffe c te d b y th e m e re fa c t o f a share b e g in n in g to tra d e o n an e x -rig h ts basis. In t u r n , th is suggests th e second c o n c lu s io n th a t, o f its e lf, a rig h ts issue has n o v a lu e to sh a re h o ld e rs. T his c o n c lu s io n s h o u ld n o t be a s u rp ris e . I f a rig h ts issue increased (decreased) sha reh old ers* w e a lth w e w o u ld e xp e ct rig h ts issues to o c c u r m u c h m o re (less) fre q u e n tly th a n th e y do. T h ird , i t suggests t h a t in th e case o f a rig h ts issue th e le v e l o f th e s u b s c rip tio n price has n o e ffe c t o n sha reh old ers* w e a lth . I f a ll s h a re h o ld e rs su b scrib e f o r a rig h ts issue, th e n w h e th e r a co m p a n y raises, say, $2 m illio n b y is s u in g 1 m illio n shares a t $2 each, o r 2 m illio n shares a t $1 each, s h o u ld n o t m a tte r to its sh a re h o ld e rs. H o w eve r, th e above a n a lysis ig n o re s som e fa c to rs t h a t can be im p o r ta n t. F irs t, th e

announcement o f a

rig h ts issue m a y a ffe c t sha reh old ers* w e a lth because th e a n n o u n c e m e n t can have in fo r m a tio n c o n te n t. F o r exam ple, US a n d A u s tra lia n evide nce suggests th a t, o n average, th e m a rk e t in te rp re ts th e a n n o u n c e m e n t o f e q u ity c a p ita l issues, in c lu d in g rig h ts issues, as 'bad* n e w s .24 S m ith (1 9 8 6 ) p ro v id e d an e x p la n a tio n o f th e n e g a tive a n n o u n c e m e n t e ffe c t: m an ag ers w ill t r y to issue e q u ity w h e n th e y be lie ve i t is o ve rva lu e d . In v e s to rs are aw are o f m anagers* in fo r m a tio n ad van ta ge a n d w ill re s p o n d b y re d u c in g t h e ir e s tim a te o f th e co m p a n y s va lu e w h e n an issue is a n n o u n ce d . The im p lic a tio n s f o r fin a n c in g d e cisio n s are discussed in S ectio n 12 .9.4. Second, th e te rm s o f a rig h ts issue such as th e s u b s c rip tio n p ric e m a y a ffe c t th e m a rk e t re a c tio n to an issue w h e n i t is a n n o u n ce d . I f th e s u b s c rip tio n p ric e is se t o n ly s lig h tly b e lo w th e m a rk e t p ric e o f th e shares, a m in o r fa ll in th e co m p a n y s share p ric e c o u ld cause th e issue to fa il— n o ra tio n a l s h a re h o ld e r w ill sub scrib e f o r th e rig h ts issue i f th e shares can be p u rch a se d m o re ch e a p ly o n th e s to c k m a rk e t. C learly, th is ris k can be red uce d b y s e ttin g a lo w e r s u b s c rip tio n p rice , b u t d o in g so m a y w a rn in v e s to rs t h a t m a n a g e m e n t is fe a rfu l o f a p o ssib le fa ll in th e co m p a n y s share p rice . Hence, s e ttin g a lo w e r s u b s c rip tio n p rice m a y re s u lt in a la rg e r fa ll in share p ric e w h e n th e issue is a n n o u n ce d . T h ird , th e a n a lysis assum es t h a t th e s u b s c rip tio n p ric e is payable o n th e e x -rig h ts da te, w h ere as, in fact, i t is u s u a lly n o t pa yab le u n t il several w eeks la te r. T his gives ris e to th e f u r t h e r p o in t t h a t th e h o ld e r o f a r ig h t is p e r m itte d to p u rch a se shares a t th e s u b s c rip tio n p ric e , b u t is n o t o b lig e d to do so. I f th e share p rice o n th e s u b s c rip tio n d a te is less th a n th e s u b s c rip tio n p ric e , th e h o ld e r o f th e r ig h t does n o t have to purchase th e shares. T his ty p e o f a g re e m e n t is k n o w n as an o p t io n , b u t th e th e o re tic a l m o d e l ig n o re s th e o p tio n -lik e fe a tu re s o f a r ig h t a n d is th e re fo re lik e ly to u n d e rs ta te th e v a lu e o f a r ig h t.

24 There is evidence that the market response to the announcement of equity issues differs between countries but is consistently negative on average. Thus, in the US, Smith reports an average decline of about 3 per cent for rights issues by industrial companies (see Smith 1986), while in the UK, Marsh found a much smaller decline for such issues (see Marsh 1979). In Australia, a study of 636 rights issues by Balachandran, Faff and Theobald (2008) found an average fall in share price of 1.74 per cent when the issues were announced.

OPTION

the right but not the obligation to buy or sell underlying assets at a fixed price for a specified period

B usiness finance

The option component o f a rig h ts value is usually small in dollar terms b u t can be a significant p ro po rtio n o f the value o f a rig ht, particularly i f the share price is close to the subscription price. For example, the subscription price fo r the rights issue by Colonial Group in 1998 was $4.50, payable no later than 13 July, and the rights were traded on the ASX from 4 June to 2 July. On 11 June, the closing price o f Colonial shares was $4.53 while the rights closed at 14.5 cents. I f holders o f the rights were obliged to pay the subscription price and had to pay it immediately, the rights would have been w orth only $4.53 - $4.50 = 3 cents. In this case, the option component o f the rig hts’ value was 11.5 cents.

Disclosure and regulation of rights issues Historically, a company m aking a rights issue was required to supply shareholders w ith a disclosure document, usually a prospectus. The cost o f preparing a disclosure document was an im p o rta n t factor that influenced issuers to prefer placements rather than rights issues. The requirements fo r rights issues have been aligned w ith those fo r placements by changes to the Corporations Act contained in the Corporations Legislation Amendment (Simpler Regulatory System) Act 2007. From 2007, issuers can proceed w ith a rights issue w ith o u t a prospectus provided they: • •

lodge w ith the ASX a notice known as a ‘rights issue cleansing notice ’ ；and send to shareholders a short document th a t describes the reasons fo r the rights issue and sets out the term s and tim in g o f the issue.

In addition to stating th a t the issuer complies w ith certain provisions o f the Corporations Act, a rights issue cleansing notice m ust deal w ith two issues. First, it m ust contain any excluded* in fo rm a tio n — that is, in fo rm a tio n that: • •

has previously been w ithheld from investors based on one o f the exceptions to disclosure contained in the listing rules25 investors would reasonably require and expect to be included in a disclosure document fo r the purpose o f assessing the financial position, performance and prospects o f the issuer.

Second, the notice m ust provide inform a tion about any effects th a t the issue could have on the control o f the listed entity. I f a company has disclosed all price-sensitive info rm a tio n related to its operations and makes a rights issue fo r a general purpose such as raising w orking capital or repaying debt, a rights issue cleansing notice would be the obvious choice. In other cases a prospectus may be preferred. For example, suppose th a t a company makes a rights issue to raise funds fo r a new project th a t has been under development fo r some tim e b u t whose existence has n o t been disclosed to the shareholders. In th a t case, a rights issue cleansing notice should contain extensive details o f the new project. However, it may instead be preferable to issue a prospectus containing the same inform ation. One factor favouring the use o f a prospectus is th a t a cleansing notice is n o t defined as a disclosure document. Therefore, i f a cleansing notice is found to contain errors or omissions, the ‘due diligence’ defence outlined in Section 9.4.1 is n o t available. As discussed in Section 9.4.2, the prospectus fo r a rights issue can be much less detailed than the prospectus fo r an issue o f unlisted securities. Provided the company s shares have been listed fo r at least 12 m onths p rio r to the issue, the prospectus does n o t have to contain extensive inform a tion on the assets, liabilities, performance and prospects o f the issuing company. Rather, the prospectus can focus on details o f the new securities and on the expected effects o f the new issue on the company.

The significance of rights issues The frequency o f rights issues fluctuates over tim e but they continue to be an im p o rta n t way o f raising equity fo r Australian companies. In the 2012-13 financial year, ASX-listed companies raised $4 b illio n through rights issues. In comparison, in the 2008-09 financial year, $28.5 b illio n was raised through rights issues. Details o f selected rights issues by listed companies are shown in Table 9.5.

25

R u le 3 .1 o f th e A u st r a lia n S e c u r it ie s E x c h a n g e L is t in g R u le s r e q u ir e s im m e d ia t e d is c lo s u r e o f m a t e r ia l in fo r m a t io n b y lis t e d e n t it ie s b u t R u le 3 .1 A p r o v id e s s o m e e x c e p tio n s t o th e c o n tin u o u s d is c lo s u r e r e q u ir e m e n t s .

C hapter n in e S ources

TABLE 9.5 Details of selected rights issues by listed companies Am ount

Issue

ra is e d ( $ m )： p r ic e ($ )

P re-issue s h a re p r ic e ($ )

1U n d e r w r itin g fe e (%)

Com pany

D a te a n n o u n c e d

Wesfarmers Ltd

22/01/2009

3:7

3700

13.50

15.78

2.1

TEN Network Holdings

15/06/2012

3:8

200

0.51

0.64

2.35

Billabong 21/06/2012 International Ltd

6:7

221

1.02

1.83

2.9

Bionomics Ltd

1:8

0.36

0.41

3.0

S o u rc e :

5/03/2013

Issue r a tio

16.4

Announ cem ents to the A S X a n d c o m p a n y prospectuses.

Designing a successful rights issue A rights issue that failed to raise all or most o f the planned funds could be very costly fo r the issuing company. The costs o f planning the issue and preparing a prospectus or other documentation have to be paid regardless o f the outcome, and failure is likely to harm a company s reputation because it may be thought th a t existing shareholders lack confidence in the company s prospects and/or the performance o f its managers. Therefore, managers w ill employ various measures to maximise the probability th a t a rights issue w ill be successful. An obvious measure o f this type is to have the issue underw ritten. Another approach m ight be to make the issue renounceable and to set the subscription price substantially below the current m arket price o f the shares so there is a high probability th a t shareholders w ill either exercise their entitlem ent, or sell th e ir rights to others who w ill subscribe fo r the shares. In this case, i t m ig ht seem that there should be no need fo r the company to have the issue underw ritten, b u t in fact the m ajority o f rights issues in Australia are underw ritten. There appear to be fo ur m ain reasons fo r this practice. First, while the subscription price may be well below the share price at the tim e an issue is announced, a substantial unexpected fall in share price is always possible and could spell failure fo r a non-underw ritten issue. Second, as discussed above, setting a low subscription price may result in a larger fall in the share price when a rights issue is announced. Therefore, managers may tr y to m inim ise the adverse effect on shareholders’ wealth by setting a higher subscription price and having the issue underw ritten. Third, there w ill always be some shareholders who, fo r one reason or another, either do n o t receive n otification o f an issue, or do n ot respond in tim e to subscribe fo r the new shares. Finally, because o f the high costs o f complying w ith securities laws in countries such as the US, Australian companies usually specify that a rights issue w ill be made only to shareholders whose registered address is in Australia or New Zealand. ASX Listing Rule 7.7 requires th a t where foreign shareholders are n o t eligible to participate in a renounceable rights issue, they m ust s till be advised o f the issue and th a t the value, i f any, o f th e ir entitlements should be paid to them. Therefore, one role o f the und erw rite r is to sell any new shares that represent the entitlem ents o f ineligible foreign shareholders. Orica Lim ited is an Australian-based manufacturer o f chemicals and explosives w ith operations in about 50 countries and its shareholders include both Australian and overseas investors. In November 2005, Orica announced a fu lly underw ritten l-fo r-8 renounceable rights issue at $15 per share, substantially less than the m arket price o f $20.55. The issue was made to all ordinary shareholders w ith a registered address in Australia or New Zealand and to in s titu tio n a l ordinary shareholders in Hong Kong, Singapore and the UK. On 19 December 2005, Orica announced a shortfall, including the entitlem ents o f ineligible foreign shareholders, o f 2.4 m illion shares, or approximately 7 per cent o f the total. In this case, the sh ortfa ll shares were sold to in s titu tio n a l investors w ith the issue price determ ined by an overnight book-build conducted by the underwriters. The issue price fo r these shares was $20.30, which m eant th a t Orica received $15 per share and the balance o f $5.30 per share was paid to the non-subscribing shareholders and ineligible foreign shareholders. In summary, u nd erw riting is one way o f ensuring that the issuing company w ill receive all the planned funds regardless o f the level o f subscriptions by shareholders and may be less costly than attem pting to increase shareholder take-up by lowering the subscription price. The closer the subscription price on the rights issue is set to the m arket price o f shares, the greater is the need to have the issue underw ritten,

of f in a n c e : equity

B usiness finance

SHORTFALL FACILITY

a m echanism under w hich a co m p a n y m ay issue shortfall shares to eligible shareholders or other investors

SHORTFALL SHARES

new shares not subscribed for b y eligible shareholders a c c o rd in g to their entitlements under a rights issue

.

and the higher the u nd erw riting fee. The u nd erw riting fee is usually between 1 and 3 per cent o f the subscription price. W hile u nd erw riting ensures th a t all the planned funds w ill be raised, there are other measures that can be used to increase the likelihood th a t a rights issue w ill be successful. The m ain such measures are issuing the rights w ith bonus share options as a sweetener* and providing a sh o rtfall facility. As discussed in Section 9.6.5, bonus share options are issued ‘free’ in a fixed pro po rtio n to the new shares taken up by existing shareholders. Balachandran, Faff and Theobald (2008) studied rights issues announced by Australian companies from 1995 to 2005 and found th a t almost one-third o f the issues in th e ir final sample provided bonus share options. A nother measure to increase the take-up o f new shares by existing shareholders is the inclusion o f a shortfall facility. In its simplest form , a shortfall fa cility allows existing shareholders to apply fo r extra shares in addition to th e ir pro-rata entitlem ent. In this case, any shares n o t subscribed fo r by some shareholders (s h o rtfa ll shares*) w ill be issued to those who applied fo r additional shares. A shortfall fa cility can also allow the company to issue sh o rtfall sh ares to other investors, including underw riters, and the company may have the rig h t to accept oversubscriptions. For example, in February 2007 Argo Investments made a rights issue th a t was n o t u nd erw ritte n and was expected to raise $441 m illion , b ut shareholders taking up th e ir entitlem ents were invite d to apply for additional shares and the company reserved the rig h t to accept oversubscriptions. The end result was that the issue raised approximately $446 m illion. As shown in Table 9.4, there is no upper lim it on the size o f a renounceable rights issue so an issue o f this type can be used to raise a large amount, provided investors are prepared to subscribe fo r the new shares. Further, provided shareholders take up th e ir entitlem ent, a rights issue w ill have no effect on the control o f the company as there is no change in shareholders1relative vo ting strengths. For these reasons a rights issue may appeal to a company s board as a means o f raising finance. W hile many companies m aking rights issues specify th a t the issue is renounceable, sometimes a rights issue w ill be non-renounceable. I f a company makes a non-renounceable issue, shareholders cannot sell th e ir entitlem ent to take up new shares. The only choices available to them are to exercise th eir entitlem ent, either fu lly or partly, or to p e rm it it to lapse.26 I f investors take the la tte r choices the issue w ill be undersubscribed. For this reason non-renounceable issues are frequently underw ritten. As noted earlier, the m arket often interprets the announcement o f equity capital issues, including rights issues, as ‘bad’ news. Balachandran, Faff and Theobald (2008) found an average abnormal return o f -1 .7 4 per cent over a 3-day announcement period fo r a sample o f 636 rights issues by Australian companies from 1995 to 2005. I f the term s o f an issue such as whether the issue is renounceable or und erw ritte n also convey info rm a tio n to investors, then the price response to issue announcements may differ between rights issues w ith different terms. Balachandran, Faff and Theobald found th a t there is no difference between the average m arket reaction to renounceable and non-renounceable issues b ut the reaction to rights issue announcements is related to the u nd erw riting status o f the issue. Alm ost 60 per cent o f the issues in th e ir sample were fu lly und erw ritte n and the average abnormal retu rn associated w ith announcement o f these issues was -1.0 4 per cent, b ut fo r non-underw ritten issues the average abnormal retu rn was -2.23 per cent. As discussed in Section 9.5.6, underw riters are seen as certifying the value or quality* o f the securities being offered. When deciding whether to have an issue underw ritten, issuers w ill consider the benefits th a t u nd e rw ritin g provides relative to the cost o f the u nd erw rite rs fee. The fee w ill be related to the risk o f undersubscription and w ill reflect any costs th a t the underw riter incurs in assessing th a t risk. This is likely to include the costs o f investigating the current financial position and the prospects o f the issuer. Thus, a decision to fu lly underw rite an issue w ill typically be associated w ith low risk and/or low investigation costs and is associated w ith a smaller negative m arket reaction. Where the risk and/ or investigation costs are higher, issuers may choose to accept the risk o f undersubscription rather than pay an underw riting fee. N ot surprisingly, w ith o u t an u n d erw rite rs certification, the m arket reaction is more negative. That is n ot to suggest th a t certification by a reputable underw riter guarantees the success o f a capital raising. To illustrate this point, consider the announcement o f a proposed $225 m illio n 6:7 entitlem ent offer by Billabong International Ltd in June 2012. The issue was jo in tly u nd erw ritte n by Goldman Sachs and Deutsche Bank, and was priced at a significant 44 per cent discount to the pre-announcement share 26

I g n o r in g tr a n s a c t io n c o s t s , th e c h o ic e s a v a ila b le to s h a r e h o ld e r s a r e n o t r e d u c e d b y a r ig h t s is s u e b e in g n o n - r e n o u n c e a b le r a t h e r t h a n re n o u n c e a b le . I f a n is s u e is n o n - r e n o u n c e a b le , s h a r e h o ld e r s c a n t a k e u p th e r ig h t s a n d th e n r e a lis e t h e ir v a lu e b y s e llin g t h e s h a r e s o b ta in e d .

C hapter n in e S ources

price. The m arket responded very negatively to the announcement, w ith Billabong shares closing down 48 per cent when the m arket reopened. A lthough the share price subsequently recovered slightly, to be above the proposed subscription price, approximately 49 per cent o f retail investors s till chose n ot to participate in the issue, leaving the underw riters to purchase the rem aining 33.2 m illio n shares. In an amazing example o f managerial o ptim ism the CEO o f Billabong, Launa Inman, issued a statement on the company s behalf stating that
Traditional and accelerated rights issues One disadvantage o f a trad ition al renounceable rights issue is th a t it is a relatively slow way o f raising funds. W hile the ASX has revised its timetables to shorten the offer period, a trad ition al renounceable rights issue cannot be completed in fewer than 23 business days. A non-renounceable issue is potentially quicker since no rights trading period is required, b u t i t is s till slower than a share placement. The traditional rights issue structure has been adapted to allow companies to raise funds more quickly. The ASX commonly grants waivers o f its listin g rules to allow companies to make non-traditional or Accelerated* rights issues. These issues involve tw o stages: an in itia l accelerated offer o f shares to institutio ns and a second offer to retail shareholders.28 The structures used fo r these issues include: •

•

•

Accelerated Non-Renounceable E ntitlem ent O ffer (or 'JumboO structure. A non-renounceable pro­ rata offer is made to in s titu tio n a l shareholders over a period o f 1 or 2 business days. The issue price may be determined by an in s titu tio n a l book-build or i t may be fixed p rio r to the announcement of the issue. In the second stage, a non-renounceable pro-rata offer is made to retail shareholders at the same price as the first-stage pro-rata offer. Accelerated Renounceable E ntitlem ent O ffer (AREO), which differs fro m the Uumbo* structure in two ways: the offer is renounceable and the procedure involves two book-builds. In the firs t stage, eligible in stitu tio n a l shareholders may subscribe fo r th e ir pro-rata e ntitlem ent to new shares at a fixed offer price. Any shares n o t taken up by in s titu tio n a l shareholders are then offered to other in stitu tio n a l investors through a book-build— so there is no trading o f rights on the exchange and any entitlem ents th a t are renounced are sold off-m arket1. The second stage is a pro-rata entitlem ent offer to retail shareholders at the same fixed offer price as the in s titu tio n a l entitlem ent offer. Retail shareholders w ill be provided w ith details o f the offer in a prospectus or offer booklet and w ill usually have about 2 weeks to decide whether to take up th e ir entitlem ents. Finally, a second bookbuild is undertaken where any shares not taken up by retail shareholders are offered to in s titu tio n a l investors. I f the prices established in either o f the book-builds exceed the fixed offer price, the excess is paid to the shareholders who did n ot take up th e ir entitlem ents. Simultaneous Accelerated Renounceable E ntitlem ent O ffer (SAREO), which is essentially the same as the AREO structure except th a t any renounced entitlem ents are sold through a single bookbuild. This book-build is open only to in s titu tio n a l investors and is carried out after b oth o f the entitlem ent offers have been completed, so it ensures th a t each group o f investors receives the same price for any entitlem ents they renounce.

While accelerated rights issues can differ in significant details, all such issues have one im p orta nt feature: the proceeds o f the in s titu tio n a l component w ill be received very soon after the issue is launched. For a company w ith large in s titu tio n a l shareholdings, the proceeds o f the in s titu tio n a l offer w ill make up the m ajority o f the issue proceeds, so the outcome is, to a large extent, sim ilar to m aking a placement. Because the tim e period involved is short, the risk o f a significant sh ortfa ll is lower than fo r a trad ition al rights issue, so the cost o f u n d e rw ritin g should also be lower. Im portantly, the accelerated structures allow funds to be raised quickly w hile retail shareholders can s till participate in the capital raising. Also, renounceable rights issues are regarded as the m ost equitable because shareholders who choose not to participate can realise some value by selling th e ir rights. However, the accelerated structures do 27

A S X A n n o u n c e m e n t, 'B illa b o n g c o m p le t e s $ 2 2 5 m illio n c a p it a l r a isin g *, 2 0 J u l y 2 0 1 2 .

28

A m e n d m e n ts to th e C o rp o ratio n s A c t in 2 0 0 7 in t r o d u c e d a n e w d e fin itio n o f l i g h t s 1 is s u e , w h ich r e q u ir e s t h a t th e t e r m s o f su c h a n is s u e m u s t b e th e s a m e f o r a ll s h a r e h o ld e r s . S in c e a c c e le r a te d is s u e s in v o lv e d iffe r e n t t e r m s fo r in s t it u t io n a l a n d r e ta il s h a r e h o ld e r s th e y d o n o t c o n fo r m t o t h is d e f in it io n a n d a r e m o r e c o r r e c tly d e s c r ib e d a s e n t it le m e n t o ff e r s . F o r e a s e o f e x p o s it io n w e u s e th e t e r m r ig h t s is s u e to e n c o m p a s s b o t h t r a d it io n a l r ig h t s is s u e s a n d a c c e le r a te d is s u e s .

of f in a n c e : equity

not necessarily ensure th a t all shareholders are treated fairly. First, the tim e allowed fo r completion of the in s titu tio n a l component can disadvantage shareholders who do n o t have sufficient funds available to take up th e ir fu ll entitlem ents at short notice. Second, the AREO structure w ith tw o separate bookbuilds means th a t any prem ium d istributed to shareholders who renounce th e ir entitlem ents can differ depending on whether the shareholder is an in s titu tio n a l or retail investor. The SAREO structure addresses the la tte r concern b u t may n o t provide a perfect solution because it means th a t in stitu tio n a l shareholders who sell1th e ir rights have to w ait fo r some weeks to find out w hat price they w ill receive.

F in a n c e in

ACTION

UNDERWRITER BUYS SHARES TO PROVIDE IMMEDIATE FUNDING_____________________________________________________

New sC ^^ In s o m e c a s e s it is im p o r t a n t f o r th e is s u e r t o re c e iv e a ll o f th e fu n d s b y a c e r t a in d a t e a n d th is c a n b e a c h ie v e d b y e x te n d in g th e r o le o f th e u n d e r w r it e r to in c lu d e th e p r o v is io n o f s h o rt-te rm f u n d in g . F o r e x a m p le , o n 9 M a r c h 2 0 0 7 , S u n c o r p - M e t w a y Ltd a n n o u n c e d a 2 - f o r - 1 5 e n title m e n t

=

1

o f f e r to ra is e a p p r o x im a t e ly $ 1 . 1 7 b illio n f r o m s h a r e h o ld e r s . T h e p u r p o s e o f th e is s u e w a s to p a r t ia lly fu n d th e c a s h c o m p o n e n t o f th e c o n s id e r a t io n p a y a b le b y S u n c o r p - M e t w a y in c o n n e c tio n w ith its th e n p r o p o s e d m e r g e r w ith P r o m in a Ltd. T h e S u n c o r p - M e t w a y issu e w a s d iv id e d in to in s titu tio n a l a n d r e ta il o ffe r s , e a c h f o llo w e d b y a n in s titu tio n a l b o o k - b u ild . T h e m e r g e r in v o lv e d a S c h e m e o f A r r a n g e m e n t t h a t w a s s u b je c t to c o u r t a p p r o v a l a t a h e a r in g s c h e d u le d to ta k e p la c e o n 1 2 M a r c h 2 0 0 7 . O n c e th e c o u r t a p p r o v e d th e s c h e m e , S u n c o r p - M e t w a y h a d a n o b lig a t io n to m a k e p a y m e n ts to P r o m in a s h a r e h o ld e r s , so it n e e d e d a c c e s s to th e issu e p r o c e e d s s h o r tly a ft e r th e c o u r t h e a r in g . T h is w a s a c h ie v e d b y n e g o tia t in g a n u n d e r w r it in g a g r e e m e n t w h e r e b y th e u n d e r w r it e r , C it ig r o u p G lo b a l M a r k e ts A u s t r a lia , s u b s c r ib e d f o r a ll o f th e n e w s h a re s t h a t w e r e o f f e r e d f o r s a le . T h e n e w s h a re s w e r e th e n t r a n s fe r r e d b y C it ig r o u p to s h a r e h o ld e r s w h o c h o s e t o t a k e u p t h e ir e n title m e n ts a n d to in v e s to rs w h o a c q u ir e d s h a re s t h r o u g h th e t w o b o o k - b u ild s . T h e c a p it a l r a is in g w a s c o m p le te d w ith th e s e c o n d b o o k - b u ild o n 1 3 A p r i l 2 0 0 7 b u t S u n c o r p M e t w a y h a d re c e iv e d th e fu ll p r o c e e d s f r o m C it ig r o u p o n 1 2 M a r c h . O f c o u r s e , th e u n d e r w r it in g a g r e e m e n t r e q u ir e d S u n c o r p - M e t w a y to p a y a d a ily f u n d in g fe e r e p r e s e n tin g in te re s t o n th e fu n d s t h a t it e ffe c tiv e ly b o r r o w e d fr o m th e u n d e r w r ite r .

9 .6 .2 1 Placements (private issues) PLACEMENT

an issue of securities direct to chosen investors rather than the ge neral public

A placem ent o f ordinary shares is a new issue o f shares made to a lim ite d number o f investors. These issues are typically made to larger in s titu tio n s such as life insurance companies and investm ent funds. Such organisations are m ajor holders o f Australian shares and have become the prim e targets for placements because they have large sums to invest. Hence, a significant am ount o f capital can be raised quickly by making a placement to a small num ber o f in s titu tio n s o r to a single in s titu tio n . Details o f some recent placements are shown in Table 9.6.

TABLE 9.6 Details of selected placements 2013-14 Am ount C om pany

D a te a n n o u n c e d i ra is e d ($ m )

Issue p r ic e as % o f

P ric in g a n d

p re -a n n o u n c e m e n t m a rk e t p ric e

issue m e th o d

The Reject Shop

A pril 2013

30

96.9

Underwritten

ERM Power

November 2013

75

93.4

Underwritten

Insurance Australia Group

December 2013

1200

96.2

Underwritten

Alumina

February 2014

452

103.0

S o u rce :

C o m p ile d from c o m p a n y announcem ents.

Issue to a single investor

C hapter n in e S ources

In some cases the shares are purchased by another company rather than by financial institutio ns, often as part o f the form ation o f a strategic alliance between tw o companies whose businesses are related. For example, in December 2006, Queensland Gas Company (QGC) entered in to an agreement w ith AGL Energy under which AGL Energy purchased a 27.5 per cent ownership interest in QGC fo r $327 m illion. The two companies also entered in to a 20-year gas supply agreement and AGL Energy was entitled to appoint three directors on the QGC board. A company m aking a placement w ill usually n o t be required to issue a disclosure document. Placements usually involve offers o f securities to sophisticated and in s titu tio n a l investors. As discussed in Section 9.4.3, these offers o f securities do n o t require a disclosure document. Many placements are underw ritten, p articularly where the issue is large and /or the new shares are distributed to many investors. Where an issue is n o t underw ritten, the company m aking the issue generally uses the services o f a broker or investm ent bank to assist in placing the shares w ith investors. The broker is n ot obliged to dispose o f all the shares: the brokers task is best described as undertaking the placement o f the shares on a ‘best-efforts’ basis. U nd erw ritin g fees fo r share placements are influenced by several factors, including the absolute size o f the placement, the size, liq u id ity and perceived m arket risk o f the issuing company and the reason fo r raising the equity. For example, a placement to fund a profitable acquisition w ill involve lower m arket risk, and lower fees, than one th a t is needed to recapitalise a company whose financial leverage has become excessive. The fees fo r arranging and/or u nd erw riting a placement are usually n o t disclosed. Macquarie Capital Advisers Lim ited has indicated th a t fo r placements by ASX-listed companies, u nd e rw ritin g fees can range from around 1 per cent to 5 per cent o f the gross offer proceeds. It has become common fo r larger placements to in s titu tio n s to be priced using the book-building process and in some cases the managers o f the book-build may also underw rite the issue. For example, in November 2006, O rigin Energy raised $400 m illio n by a placement th a t was priced using a book-build and also underw ritten by the two investm ent banks th a t conducted the book-build. U nderw ritin g may be preferred when a company has entered in to a com m itm ent th a t creates a specific need fo r additional funds. In the case o f the O rigin Energy placement, the proceeds were used to p a rtly fund the acquisition o f a gas retailing business th a t O rigin had agreed to purchase from the Queensland Government. There has been considerable opposition from shareholders to companies m aking placements o f shares. Some shareholders may oppose placements because they reduce the percentage o f ownership and voting power o f existing shareholders. Also, some shareholders may believe th a t they are being deprived o f a possible p ro fit from the sale o f the rights. However, we have already shown th a t the retu rn that shareholders receive from the sale o f rights represents, in effect, a retu rn o f a p o rtio n o f th e ir investm ent in the company. More im p orta ntly, i f the placement is made to new shareholders at a price below the current m arket price, there is a reduction in the value o f the existing shareholders’ investment. The ASX has placed a general lim it o f 15 per cent on the am ount o f capital th a t a company can issue privately in any 1 year w ith o u t the p rio r approval o f its shareholders.29 However, it is n o t d ifficu lt to exceed this lim it w ith o u t viola ting the ASX rules. A fte r m aking a placement th a t falls w ith in the 15 per cent lim it, a company w ill often have the placement ratified by shareholders. Ratification o f a placement ‘refreshes’ the company’s capacity to raise capital because it means th a t the placement w ill n o t be included when assessing the company s a b ility to make a future placement. In other words, a company may make two or more placements in a 12-m onth period, provided each placement increases its issued capital by less than 15 per cent and each placement is ratified by shareholders before the next placement occurs. Also, the ASX has allowed larger placements in cases where i t is confident th a t a company s issued capital is about to be increased by another share issue. In such cases, the ASX is w illin g to apply the 15 per cent lim it to the expanded capital base rather than to the existing issued capital. For example, a company that is comm itted to m aking a fu lly und erw ritte n 1 -fo r-l e ntitlem ent offer could obtain a waiver o f the '15 per cent rule, th a t allows i t to make a placement o f 30 per cent o f its issued capital p rio r to the entitlem ent offer (ISS Governance Services, 2010, p. 13).

29

S e e R u le s 7 .1 a n d 7 .2 o f th e A u s t r a lia n S e c u r it ie s E x c h a n g e L is t in g R u le s, w h ich p r o v id e t h a t , in g e n e r a l, o n ly 1 5 p e r c e n t o f a c o m p a n y s is s u e d s h a r e c a p it a l m a y b e is s u e d t o n o n - s h a r e h o ld e r s w ith o u t th e p r io r a p p r o v a l o f s h a r e h o ld e r s a t a g e n e r a l m e e tin g . T h ere a re e x c e p tio n s to t h is r u le t h a t r e la te sp e c ific a lly t o s m a ll a n d m id - siz e c o m p a n ie s w ith m a r k e t c a p it a lis a t io n s le s s t h a n $ 3 0 0 m illio n .

of fin a n c e : equity

B usiness finance

CONTRIBUTING SHARES

shares on w hich only part of the issue price has been paid. A lso known as p a 厂 f/y pa/c/

shares

INSTALMENT RECEIPT

marketable security for w hich on ly part of the issue price has been paid. The balance is p a y a b le in a final instalment on

As discussed in Section 9.2, con tributing sh ares, also known as p a rtly paid shares, are shares on which only p a rt o f the issue price has been paid. The issuing company can call up the unpaid part o f the issue price in one or more instalments (known as calls*) and, in the case o f a lim ite d lia b ility company, the holder has a legal obligation to pay these calls. C ontributing shares are quite common in Australia and can be used to provide a company w ith a reliable source o f funds. The unpaid am ount is referred to as Reserve capital1and the shares can be created by a rights issue where the issue price is to be contributed in stages at specified times. Many co ntribu ting shares are issued by m ining and oil exploration companies, which make calls when additional funds are required. C ontributing shares can be im p o rta n t in raising capital b ut the amounts involved are typically small in comparison to other sources o f equity.30 Typically, in stalm en t receipts are issued when existing fu lly paid shares are offered to the public, w ith the sale price to be paid in two instalments. A ll three sales by the Australian Government o f shares in Telstra Ltd involved instalm ent receipts. For example, in the case o f the th ird Telstra share offer in November 2006, retail investors paid a firs t instalm ent o f $2 w ith a second instalm ent o f $1.60 payable by 29 May 2008. Partly paid shares and instalm ent receipts are very sim ilar b ut there are some im p orta nt differences between them. These differences include:

or before a specified date

• • •

fo r instalm ent receipts, the amount and tim in g o f all instalm ents are specified at the tim e o f the original sale rather than being at the discretion o f directors instalm ents are payable to the vendor o f the shares rather than to the issuing company holders o f instalm ent receipts are usually e ntitled to the same dividends as holders o f fu lly paid shares, whereas holders o f p artly paid shares usually receive a p artial dividend based on the p roportion o f the issue price th a t has been paid.

Companies listed on the ASX are p erm itted to raise lim ite d amounts o f funds from existing shareholders through share purchase plans (SPPs). These issues do n o t require a prospectus provided they comply w ith ASIC Regulatory Guide 125, which requires th a t SPPs are accompanied by a cleansing notice. ASIC recognises th a t the costs o f preparing and d istrib u tin g a prospectus could be very high relative to the benefits when the risk to investors is lim ite d because the am ount th a t can be invested is restricted. Accordingly, the am ount th a t a listed company can raise in this way is restricted to $15 000 per annum from each shareholder. Share purchase plans may be attractive to shareholders because the subscription price m ust be less than the m arket price p rio r to the announcement o f the issue and there is no brokerage. As discussed in Section 9.6.6’ share purchase plans are sometimes used in conjunction w ith an in s titu tio n a l placement, giving all existing shareholders the o p p o rtu n ity to purchase additional shares at the price paid by the in stitu tio n s th a t took up the placement.

An o ption to purchase the shares o f a company gives the holder o f that option the rig h t to take up shares in the company by a specified date on predeterm ined term s.31 For example, a company may issue, at no cost, 10000 options th a t may be exercised by the payment o f $1 per option during the next 5 years. Consequently, option holders can purchase a m axim um o f 10 000 shares fo r $1 each at any tim e during the next 5 years, regardless o f th e ir m arket price at the tim e. The option holder therefore has the o pp ortu nity to benefit from an increase in the m arket price o f the company s shares. I f the company s share price 30

C o n t r ib u t in g s h a r e s c a n a ls o b e is s u e d t o d ir e c t o r s a n d o t h e r s a s p a r t o f a c o m p e n s a t io n p a c k a g e . T h is u s e o f c o n tr ib u t in g

31

A n im p o r t a n t d iffe re n c e b e tw e e n th e o p t io n s d is c u s s e d h e r e a n d th e e x c h a n g e - t r a d e d o p t io n s d is c u s s e d in C h a p t e r 1 8 is th a t

s h a r e s is a n a ly s e d b y B ro w n a n d H a th a w a y ( 1 9 9 1 ). t h is s e c t io n d is c u s s e s o p t io n s is s u e d b y th e c o m p a n ie s t h e m s e lv e s . In c o n t r a s t , a n e x c h a n g e - t r a d e d o p t io n is c r e a te d b y a c o n tr a c t b e tw e e n tw o in v e s t o r s a n d d o e s n o t in v o lv e th e c o m p a n y w h o se s h a r e s u n d e r lie t h e o p t io n . T h a t is , u p o n e x e r c ise o f a c o m p a n y - is s u e d o p t io n , th e c o m p a n y c r e a t e s a n d i s s u e s n e w s h a r e s , w h e r e a s w h e n a n e x c h a n g e - t r a d e d o p t io n is e x e r c ise d , o n ly e x is t in g s h a r e s c h a n g e o w n e r s h ip a n d n o n e w s h a r e s a r e c r e a te d .

C hapter n in e S ources

increases to $1.20, then option holders can purchase 10000 shares fo r $10000, which is $2000 below their current m arket value. There are three m ajor provisions included in an option agreement: • • •

the exercise price o f the option the period during which the options may be exercised the rights o f option holders in the event o f new issues o f shares by the company.

In general, it is usual fo r the exercise price o f an option to be set near the share price at the tim e the option is issued. The term o f an option may extend fo r several years and, other things being equal, a long-term option is more valuable than a short-term option. In the case o f company-issued options, the option holder is often prevented from exercising the option fo r a certain period after it has been granted. I f a company makes an issue o f shares during the o ptio ns life, it is possible fo r the value o f the option to be reduced to almost zero. For example, i f a company splits each o f its shares in to two, other things being equal, the price per share w ill be halved. In tu rn , this w ill result in a corresponding reduction in the benefit that the option holder w ill receive from any subsequent increase in the share price. As a result, option agreements usually provide holders w ith the rig h t to participate in share issues by the company during the life o f the option. Options may be issued as follows:

To employees. The objective when m aking o ption issues is to reward employees in a way th a t is likely to encourage them to w ork towards im proving the company s profitability. Such issues are typically made w ith an exercise price equal to the current share price, which does n ot expose the employee to any immediate tax obligation. I f the company becomes more profitable, it is likely to command a higher share price, which, in tu rn , w ill increase the value o f the option, b As a sweetener to an equity issue. Many exploration and m in ing companies issue both ordinary shares and options to subscribe fo r additional shares. For example, an investor purchasing 1000 shares in a new issue may also receive 1000 options, each o f which entitles the investor to buy one additional share at a fixed price before a specified date. Frequently these options are listed separately on the stock exchange. Therefore, an investor obtains the o p p o rtu n ity to make an additional gain from an increase in the company s share price. A company th a t issues shares accompanied by options hopes to encourage investors to participate in the issue, thereby reducing the possibility o f undersubscription. c As a sweetener to a private debt issue. On occasions, a company seeking debt finance w ill offer share options to the lender. The company benefits either by obtaining debt finance th a t i t would not otherwise have received o r by obtaining the funds on better term s— fo r example, at a lower interest rate. However, neither p arty to an agreement o f this type w ill make the options conditional on the granting o f the loan because this may jeopardise the tax d eductibility o f interest on the debt.

a

In the cases outlined above, i t is evident th a t options are n ot issued p rim a rily as a means o f raising finance, although they are often issued as p art o f a finance package. Nevertheless, significant sums can be raised when company-issued options are exercised.

9.6.6 | Choosing between equity-raising methods The previous sections have outlined several external methods to raise equity funds, including rights issues, placements, share purchase plans, calls on p a rtly paid shares and the exercise o f company-issued options. M ost o f these methods involve long-term arrangements and i f a significant ‘one-off’ equity raising is needed, it w ill involve a rights issue a nd/or a placement o f shares. W hat factors influence the choice between these methods? Chan and Brown (2004) studied this question using Australian data from July 1996 to March 2001, a period in which the ASX increased the annual ceiling fo r placements w ith o u t shareholder agreement* from 10 per cent to 15 per cent o f ordinary share capital. They found th a t the ceiling imposed by the lis tin g rules has a strong effect on company behaviour, w ith a significant tendency fo r the issue size to be chosen so th a t i t falls just under the prescribed ceiling. As expected, placements w ith o u t shareholder agreement* became more common after the ceiling was increased to 15 per cent and it was rare fo r companies to make rights issues where

of f in a n c e : equity

B usiness finance

the am ount o f funds raised was less than the ceiling fo r placements. Where the am ount o f funds sought exceeded the prescribed ceiling, it was more common fo r companies to make a placement w ith shareholder agreement than to make a rights issue. In summary, th e ir m ain conclusion was th a t companies generally prefer placements to rights issues. A part from the influence o f any ceiling imposed by stock exchange lis tin g rules, the m ain advantages o f placements are speed (funds can be raised in a few days rather than weeks), certainty (a placement may be u nd erw ritte n and, given th a t the risk o f a shortfall exists fo r only a short period, i t should n ot be d ifficu lt to obtain the support o f an underw riter), lower transaction costs and the shares may be placed w ith investors considered to be frien dly* to the existing management. Rights issues have the advantage that shareholders can preserve th e ir ownership proportions and voting power. Thus, rights issues are seen as being more equitable to existing shareholders. A rights issue may require a prospectus and is slower than a placement, but, as noted in Section 9.6.1, fo r companies w ith m ostly in s titu tio n a l shareholders, the m a jo rity o f the funds raised by a rights issue can be received quickly i f one o f the accelerated offer structures is used.

C om bination issues As noted above, where the am ount o f funds sought is below the ceiling fo r a placement w ith o u t shareholder agreement,, companies almost invariably opt fo r a placement rather than a rights issue. Where the am ount o f funds sought is above the ceiling, a rights issue may be chosen b ut the choice involved is n ot sim ply lig h ts issue versus placement w ith shareholder agreement'. Rather, the company may make a placement in combination w ith another m ethod o f equity raising, such as a share purchase plan or a nonrenounceable rights issue. Where these com bination issues are used, the placement component is almost invariably just under the 15 per cent ceiling so th a t shareholder agreement is n ot required. Another feature o f combination issues is th a t the placement is often priced using an in s titu tio n a l book-build. The issue price established by the book-build is then used to determine the price o f the shares fo r the second component o f the issue. Since retail shareholders have the o pp o rtu n ity to participate in the capital raising at the same price as institutio ns, this approach addresses the concern th a t a placement alone discriminates against those shareholders who are n o t invited to participate. Com bination issues involving a placement and an SPP in close p ro xim ity have become common. W hile the placement/SPP combination may be appealing as a way o f accommodating small shareholders, it has been criticised as being far less equitable to small shareholders than a rights issue. The critics make two main points. First, the lim it o f $15 000 per shareholder fo r share purchase plans means th a t the b ulk o f new shares is issued to institutio ns. Second, i f the SPP price is set at a large discount to the m arket price, demand w ill be high and retail investors can end up w ith much less than th e ir $15 000 entitlement*. This problem arose w ith the issues by O rigin Energy, which started w ith a $400 m illion placement to in stitu tio n s in November 2006. The issue price was $7.10 per share, which represented a discount o f about 2.5 per cent to the m arket price at the tim e. A t the same tim e, O rigin announced th a t it would raise additional funds on sim ilar term s through an SPP early in 2007. The details announced in January 2007 included a target o f $75 m illio n fo r the SPP. By the closing date fo r applications, the m arket price o f O rigin shares had increased to about $9. N ot surprisingly, many shareholders applied to purchase shares, w ith the result th a t allocations were scaled back to a m axim um o f 200 shares per shareholder. A nother type o f com bination involves three offers o f shares: a placement, an in s titu tio n a l entitlem ent offer and a retail entitlem ent offer. For example, Alesco Corporation used this approach to raise a total o f $193 m illio n in July and August 2007. The closing price o f Alesco shares on 23 July was $13.96, after which the company announced the acquisition o f another business and details o f an associated capital raising, including an in s titu tio n a l placement w ith the issue price to be determ ined by a book-build w ith an indicative price range o f $12.10 to $12.80 per share. The capital raising also included an in stitu tio n a l e ntitle m e nt offer and a non-renounceable und erw ritte n l-fo r-9 rights issue (retail entitlem ent offer). It was announced th a t the issue price fo r both o f these offers would be set equal to the price set fo r the in s titu tio n a l placement. On 26 July, the company announced th a t the issue price had been set at the top o f the book-build price range at $12.80 per share and th a t the in s titu tio n a l offers were *strongly oversubscribed’. On 23 August, Alesco announced th a t its retail e ntitlem ent offer had raised approximately $61 m illio n in addition to the am ount o f approximately $132 m illio n raised from in s titu tio n s in late July. The company stated th a t the retail offer had been ^strongly supported by existing shareholders w ith over

C hapter n in e S ources

of fin a n c e : equity

60 per cent o f the rights being taken up by eligible shareholders1. The approach used by Alesco has been used by several other companies, including Asciano Group, which raised $2.35 b illio n in June 2009, and Graincorp, which raised about $600 m illio n in October 2009. W hile it is n ot very common, i t is also possible to combine an issue to existing shareholders w ith a public offer o f shares. This approach may be favoured i f the company wishes to attract a wider spread o f shareholders, or i f the am ount o f funds sought is large relative to the size o f the company. For example, in October 2007, Essential Petroleum Resources Ltd (EPR) (see Finance in Action), a small explorer w ith a market capitalisation o f less than $20 m illion , made a l-fo r-2 non-renounceable rights issue and a public offer to raise a total o f $10 m illio n .32

ESSENTIAL PETROLEUM MAKES RIGHTS ISSUE A N D PUBLIC OFFER E s s e n tia l P e tro le u m h a s n 't e x a c t ly s e t th e w o r ld o n f ir e s in c e its F e b r u a r y 2 0 0 1

Finance in ACTION

lis tin g . F r id a y ’s

c lo s in g p r ic e o f 5 . 5 c e n ts a s h a r e te lls a s m u c h . B u t p a t ie n c e w it h th e O t w a y B a s in o il a n d g a s e x p lo r e r , lik e t h a t s h o w n b y th e g r o u p ’ s b ig g e s t s h a r e h o ld e r , f o r m e r JB W e r e re s o u rc e s g u r u P e te r W o o d f o r d , m ig h t ju s t d e liv e r s o m e b ig r e w a r d s in 2 0 0 8 . M a n a g in g d ir e c t o r J o h n R e m fry h a s w o r k e d th e g r o u p in to a p o s it io n w h e r e it w i ll b e a s to c k t o w a t c h n e x t y e a r a s it sets a b o u t d r illin g n e a r-te rm d e v e lo p m e n t o p p o r t u n it ie s in th e o n s h o r e O t w a y w h ile a ls o c h a s in g u p th e b ig - t im e p o t e n t ia l o f its o f f s h o r e p e r m its , f la n k in g w h a t E s s e n tia l r e c k o n s c o u ld b e th e n e x t m a jo r h y d r o c a r b o n p r o v in c e — th e D is c o v e r y B a y ' H i g h 7 o f f s h o r e fr o m P o r tla n d in w e s te r n V ic t o r ia . A n o t h e r g e o lo g ic a l f e a tu r e , th e P e c te n 'H i g h 7 o f f s h o r e fr o m P o rt C a m p b e ll h a s a l r e a d y b e e n p r o v e n a s a h y d r o c a r b o n f a ir w a y . E s s e n tia l re c k o n s t h a t b a c k a t th e b i g g e r D is c o v e r y B a y H ig h , th e p o t e n t ia l in its p e r m its is f o r m o r e th a n 5 t r illio n c u b ic f e e t o f r e c o v e r a b le g a s a n d m o re th a n 2 b illio n b a r r e ls o f r e c o v e r a b le o il. T h a t ’s b ig t a lk f r o m a c o m p a n y o f E s s e n tia T s s iz e , b u t w e l l s o o n k n o w i f it 7s h o t a i r o r n o t. T h a t's b e c a u s e E s s e n tia l is p u llin g in $ 1 0 m illio n fr o m a $ 6 m illio n r ig h ts is s u e ( u n d e r w r it t e n b y B e ll P o tte r a n d C o m s e c ) a n d $ 4 m illio n fr o m a p u b lic o f f e r a t 4 c e n ts a s h a r e . A t th e is s u e p r ic e , th e g r o u p 's m a r k e t c a p it a lis a t io n w i ll b e a ll o f $ 2 2 m illio n . S o u rc e : 2 9

'After a few quiet years, Essential m a y prove it h a s all the ingredie nts,/ B a rry Fitzgerald,

The A g e ,

O c to b e r 2 0 0 7 .

Table 9.1 shows th a t listed companies have raised significant funds through employee share plans, although the prim ary purpose o f such plans is to m otivate senior managers and other employees by giving them an ownership interest in th e ir employer. There are several types o f employee share plans that have been used in Australia, including:3 33 2 •

•

32

Fully paid share plans. Employees are able to purchase new or existing shares, usually at a discount from m arket value. The purchases are usually funded by loans from the company th a t are interestfree or at a low interest rate and dividends on the shares may be used to repay the loans. Sometimes there is a provision to w rite o ff the loans i f the company fails. Partly paid share plans. The shares issued to employees are in itia lly p a rtly paid and converted to fu lly paid shares by a series o f calls. In this case employees can be liable fo r calls i f the company fails before the shares are fu lly paid.

In th e y e a r t o 3 0 J u n e 2 0 0 8 , E P R r e c o r d e d a n e t lo s s o f $ 1 0 .9 m illio n a n d in th e fo llo w in g y e a r a fu r t h e r lo s s o f a lm o s t $ 2 4 .8 m illio n . In F e b r u a r y 2 0 1 0 , it s s h a r e h o ld e r s a p p r o v e d a c a p it a l r e s t r u c t u r e w h e r e b y d e b t o b lig a t io n s o f $ 2 3 m illio n w ere c o n v e r te d in t o e q u it y o r fo r g iv e n . F o llo w in g th e r e s t r u c t u r e , 5 1 .9 p e r c e n t o f th e c o m p a n y s v o t in g s h a r e s w e re h e ld b y B e a c h E n e r g y L t d ， a n e w b o a r d w a s a p p o in t e d a n d t h e c o m p a n y ’s n a m e c h a n g e d t o S o m e r t o n E n e r g y L td .

33

C h a r a c te r istic s o f th e v a r io u s t y p e s o f e m p lo y e e s h a r e p la n s a re d is c u s s e d in d e t a il b y S tr a d w ic k ( 1 9 9 6 ) .

LEARNING OBJECTIVE 9 O utline the different types of em ployee share plans

B usiness finance

•

•

•

Option plans. Under these plans employees in itia lly purchase (or are granted) an option to buy shares at some future tim e at a specified price. O ption plans involve a small in itia l outlay w ith potential for large capital gains i f the company is successful. Employee share trusts. Employees have an interest in a tru s t th a t holds shares in the employer company. The tru s t is norm ally funded by the employer. Employees who hold units in the tru s t can dispose o f the u nits only to other members o f the trust. Replicator plans. Replicator plans do n ot involve shares in the employer company. Instead, payments are made to employees based on the achievement o f certain performance criteria. For example, such a plan may involve phantom shares* w ith a price th a t is linked to the p ro fita b ility o f the company or to the performance o f a division.

The popularity o f the various plans varies among different types o f employers. For example, in Australia the m a jo rity o f employee share plans are option plans and this type o f plan is p articularly popular as a way o f rewarding the senior executives o f large listed companies. Recent changes in the taxation treatm ent of employee share plans may encourage more widespread use o f plans o f other types fo r general staff. The use o f a tru s t structure can be attractive fo r private companies where there are restrictions on ownership o f shares in the company itself. Replicator plans are popular w ith unlisted companies, where i t is d ifficult to establish a m arket price fo r the shares, and can also be useful fo r relatively new businesses, where issuing shares would dilute the ownership and control o f the founders. Over the years the Commonwealth Government has sought to encourage employee share ownership by providing tax concessions in cases where shares or rights to shares are given to employees or issued to them at a discount. The tax status o f employee share plans has been subject to frequent change and some degree o f uncertainty. The provisions th a t apply to employee shares mean that, in general, any benefit to an employee under an employee share plan is taxable in the year in which the share or rig h t is acquired. Consequently, the difference between the m arket value o f a share and the consideration paid to acquire i t is assessable in the year o f acquisition. However, where the employee share scheme meets the conditions fo r classification as a ‘tax-deferred’ scheme, tax may be deferred to a later date. The m ain conditions fo r ‘tax-deferred’ status would generally be satisfied i f the shares have been purchased via a salary-sacrifice scheme or alternatively where the employee faces a *real risk o f forfeiture* o f the shares due to em ploym ent circumstances such as failing to meet performance hurdles or serving a m inim um term o f em ploym ent.34 Under the ASX Listing Rules a company m ust have a proposed employee share plan approved by shareholders and employees may even have to be provided w ith a prospectus i f the prim ary m otivation fo r the plan is fundraising as opposed to providing employees w ith the o pp o rtu n ity to participate in ownership o f the company. Given the complexity o f the taxation provisions and other regulatory requirements, the financial manager o f a company th a t introduces an employee share plan is likely to need specialised advice.

9.8 LEARNING OBJECTIVE 10 O u tline the a d va ntage s of internal funds a s a source of finance

Internal funds

So far we have discussed external sources o f equity finance. However, a company th a t is operating profitably w ill also generate funds internally. The relative importance o f interna l and external sources o f funds may be assessed using different measures o f in te rn a l funds*. One approach is to define internal equity finance as retained profits plus depreciation charges, where retained p ro fit is equal to accounting p ro fit after company tax, less dividends paid to shareholders. A problem w ith this approach is th a t a company cannot spend its accounting p ro fit— suppliers and employees m ust be paid w ith cash. In other words, the prim ary source o f interna l funding is cash p ro fit, which can differ significantly from accounting profit, which is prepared on an accrual basis. Cash p ro fit is reported by companies in th e ir cash flow statements. The cash flow statement is a funds statement th a t shows the sources and uses o f funds, where funds are defined as cash. A 2009 Reserve Bank o f Australia (RBA) analysis o f corporate sources and uses o f funds relied on data from these statements.35 The approach adopted by the RBA divides sources o f funds into two basic categories: interna l funding and external funding. Internal funding is equal to cash p ro fit— that 34

F o r fu r t h e r in fo r m a t io n o n th e t a x t r e a t m e n t o f e m p lo y e e s h a r e s c h e m e s s e e w w w .a t o .g o v .a u / G e n e r a l/ E m p lo y e e - s h a r e sc h e m e s/.

35

S e e R B A ( 2 0 0 9 ).

C hapter n in e S ources

is, cash received from customers and non-interest-bearing investments (e.g. dividends) less payments to suppliers, wages and salaries paid to employees and tax payments. Thus, cash p ro fit is measured before payment o f interest expense and any other financing charges and is n o t affected by depreciation. External funding comprises tw o sources: net debt and net equity, where net debt is equal to funds borrowed from intermediated (e.g. bank loans) and non-interm ediated (e.g. issuing corporate bonds) sources. Finally, net equity is equal to funds raised by issuing new shares, less cash paid o ut to repurchase shares. Funds may be used in three ways: investm ent in assets, payment o f dividends and payment o f interest. The use o f internal funds as a source o f finance has im p o rta n t advantages. Using interna l funds does not affect the control o f the company as it does n o t involve the company in issuing any additional shares. Therefore, using internal funds does n o t com m it the company to increased dividend payments in the future, w ith the result that no additional strain is placed on the company s cash resources. A fu rth e r advantage is that, unlike a new issue o f shares, internal funding involves no issue costs such as brokerage, fees paid to underw riters and other advisers or costs incurred in preparing a prospectus. Internal funds are a convenient source o f finance th a t does n ot involve any explicit costs such as transaction costs, but they are n ot a free source o f finance fo r a company. Internal funds generated by a company are invested by the company on its shareholders’ behalf. I t follows th a t internal funds have an o pportunity cost— th a t is, the funds could have been invested elsewhere by shareholders. Therefore, when a company uses internal funds, shareholders w ill n ot benefit unless the company is able to invest the funds profitably. This analysis is discussed in more detail in Chapter 14. The relative importance o f interna l funds in providing a company s to ta l financial requirements is related to the nature o f a company s business and can also vary considerably over tim e. Between 2003 and 2012, around 86 per cent o f funding fo r resource companies has been sourced internally, whereas only about 68 per cent o f funding fo r non-resource based companies comes from internal sources. Furthermore, both o f these percentages rose dramatically during the global financial crisis beginning in 2007 when external finance was increasingly hard to obtain. (Reserve Bank o f Australia, March 2013, p. 53).

A dividend reinvestment plan (DRP) allows shareholders the choice o f using th e ir dividends to purchase additional shares instead o f receiving cash.36 The firs t DRPs were introduced by Australian companies in the early 1980s. W ith in 10 years, m ost o f Australia’s largest companies were offering such plans and reinvestment o f dividends has become a significant source o f equity fo r listed companies, particularly larger companies. The main reason fo r the popularity o f DRPs is related to the intro du ction o f the dividend im putation tax system, which caused investors to demand high dividend payouts. A dividend reinvestment plan allows a company to meet the demand fo r a high dividend payout w ith o u t straining its cash resources. Technically, investors who participate in a DRP receive the dividends and therefore obtain the tax benefits o f im putation, and then reinvest the cash in additional shares. This means that, for tax purposes, dividends can be considered as being paid* to investors w ith o u t any cash payment by the company. Provided the shares issued under a DRP are fu lly paid, there is no need fo r a prospectus and shares issued under a DRP are exempt from the *15 per cent in 12 m onths1capital raising lim it contained in the Listing Rules. DRPs are inflexible in th a t the tim in g o f any capital raising is tied to the tim in g o f dividend payments and may n o t provide a reliable source o f funds because participation by shareholders is voluntary. The la tte r problem can be overcome, at a cost, by having a company s DRP underw ritten. The main advantage o f DRPs centres on transaction costs: fo r many companies, the costs o f operating a DRP are lower than the costs involved in m aking rights issues and share placements to replace cash paid out as dividends. D uring the 2012-13 financial year, A ustralian-listed companies used DRPs to raise $6.9 b illion (Australian Financial Markets Association, 2013, p. 55).

36

A S X s t a t is t ic s in c lu d e d iv id e n d r e i n v e s t m e n t a s p a r t o f e q u it y r a is e d e x te rn a lly . H o w e v e r, w e d is c u s s D R P s in th e c o n te x t o f in t e r n a l fu n d s b e c a u s e d iv id e n d r e in v e s t m e n t la r g e ly in v o lv e s fu n d s t h a t c o m p a n ie s w o u ld h a v e r e ta in e d , b u t fo r th e h ig h e r d iv id e n d p a y o u t s n e e d e d t o t r a n s f e r f r a n k in g c r e d it s t o s h a r e h o ld e r s . In o t h e r w o r d s, e q u it y 'ra ise d * th r o u g h d iv id e n d r e in v e st m e n t is, in e ffe c t, in t e r n a l fu n d s t h a t h a v e b e e n
of fin a n c e : equity

9.9

M a n a g in g a com pany’s equity structure

In this chapter we have discussed the various sources o f equity individually. In practice, the financial manager w ill usually have a long-term plan fo r the management o f a company s capital structure, including its equity structure. The m ost im p o rta n t aspect o f such a plan involves the tim in g and amounts o f future capital raisings based on forecasts o f the company s cash flows, capital expenditures and loan repayments. As part o f this process, companies, equity structures are sometimes rearranged through procedures th a t change the number o f shares on issue w ith o u t either raising capital or returning capital to shareholders. These procedures— which include bonus issues, share splits and consolidations— are now considered.

9.9.1 | Bonus issues and share splits

L E A R N IN G O B JEC TIVE 11 Outline the effects of bonus issues, share splits a n d share consolidation s

A bonus issue is a ‘free’ issue o f shares made to existing shareholders in p ro p o rtio n to th e ir current investm ent. Bonus issues used to be common in Australia and were used as a way o f increasing the dividends paid to shareholders. A bonus issue is equivalent to a rights issue w ith a zero subscription price. In accounting terms, a company could make a bonus issue by using the balances o f reserves, such as a share premium reserve, and /or retained earnings— th a t is, p art o f a reserve is converted to issued capital b u t the to ta l o f shareholders’ funds remains unchanged. Regulatory changes, including the intro du ction o f the dividend im p utatio n tax system and the abolition o f par value fo r shares, removed any tax advantage associated w ith bonus issues. Accordingly, companies th a t have the capacity to pay higher dividends usually increase the rate o f dividend per existing share rather than making a bonus issue and m aintaining the same dividend rate. W hile bonus issues have virtu a lly disappeared from the Australian market, companies can achieve a sim ilar result by sp littin g th e ir shares. For example, a share s p lit th a t doubles the num ber o f a company s issued shares has the same effect fo r shareholders as a 1 -fo r-l bonus issue. Australian companies that have made share splits since 2002 include Toll Holdings, W H K Group, CSL Lim ited, Incitec Pivot and Fortescue Metals Group. A bonus issue or share sp lit involves no cash flow — apart from the adm inistration costs involved— and should n o t have any effect on shareholders’ wealth. Therefore, i f a company makes, say, a 1 -fo r-l bonus issue, the num ber o f shares on issue w ill double and the m arket price o f each share should decrease by half, leaving unchanged the to ta l m arket value o f the shares held by each investor. The Australian evidence is consistent w ith this expectation— th a t is, bonus issues do n o t affect shareholders1wealth.37 A lthough a bonus issue— by its e lf— would n o t be expected to have an im pact upon shareholder wealth, the in fo rm a tio n contained w ith in the announcement o f a bonus issue may result in a significant change in wealth. Bonus issues and share splits are typically made by companies th a t have been perform ing well and th a t have recently experienced significant increases in share price. Investors are aware that, follow ing a bonus o r split, companies usually do n o t reduce dividends per share to the extent necessary to m aintain the same to ta l dividend payout. For example, after a 1 -fo r-l bonus issue, a company currently paying a dividend o f 10 cents per share would need to pay a dividend o f only 5 cents per share to m aintain its dividend payout. However, companies w ill often n ot reduce th e ir dividend per share to th a t extent. For example, the company may end up paying a dividend of, say, 7.5 cents per share after the bonus issue has been made. I f the behaviour o f m ost companies after a bonus issue follows this pattern, the m arket w ill be confident th a t a company m aking a bonus issue w ill probably increase its to ta l dividend payout (Ball, Brown & Finn 1977). This, in tu rn , indicates the confidence o f management in the company s future. Consequently, the share price may increase in response to this new inform ation. Therefore, bonus issues may result in an increase in shareholder wealth— n o t sim ply because o f the new shares issued— but instead because the announcement o f the issue provides an o pp o rtu n ity fo r management to signal to the m arket positive info rm a tio n th a t was n o t already incorporated into the company s share price.

37

S e e S lo a n ( 1 9 8 7 ) . T h is e v id e n c e c o n t r a s t s w ith th e U S e v id e n c e , w h ich h a s fo u n d p o s it iv e a b n o r m a l r e t u r n s o n th e e x -b o n u s d a y fo r U S s t o c k d iv id e n d s a n d s h a r e s p lit s ; s e e L a k o n is h o k a n d V e r m a e le n ( 1 9 8 6 ) a n d G r in b la t t , M a s u lis a n d T it m a n ( 1 9 8 4 ).

C hapter n in e S ources

The dividend-based explanation fo r the m arket reaction to bonus and sp lit announcements, which was firs t proposed by Fama et al. (1969), does n o t appear to explain fu lly the m arket reaction to such announcements. Asquith, Healy and Palepu (1989) studied share splits by companies th a t did n o t pay cash dividends. They found th a t these companies had large earnings increases before the split, b u t no unusual changes in earnings or in itia tio n o f dividends after the split. An im p o rta n t conclusion o f th eir study was th a t the announcement o f a sp lit leads investors to expect th a t past earnings increases are permanent. A share split may be made by a company w ith a *thin, market fo r its shares. Management may believe that reducing the m arket price per share w ill increase the demand fo r the company s shares. In September 2008, fe rtiliser and explosives m anufacturer Incitec Pivot, which had a share price around $140, made a 2 0 -fo r-l share split. The stated purpose was to benefit shareholders by m aking the company s shares more affordable to retail investors. W hile there is evidence th a t both announcement and execution o f share splits are associated w ith significant positive returns, empirical evidence that splits lead to improved liq u id ity and m arketability is mixed. On the one hand, there is evidence th a t both the number o f shareholders and the num ber o f share transactions increase after splits, b ut little evidence th a t the dollar value o f trading increases. On the other hand, there is evidence th a t splits increase bid-ask spreads and return volatility, both o f which suggest a decrease in liq u id ity .38

A share consolidation— also know n as a reverse sp lit— decreases the number o f shares on issue and increases the price per share. For example, i f a company w ith 100 m illio n issued shares makes a l-fo r-1 0 consolidation, i t w ill end up w ith 10 m illio n issued shares. A fte r the consolidation, the m arket price per share should increase by a factor o f 10. Consolidations are unusual in Australia b ut have become more common follow ing the global financial crisis. For example, in September 2010, gold m iner St Barbara Ltd announced th a t it planned a share consolidation o f six existing shares fo r one new share. Directors noted th a t the company s share price o f around 40 cents meant th a t some international in s titu tio n s that were potential investors in the company were precluded from investing in companies w ith share prices less than US$1. Sim ilar reasons usually given fo r consolidations include raising the share price into a popular trading range, overcoming perceptions th a t a company is n o t respectable because o f its low share price, and reducing shareholder servicing costs. O ther companies th a t have recently consolidated th e ir securities include Australand, Boart Longyear and GPT Group. I f these suggested reasons are correct and consolidations provide benefits fo r shareholders, the market response to these events should be positive. This does n o t appear to be the case: several US studies report th a t consolidations are associated w ith negative share returns. For example, Desai and Jain (1997) report an average abnormal retu rn o f -4.5 9 per cent in the m onth th a t consolidations are announced. They also found th a t negative returns in the announcement period were followed by a d rift th a t averaged 10.76 per cent in 1 year and 33.90 per cent in 3 years. One interpretation is th a t consolidations convey a signal th a t management lacks confidence th a t there w ill be future share price increases resulting from improvements in earnings. There is evidence th a t consolidations are followed by higher trading volume and a decrease in bid-ask spread. This finding suggests th a t consolidations enhance the liq u id ity o f a stock, which should be beneficial fo r investors. Taken together, the evidence suggests th a t consolidations *may be better characterised as a device th a t management, given its assessment o f future earnings, can use to improve the liq u id ity o f the stock’ （ Han 1995, p. 169).

38

S tu d ie s t h a t r e p o r t e v id e n c e o n t h e e ffe c t s o f s h a r e s p l i t s o n liq u id ity in c lu d e Ik e n b e r ry , R a n k in e a n d S tic e ( 1 9 9 6 ) a n d M u sc a r e lla a n d V e ts u y p e n s ( 1 9 9 6 ) .

〇

f fin a n c e : equity

B usiness finance

SUMMARY •

•

In th is c h a p te r w e c o n s id e r e d th e w a y s in w h ic h

r a t io to th e n u m b e r o f s h a re s a lr e a d y h e ld . A

•

t r a d itio n a l

Those

who

in v e s t in

new

v e n tu re s

w h e re

an

issu e

is

s lo w

in v o lv e s

o f a n in v e n tio n o r id e a in c lu d e w e a lt h y in d iv id u a ls

ra is e la r g e a m o u n ts o f fu n d s . R ig h ts issues m a y

a n d p r iv a te e q u ity fu n d s .

b e r e n o u n c e a b le o r n o n -re n o u n c e a b le a n d c a n

W h e re

c a p it a l

a

is ra is e d

in v e s to rs

by

is s u in g

m u st g e n e r a lly

d is c lo s u re

d o c u m e n t.

b e m a d e w ith o u t a p ro s p e c tu s . T h e fu n d s c a n b e

s e c u ritie s ,

re c e iv e d s o o n e r th a n u s u a l b y a d o p tin g o n e o f

b e s u p p lie d

T h is

th e a c c e le r a te d o ffe r s tru ctu re s.

d o c u m e n t,

often a p ro s p e c tu s , sets o u t in fo r m a tio n to e n a b le in v e s to rs to

assess th e

risks in v o lv e d

and

•

•

A

p la c e m e n t is a n issu e o f s h a re s to b r o k e r s 7

c lie n ts

th e

a n d /o r

in s titu tio n a l

in v e s to rs

s u ch

as

life in s u r a n c e c o m p a n ie s a n d in v e s tm e n t fu n d s .

v a lu e o f th e s e c u ritie s . O r d in a r y s h a re h o ld e rs fa c e h ig h e r ris k th a n o th e r

Issue c o sts a r e

in v e s to rs,

rig h ts issu e s, b u t f o r a lis te d c o m p a n y a lim it

b u t a re

p ro te c te d

to so m e e x te n t b y

lim ite d lia b ility . A s p a rt-o w n e rs o f th e c o m p a n y ,

of

c a p it a l th a t it c a n ra is e b y p la c e m e n ts in a n y

v irtu e o f th e ir r ig h t to e le c t m e m b e rs o f th e B o a rd o f

y e a r w ith o u t th e p r io r a p p r o v a l o f s h a r e h o ld e r s .

D ire c to rs . S h a re h o ld e rs in a liste d p u b lic c o m p a n y

W h e re

m a y sell th e ir sh a re s o n a s to ck e x c h a n g e .

th e

E q u ity

has

im p o r ta n t a d v a n ta g e s

as a

s o u rc e

15

lo w e r f o r p la c e m e n ts th a n fo r

o r d in a r y s h a re h o ld e rs e x e rt a d e g r e e o f c o n tro l b y

p e r c e n t is

th e

15

A lte r n a tiv e ly ,

o r to re d e e m (re p a y ) o r d in a r y s h a re s. R a isin g n e w

w ith

e q u ity c a p ita l lo w e rs fin a n c ia l ris k a n d

issu e.

lo w e rs th e •

a

cent

c e ilin g ,

th e

am ount of

sought exceeds c o m p a n ie s

o fte n

p la c e m e n t c a n

p u rc h a s e

p la n

be

c o m b in e d

a n d /o r

a

rig h ts

E q u ity c a n a ls o b e ra is e d b y is s u in g c o n trib u tin g o p tio n s

e m p lo y e e s .

(IPO ) o f o r d in a r y

a

s h a re

s h a re s ,

it b o rro w s .

on

s h a re s

E m p lo y e e s h a re

and

sh a re s

to

p la n s c a n q u a lif y

fo r ta x c o n c e s s io n s .

s h a re s is re fe r r e d to as f lo a t in g a c o m p a n y a n d is u s u a lly a c c o m p a n ie d b y th e lis tin g o f th e s h a re s o n

on

a m o u n t o f fu n d s

per

fin a n c e . C o m p a n ie s a r e n o t re q u ire d to p a y d iv id e n d s

M a k in g a n in it ia l p u b lic o ffe r in g

p la c e d

m a k e a p la c e m e n t w ith s h a r e h o ld e r a p p r o v a l.

of

in te re s t ra te th a t th e c o m p a n y w ill h a v e to p a y w h e n

•

A m a jo r s o u rc e o f e q u ity fin a n c e is in te rn a l in th e

a s to c k e x c h a n g e . D e te r m in in g th e issu e p r ic e f o r a n

se n se th a t it re su lts fro m th e p o s itiv e n e t c a s h flo w s

IP O c a n b e d iff ic u lt a n d in la r g e flo a ts it h a s b e c o m e

th a t

c o m m o n to use c o m p e titiv e b id d in g

g e n e r a te d

b y in s titu tio n s

to set th e p ric e . D e ta ils o f th e issu e a n d th e is s u in g

a

s u c ce ssfu l fu n d s

com pany have

g e n e ra te s .

s e v e ra l

In te rn a lly

a d v a n ta g e s

over

e q u ity fu n d s ra is e d e x te rn a lly . In c o n ju n c tio n w ith

c o m p a n y m u st b e p r o v id e d in a p ro s p e c tu s . F lo a tin g

h ig h e r d iv id e n d p a y m e n ts u n d e r th e im p u ta tio n ta x

a

th e

syste m , m a n y A u s tr a lia n c o m p a n ie s h a v e in tro d u c e d

la rg e s t c o s t is a s s o c ia te d w ith th e u n d e r p r ic in g o f

d iv id e n d re in v e s tm e n t p la n s th a t a llo w in v e s to rs to

com pany

in v o lv e s

s ig n if ic a n t co sts.

O fte n ,

th e s h a re s — th e issu e p r ic e f o r a n IP O is u s u a lly less

use

th a n th e m a rk e t p r ic e w h e n t r a d in g c o m m e n c e s .

s h a re s . T h is a llo w s d iv id e n d s to b e p a id a n d f r a n k in g

A fte r a c o m p a n y h a s b e e n flo a te d , a d d itio n a l e q u ity

c re d its to b e d is tr ib u te d to in v e s to rs w h ile re ta in in g

can

c a s h w ith in th e c o m p a n y .

be

ra is e d

in

s e v e ra l

w ays,

in c lu d in g

rig h ts

th e ir

cash

d iv id e n d s

to

p u rc h a s e

issu es, p la c e m e n ts a n d s h a re p u rc h a s e p la n s .

KEY TERMS c a ll

234

c o n trib u tin g sh a re s c u m rig h ts

262

e x -rig h ts d a te

240

253

in fo rm a tio n a s y m m e try in itia l p u b lic o ffe r in g in s ta lm e n t re c e ip t lim ite d lia b ilit y o p tio n

237 237

262

234

260

p ro s p e c tu s

240 234

se a s o n e d e q u ity o ffe r in g s h o rtfa ll f a c ility

258

s h o rtfa ll sh a re s

258

s ta p le d se c u ritie s

234

25 1

233

s u b s c rip tio n p ric e

253

th e o re tic a l e x -rig h ts s h a re p ric e th e o re tic a l rig h ts p ric e

255

o r d in a r y sh a re s

p la c e m e n t

re s id u a l c la im

253

d is c lo s u re d o c u m e n t

270

and

h ig h e r co sts th a n a p la c e m e n t b u t c a n b e u se d to

w ith

•

rig h ts

e n tre p re n e u r n e e d s f in a n c e fo r th e d e v e lo p m e n t

p o te n tia l

•

rig h ts issu e (e n title m e n t o ffe r) is a n o ffe r to

s h a re s . E v e ry c o m p a n y m u st issu e o r d in a r y s h a re s.

•

•

A

e x is tin g s h a re h o ld e rs o f n e w s h a re s in a fix e d

a c o m p a n y m a y ra is e e q u ity b y is s u in g o r d in a r y

w in n e r ’s cu rs e

248

254

254

a d d itio n a l

C hapter n in e S ources

of f in a n c e : equity

1

[L0 1] The interest held by ordinary shareholders is a residual claim. E x p la in th e m e a n in g a n d s ig n ific a n c e o f th is s ta te m e n t.

2 3

[L O 1] W h a t a re th e m o s t im p o r t a n t rig h ts o f s h a re h o ld e rs in a c o m p a n y ? [ L O l ] W h a t a r e th e m a in s im ila ritie s b e tw e e n c o n tr ib u tin g s h a re s a n d in s ta lm e n t re c e ip ts ? H o w d o th e y d iffe r?

4 5

[LO 2 ] W h a t a r e th e m a in a d v a n ta g e s o f r a is in g e q u ity ra th e r th a n b o r r o w in g ? [LO 2: D is tin g u is h b e tw e e n lim ite d lia b ilit y a n d n o lia b ilit y c o m p a n ie s . W h y a r e n o lia b ilit y c o m p a n ie s c o n fin e d to e x p lo r a t io n a n d m in in g c o m p a n ie s ?

6

[LO 3 ] D e fin e p r iv a te e q u ity . W h a t a r e th e m a in fe a tu re s th a t d is tin g u is h p r iv a te e q u ity fro m o th e r fo rm s o f e q u ity fin a n c e ?

7

[LO 31 P riv a te e q u ity fu n d in g fo r n e w v e n tu re s is t y p ic a lly p r o v id e d in s ta g e s . W h a t a r e th e m a in re a s o n s fo r th is a p p r o a c h ?

8

[LO 4 ] W h a t ty p e o f in fo r m a tio n is g e n e r a lly r e q u ire d in th e o f fe r d o c u m e n ts is s u e d p r io r to c a p it a l r a is in g ? W h y d o y o u th in k r e g u la to rs m ig h t h a v e a v o id e d p r o v id in g a s im p le 'c h e c k lis t7 o f ite m s f o r in c lu s io n a n d

C H A P T E R Isfl^E R E V I E W

QUESTIONS

in s te a d ta k e n a b r o a d e r a p p r o a c h to r e g u la tio n ? 9

[L O 5 ] Listed p u b lic c o m p a n ie s h a v e th e a d v a n ta g e o f g r e a te r a c c e s s to th e c a p it a l m a rk e t th a n p r iv a te o r u n lis te d c o m p a n ie s . H o w e v e r, th is a d v a n ta g e a ls o in v o lv e s s ig n ific a n t costs. W h a t a r e th e m a in co sts?

10

[L O 5 ] A com pany is floated by m aking a public issue of ordinary shores. O u t lin e th e p ro c e d u re s in v o lv e d

11

[L O 5 ]

12

[L O 5 ] O u tlin e th e m a in a d v a n ta g e s o f u s in g b o o k - b u ild in g fo r a n in it ia l p u b lic o ffe r in g o f s h a re s ra th e r th a n

13

[ L 0 5 ] W h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f h a v in g a s h a re issu e u n d e r w r itte n ?

14

[L O 5 ] W h y a r e u n d e r w r it in g fe e s h ig h e r f o r c o m p a n y flo a ts th a n f o r rig h ts issues?

15

[L O 6

in f lo a tin g a c o m p a n y .

A company usually seeks the assistance o f a financial institution before undertaking any large capital raising. E x p la in w h y th is is so . D e s c rib e fu lly th e re le v a n t s e rv ic e s th a t a f in a n c ia l in s titu tio n p ro v id e s . m a k in g a fix e d - p r ic e o ffe r. W h a t a r e th e d is a d v a n ta g e s o f b o o k - b u ild in g ?

In itia l p u b lic o ffe r in g s o f s h a re s a re t y p ic a lly u n d e r p r ic e d b u t v e n d o rs a r e r a r e ly u p s e t a b o u t le a v in g

la r g e a m o u n ts o f m o n e y o n th e ta b le . H o w is 'm o n e y le ft o n th e t a b le 7 u s u a lly m e a s u re d ? H o w c a n th e p u z z lin g a ttitu d e o f v e n d o rs b e e x p la in e d ? 16

[ L 0 6 ] In d is c u s s in g th e ir re s e a rc h o n IP O s, C a m p e t a l. ( 2 0 0 6 ) c o n c lu d e th a t 'th e c h o ic e s issu ers m a k e a t th e o ffe r in g re fle c t th e tr a d e - o ff b e tw e e n th e co sts a n d b e n e fits o f th e IP O 7. F o r issu e rs, th e m a in c o s t o f a n IP O is re p re s e n te d b y u n d e r p r ic in g . W h a t a r e th e m a in b e n e fits ?

17

[L O 7 ] O u tlin e th e 'n e w issues p u z z le 7. W h y is th e e v id e n c e f o r its e x is te n c e c o n tro v e rs ia l?

18

[L O 8 ] A lth o u g h m o st c o m p a n ie s p e r m it rig h ts to b e tr a d e d o n th e s to c k e x c h a n g e , a n u m b e r o f c o m p a n ie s h a v e m a d e n o n -re n o u n c e a b le rig h ts issu es. W h y w o u ld c o m p a n ie s w is h to m a k e th e ir rig h ts issues n o n -re n o u n c e a b le ?

19

[ L 0 8 ] T h e re h a s b e e n re s is ta n c e to c o m p a n ie s r a is in g fu n d s b y a p r iv a te p la c e m e n t o f s h a re s . D e s c rib e th e

20

[ L 0 8 ] M W B Ltd is a p r o fita b le c o m p a n y w h o s e o r d in a r y s h a re s a r e lis te d o n th e A S X . T h e c o m p a n y ha s

a d v a n ta g e s a n d d is a d v a n ta g e s to e x is tin g s h a re h o ld e rs o f a p r iv a te p la c e m e n t.

p a id r e g u la r d iv id e n d s to s h a re h o ld e rs a n d h a s g e n e r a lly fin a n c e d its g r o w th b y r e ta in in g a b o u t 5 0 p e r c e n t o f p ro fits . Its c u rre n t 5 - y e a r p la n in c lu d e s in v e s tm e n t in f ix e d a sse ts o n a s c a le th a t w ill re q u ire th e r a is in g o f e x te rn a l e q u ity fin a n c e d u r in g th e p la n n in g p e r io d . A d v is e th e d ir e c to r s o n th e m a in fa c to rs th a t th e y s h o u ld c o n s id e r in d e c id in g h o w to ra is e e q u ity . T he d ir e c to r s a r e c o n s id e r in g :

21

a)

a rig h ts issue

b)

a se rie s o f s h a re p la c e m e n ts

c)

e s ta b lis h in g a d iv id e n d re in v e s tm e n t p la n .

Combining a shore purchase plan with a placement to institutions should satisfy shareholders who argue that as far as possible, companies should raise equity through rights issues. D o y o u a g r e e w ith th is

[L O 8 ]

s ta te m e n t? E x p la in y o u r a n s w e r.

271

B usiness finance

22

[ L 0 8 ] N o w that rights issues con be made without a prospectus, they w ill become much more popular and placements may become rare. D o y o u a g r e e w ith th is s ta te m e n t? E x p la in y o u r a n s w e r.

23

[L O 8 ] O u tlin e th e m a in fe a tu re s o f a n a c c e le r a te d r e n o u n c e a b le e n title m e n t o ffe r. W h a t a r e th e m a in d iffe re n c e s b e tw e e n su ch a n o ffe r a n d a t r a d itio n a l r e n o u n c e a b le rig h ts issue?

24

[L O 8 ] A lis te d c o m p a n y m a y m a k e a p u b lic o f fe r o f s h a re s , p o s s ib ly in c o n ju n c tio n w ith a rig h ts issue. Id e n tify fa c to rs th a t m a y f a v o u r th e use o f a fu rth e r p u b lic o ff e r o f s h a re s ra th e r th a n a p la c e m e n t o r a rig h ts issue a lo n e .

25

[L O 8 ]

Options are often used as on incentive to various groups or individuals. D e s c rib e h o w o p tio n s c a n b e

u se d to th e a d v a n ta g e o f a c o m p a n y a n d its s h a re h o ld e rs . 26

[ L 0 9 ] W h a t is th e in c e n tiv e fo r a c o m p a n y to p r o v id e c o m p e n s a tio n f o r m a n a g e rs in th e fo rm o f sh a re s ra th e r th a n s a la r y ? W h a t is th e a d v a n ta g e o f s h a re c o m p e n s a tio n o v e r a n d a b o v e c o m p e n s a tio n u s in g s h a re o p tio n s ?

27

[L O 1 0 ] W h a t a r e in te rn a l fu n d s ? W h a t a r e th e ir a d v a n ta g e s a s a s o u rc e o f e q u ity ?

28

[L O 1 0 ] O u t lin e th e im p a c t o f th e g lo b a l f in a n c ia l c ris is o n A u s tr a lia n c o m p a n ie s in te rm s o f th e ir m ix o f in te rn a l ve rsu s e x te rn a l fu n d in g o v e r th e 2 -y e a r p e r io d fro m m id - 2 0 0 7 .

29

[L O ll]

W h a t is a s h a re s p lit? W h y m ig h t th e d ir e c to r s o f a c o m p a n y w is h to s p lit its s h a re s ?

30

[L O ll]

W h a t is a s h a re c o n s o lid a tio n ? E v a lu a te th e re a s o n s th a t m a y b e g iv e n to ju s tify a s h a re

c o n s o lid a tio n . 31

[L O 1 1 ] E x p la in b r ie f ly w h y th e s h a re p r ic e o f a c o m p a n y m a y in c re a s e w h e n th e c o m p a n y a n n o u n c e s a b o n u s issu e o r s h a re s p lit.

PROBLEMS 1

E co n o m ic fa c to rs a n d f in a n c in g p o lic y [L O 2 】 C h o o s e a c o m p a n y a n d tra c e th e m a jo r c h a n g e s in its c a p ita l stru ctu re d u rin g th e p a s t 1 0 y e a rs . O u tlin e th e e c o n o m ic fa c to rs th a t y o u c o n s id e r h a v e c o n trib u te d to th e m a jo r c h a n g e s in its fin a n c in g p o lic y d u r in g this p e rio d .

2

P u b lic s h a re issu e [L O 5 ] K a tz Pty Ltd is a w e ll-e s ta b lis h e d c o m p a n y w h o s e d ire c to rs h a v e d e c id e d to c o n v e rt to p u b lic c o m p a n y status, m a k e a p u b lic s h a re issue a n d list o n th e s to ck e x c h a n g e . T he c o m p a n y n e e d s to ra is e $ 7 9 2 0 0 0 0 to e x p a n d its o p e ra tio n s . Its p ro s p e c tu s fo re c a s ts a d iv id e n d o f 2 0 cen ts p e r sh a re in its firs t y e a r a s a p u b lic c o m p a n y a n d d iv id e n d s a r e e x p e c te d to g r o w a t 6 p e r c e n t p e r a n n u m in d e fin ite ly . S h a re h o ld e rs re q u ire a re tu rn o f 1 4 p e r c e n t p e r a n n u m a n d th e c o s t o f lis tin g a m o u n ts to 1 2 p e r c e n t o f th e g ro s s p ro c e e d s fro m th e issue. H o w m a n y s h a re s m ust K a tz issue?

3

R ig h ts issu e [L O 8 ] C o m p a n y A h a s 4 m illio n sh a re s o n issue a n d w is h e s to ra is e $ 4 m illio n b y a l- f o r - 4 rig h ts issue.

4

a)

W h a t is th e th e o re tic a l v a lu e o f 1 r ig h t if th e m a rk e t p r ic e o f 1 s h a re (cum rig h ts) is $ 5 ?

b)

W h a t is th e th e o re tic a l s h a re p r ic e (ex-rights)?

c)

D o e s a n in v e s to r g a in th ro u g h a rig h ts issue?

R ig h ts issu e [L O 8 ] C r o s lin g Ltd sh a re s a re tr a d in g a t $ 1 2 e a c h . Its d ire c to rs h a v e a n n o u n c e d a l- fo r - 6 rig h ts issue w ith a s u b s c rip tio n p r ic e o f $ 1 0 . 6 0 p e r sh a re . W h a t is:

5

a)

th e th e o re tic a l v a lu e o f a r ig h t to o n e n e w s h a re

b)

th e th e o re tic a l e x -rig h ts s h a re p ric e ?

R ig h ts issu e [L O 8 ] M a x w e ll Ltd is a liste d b io te c h n o lo g y c o m p a n y . O n 5 M a y 2 0 1 4 it a n n o u n c e d a l- fo r - 3 re n o u n c e a b le rig h ts issue a t a s u b s c rip tio n p r ic e o f $ 6 . 2 0 p e r sh a re w ith a n e x -rig h ts d a te o f 2 5 M a y . T he c o m p a n y a ls o a n n o u n c e d th a t fu n d s ra is e d b y th e issue w o u ld b e use d to e s ta b lis h p r o d u c tio n fa c ilitie s fo r its n e w a n tim a la r ia d ru g th a t re c e n tly p a s s e d its fin a l c lin ic a l tria ls . T he s h a re p r ic e ro s e fro m $ 6 . 9 0 to $ 7 . 0 5 a fte r th o se a n n o u n c e m e n ts . T he c lo s in g p ric e o f M a x w e ll sh a re s o n 2 4 M a y w a s $ 7 p e r sh a re .

272

C hapter n in e S ources

W h a t is a r e n o u n c e a b le rig h ts issue?

b) W h a t is th e m o st lik e ly e x p la n a tio n fo r th e s h a re p ric e ris e o n 5 M a y a fte r th e c o m p a n y 's a n n o u n c e m e n ts ? c)

W h a t d o y o u e x p e c t th e p r ic e o f th e sh a re s to b e o n 2 5 M a y ? S h o w a ll c a lc u la tio n s .

d)

W h a t is th e th e o re tic a l v a lu e o f a rig h t? S h o w a ll c a lc u la tio n s .

e)

E x p la in w h y th e sh a re p ric e c h a n g e fro m 2 4 M a y to 2 5 M a y d o e s n o t re fle c t a n y c h a n g e in s h a re h o ld e rs 7 w e a lth .

6

Alternative w ays of raising equity [LO 8 】 G e o rg e B a n ks In te rn a tio n a l (G B I) Ltd h a s 1 0 0 m illio n fu lly p a id o r d in a r y sh a re s o n issue a n d its sh a re s a r e liste d o n th e A S X . A b o u t 6 0 p e r c e n t o f th e sh a re s a r e h e ld b y A u s tra lia n fin a n c ia l in s titu tio n s a n d th e c lo s in g p ric e o f th e s h a re s o n 1 5 O c to b e r 2 0 1 4 w a s $ 4 . The c o m p a n y h a s a fu lly d r a w n $ 5 0 0 m illio n b a n k lo a n fa c ility , w h ic h is d u e to b e r o lle d o v e r o r r e p a id o n 3 0 N o v e m b e r 2 0 1 4 . G B I Ltd is c lo s e to b re a c h in g a n im p o rta n t c o v e n a n t a n d its d ire c to rs h a v e re s o lv e d to ra is e e q u ity to r e p a y th e lo a n o n o r b e fo re th e d u e d a te . The c o m p a n y 's la s t sh a re issue o c c u rre d in 2 0 1 1. a) A s s u m in g a n issue p r ic e o f $ 3 . 8 0 p e r s h a re , w h a t is th e m a x im u m a m o u n t th a t G B I Ltd c a n ra is e b y m a k in g a s h a re p la c e m e n t w ith o u t s h a re h o ld e r a p p r o v a l? b) A d v is e th e d ire c to rs o n th e fe a s ib ility o f ra is in g th e re q u ire d fu n d s b y a tr a d itio n a l re n o u n c e a b le o r n o n -re n o u n c e a b le rig h ts issue. c)

C H A P T E R NINE R E V I E W

a)

of f in a n c e : equity

A fte r r e c e iv in g y o u r a d v ic e , th e d ire c to rs a re c o n s id e rin g th e c o m b in a tio n o f a n in s titu tio n a l p la c e m e n t fo llo w e d im m e d ia te ly b y a n a c c e le ra te d e n title m e n t o ffe r. i) D o e s th e m a x im u m a m o u n t th a t c a n b e ra is e d b y th e p la c e m e n t re m a in th e s a m e a s in (a)? W h y , o r w h y not? ii) R e v ie w y o u r a n s w e r to (b). H o w w ill y o u r a d v ic e c h a n g e , g iv e n th a t a n a c c e le ra te d o ffe r s tru c tu re is to b e used?

d)

A s s u m e th a t th e c o m p a n y p ro c e e d s w ith a n a c c e le ra te d e n title m e n t o ffe r. F rom th e v ie w p o in t o f G B I's s h a re h o ld e rs , w h a t is th e m a in e ffe c t o f m a k in g th e o ffe r re n o u n c e a b le ra th e r th a n n o n -re n o u n c e a b le ? W ill a re n o u n c e a b le o ffe r n e c e s s a rily e n s u re th a t a ll s h a re h o ld e rs a re tre a te d e q u a lly ? W h y , o r w h y not?

Lj

REFERENCES

Abernethy, M. Heidtman, Unwin, Sydney, 1999.

Business Angels, Allen &

Asquith, P., Healy, P. & Palepu, K., 'Earnings and stock splits7, The Accounting Review, July 1989, pp. 3 8 7 -4 0 3 . Australian Bureau of Statistics, Venture Capital and Later Stage Private Equity, Australia, 2012-13 cat. no. 5 6 7 8 .0 , ABS, Canberra, 2 0 1 4 . Australian Financial Markets Association, 2013 Australian Financial Markets Report, Sydney, 20 1 3 . Balachandran, B., Faff, R. & Theobald, M ., 'Rights offerings, takeup, renounceability, and underwriting status', Journal of Financial Economics, August 2 0 0 8 , pp. 3 2 8 -4 6 .

Camp, G ., Comer, A. & How, J., 'Incentives to underprice ’， >Acc〇 L/nf/‘ng anc/ Pnonc6, December 2 0 0 6 , pp. . Chan, H.W . & Brown, R.L., 'Rights issues versus placements in Australia: regulation or choice?7, Company and Securities Law Journal, 2 0 0 4 , pp. 2 9 9 -3 1 0 . Cliff, M . & Denis, D., 'Do initial public offering firms purchase analyst coverage with underpricing?', Journal of Finance, December 2 0 0 4 , pp. 2 8 7 1 -9 0 1 . Connolly, E. & Tan, A., The private equity market in Australia', Bulletin, Reserve Bank of Australia, June 2 0 0 2 , pp. 1 -5 .

Ball R., Brown, P. & Finn, F.J., 'Share capitalisation changes, information and the Australian equity market', Australian Journal of Management, O ctober 1977, pp. 1 0 5 -2 5 .

Da Silva Rosa, R., Velayuthen, G. & W alter, T., 'The sharemarket performance of Australian venture capitalbacked and non-venture capital-backed IPOs', Pacific-Basin Finance Journal, April 20 0 3 , pp. 1 9 7 -2 1 8 .

Brau, J. & Fawcett, S., ’Initial public offerings: an analysis of theory and practice', Journal of Finance, February 2 0 0 6 , pp. 3 9 9 -4 3 6 .

Desai, H. & Jain, P., 'Long-run common stock returns follow ing stock splits and reverse splits', Journal of Business, July 19 97 , pp. 4 0 9 -3 3 .

Brav, A. & Gompers, P., 'M yth or reality? The long-run underperformance of initial public offerings: evidence from venture and non-venture capital-backed companies', Journal of Finance, December 1997, pp. 1 7 9 1 -8 2 1 .

Dimovski, W . & Brooks, R., 'Financial characteristics of Australian initial public offerings from 1994 to 1 9 9 9 7, App"ec/ Econom/cs, 2 0 0 3 , vol. 35, no. 14, pp. 1 5 9 9 -6 0 7 .

Brown, R. & Hathaway, N ., 'Valuing contributing shares’， Accounf/ng and F/nance, Novem ber 1991, pp. 5 3 -6 7 .

Eckbo, B., Masulis, R. & N o r li, 〇 .，'Seasoned public offerings: resolution of the ;/new issues puzzle/,,/ Journal of Financial Economics, A pril 2 0 0 0 , pp. 2 5 1 -9 1 .

2 73

Fama, E., Fisher, L., Jensen M. & Roll, R., 'The adjustment of stock prices to new information', International Economic Review, February 1969, pp. 1-21. Gompers, P. & Lerner, J., The really long-run performance of initial public offerings: the pre-Nasdaq evidence', Journal of Finance, August 2003, pp. 1355-92. Gong, N. & Shekhar, C.; Underpricing of privatised IPOs: the Australian experience', Australian Journal of Management, December 2001; pp. 91-106. Grinblatt, M., Masulis, R. & Titman, S., 'The valuation effects of stock splits and stock dividends', Journal of Financial Economics, December 1984, pp. 461-90. Han, K.C., 'The effects of reverse splits on the liquidity of the stock', journa/ of F/ncrnd。/ anc/ Qucmf/7a"Ve Ana/ys/s, March 1995, pp. 159-69. Herbert, A., Australian Private Equity & Venture Capitol Guide 2010, 17th edn, Private Equity Media, Melbourne,

2010 . How, Izan, H. & Monroe, G., 'Differential information and the underpricing of initial public offerings: Australian evidence', Accounting and Finance, May 1995, pp. 87-105. Ibbotson, R., Sindelar, J. & Ritter,丄，'The market's problems with the pricing of initial public offerings', Journal of Applied Corporate Finance, Spring 1994, pp. 66-74. Ikenberry, D., Rankine, G. & Stice, E., ’What do stock splits really signal?', Journal of Financial and Quantitative Analysis, September 1996, pp. 357-75. ISS Governance Services, Equity Capital Raising in Australia during 2008 and 2009, ISS Governance Services, August

2010 . Lakonishok, J. & Vermaelen, J., 'Tax induced trading around ex-dividend days', Journal of Financial Economics, 1986, pp. 287-319. Lee, P., Taylor, S. & Walter, T., 'Australian IP〇 pricing in the short and long run', Journal of Banking and Finance, August 1996, pp. 1189-210. — ,— — & — /IPO underpricing explanations: implications from investor application and allocation schedules', Journal of Financial and Quontitotive Analysis, December 1999, pp. 425-44. Lipton, Pw Herzberg, A. «& Welsh, M .; Understanding Company Law, 15th edn, Lawbook Co., Sydney, 2010. Loughran, T. & Ritter, J., 'The new issues puzzle', Journal of Finance, March 1995, pp. 23-51.

— & — /W hy don't issuers get upset about leaving money on the table in IPOs?', /?ewew of F/nanaa/ SfucZ/es, 2002, vol. 15, no. 2, pp. 413-43. ---- & — ■,'Why has IPO underpricing changed over time? ’， Financial Management, Autumn 2004, pp. 5-37. Loughran, T., Ritter, J. & Rydqvist, K., Initial public offerings: International insights: 2014 update7, 17 January 2014, http://bear.warrington.ufl.edu/ritter/ Int2014.pdf. Marsh, 'Equity rights issues and efficiency of the UK stock market7, Journo/of F/nonce, September 1979, pp. 839-62. Muscarella, C. & Vetsuypens, M w 'Stock splits: signaling or liquidity? The case of ADR /;solo-splits//;, Journal of Financial Economics, September 1996, pp. 3-26. Pham, P., Kalev, P. & Steen, A., 'Underpricing, stock allocation, ownership structure and post-listing liquidity of newly listed firms7, Journal of Banking and Finance, May 2003, pp. 919-47. Reserve Bank of Australia, 'Australian corporates7sources and uses of funds7, Bulletin, October 2009, pp. 1-12. — /Funding the Australian resources investment boom', Bulletin, March 2013, pp. 51-61. Ritter, J., 'The long-run performance of initial public offerings', Journal of Finance, March 1991, pp. 3-27. Ritter J. & Welch, l.; yA review of IPO activity, pricing and allocations^ Journal of Finance, August 2002, pp. 1795-828. Rock, K., 'Why new issues are underpriced7, Journal of Financial Economics, January-February 1986, pp. 187-212. Sloan, R.G., 'Bonus issues, share splits and ex-day share price behaviour: Australian evidence', Australian Journal of Management, December 1987, pp. 2 7 7 -9 ]. Smith, C.W. Jr, 'Raising capital: theory and evidence', Midland Corporate Finance Journal, Spring 1986, pp. 6-22. Smith, R.L. & Smith, J.K., Entrepreneurial Finance, Wiley, New York, 2000. Stradwick, R., Employee Shore Plans, 2nd edn, Pitman Publishing, Melbourne, 1996. Viney, C., McGrath's Financial Institutions, Instruments and Markets, 6th edn, McGraw-Hill, Sydney, 2009, Chapter 5. Welch, l_, 'Seasoned offerings, imitation costs and the underpricing of initial public offerings7, Journal of Finance, June 1989, pp. 421-49.

CHAPTER CONTENTS 10.1

I n t r o d u c t io n G e n e r a l c h a r a c t e r is tic s o f

10.3

debt

277

S h o rt-te rm b o r r o w i n g fr o m b a n k s a n d o th e r f in a n c ia l in s titu tio n s

10.4

D e b t s e c u r itie s

289

10.6

P r o je c t f in a n c e

301

10.7

H y b r id s o f d e b t a n d e q u it y

302

276

282

L o n g -te rm b o r r o w i n g f r o m b a n k s a n d o t h e r f in a n c ia l in s titu tio n s

285

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

id e n t if y th e m a in fo r m s o f b o r r o w i n g b y A u s t r a lia n c o m p a n ie s

2

e x p la in th e g e n e r a l c h a r a c t e r is tic s o f d e b t

3

u n d e r s ta n d th e m a in fo r m s o f s h o rt-te rm b a n k le n d in g a n d r e c o g n is e w h e n e a c h m a y b e s u ita b le to a b o r r o w e r ’s n e e d s

4

u n d e r s ta n d d e b t o r f in a n c e , in v e n t o r y lo a n s a n d b r i d g in g f in a n c e a n d b e a b le to d is tin g u is h b e t w e e n th e m

5

id e n t if y a n d e x p la in t h e f e a tu r e s o f th e m a in ty p e s o f lo n g - te r m lo a n s

6

c o m p a r e a n d c o n t r a s t th e m a in fe a tu r e s o f s h o rt-te rm a n d lo n g - te r m d e b t s e c u r itie s

7

u n d e r s ta n d th e p r o c e s s o f u s in g c o m m e r c ia l p a p e r to r a is e fu n d s a n d h o w c o m m e r c ia l p a p e r is p r ic e d

8

u n d e r s ta n d th e p r o c e s s o f u s in g b ills o f e x c h a n g e t o r a is e fu n d s a n d h o w b ills o f e x c h a n g e a r e p r ic e d

9

id e n t if y a n d e x p la in th e fe a tu r e s o f th e m a in ty p e s o f lo n g - te r m d e b t s e c u r itie s

10

id e n t if y a n d e x p la in th e m a in f e a tu r e s o f p r o je c t f in a n c e

11

id e n t if y a n d e x p la in th e fe a tu r e s o f s e c u r itie s t h a t h a v e c h a r a c t e r is tic s o f b o th d e b t a n d e q u ity .

B usiness finance

10.1 LEARNING OBJECTIVE 1

Identify the main forms of borrowing by Australian companies INTERMEDIATION

process in which a bank or other financial institution raises funds from investors and then lends those funds to borrowers SECURITIES

in the context of financial markets, financial assets that can be traded DISINTERMEDIATION

movement of funds from accounts with deposit­ taking financial intermediaries and the reinvestment of those funds in securities

Introduction

The types o f debt finance used by Australian businesses can be divided in to tw o categories based on the source o f the funds. First, there are loans from banks and other financial institutio ns. In this case, cash th a t has been deposited w ith a financial interm ediary or invested w ith an in s titu tio n such as an insurance company is le n t to a business. Thus, the flow o f funds from the ultim ate investors to the borrower is indirect. This process is referred to as in te rm e d ia tio n . Im portantly, a financial interm ediary acts as a principal and the term s on which funds are advanced to the borrow er may be quite different from the terms on w hich funds are len t to the interm ediary. For example, a bank may raise short-term deposits at an interest rate o f 5 per cent and provide long-term loans on which it charges interest at a rate o f 8 per cent. Second, businesses can raise funds by issuing debt secu rities such as commercial paper, bills o f exchange and corporate bonds. In this case, financial in s titu tio n s are usually involved in the fund raising b u t they act as agents rather than as principals. For example, a bank or investm ent bank may underw rite an issue o f debt securities and distribute the securities to investors. In th is case the flow o f funds fro m the investor to the borrow er is essentially direct. This m ethod o f raising debt is sometimes referred to as ‘borrow ing in the capital m arket’ or ‘issuing securities in open financial m arkets’. When this m ethod is used in a case in which bank debt would previously have been used, the process is referred to as d isin term ed ia tio n . The d istin ction between indirect and direct debt finance is im p orta nt. For ease o f exposition, we refer to these tw o types o f debt finance as ‘loans’ and ‘debt securities’, respectively. The largest providers o f loans are banks, so when discussing loans we focus on bank loans. Table 10.1 shows the relative importance o f debt securities and bank loans as sources o f debt finance fo r Australian businesses.

TABLE 10.1 Debt securities (outstanding) issued by non-financial corporations and bank lending to business as at September 2013 ($ billion) D e b t s e c u ritie s

$ b illio n

Short-term securities issued in Australia

2.4

Long-term securities issued in Australia

52.0

Securities issued offshore

180.0

Total

234.4

B a n k le n d in g to bu sin e ss

Variable interest rate loans

262.1

Fixed interest rate loans

184.8

Subtotal: bank loans

446.9

Bills outstanding

272.8

Total

719.7

Source: Tables D4 and D8, Reserve Bank of Australia website, www.rba.gov.au. The figures in Table 10.1 show th a t at September 2013 bank loans to ta llin g almost $447 b illio n were the largest source o f debt finance fo r Australian businesses, followed by bills outstanding o f $272.8 billion. When a b ill is issued, finance is provided directly by the discounter to the drawer. W hile the finance is direct rather than intermediated, banks are s till involved in the process because a b ill requires an acceptor (effectively a guarantor) and the acceptor is usually a m ajor bank. Part o f the to ta l o f $272.8 b illio n would comprise bills th a t were also discounted (bought) by banks, so at September 2013 debt finance provided by or through banks to businesses was $719.7 b illio n or 75 per cent o f the to ta l debt shown in Table 10.1. It is also common to categorise debt as either short term or long term . Short-term debt is defined as debt due fo r repayment w ith in a period o f 12 months. The m ajor short-term borrow ing choices available to Australian businesses include borrow ing from banks and other financial in s titu tio n s , which

C hapter ten S ources

〇卩

fin a n c e : debt

is discussed in Section 10.3, and issuing short-term debt securities such as commercial paper and bills o f exchange, which is discussed in Sections 10.5.2 and 10.5.3. Long-term debt— th a t is, debt w ith a term to m a tu rity greater than 12 m onths— can be raised by borrow ing from banks and other financial institutio ns as discussed in Section 10.4. Businesses th a t are incorporated can also borrow long term by issuing securities such as debentures, unsecured notes and corporate bonds, which are discussed in Sections 10.5.4 to 10.5.6. In the next section, we outline the main characteristics o f debt, the m ain effects o f using debt and discuss security arrangements fo r debt. Next, we discuss the m ain types o f short- and long-term debt provided by banks and other financial institutio ns. This is followed by discussion o f the m ajor types o f debt securities used by Australian businesses, and by discussion o f project finance. The chapter concludes by considering preference shares and convertible securities th a t are hybrids o f debt and equity securities.

10.2 G eneral characteristics of debt Debt involves a contract whereby the borrower promises to pay future cash flows to the lender. Short­ term debt often involves only a single cash flow payable by the borrower at the end o f the contract. In the case o f long-term debt, the promised cash flows usually include payments at regular intervals b ut the parties can negotiate arrangements th a t involve any set o f cash flows. A debt contract w ill specify either the size and tim in g o f interest payments or a set o f rules th a t w ill be used to calculate those payments. For example, a contract may specify th a t interest w ill be calculated daily b ut charged m on thly at a rate equal to the 90-day bank-bill rate plus a m argin o f 3 per cent per annum. The contract w ill also specify how the principal is to be repaid. In addition to specifications about cash flows, a debt contract w ill usually also specify: • • • •

whether the borrower is required to pledge assets as security (also known as collateral) fo r the debt whether ownership o f the debt is transferable any requirements or restrictions th a t m ust be m et by the borrower the rights o f the lender i f the borrower defaults.

I f the borrower is required to support its promise to repay the debt w ith a pledge o f assets, the debt is classified as secured debt. I f the debt is unsecured, the borrow er has an obligation to repay the loan but this obligation is n o t supported by any pledge o f assets. Security arrangements fo r debt are discussed in Section 10.2.4. I f ownership o f the debt is transferable, the original lender can sell the contract to another investor. I f the debt is transferable i t usually takes the fo rm o f securities such as commercial paper, bonds or debentures th a t are issued directly to investors and can then be traded in a secondary m arket. The ownership o f all securities is transferable and some securities are traded actively in markets th a t are very liquid, while the markets fo r other securities are much less liquid. Therefore, the term ‘marketable securities* is typically used to refer to securities th a t are easily sold and readily converted in to cash. M ost non-marketable debt takes the fo rm o f loans arranged privately between two parties, where the lender is usually a bank or other financial in stitu tio n . A debt contract usually places some requirements and/or restrictions know n as covenants on the borrower. For example, i f debt is secured by pledged assets, the borrower w ill be required to m aintain those assets in good condition. W hether debt is secured or unsecured, the borrow er may be restricted from increasing its borrow ing and other liabilities beyond a specified pro po rtio n o f its to ta l assets. The rights o f the lender i f the borrow er defaults w ill depend on the nature o f the default and whether the debt is secured or unsecured. Any breach by the borrow er o f the terms o f the contract may constitute default and act as a trigger fo r the lender to enforce its rights under the contract. For example, the lender may have the rig h t to increase the interest rate on the debt to a penalty rate. I f the breach is o f a m in or or technical nature the lender may waive its rig h t to act b ut i f the breach is more serious, such as the failure to make a promised payment, the lender w ill usually enforce its rights. For example, i f a borrow er defaults on secured debt, the lender has the rig h t to take possession o f the assets th a t were pledged as security and sell them to pay o ff the loan. M ost types o f debt have some common characteristics th a t we now discuss.

LEARNING OBJECTIVE 2 Explain the general characteristics of debt

PRINCIPAL

the amount borrowed at the outset of a loan

DEFAULT

failure to perform a contractual obligation

COVENANT

provision in a loan agreement to protect lenders' interests by requiring certain actions to be taken and others refrained from

B usiness finance

10.2.1 | The interest cost of debt

INTERBANK CASH RATE

the interest rate on overnight loans between a bank and another bank (including the Reserve Bank of Australia)

When a company borrows, i t is com m itted to the payment o f interest and to the repayment o f the principal. In Chapter 4, the default-risk structure o f interest rates was discussed. It was pointed out that, given the general structure o f interest rates at a p o in t in tim e, the interest rate a company has to pay to borrow funds fo r a specified period w ill depend on the risk characteristics o f the company. For example, at a tim e when the Commonwealth Government has to pay an interest rate o f 8 per cent per annum to borrow funds fo r 5 years, a secure ind ustria l company may have to pay 9.5 per cent, while a less secure industrial company may have to pay 12 per cent. The interest rate applicable to debt may be fixed or variable. The interest rates on short-term and variable-rate debt are closely related to the interbank cash rate (or sim ply the cash rate), which is an im p o rta n t benchmark rate in the economy. Each bank holds an Exchange Settlement Account w ith the Reserve Bank o f Australia (RBA), which is used to make payments between the banks. I f a bank has insufficient (excess) funds in its Exchange Settlement Account, i t can borrow from (lend to) other banks at an interest rate th a t reflects current m arket forces. However, the RBA has a very significant impact on interest rates in the interbank m arket. From tim e to tim e the RBA publicly announces the target cash rate and stands ready to lend to (borrow from ) banks at interest rates th a t are 0.25 per cent above (below) the target rate. The actual cash rate is therefore almost certain to be w ith in ±0.25 per cent o f the target rate and, in practice, the actual cash rate is rarely very different from the target cash rate. In the 5-year period from January 2009 to December 2013, there were only 25 days when the cash rate deviated from the target and in all cases b ut one the deviation was less than 0.01 percentage p oints.1 The data in Table 10.2 show the cash rate and, fo r the purposes o f comparison, include indicator lending rates on variable-rate loans made by banks to small businesses. As would be expected, the cash rate is well below the indicator rates fo r business lending. A significant gap is needed to cover the banks1 costs and to compensate fo r the greater risk o f lending to customers rather than to another bank. M ost long-term debt securities have a fixed interest rate, known as the coupon rate*, which does n ot vary over the life o f the security. Long-term loans can also have a fixed interest rate. Where a variable interest rate applies, the rate w ill generally consist o f a base rate, or indicator lending rate, plus a margin th a t depends on the risk o f the borrower. In some variable interest rate loans the base rate (and therefore the interest rate payable) may be changed at any time. In other variable interest rate loans, the interest rate is reviewed at fixed intervals. For example, the interest rate may be reset every quarter to reflect the general m ovement in interest rates since the last quarterly reset date. Lenders rank ahead o f shareholders in th a t dividends cannot be paid unless all accrued interest payments to lenders have been met. Further, i f a company is liquidated, all obligations to lenders have

TABLE 10.2 Selected short-term interest rates

(%p.a.),

2000-13

In d ic a to r ra te s : s m a ll b u sin e ss^)

[

D a te

C a s h ra te ( 。 ）

i O v e r d r a f t — re s id e n tia l s e cu re d

O v e rd ra ft-o th e r

June 2000

6.00

8.55

9.10

June 2005

5.50

8.30

8.95

June 2010

4.50

9.45

10.30

June 2011

4.75

9.85

10.65

June 2012

3.54

8.85

9.75

June 2013

2.75

8.20

9.20

(°) Average of daily figures for the interbank cash rate for the month. ^ Average indicator rates for lending by major banks to small businesses on a variable-rate basis. Source: Tables FI and F5, Reserve Bank of Australia website, www.rba.gov.au.

1

Analysis by the authors of data in Reserve Bank of Australia, www.rba.gov.au, Table FI.

G hapter TEN S ources OF FINANCE: DEBT

p rio rity and shareholders have only a residual claim to any cash raised fro m the sale o f the company s assets. As a consequence, lenders are subject to less risk than are shareholders and they are therefore prepared to accept a lower expected rate o f return. However, n o t all lenders rank equally in terms o f th e ir claims when it comes to interest and principal repayments. Some debt can be subordinated to other debt and, as a consequence, the holders o f subordinated debt require a higher interest rate than the holders o f unsubordinated debt. Where borrowed funds are used to generate taxable income, interest on the debt is tax deductible. However, interest income is taxable in the hands o f lenders and this increases the interest rate th a t lenders would otherwise require. Therefore, the fact th a t interest is tax deductible does n ot necessarily give debt a cost advantage over equity finance. Under the im p utatio n system, taxes are v irtu a lly neutral in terms o f th e ir effect on the costs o f debt and equity finance. This is discussed in Chapters 12 and 13. As noted earlier, a feature th a t distinguishes the various types o f debt securities is th e ir m arketability. M arketability is the ease w ith which the holder is able to trade the security. Investors favour being able to sell securities at short notice. In other words, they favour securities th a t are traded actively in a liquid market. Therefore, marketable securities tend to be issued at a lower interest rate than other types o f debt, provided, o f course, th a t the other characteristics o f the debt are equivalent. In addition to interest, other costs associated w ith borrow ing may be significant. Some fees apply only to loans, while other fees apply only to debt securities. From the borrow ers view point, it is the overall cost that matters.

SUBORDINATED DEBT

debt that ranks below other debt in the event that a company is wound up UNSUBORDINATED DEBT

debt that has not been subordinated

10.2 .2 ! Effect of debt on risk While the rate o f return required by lenders is less than the rate o f return required by shareholders, increasing the am ount o f debt also increases the company s financial risk. The effects o f financial risk include effects on the rate o f re tu rn required by shareholders. A company financed solely by ordinary shares is n ot required to pay dividends and therefore has no financial risk. Borrowing introduces financial risk, which involves tw o separate b ut related effects. First, because the returns to lenders are ^ e d * , debt has a leverage effect— th a t is, i t increases the variability o f returns to shareholders and increases the rate o f retu rn they require. Second, the more a company borrows, the greater the interest and principal repayments to which it is committed, and therefore the greater is the risk o f financial d istress. In the extreme case, where a company has insufficient cash to meet its contractual obligations, the consequences can be far reaching and may result in the company being placed in to liquidation. In such a situation, the shareholders w ill usually receive little or no retu rn from the sale o f the company s assets because the company s lenders have a p rio r claim to the proceeds. However, financial distress is costly and many o f the costs fall on lenders. For example, the costs incurred by the liqu id ator in arranging the sale o f the assets are, in effect, paid by the lenders. Therefore, lenders require a m argin to compensate fo r the expected level o f these costs and this w ill be reflected in higher interest rates on loans to borrowers th a t have a higher risk o f default. Also, to lim it th e ir exposure to risk, lenders w ill generally impose a covenant th a t sets an upper lim it on the financial leverage o f borrowers. The effects o f financial risk are discussed in more detail in Chapter 12.

10.2 .3 ! Effect of debt on control Another im p o rta n t feature o f debt is that, provided the company meets its obligations, lenders have no control over the company s operations. Unlike shareholders, lenders have no voting rights. However, if a company fails to meet its obligations, lenders can exert, either directly or indirectly, significant influence over the operations o f the company. In this case the lenders, or frequently a trustee acting on th eir behalf, can seek to protect th e ir interests. This may be achieved by taking control o f the security fo r the loan, appointing an adm inistrator, having the company placed in to receivership or having the company placed in to liquidation. Therefore, while lenders usually exert little or no control over a company, they have a large degree o f potential control, which they can exert i f the company breaches a loan agreement.

FINAN C IAL RISK

risk attributable to the use of debt as a source of finance

FINANCIAL DISTRESS

situation where a company’s financial obligations cannot be met, or can be met only with difficulty

1 0 .2 .4 1 Security for debt

MORTGAGE

a type of security for a loan in which specific land or other tangible property is pledged by the borrower (mortgagor) to the lender (mortgagee)

Lenders, particularly those providing long-term debt, generally require th a t the borrow er enter into a loan agreement th a t includes various requirements designed to protect the lender against possible loss. These requirements are commonly referred to as security* arrangements, although s tric tly speaking a loan is secured only i f it involves a m ortgage or other charge over assets. The security arrangements that may be applied to debt finance used by companies include the following.

Legal ownership Instead o f providing a loan to a company to enable i t to buy an asset, a bank or other financier can purchase the asset and lend* the asset to the company. This form o f debt finance is know n as leasing. A lease is an agreement under which one party who owns an asset (the lessor) gives another (the lessee) the rig h t to possess and use an asset fo r a specified period in retu rn fo r rental payments. The financier has the security o f legal ownership o f the leased asset and can therefore repossess the asset quickly in the event o f default by the lessee. Leasing is an im p o rta n t means o f financing the use o f assets by companies and is discussed in Chapter 15.

Fixed charge A fixed charge means th a t the lender has a charge over a specific asset or group o f assets. For example, a loan may be secured by a mortgage over land and buildings owned by the borrower. I f the borrower defaults, the lender can take possession o f the assets and sell them in order to recover the outstanding debt. A fixed charge restricts the ability o f the borrower to deal in the asset(s). For example, an asset that has been mortgaged cannot be sold unless the mortgage is discharged p rio r to settlem ent. Borrowers may therefore prefer the fle x ib ility inherent in a floating charge.

Floating charge In this case, the lender has a charge over a class o f assets such as inventory. This means th a t the borrower can deal in the inventory b ut m ust undertake to m aintain the stock o f inventory above a specified level. I f the borrow er defaults, the floating charge is said to crystallise and becomes a fixed charge over the items o f inve ntory currently held by the borrower.

Covenants When banks lend to small and medium-sized businesses they generally require loans to be secured by a mortgage or other charge over assets. In the case o f larger loans such as loans to listed companies, the loan may be unsecured b ut include various covenants to protect the lender against possible loss by im posing various restrictions on the borrower. Similarly, covenants are commonly used where borrowers issue debt securities such as bonds or debentures. Common financial covenants require the borrower to lim it the size o f dividend payments, to m aintain a m in im u m ratio o f p ro fit to interest cost (known as In te re st cover1) and lim it to ta l liabilities to no more than a certain percentage o f to ta l assets. O ther covenants may be designed to protect investors in the event o f a m ajor asset sale or a change o f control. I f a borrow er breaches a covenant i t is in technical default and the lender may have the rig h t to call fo r immediate repayment o f the loan or take other actions to lim it its risk o f loss. For example, the lender may waive its rig h t to demand immediate repayment b ut the waiver may be conditional on the borrow er taking actions such as suspending dividend payments and m eeting p ro fita b ility and/or cash flow targets. Thus, breaching loan covenants can effectively result in the im position o f additional covenants (see Finance in Action). Alternatively, i f the breach is considered to be m in or and the borrower has adhered to the agreed repayment schedule, the lender is likely to allow the loan to continue on the original terms.

N egative pledge Financial in stitu tio n s may be prepared to lend on an unsecured basis where the loan agreement includes a negative pledge provision. The basic principle o f a negative pledge is th a t the borrower agrees n ot to do certain things. In particular, the borrower w ill agree n o t to pledge existing or future assets o f the company or group to anyone else w ith o u t the consent o f the lender.

C hapter ten S ources

COVENANT WAIVER BUYS TIME FOR NUFARM________________ O n 1 5 J u ly 2 0 1 0 a g r ic u lt u r a l c h e m ic a l m a n u f a c t u r e r N u f a r m L im ite d re v e a le d t h a t b a s e d o n fo re c a s ts f o r th e r e m a in d e r o f its f in a n c ia l y e a r , w h ic h e n d s o n 31 Ju ly , it e x p e c te d to b r e a c h o n e o f its m a in b a n k in g c o v e n a n ts . O n 1 S e p te m b e r it a n n o u n c e d t h a t its n e t d e b t a t 31 J u ly w o u ld b e a p p r o x im a t e ly $ 6 2 0 m illio n (m u c h h ig h e r th a n its e s tim a te p r o v id e d o n 1 4 J u ly o f $ 4 5 0 m illio n ) , w h ic h w o u ld c a u s e a s e c o n d c o v e n a n t b r e a c h . N u f a r m a ls o c o n f ir m e d t h a t it w a s p r o g r e s s in g to w a r d s s e c u rin g a w a iv e r f r o m its b a n k le n d e rs r e la te d to th e c o v e n a n ts in v o lv e d in its e x is tin g b a n k in g fa c ilitie s . O n 2 7 S e p te m b e r N u fa r m a n n o u n c e d th e o u tc o m e o f th e d is c u s s io n s w it h its b a n k le n d e rs . D e b t- la d e n N u f a r m h a s g a in e d a s h o r t r e p r ie v e a s in v e s to r s b r a c e f o r its c r u c ia l f u ll- y e a r re s u lt to d a y . N u fa r m y e s t e r d a y s e c u r e d a t e m p o r a r y w a iv e r o n its b a n k in g c o v e n a n t b r e a c h e s b u t s a id it w o u ld n o t p a y a f u ll- y e a r d iv id e n d . T h e w a iv e r w i ll b e in p la c e u n til th e e n d o f n e x t m o n th a s it se e k s a lo n g - te r m s o lu tio n . C r e d it S u is s e a n a ly s t R o h a n G a lla g h e r s a id th is w a s p r o m is in g b u t it w a s m e r e ly b u y in g tim e . 'W h a t is n o t b e in g s a id is th e lik e ly p r o h ib it iv e c o s t o f r e c e iv in g s u c h a w a iv e r a n d th e c o s t in v o lv e d in s e c u r ity o v e r th o s e a s s e t s / M r G a ll a g h e r s a id . N u fa r m a ls o a g r e e d to a s h o rt-te rm f u n d in g f a c il it y o f $1 8 0 m illio n to m id - D e c e m b e r w it h its le n d e r s , to m e e t r e p a y m e n t s t h a t w i ll f a ll d u e b y th e e n d o f th e y e a r . T h e f a c il it y is s u b je c t to s a t is f a c to r y p e r f o r m a n c e a g a in s t 'in t e r im m ile s to n e s b a s e d o n th e c o m p a n y 's o w n p r o je c tio n s a n d o b je c tiv e s ’ ，a s w e ll a s 'p r o g r e s s r e la t in g to s t r a t e g y a n d m a n a g e m e n t p la n s ', a s a g r e e d w ith its le n d e rs .

Source: Philip Wen, 'Provisional waiver for Nufarm,/ The Age, 28 September 2010. L a te r p re s s r e p o r ts r e v e a le d a d d it io n a l d e ta ils , w h ic h in c lu d e th e f o llo w in g : •

o n e o f th e c o m p a n y ’s b a n k s r e g is te r e d t w o fix e d a n d f lo a t in g c h a r g e s o v e r N u fa r m 's a sse ts o n

•

N u fa r m w o u ld b e u n a b le to b o r r o w a n y m o r e fr o m its e x is tin g $ 1 . 2 b illio n u n s e c u re d fa c ility ,

2 7 S e p te m b e r w h ic h w a s th e n d r a w n d o w n b y $ 7 0 1 m illio n •

th a t f a c ilit y h a d b e e n r e p la c e d b y a $ 1 7 6 m illio n s e c u re d lin e o f c r e d it o f w h ic h $ 5 5 m illio n w a s a v a ila b le im m e d ia te ly w it h a c c e s s to th e r e m a in d e r s u b je c t to th e p r o v is io n o f e x tr a s e c u rity to th e le n d e rs a n d to m e e tin g c o n f id e n t ia l p r o f it a b ilit y a n d c a s h f lo w ta rg e ts .

As well as agreeing n ot to borrow additional funds on a secured basis, the loan agreement usually includes other covenants th a t restrict the borrow ing company. These covenants may include a restriction on increasing its borrow ing and to ta l external liabilities beyond a specified p roportion o f to ta l tangible assets. Other covenants in the loan agreement may lim it the size o f dividend payments and require the borrower to m aintain its interest coverage ratio above a specified level. The aim o f such covenants is to provide protection fo r lenders, while also allowing the company to be managed in ways th a t maximise profits fo r shareholders. Borrowing on this basis in itia lly became popular in Australia among companies that found the covenants in debenture tru s t deeds unduly restrictive.

Limited recourse Lim ited recourse debt is com m only used fo r project finance, which is discussed in Section 10.6.

Guarantee A guarantee is a promise from another party to cover a debt obligation in the event o f default by the borrower. Lenders may require a guarantee i f a borrower does n ot have sufficient assets to pledge as security fo r a loan but other related parties are in a stronger financial position. For example, i f a loan is made to a subsidiary w ith lim ite d financial strength, the lender may require a guarantee from the parent company.

of fin a n c e : debt

F in a n c e in

A C T IO N

Short-term borrow ing from banks and other financial institutions 2

i^ ： LEARNING OBJECTIVE 3 Understand the main forms of short-term bank lending and recognise when each may be suitable to a borrower’s needs

Banks are the m ost im p o rta n t in s titu tio n s th a t lend to Australian companies, b u t short-term funding may also be obtained from other financial in s titu tio n s such as finance companies, investm ent banks and (for small businesses) from credit unions. In this section we discuss the m ajor form s o f direct lending available from banks and other financial institutio ns. However, a m ajor lender such as a bank w ill often provide a company w ith a funding package th a t includes various kinds o f both short-term and long-term loans. In addition, banks may also assist companies th a t borrow by issuing securities such as commercial paper and bills o f exchange. This assistance may be in the fo rm o f a commercial paper und erw riting fa cility and a b ill acceptance and/or discount facility. Borrowing by issuing short-term securities is discussed in Section 10.5.

10.3.1 | Bank overdraft OVERDRAFT LIMIT

level to which a company is permitted to overdraw its account AT CALL

money repayable immediately, at the option of the lender INDICATOR RATE

interest rate set and published by a lender from time to time and used as a base on which interest rates on individual loans are determined, usually by adding a margin

An overdraft perm its a company to run a bank account— often its current (cheque) account— in to deficit up to an agreed lim it. The overdraft lim it specifies the am ount by which the company can overdraw its account. S trictly speaking, the am ount by which the company s current account is overdrawn is usually a t call, which means th a t the bank can w ithdraw the overdraft fa cility at any tim e and require repayment o f the overdrawn amount. However, banks rarely exercise this right. The cost o f a bank overdraft includes interest and fees. O verdraft interest rates are negotiated between the bank and the borrower and w ill depend on factors such as the borrow ers credit-worthiness and the purposes fo r which the overdraft is sought. The interest rate charged is norm ally on the basis o f a m argin above an indicator rate published regularly by the bank. Interest is charged only on the am ount by which the borrow ers account is overdrawn, n ot on the am ount o f the overdraft lim it. The interest cost is calculated daily by applying the interest rate to the overdrawn balance and is then charged m onthly or quarterly in arrears. O verdraft fees w ill usually include an establishment fee and an ongoing fee. Details vary between banks and between customers b u t the follow ing arrangements are typical. The establishment, or approval, fee is payable at the commencement o f the overdraft. The ongoing fee is payable periodically (for example, quarterly in arrears) and may be a fixed am ount or a percentage o f the approved lim it. In assessing an application fo r an overdraft, a bank can use the applicant company s financial statements to obtain an indication o f its financial performance and financial position. In addition, an applicant may be required to supply a cash budget to assist the bank in assessing the applicants ability to service an overdraft. The bank w ill be particularly interested in the reasons fo r an overdraft application and the likely effects th a t providing an overdraft w ill have on the company s future financial performance and financial position. Generally speaking, banks regard an overdraft as suitable fo r funding the purchase o f inve ntory th a t w ill quickly be converted in to cash, to assist a company through seasonal downturns in liquidity, to meet unexpected short-term cash flow problems and to enable short-term opportunities to be exploited. Some companies may be granted an overdraft w ith o u t any security, b u t in m ost cases a bank w ill insist th a t an overdraft be secured. Indeed, the terms o f the overdraft are likely to depend on the security that is offered. For a small business, the personal assets o f the owner(s) may need to be pledged as security. In addition, the bank may include various covenants in the loan agreement. For example, in an e ffo rt to lim it the chance o f a borrow er running into excessive short-term liq u id ity problems, the bank may impose a covenant requiring the borrower to m aintain some m inim um ratio o f current assets to current liabilities. A fte r an overdraft has been granted, the borrower can draw on the account u n til the overdraft lim it is reached. Therefore, an overdraft provides a convenient source o f funds th a t can be accessed simply by w ritin g cheques and m aking electronic fund transfers. A borrower w ill generally draw on only part

2

M o s t b a n k s u s e t h e in t e r n e t t o p r o v id e u p - t o - d a t e in fo r m a t io n o n t h e ir lo a n p r o d u c ts . T h e w e b s it e s o f t h e fo u r la r g e s t A u s t r a lia n b a n k s a r e w w w .a n z .c o m .a u , w w w . c o m m b a n k .c o m .a u , w w w .n a b .c o m .a u a n d w w w .w e s t p a c .c o m .a u .

C hapter ten S ources

o f the available lim it so th a t it has ready access to cash in an emergency. The overdraft lim it is likely to be reviewed by the bank at regular intervals. In general, a borrow er w ill be able to m aintain the same overdraft lim it from year to year unless its financial performance or financial position has markedly deteriorated. Therefore, a profitable company can often regard a significant p roportion o f its overdraft as a relatively long-term source o f funds, even though technically speaking the overdraft is at call. W hile overdrafts are an im p o rta n t fo rm o f corporate borrowing, th e ir significance has declined in recent years. Correspondingly, other methods o f acquiring short-term finance have grown in importance. For example, many companies have turned to corporate credit cards as an alternative source o f short-term funding. For larger companies, other alternatives include the issuing o f bills o f exchange and commercial paper (or promissory notes).

Debtor finance3 allows a company to raise funds by using its accounts receivable as security fo r a loan. The two main types o f debtor finance are invoice discounting and factoring. The loan providers are known as an invoice discounter and factor respectively. Debtor finance is provided by most banks or bank subsidiaries and by independent financiers specialising in this form o f lending. The follow ing example shows how a typical invoice discounting agreement works. Suppose th a t Lewis P rin tin g Ltd enters into an invoice discounting agreement w ith Debtor Finance Ltd (DFL). Lewis has just completed a p rin t job o f $100000 fo r its customer Books Ltd. Lewis sends an invoice fo r this am ount to Books Ltd, thus creating an account receivable. Lewis then inform s DFL o f the account receivable and, perhaps after assessing the credit-worthiness o f Books Ltd, DFL advances 80 per cent (that is, $80 000) o f the invoiced am ount to Lewis.4 DFL then begins charging Lewis interest on the $80000. Books Ltd is unaware o f the invoice discounting agreement between Lewis and DFL and in due course pays Lewis the $100000 it owes. Lewis then passes this payment to DFL, which then credits this amount to Lewis’s account w ith DFL, in effect causing the interest charge on the $80 000 to cease. Lewis can then w ithdraw the rem aining $20000, or i t can leave the $20000 w ith DFL to reduce the balance owing on other loans th a t DFL has advanced to Lewis in respect o f other accounts receivable. Note th a t Lewiss customers are unaware o f the agreement and the borrower (Lewis) retains the functions o f administering its sales ledger and collecting debts owed to it. Suppose, instead, th a t the agreement between Lewis and DFL had been a factoring agreement. In this case, DFL takes over from Lewis the adm inistration o f Lewis’s sales ledger and debt collection. Lewis’s customers are inform ed th a t future account payments should be made to DFL, n o t to Lewis. DFL invoices Books Ltd on Lewiss behalf and simultaneously advances $80000 to Lewis. DFL then begins to charge Lewis interest on the advance o f $80 000. When Books Ltd pays the $100 000 to DFL, this am ount is credited to Lewiss account w ith DFL. As in the case o f an invoice discounting agreement, the interest charge then ceases and Lewis can w ithdraw the rem aining $20000 or leave i t in its account w ith DFL to reduce the balance owing on o the r loans th a t DFL has made to Lewis. From the borrow ers view point, both form s o f debtor finance accelerate its cash inflo w from accounts receivable and, depending on the term s o f the agreement, may relieve the borrower o f some, or all, o f the associated adm inistrative burden. In addition, debtor finance does n o t require a small business owner to mortgage personal property to secure the loan. From the providers view point, the account receivable provides security fo r the funds it has advanced and it earns a retu rn from the interest i t charges. In addition, in both invoice discounting and factoring, there w ill be various fees payable by the borrower to the provider. These fees may include an application fee, an adm inistration fee and an activity fee. W hat i f the customer does n o t pay the account receivable in fu ll or on time? That is, who bears the credit risk? Most debtor finance agreements in Australia provide fo r debtor finance with recourse, which means th a t i f an account receivable becomes a bad debt the borrower has to compensate the provider fo r the loss. Nevertheless, to spread the risk, many providers impose a lim it on the funds they w ill provide against any one debtors account. Debtor finance w ithout recourse means th a t the account receivable is effectively sold to the provider who thereafter bears the bad debt risk.

3

D e b to r fin a n c e is a ls o k n o w n a s re c e iv a b le s fin a n c e , in v o ic e fin a n c e a n d c a sh - flo w fin a n c e .

4

Th e p e r c e n ta g e a d v a n c e d is u s u a lly b e tw e e n 7 5 p e r c e n t a n d 9 0 p e r c e n t.

of fin a n c e : debt

m

LEARNING OBJECTIVE 4 Understand debtor finance, inventory loans and bridging finance and be able to distinguish between them

DEBTOR FINANCE

ongoing form of funding in which a finance provider advances funds to a borrower using the borrower’s accounts receivable as security for the loan INVOICE DISCOUNTING

form of debtor finance in which the borrower retains control of its sales ledger and debt collection functions and passes account payments on to the discounter FACTORING

form of debtor finance in which the finance provider (the factor) takes control of the borrower’s sales ledger and debt collection functions and passes account payments on to the borrower DEBTOR FINANCE WITH RECOURSE

debtor finance agreement under which the provider is reimbursed by the borrower if the debtor defaults DEBTOR FINANCE W ITH O U T RECOURSE

debtor finance agreement under which the provider is not reimbursed by the borrower if the debtor defaults

B usiness finance

Debtor finance is based on a simple principle. Accounts receivable are a valuable asset o f a company and, like other valuable assets such as land and buildings, can be used as security fo r a loan. Debtor finance is well suited to companies th a t have a large number o f short-term debtors, none o f w hom represents a significant p roportion o f its to ta l debtors. In general, companies operating in a service in d u stry may find debtor finance attractive because accounts receivable are often th e ir m ajor asset. Compared w ith, say, a m anufacturing company th a t owns plant and machinery, a service company w ill have fewer physical assets to offer as security fo r a loan. Examples o f industries in which companies have found debtor finance particularly attractive include labour hire, wholesale trade, transport, p rin tin g and smash repairs. Factoring is p articularly w ell suited to smaller companies, especially those th a t expect to grow quickly. Smaller companies may n o t have the specialised staff needed to assess credit-worthiness, adm inister the sales ledger and collect debts; factoring shifts most o f these responsibilities to the factor. Further, as a company’s sales increase, so do its accounts receivable and, in tu rn , so also does the flow o f finance from the factor— th a t is, the finance available keeps pace automatically w ith the company s growth. O ther form s o f finance, such as overdrafts, have a set lim it and therefore these agreements w ill need to be renegotiated as the company grows. Debtor finance in Australia grew rapidly from 2002 to 2009 b ut its use has been stable in recent years. Statistics compiled by the Debtor and Invoice Finance Association o f Australia and New Zealand from surveying its members show th a t to ta l turnover fo r the year to the end o f December 2013 was $63.3 b illion , while the corresponding figure fo r the year to the end o f December 2009 was $63.0 billion. However, the components have changed: whereas factoring accounted fo r only about 5 per cent o f debtor finance in 2009, it accounted fo r 9 per cent in 2013 (Debtor and Invoice Finance Association o f Australia and New Zealand, 2013). Debtor finance has been used fo r an increasing variety o f purposes. For example, debtor finance has been used as p art o f a funding package to finance some management buyouts and company takeovers.

FLOOR-PLAN (OR w h o lesale)

FINANCE

loan, usually made by a wholesaler to a retailer, that finances an inventory of durable goods such as motor vehicles

BRIDGING FINANCE

short-term loan to cover a need often arising from timing differences between two or more transactions

A company s inve ntory is p art o f its asset base and, as w ith accounts receivable, can be used to secure loan funds. Inventory loans are usually provided by finance companies. Inventories o f m ost durable items, including raw materials, finished goods and agricultural outputs such as grain, may be used to secure an inve ntory loan. The proceeds o f an inventory loan are often used to acquire the inventory but may be used fo r any purpose in the company. In Australia, the bulk o f inventory loans take the fo rm o f floor-plan (or w holesale) finance, which is a loan designed to assist retailers to purchase the inventory th a t then form s the security fo r the loan. For example, a finance company may lend a m otor vehicle retailer the funds needed to purchase an inventory o f vehicles and the finance company then uses those vehicles as security fo r the loan. The interest rate charged on inventory loans is based on the current interest rate on a specified short-term security, plus a margin.

Bridging finance refers to a short-term loan, often in the form o f a mortgage over property, used to ‘bridge’ a short period o f tim e. O ften the need fo r this type o f funding arises from the tim in g o f a series o f transactions. For example, a property investor may wish to sell one building and use the sale proceeds to buy another building but, unfortunately, the tim in g o f the transactions is such th a t the payment for the second building m ust be made, say, a m onth before the sale proceeds from the firs t are received. A loan is required to bridge this gap o f 1 m onth. D uring this period the investor w ill own both properties, and i f necessary both may therefore be mortgaged to secure the bridging loan. Corporate uses o f bridging finance include short-term funding in the lead-up to a m ajor transaction such as a financial restructure5 or a new issue o f securities.

5

F o r e x a m p le , in J u l y 2 0 1 3 th e A u st r a lia n s u r f in g w e a r c o m p a n y B illa b o n g o b t a in e d a b r id g in g lo a n fr o m a c o n s o r t iu m o f p r iv a t e e q u it y fir m s a s p a r t o f a fin a n c ia l r e s t r u c t u r e . S e e S to c k ( 2 0 1 3 ).

C hapter ten S ources

of fin a n c e : debt

10.4 Long-term borrow ing from banks and other financial institutions As shown in Table 10.1, Australian companies obtain debt finance largely through loans rather than by issuing debt securities. Banks are the largest providers o f business loans. However, investm ent banks, life insurance companies and other financial in stitu tio n s also provide long-term loans. We illustrate the main features o f long-term loans in Example 10.1.

Exam ple

LEARNING OBJECTIVE 5 Identify and explain the features of the main types of long­ term loans

1 0 .1

A tla s G lo b a l S ystem s Ltd (A G S ) m a n u fa c tu re s p o r ta b le g lo b a l p o s itio n in g system (GPS) u n its. A G S n e e d s to b o r r o w $ 2 0 m illio n to c o n s tru c t a n d in s ta ll a p la n t th a t w ill a llo w it to p r o d u c e a n e w m o d e l th a t is w a t e r p r o o f a n d w ill flo a t. T h e se u n its a r e e x p e c te d to b e p o p u la r w ith b o a t o p e r a to r s b e c a u s e n o n e o f th e c u r r e n tly a v a ila b le u n its is d e s ig n e d f o r use in a m a r in e e n v iro n m e n t. A G S a p p lie s to its b a n k fo r a te rm lo a n a n d th e b a n k a g re e s to le n d th e c o m p a n y $ 2 0 m illio n r e p a y a b le o v e r 5 y e a rs a t a n in te re s t ra te o f 7 . 5 p e r c e n t p e r a n n u m w ith e q u a l m o n th ly re p a y m e n ts . T he lo a n w ill re q u ire 6 0 re p a y m e n ts a n d th e e ffe c tiv e in te re s t ra te is 7 . 5 / 1 2 = 0 . 6 2 5 p e r c e n t p e r m o n th . T he re p a y m e n ts fo rm a n o r d in a r y a n n u ity a n d use o f E q u a tio n 3 . 1 9 s h o w s th a t e a c h p a y m e n t w ill b e $ 4 0 0 7 5 9 w ith th e firs t p a y m e n t r e q u ire d 1 m o n th a fte r th e p r in c ip a l o f $ 2 0 m illio n is a d v a n c e d b y th e b a n k .

The loan obtained by AGS has four im p o rta n t features. The company has borrowed a fixed ($20 m illion), repayable over a fixed period (5 years) at a fixed interest rate (7.5 per cent per w ith fixed repayments ($400 759 per m onth) th a t cover b oth principal and interest. In practice, necessary th a t all o f these characteristics should be fixed. However, the one element common to loans is th a t they are entered in to fo r a fixed period.

am ount annum) i t is n ot all term

10.4.1 | Long-term loan choices available to borrowers While the period m ust be fixed, the borrower can choose the length o f th a t period w ith in m inim um and maximum lim its th a t may be specified by the bank. Similarly, the borrower can generally exercise choices related to the am ount borrowed, the interest rate and the repayment pattern. We outline the choices that are generally offered by Australian banks.

The amount borrowed Each bank w ill generally specify a m inim um am ount fo r term loans b u t there is usually no m axim um amount— the amount that may be borrowed depends on the borrow ers financial position and capacity to repay the loan. As w ith the loan obtained by AGS, a term loan may be advanced in a lum p sum or the bank may provide the funds in separate tranches over time.

The term of the loan Each bank w ill usually specify m inim um and m axim um terms fo r its long-term loans. These loans are typically available fo r periods o f up to 10 years b ut longer term s are possible in some cases.

The interest rate The interest rate on a term loan may be fixed or variable. Banks w ill typically quote fixed interest rates for periods ranging from 1 to 10 years. These rates are higher than, b u t related to, the yields on government bonds o f the same term to m aturity. I f the borrow er chooses a variable interest rate, i t w ill be charged a rate that is variable at the banks discretion. In Australia, the interest rates on variable-rate loans generally change in response to changes in the cash rate set by the RBA, b ut can also vary in response to

6

B usiness finance

other factors th a t cause changes in the cost and composition o f banks* funds. For example, follow ing the global financial crisis, which saw tu rm o il in many financial markets, particularly during 2008, the funding m ix o f banks operating in Australia changed. In particular, banks increased th e ir use o f deposits and long­ term debt and reduced th e ir use o f short-term debt and securitisation. Deposits and long-term debt have the advantage o f being relatively stable sources o f funds, b ut often they are also more costly than short­ term debt. Therefore, between June 2007 and January 2010, the banks1overall funding costs increased relative to the cash rate and th eir lending rates also rose relative to the cash rate.6 Banks generally publish weekly notices stating the current interest rates on th e ir loans and these rates are also available on each banks website. For smaller loans, such as a loan to a small business secured by a mortgage over residential property, the published rate w ill usually be a set rate that applies to all loans of a given type. For larger loans, banks w ill undertake a detailed analysis o f each borrow ers credit risk and w ill establish individual margins th a t are added to a published base rate. W hether the interest rate on a loan is fixed or variable, the level o f the rate w ill depend on whether the loan is secured, and may also depend on the type o f assets th a t are pledged as security.

Loan repayments

CREDIT FONCIER LOAN

type of loan that involves regular repayments that include principal and interest

Borrowers can exercise choices in terms o f the pattern o f repayments and the frequency o f those repayments. The loan obtained by AGS involved equal m onthly repayments w ith each repayment consisting p a rtly o f interest and p a rtly o f principal. A loan w ith th a t repayment pattern is known as a principal-and-interest loan, a credit foncier loan or an instalment loan.7 Because the principal outstanding is reduced over tim e— at firs t gradually and then more rapidly— this type o f loan is also referred to as a reducible loan. A related b u t d iffe re n t repaym ent p atte rn involves a fixed program o f repayments covering p rin cip a l only w ith the in te re st being paid separately. For example, p rincip al repayments may be made yearly, w ith interest being paid m onthly. This repaym ent p attern may be described as p rin cip a l plus interest* and differs fro m the <principal-fl??c?-interest, pattern in th a t the payments w ill decline over tim e rath er than rem aining constant in each period. A lternatively, the borrow er can choose to make in te re s t o n ly, payments d u rin g the loan te rm w ith a fin al lum p sum repaym ent o f the p rincipal. A large fin a l loan repaym ent is know n as a balloon paym ent or a b u lle t paym ent. In cases where the interest rate has been fixed fo r a period such as a year, the bank may allow borrow ers to pay interest in advance. This may be advantageous where the borrow er wishes to claim a tax deduction fo r interest earlier th an w ould otherwise be the case. As noted above, the frequency o f payments can also vary w ith borrow ers allowed to choose weekly, fo rtn ig h tly , m on thly, q u a rte rly or half-yearly payments. In summary, a variety o f choices is available to borrowers who take o ut term loans b u t it should be noted th a t these choices are often linked to other choices. In particular, i f the borrow er chooses a variable-rate loan this usually opens up a w ider variety o f other choices than is the case w ith a fixed-rate loan. We now discuss the variable- and fixed-rate term loans offered by banks.

As discussed earlier, a term loan covers a fixed period and has three other m ain features— the interest rate, the am ount borrowed and the repayment pattern. I f the borrow er chooses a variable interest rate, there is considerable fle xib ility fo r the last two features. W hile the m axim um am ount th a t can be borrowed w ill be specified, the bank w ill usually allow the funds to be drawn down progressively or fu lly drawn in a single amount. A variable-rate loan is flexible in th a t it can be repaid early w ith o u t penalty, and a redraw fa cility is often available. This fa cility allows borrowers access to any excess repayments th a t have been made. Also, a variable-rate loan can usually be converted to a fixed-rate loan at any tim e w ith o u t penalty fees.

6

S e e B ro w n e t al. ( 2 0 1 0 ) .

7

F o r d e t a ils o n p r ic in g t h is ty p e o f lo a n , s e e S e c t io n 3 .7 .

C hapter ten S ources

of fin a n c e : debt

Borrowers who wish to be protected against possible increases in interest rates may be offered a capped option*, which means th a t the interest rate can go up, b ut w ill n ot exceed a specified ceiling rate fo r a specified term.

The purest form o f a fixed-rate term loan is one in which the interest rate is fixed fo r the whole term o f the loan. W hile loans o f this type are made in Australia, many so-called fixed-rate loans fix the interest rate fo r a period that is less than the term o f the loan. For example, a loan may be repayable over a term o f 10 years, w ith the interest rate fixed fo r the firs t 3 years. A t the end o f the th ird year, the borrower m ust decide whether to fix the interest rate fo r a fu rth e r period, o r switch to a variable-rate loan. In either case, the loans m a tu rity date is unchanged, unless the borrow er and lender agree otherwise. The maximum fixed-rate period offered is usually between 5 and 10 years. By fixing the interest rate, the borrower gives up some o f the fle x ib ility th a t is inherent in a variablerate loan. In a fixed-rate loan, progressive draw-down may n ot be allowed— th a t is, the loan may have to be drawn down in a lum p sum. However, the equivalent o f progressive advances can be achieved by arranging to take out a series o f separate fixed-rate loans, each having its own separate documentation, loan account number and fixed interest rate. This approach is likely to involve higher transaction costs. The borrower may be able to choose any o f the usual repayment patterns, including interest only in advance, and the frequency o f repayments can range from weekly to annually. However, the repayments, once set, cannot be changed during the fixed-rate period (unless the parties agree otherwise), b ut can be renegotiated at the end o f the fixed-rate period. In some fixed-rate loans, borrowers w ill n ot be penalised i f they make early repayments up to an agreed maximum. In other loans, borrowers who make early repayments, including early repayment o f the fu ll amount, w ill be required to pay an adm inistration fee and, i f interest rates have fallen, an am ount to compensate the lender fo r the lost future interest income.

In addition to the interest payable on a term loan, borrowers are usually required to pay an establishment fee and periodic loan service fees. As noted above, banks norm ally require th a t term loans are secured and this may take the form o f a charge over property or other company assets, or the guarantee o f an overseas bank or parent company. A loan that is secured by a mortgage over land or other property is often referred to as a mortgage loan. Mortgage finance is often used by borrowers who wish to finance th e ir own offices, shops and factories, and by property developers who wish to undertake activities such as the construction o f buildings and the subdivision o f land. The risk management measures used by banks include lim its on a banks exposure to a single borrower or group o f related borrowers. Accordingly, there are often cases where a credit-w orthy borrower may require more funds than a single lender is w illin g to provide. This problem can be overcome by obtaining a syn dicated lo a n . The main feature o f these loans is th a t a num ber o f banks jo in together to provide what is in effect a term loan, w ith each lender having identical rights. Because each lender provides only p art o f the funds, the credit risk exposure is divided between the lenders. Such loans are generally unsecured and have a variable interest rate, usually based on the bank-bill rate. A lending syndicate often involves both Australian and foreign banks. For example, in 2007, Wesfarmers Lim ited obtained a loan o f $10 b illio n from a syndicate o f domestic and offshore banks to finance its takeover o f the Coles Group (see Finance in Action). The loan was originally underw ritten by a group o f three banks, which then arranged fo r at least 10 more banks to provide the m ajority o f the funds. As well as borrow ing locally, Australian companies frequently borrow overseas. Reasons fo r borrowing overseas include diversification o f funding sources and achieving exposure to one or more foreign currencies. Decisions on borrow ing overseas should be based on an assessment o f exchange risk as well as the interest cost. An Australian borrower o f foreign currency w ill benefit (lose) i f the value o f an Australian dollar rises (falls) in foreign currency terms.

SYNDICATED LOAN

loan arranged by one or more lead banks, funded by a syndicate that usually includes other banks

B usiness finance

Finance in

ACTION

WESFARMERS CAN BANK O N COLES LOAN__________________ T h e b i g g e s t b a n k lo a n in A u s t r a lia n c o r p o r a t e h i s t o r y is l a r g e ly c o m p le t e , d e s p i t e a c r e d it c r u n c h p u t t in g f e a r in t o b a n k s . T h e f u n d in g w i l l u n d e r p in A u s t r a l i a ’s la r g e s t t a k e o v e r : W e s f a r m e r s 7 $ 2 0 b i lli o n b u y - o u t o f C o le s . T h e t h r e e le a d a r r a n g e r s o f t h e lo a n , A N Z B a n k , B N P P a r ib a s a n d N A B , s a y t h e y a n d

1 0 o th e r b a n k s h a v e ta k e n u p 8 5 p e r c e n t o f

t h e $ 1 0 b i l l i o n lo a n o n t e r m s d r a w n u p b e f o r e t h e w o r s t o f t h e c r u n c h h it. B N P P a r ib a s w o u ld n o t d is c lo s e th e a m o u n t o f d e b t e a c h le a d a r r a n g e r h a d d e c id e d to ta k e in its o w n r ig h t , a lth o u g h m a r k e t s o u rc e s s p e c u la t e d it c o u ld b e a b o u t $1 b illio n b e t w e e n th e m . In te re s t r a te s o n th e lo a n h a v e n o t b e e n d is c lo s e d , b u t W e s f a r m e r s u s e d a r a te o f 7 . 4 5 p e r c e n t in its s c h e m e b o o k le t to c a lc u la t e its p a y m e n ts , o r 5 8 b a s is p o in ts a b o v e th e 9 0 - d a y b ill r a te w h e n t h e b o o k le t w a s p u b lis h e d . T h e 1 0 b a n k s ' c o m m itm e n t to th e W e s f a r m e r s d e a l p a in ts a p ic tu r e o f a t w o - s p e e d d e b t m a r k e t s in c e c r e d it fe a r s g r ip p e d le n d e r s in m id - A u g u s t. O n th e o n e h a n d , th e r e a r e m a jo r b a n k s t h a t a r e la r g e ly u n r u f f le d b y th e c r is is a n d w i lli n g to le n d to g o o d c r e d it ris k s . O n th e o th e r , th e r e a r e lo w e r - q u a lit y a s s e ts t h a t n o - o n e is w i lli n g to le n d o n , a n d d e b t m a r k e ts t h a t h a v e e f f e c t iv e ly c lo s e d . S o m e m a r k e t c o m m e n t a t o r s s p e c u la te th e m o r t g a g e - b a c k e d s e c u r itie s m a r k e t in th e U S m a y n e v e r r e a p p e a r . ' W h a t w e 'r e s e e in g is q u it e a lo t o f a p p e t it e f o r w e ll- s tr u c tu r e d t r a n s a c t io n s 7, s a id S te p h e n B o y d , N A B C a p i t a l ’s s p o k e s m a n f o r th e d e a l. M r B o y d s a id th e s y n d ic a tio n w a s o n s c h e d u le , d e s p ite s o m e v ie w s t h a t p r o g r e s s h a d b e e n s lo w s in c e th e th r e e b a n k s c o m m itt e d to th e d e a l o n J u ly 1 0 . ' W h a t w e h a v e s e e n is, c e r t a in ly , b a n k s a r e m o r e s e n s itiv e in d is c e r n in g c r e d it q u a l it y 7, M r B o y d s a id . 'E a c h b a n k is d if f e r e n t in h o w th e y h a v e b e e n im p a c t e d in th is c r e d it c ru n c h .’ T h e d e a l n o w e n te rs p h a s e t w o , w h ic h in c lu d e s r o a d s h o w s in S y d n e y , S in g a p o r e a n d H o n g K o n g , a s th e le a d b a n k s t r y to p la c e th e r e m a in in g $ 1 . 5 b illio n in d e b t . B a n k s t h a t h a v e s ig n e d u p a r e W e s t p a c , C o m m o n w e a lt h , A B N A m r o , B a n k o f T o k y o - M its u b is h i UFJ, JP M o r g a n C h a s e , S u m ito m o M it s u i, W e s tL B , M iz u h o C o r p o r a t e , S o c ie te G e n e r a le a n d B a r c la y s C a p it a l.

Source: 'Wesfarmers can bank on Coles loan', Stuart Washington, The Age, 27 October 2007.

1 0 .4 .5 1 W h y do borrowers use term loans instead of security issues? The in te re s t ra te o n a te rm lo a n is u s u a lly h ig h e r th a n th e y ie ld s o n d e b t s e c u ritie s o f th e sam e te rm to m a tu r ity . This fa c t p ro m p ts th e q u e s tio n : W h y do businesses use te r m lo a n s ra th e r th a n issue t h e ir o w n s e c u ritie s d ire c tly to in v e s to rs ? F irs t, th e re m a y be g re a te r eco no m ies o f scale in is s u in g a s e c u rity th a n in ra is in g a lo a n . In th is case, s e c u rity issues w o u ld be fa v o u re d i f th e a m o u n t s o u g h t is re la tiv e ly la rge , w h ile lo a n s w o u ld be fa v o u re d i f th e a m o u n t s o u g h t is re la tiv e ly sm a ll. Table 10 .3 gives som e s u p p o rt to th is su g g e stio n . W h e re a b a n k p ro v id e s a c re d it f a c ilit y o f less th a n $2 m illio n , v a ria b le -ra te a n d fix e d -ra te lo a n s (in te rm e d ia te d fin a n ce ) p re d o m in a te o v e r b ills (d ire c t fin a n c e ). I n c o n tra s t, f o r fa c ilitie s o f $2 m illio n a n d over, th e va lu e o f b ills is u s u a lly s im ila r to th e c o m b in e d va lu e o f b a n k lo a n s. A lth o u g h o n ly s h o r t- te rm s e c u ritie s (b ills ) are in c lu d e d in Table 10 .3, th e a rg u m e n t also a p p lie s to lo n g e r te rm s e c u ritie s such as b o n d s: is s u in g a s e c u rity ty p ic a lly in v o lv e s tra n s a c tio n costs t h a t in c lu d e s ig n ific a n t fix e d co m p o n e n ts . Second, a b o rro w e r can p ro v id e in fo r m a tio n a b o u t its fin a n c ia l p o s itio n , fo re c a s t cash flo w s , p ro sp e cts a n d s tra te g ic p la n s p r iv a te ly to a b a n k , w h ic h w ill use th e in fo r m a tio n to assess th e c re d it r is k a n d p rice th e lo a n . In c o n tra s t, a c o m p a n y t h a t b o rro w s b y is s u in g d e b t s e c u ritie s has to disclose m u c h in fo r m a tio n p u b lic ly , w h ic h m a y p ro v id e va lu a b le in s ig h ts to c o m p e tito rs . T h ird , b a n k lo a n s are m u c h m o re fle x ib le th a n d e b t s e c u ritie s . F o r exa m ple, th e re p a y m e n t p a tte rn o f a b a n k lo a n can be ta ilo re d to s u it th e b o rro w e rs cash flo w s and, i f c ircu m sta n ce s change u n e xp e cte d ly, th e te rm s o f a b a n k lo a n can o fte n be re n e g o tia te d . In c o n tra s t, th e re p a y m e n t p a tte r n a n d o th e r te rm s o f d e b t s e c u ritie s are set a t th e tim e o f th e issue a n d i t is e x tre m e ly d iff ic u lt to m a ke a n y changes to th o se te rm s la te r.

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TABLE 10.3 Bank lending to businesses, total credit outstanding by size and by type of facility ($ million)

1

U n d e r $ 2 m illio n

V a r ia b le

V a r ia b le ra te

$ 2 m illio n a n d o v e r

F ix e d ra te

Bills

Total

ra te

F ix e d ra te

Bills

Total

June 2000

43068

43 902

19956

106926

20683

30456

93500

144638

June 2005

85 941

42166

30324

158431

85 749

24026

105854

215 628

June 2010

11 0 6 1 9

78546

35 731

224897

147863

58781

215009

421653

June 2011

117443

77979

32 757

228179

145660

58327

205878

409865

June 2012

116452

82 543

40732

239728

151665

69263

233166

454094

June 2013

113920

86610

42539

243069

144690

95292

227321

467304

Source: Table D8, Reserve Bank of Australia website, www.rba.gov.au.

F o u rth , d e b t se c u ritie s m a y be d iff ic u lt to se ll to in v e s to rs un le ss th e y have a r a tin g fr o m one o f th e ra tin g agencies such as S ta n d a rd & P o o rs . U n less th e b o rro w e r is v e ry la rge i t m a y be che ap er to deal w ith a b a n k th a n i t is to o b ta in a ra tin g . In s u m m a ry, te rm lo a n s ha ve several advan ta ge s t h a t m ake th e m a ttra c tiv e co m p a re d to s e c u rity issues, p a rtic u la rly w h e re s m a lle r b o rro w in g s are in v o lv e d .

10.5 Debt securities W h ile lo a n s fro m ba n ks a n d o th e r le n d e rs are a va ila b le to businesses o f a n y ty p e , la rg e r businesses are able to b o rro w b y c re a tin g a n d is s u in g d e b t s e c u ritie s . These s e c u ritie s in c lu d e c o m m e rc ia l paper, b ills o f exchange, d e b e n tu re s, n o te s a n d b o n d s.

10.5.1 I Debt securities: the general principles

LEARNING OBJECTIVE 6 Compare and contrast the main features of short-term and long­ term debt securities

C om panies can o b ta in s h o r t- te rm d e b t fu n d in g b y is s u in g (s e llin g ) s e c u ritie s such as c o m m e rc ia l p a p e r and b ills o f exchange. The sam e g e ne ral p rin c ip le s are a p p lica b le to b o th typ e s o f s e c u rity an d, in b ro a d te rm s , are as fo llo w s . The s e c u ritie s are a p ro m is e to pay a su m o f m o n e y o n a fu tu r e da te, k n o w n as th e m a tu r ity date, w h ic h is less th a n 1 yea r in to th e fu tu r e .8 P ro v id e d t h a t th e p ro m is e is m ad e b y an e n t it y o f cred ib le fin a n c ia l s ta n d in g , such a p ro m is e is va lu a b le a n d hence m a y be sold. In p rin c ip le , th e p u rc h a s e r m a y be a n y e n t it y w it h fu n d s a va ila b le f o r le n d in g . H o w m u c h th e p u rc h a s e r is w illin g to p a y w ill d e pe nd o n several fa c to rs , in c lu d in g th e c u rre n t le ve l o f in te re s t rates. W h e n th e s e c u rity is sold, th e issu e r receives th e sale p ric e b u t is, o f course, c o m m itte d to m a k in g th e fu tu r e p a y m e n t p ro m is e d . Thus, in effect, th e s e c u rity is a s h o r t- te rm lo a n w h e re th e lo a n p rin c ip a l is e q u a l to th e sale p rice . The pu rcha ser, how ever, is n o t c o m m itte d to h o ld in g th e s e c u rity f o r th e w h o le p e rio d fr o m th e da te o f purcha se u n t il th e m a t u r ity date. A t a n y tim e , th e p u rc h a s e r m a y se ll th e s e c u rity to som e o th e r p a rty . Such a sale is k n o w n as a s e c o n d a r y m a r k e t t r a n s a c t io n . M a n y such tra n s a c tio n s m a y be u n d e rta k e n d u r in g th e life o f one o f these s e c u ritie s .9 W h o e v e r o w n s th e s e c u rity o n th e m a t u r ity d a te w ill th e n seek p a y m e n t o f th e su m p ro m is e d . C o m m e rc ia l p a p e r a n d b ills o f exchange are discussed in S ectio ns 1 0 .5 .2 a n d 1 0 .5 .3 , respectively.

8 9

This definition is standard but in Australia virtually all such securities have terms of 6 months or less. At one time physical transactions were made but today most trades are recorded through Austraclear, which is a computerised central clearing house for promissory notes, bank bills and other money market securities. Austraclear is a subsidiary of the Australian Securities Exchange. For further details visit w w w .a s x .c o m .a u .

SECONDARY MARKET TRANSACTION purchase or sale of an existing security

B usiness finance

C o m pa nie s can also issue s e c u ritie s w it h a te rm to m a t u r ity g re a te r th a n 1 year. These s e cu ritie s in c lu d e d e b e n tu re s, n o te s a n d c o rp o ra te b o n d s. There can be im p o r t a n t d iffe re n ce s b e tw e e n these types o f s e c u ritie s , b u t th e y share m a n y fe a tu re s. In c o m m o n w it h g o v e rn m e n t b o n d s, th e se se c u ritie s are u s u a lly issu ed a t face value . In som e cases, th e issue p ric e is d e te rm in e d b y a te n d e r process, w h ic h can re s u lt in th e issue p ric e b e in g g re a te r o r less th a n th e face value . A f t e r th e se c u ritie s ha ve been issued,

COUPON PAYMENTS periodic payments of interest, often at halfyearly intervals, on debt securities such as debentures and bonds

th e b o rro w e r m akes re g u la r in te re s t p a y m e n ts k n o w n as

coupon paym ents

a n d th e n repays th e face

va lu e (p rin c ip a l) in f u ll a t m a tu rity . A lte rn a tiv e ly , th e s e c u rity m a y be c o n v e rtib le in to o rd in a ry shares, in w h ic h case th e h o ld e r has a choice. I f th e h o ld e r chooses n o t to exercise th e c o n v e rs io n o p tio n , th e n th e p rin c ip a l w ill be re p a id . The c h a ra c te ris tic s o f d e b e n tu re s, u n se cu re d n o te s a n d c o rp o ra te b o n d s are discussed in S ectio ns 1 0 .5 .4 to 1 0 .5 .6 . F o r d e ta ils o f th e v a lu a tio n o f the se s e c u ritie s , re fe r to S e ctio n 4.4. C o n v e rtib le n o te s a n d c o n v e rtib le b o n d s are discussed in S e ctio n 10 .7.1.

1 0 .5 .2 1 Commercial paper C o m m e r c ia l p a p e r is th e te r m t h a t is c o m m o n ly used to re fe r to m a rk e ta b le , s h o r t- te rm , un se cu re d d e b t s e c u ritie s w ith th e le g a l s ta tu s o f p ro m is s o ry n o te s .10 A p ro m is s o ry n o te is s im p ly a p ro m is e to pa y a LEARNING OBJECTIVE 7 Understand the process of using commercial paper to raise funds and how commercial paper is priced

COMMERCIAL PAPER (OR PROMISSORY note) short-term marketable debt security in which the borrower promises to pay a stated sum on a stated future date. Also known as onename paper

s ta te d s u m o f m o n e y (such as $ 5 0 0 0 0 0 ) o n a s ta te d fu tu re date (such as a da te 90 days he nce ). The sta te d su m o f m o n e y is re fe rre d to as th e p a p e rs fa c e v a lu e . The is s u e r o f th e p a p e r— t h a t is, th e b o rro w e r— is th e o n ly p a r ty w it h an o b lig a tio n to p a y th e face va lu e a t m a tu rity , so c o m m e rc ia l p a p e r is s o m e tim e s called

one-name paper.11 In

p ra c tic e , o n ly *blue c h ip J co m p a n ie s— t h a t is, la rge , re p u ta b le co m p a n ie s w ith

a h ig h c re d it r a tin g — a n d g o v e rn m e n t e n titie s are able to raise fu n d s b y is s u in g c o m m e rc ia l paper. Issuers o f c o m m e rc ia l p a p e r in A u s tra lia have in c lu d e d A m c o r, B H P B illito n , O ric a a n d W o o lw o rth s , as w e ll as several n o n -b a n k fin a n c ia l in s titu tio n s . C o m m e rc ia l p a p e r is u s u a lly issu e d w it h a te r m to m a t u r ity w it h in th e range o f 30 days to 1 8 0 days, a lth o u g h o th e r te rm s m a y be po ssib le. In p ra ctice , a lm o s t a ll c o m m e rc ia l p a p e r is issu e d to th e m em b ers o f d e aler p anels, m ade u p o f la rg e b a n ks, w h ic h b id f o r th e p a p e r w h e n a co m p a n y a n n o u n ce s th e te rm s o f a p la n n e d issue. The pu rch a se rs are k n o w n as d is c o u n t e r s a n d th e y m a y h o ld th e p a p e r u n t il i t m a tu re s or, m o re u su a lly, se ll i t to o th e r in v e s to rs . I f an is s u e r s u b s e q u e n tly fin d s t h a t i t does n o t re q u ire th e fu n d s f o r th e f u ll p e rio d o f th e lo a n , i t can re p urch ase th e p a p e r b y b u y in g th e s e c u ritie s in th e se co n d a ry m a rk e t a t th e c u rre n t m a rk e t p rice . The a m o u n t t h a t th e s e lle r o f a s e c u rity receives fr o m th e d is c o u n te r de pe nd s o n m a rk e t forces. F or exa m ple, suppose t h a t J in d a b y n e Resources L td issues 9 0 -d a y c o m m e rc ia l p a p e r w it h a face va lu e o f

FACE VALUE

$ 5 0 0 0 0 0 a n d is able to se ll th e p a p e r to K lo n d ik e In v e s tm e n ts f o r $ 4 9 4 0 0 0 . J in d a b y n e Resources w ill

sum promised to be paid in the future on a debt security, such as commercial paper or a bill of exchange

have to re p a y $ 5 0 0 0 0 0 o n th e m a t u r ity da te, so th e in te re s t cost is $ 6 0 0 0 o n a lo a n o f $ 4 9 4 0 0 0 f o r a

DISCOUNTER (OF COMMERCIAL PAPER)

te rm o f 9 0 days. The s im p le a n n u a lis e d y ie ld is ($ 6 0 0 0 /$ 4 9 4 0 0 0 ) x (3 6 5 /9 0 ) = 4 .9 2 6 p e r c e n t p e r a n n u m . In d e c id in g to p a y $ 4 9 4 0 0 0 f o r th e s e c u rity , K lo n d ik e In v e s tm e n ts w o u ld , o f course, have c o m p a re d th e y ie ld o f 4 .9 2 6 p e r ce n t p e r a n n u m w it h y ie ld s (in te re s t rates) a va ila b le a t t h a t tim e o n s im ila r se cu ritie s. T his lo g ic , w h ic h is re a lly ju s t an a p p lic a tio n o f s im p le in te re s t, is s u m m a ris e d in E q u a tio n 10.1:

P= 1+ r

the initial purchaser of commercial paper w h e re

x

d 365

IBfl

F = face va lu e (= fu tu r e su m payable) r = y ie ld p e r a n n u m o n a s im p le in te re s t basis d = n u m b e r o f days to m a t u r ity

In p ra c tic e , m a rk e t p a rtic ip a n ts w ill agree o n a y ie ld a n d th e p ric e w ill th e n be d e te rm in e d u s in g th e agreed fo rm u la . The use o f s im p le in te re s t to calcula te th e p ric e o f a se c u rity , g iv e n th e y ie ld , is illu s tra te d in E xa m p le 10.2.

10 The term commercial paper* is also used as a generic term to cover other short-term debt securities known by various terms, including certificates of deposit, short-term notes and transferable deposits, as well as promissory notes. 11 The term 'one-name paper1includes securities such as Treasury notes, which are issued by the government, and certificates of deposit, which are issued by banks.

C hapter ten S ources

E xample

10.2

C o m m e r c ia l p a p e r w ith a fa c e v a lu e o f $ 5 0 0 0 0 0 a n d 9 0 d a y s to m a tu r ity is is s u e d a t a y ie ld o f 4 . 9 2 6 p e r c e n t p e r a n n u m . C a lc u la te th e p r ic e o f th e s e c u rity .

6

SOLUTION U s in g E q u a tio n 1 0 .1 :

1 + rx 355

=

$500000 1 +0.049 26 x

晶

$500000 _ 1.012 146 301 =$493 999.73

E qu atio n 10.1 also applies to co m m e rcia l pa p e r w h e n i t is tra d e d in th e secondary m a rk e t. Exam ple 10.3 provides an illu s tra tio n .

E xample

10.3

S u p p o s e th a t 3 0 d a y s a fte r p u r c h a s in g th e c o m m e r c ia l p a p e r (see E x a m p le 1 0 . 2 ) , K lo n d ik e In ve stm e n ts d e c id e s to sell th e s e c u rity in th e s e c o n d a r y m a rk e t a n d a g re e s to sell it to St A n d r e w B a n k a t a y ie ld o f 5 . 0 5 p e r c e n t p e r a n n u m . W h a t p r ic e w ill St A n d r e w B a n k p a y ?

SOLUTION T he c o m m e rc ia l p a p e r n o w h a s 6 0 d a y s le ft u n til m a tu rity . U s in g E q u a tio n 1 0 . 1 , th e p r ic e is:

$500000 1 + 0.0505 x ^ $500000 _ 1.008 301 370 =$495 883.49

F or f u r t h e r d iscu ssio n o f c a lc u la tin g p rice s a n d y ie ld s , see S e ctio n 3.3 .4 . C o m m e rcia l p a p e r is g e n e ra lly issu e d th ro u g h a p ro g ra m a rra n g e d b y a m a jo r b a n k o r in v e s tm e n t b a n k. The p ro g ra m a rra n g e r (o r le a d m a n a g e r) w i ll fo r m a d e a le r p a n e l, g e n e ra lly m ad e u p o f la rge banks. The d o c u m e n ts t h a t e s ta b lis h th e p ro g ra m w i ll u s u a lly sp e c ify an u p p e r li m i t o n th e v a lu e o f th e se cu ritie s o u ts ta n d in g a t a n y tim e . As e x is tin g s e c u ritie s m a tu re , n e w s e c u ritie s can be cre a te d a n d d is c o u n te d i f re q u ire d b y th e issuer. I f th e p ro g ra m is to be u n d e r w r itte n , an u n d e r w r itin g s y n d ica te w ill also be fo rm e d . The d e aler p a n e l is g iv e n th e f ir s t o p p o r tu n it y to p u rcha se th e se c u ritie s . I f th e re is a s h o r tfa ll in th e a m o u n t o f th e issue p u rc h a s e d b y th e d e aler pa ne l, th e balance is b o u g h t b y th e u n d e r w r itin g syndicate. Each m e m b e r o f th e sy n d ic a te agrees th a t, i f re q u ire d b y th e issuer, i t w ill p u rch a se s e c u ritie s up to a sp e cifie d a m o u n t. To fa c ilita te tra d in g , i t is u su a l f o r c o m m e rc ia l p a p e r issues to have a c re d it ra tin g fro m a ra tin g s agency (see S e ctio n 4 .7 ).

6

of fin a n c e : debt

B usiness finance

The size o f a c o m m e rc ia l p a p e r p ro g ra m w ill d e p e n d o n fa c to rs such as th e b o r r o w e r ^ n e ed f o r fu n d s , its c re d it ra tin g a n d th e co st o f c o m m e rc ia l p a p e r in c o m p a ris o n w it h o th e r sources o f fu n d s . Because o f th e costs in v o lv e d in e s ta b lis h in g a p ro g ra m , c o m m e rc ia l p a p e r issues are g e n e ra lly n o t v ia b le un le ss th e a m o u n t t o be b o rro w e d is a t le a s t $ 2 0 0 m illio n . The m a x im u m a m o u n t t h a t a g iv e n is s u e r can b o rro w w ill de p e n d o n its c re d it ra tin g a n d its re p u ta tio n w ith in v e s to rs . A t th e e n d o f S e p te m b e r 2 0 1 3 , th e re was $ 3 4 3 .3 b illio n in o u ts ta n d in g o n e -n a m e p a p e r issued b y A u s tra lia n b o rro w e rs . O f th is a m o u n t, $ 2 1 4 .9 b illio n (6 3 p e r c e n t) was issu ed in A u s tra lia a n d $ 1 2 8 .4 b illio n (3 7 p e r c e n t) was issu ed overseas. M o re th a n 8 0 p e r c e n t o f th e o u ts ta n d in g o n e -n a m e p a p e r was issu ed b y b a n ks; o n ly 2.5 p e r c e n t was issu e d b y p riv a te co m p a n ie s o u ts id e th e fin a n c e s e c to r.12

LEARNING OBJECTIVE 8 Understand the process of using bills of exchange to raise funds and how bills of exchange are priced

BILL OF EXCHANGE marketable short-term debt security in which one party (the drawer) directs another party (the acceptor) to pay a stated sum on a stated future date

10 .5 .3 ! Bills of exchange The usual w ay bills of exchange are created and traded In p ra c tic e , i f a c o m p a n y does n o t have a c re d it r a tin g fr o m a ra tin g s agency, i t w ill fin d i t v e ry d iffic u lt to issue a n d se ll c o m m e rc ia l paper. F o r the se co m p a n ie s an a lte rn a tiv e is to issue a b i l l o f e x c h a n g e . There are m a n y s im ila ritie s b e tw e e n c o m m e rc ia l p a p e r a n d b ills o f exchange. B o th are s h o r t- te rm d e b t in s tru m e n ts t h a t p ro m is e to p a y a s ta te d s u m (k n o w n as th e face va lu e ) o n a s ta te d fu tu r e date; b o th can be tra d e d in a c tiv e s e c o n d a ry m a rk e ts ; a n d b o th are s o ld a t p rice s t h a t re fle c t th e c u rre n t le ve l o f in te re s t rates. The m a jo r d iffe re n c e is in th e n u m b e r o f p a rtie s to th e in s tr u m e n t. In th e case o f c o m m e rc ia l paper, o n ly th e is s u e r p ro m is e s to p a y th e face v a lu e o n th e m a t u r ity date. In a b ill o f exchange th e re is also a n o th e r p a rty , k n o w n as th e acceptor, so n a m e d because th is p a r ty accepts th e re s p o n s ib ility to pay th e face v a lu e o n th e m a t u r ity date. M o s t o fte n , th is ro le is fille d b y a b a n k . The b o rro w e r pays a fee to th e b a n k f o r t h is service a n d also agrees to re im b u rs e th e b a n k f o r p a y in g th e face v a lu e o n th e m a t u r ity date.

DRAWER

Because th e a cce p to r is a w e ll-k n o w n in s t it u t io n w it h a h ig h c re d it ra tin g , th e re w ill be le n d e rs w illin g to

in a bill of exchange, the party initiating the creation of the bill; usually the borrower

p u rcha se th e b ill even i f th e b o rro w e r is n o t so w e ll k n o w n . The y ie ld o n a b ill w i ll re fle c t th e c re d it ra tin g

ACCEPTOR (OR

(o r d ra w e e ) a n d th e d is c o u n t e r . In th e u s u a l w a y b ills o f exchange are crea te d, th e d ra w e r is th e b o rro w e r

o f th e a c c e p to r a n d b ill y ie ld s are a lm o s t alw ays lo w e r th a n th e y ie ld s o n c o m m e rc ia l p a p e r o f th e same te rm to m a tu rity . The p a rtie s in v o lv e d in th e c re a tio n o f a b ill o f exchange are re fe rre d to as th e d r a w e r , th e a c c e p to r

in a bill of exchange, the party agreeing to pay the holder the bill’s face value on the maturity date; usually a bank or other financial institution

DISCOUNTER (OF A BILL OF EXCHANGE) the initial purchaser of a bill of exchange

a n d th e a c c e p to r pays th e face va lu e a t m a t u r ity o n b e h a lf o f th e b o rro w e r. The face va lu e is p a id to w h o e v e r h o ld s (o w n s ) th e b ill o n th e m a t u r ity date. The ro le o f th e d is c o u n te r is to p ro v id e (le n d ) th e fu n d s b y p u rc h a s in g th e b ill fr o m th e dra w e r. In p rin c ip le , th e d is c o u n te r c o u ld be a n y e n t it y w it h fu n d s to le n d , b u t in p ra c tic e is u s u a lly a fin a n c ia l in te rm e d ia ry o r som e o th e r fin a n c ia l in s titu t io n . As w it h c o m m e rc ia l pa pe r, th e a m o u n t p a id b y th e d is c o u n te r w i ll d e p e n d o n m a rk e t forces an d, in p a rtic u la r, o n y ie ld s c u r r e n tly a va ila b le o n s im ila r s e c u ritie s . By c o n v e n tio n , s im p le in te re s t is use d to ca lcu la te b ill p ric e s .13 The a cce p to r a n d d is c o u n te r m a y be th e sam e e n tity . F ig u re 10 .1 show s th e steps in th e c re a tio n o f a b ill w h e re th e a cce p to r a n d th e d is c o u n te r are d iffe re n t e n titie s . The d is c o u n te r has th e choice o f e ith e r h o ld in g th e b ill u n t il m a tu r ity , w h e n p a y m e n t w i ll be rece ive d fr o m th e acceptor, o r s e llin g ( r e d is c o u n t in g ) th e b ill. H o w e ve r, i f th e b ill is sold, th e s e lle r n o rm a lly endorses th e b ill a t th e tim e o f sale. E n d o r s e m e n t m ea ns t h a t i f th e a cce p to r is u n a b le to p a y th e face value

REDISCOUNTING

o n th e m a t u r it y da te, an e n d o rs e r m a y be o b lig e d to p a y a su b se q u e n t h o ld e r o f th e b ill. C o n se q u e n tly,

selling a short-term debt security in the secondary market

w h e n a s e lle r endo rses a b ill th e s e lle r has a c o n tin g e n t lia b ilit y u n t il th e b ill m a tu re s a n d is p a id .14 O n th e

ENDORSEMENT the seller of a bill in the secondary market accepts responsibility to pay the face value if there is default by the acceptor, drawer and earlier endorsers

b ills m a t u r it y d a te th e a cce p to r pays th e face va lu e to th e h o ld e r o f th e b ill a n d th e a c c e p to r w ill re q u ire th e d ra w e r to re im b u rs e th e a cce p to r f o r th is p a y m e n t. In th e u n lik e ly e v e n t t h a t th e a c c e p to r is u n a b le to p a y th e face value , lia b ilit y f o r p a y m e n t fa lls n e x t o n th e dra w e r. I f th e d ra w e r is also u n a b le to pay, each e n d o rs e r becom es lia b le to pay s u b se q u e n t en do rsers; th u s th e re is a ‘c h a in o f p r o te c tio n ’ c o n s is tin g o f a ll th o se e n titie s t h a t have e n d o rse d th e b ill. H o w e ve r, in p ra c tic e i t is ra re f o r p ro b le m s to arise a n d th e a cce ptor pays th e face va lu e as expected. The n o rm a l process o f re p a y m e n t is illu s tr a te d in F ig u re 10.2.

12 See Australian Bureau of Statistics (September 2013). 13 Equation 10.1 can be used. For further details, see Section 3.3.4. 14 For some lenders, this fact may make commercial paper, which is rarely endorsed when sold, a more attractive investment than bills of exchange.

C hapter ten S ources

of fin a n c e : debt

Figure 10.2 Current holder

approaches the acceptor for repayment

approaches the drawer

Acceptor

recompense

the drawer reimburses the acceptor for this payment to the holder

initially the acceptor pays the holder the face value of the bill

Bank accepted bills W h e n a b a n k accepts a b ill, i t is o b lig e d to re p a y th e b ill a t m a tu r ity , a n d f o r th is rea son such a b ill is u s u a lly re fe rre d to as a

bank accepted bill

o r s im p ly a

bank bill.

In p rin c ip le , in s titu t io n s o u ts id e th e

b a n k in g se cto r c o u ld also accept b ills . W h e re th is occurs, th e b ill is k n o w n as a p ra ctice n e a rly a ll b ills in A u s tra lia are accepted b y ba nks. The g ro w th o f th e A u s tra lia n b ill m a rk e t since 1 9 9 0 is s h o w n in Table 10.4.

non-bank bill,

b u t in

BANK BILL (OR BANK ACCEPTED BILL) bill of exchange that has been accepted or endorsed by a bank

NON-BANK BILL

TABLE 10.4 Bills on issue ($ billion), 1990-2013 D a te

B ills o n issue

June 1990

68.3

June 1995

59.1

June 2000

76.4

June 2005

91.4

June 2010

138.1

June 2011

125.9

June 2012

121.8

June 2013

110.7

Source: Table D2; Reserve Bank of Australia website, www.rba.gov.au.

bill of exchange that has been neither accepted nor endorsed by a bank

B usiness finance

BILL DISCOUNT FACILITY agreement in which one entity (normally a bank) undertakes to discount (buy) bills of exchange drawn by another entity (the borrower)

BILL ACCEPTANCE FACILITY agreement in which one entity (normally a bank) undertakes to accept bills of exchange drawn by another entity (the borrower)

Bill facilities M a n y co m p a n ie s do n o t r e s tr ic t t h e ir use o f b ill fin a n c in g to th o se occasions w h e n th e y re q u ire fu n d s to m e e t t h e ir im m e d ia te needs, a n d in s te a d m a in ta in a c o n tin u in g b ill fa c ilit y w ith a b a n k .15 A b ill fa c ility m a y be e ith e r a d is c o u n t f a c ility o r an acceptance fa c ility . In a

bill discount facility,

th e b a n k u n d e rta k e s

to d is c o u n t (b u y ) b ills o f exchange d ra w n b y th e b o rro w e r u p to a sp e cifie d t o ta l a m o u n t— t h a t is, th e b a n k p ro m is e s to le n d u p to th e s p e c ifie d to t a l a m o u n t. F ro m th e b a n k s v ie w p o in t, th e a d va n ta g e o f th is m e th o d o f le n d in g is t h a t th e b a n k h o ld s a m a rk e ta b le s e c u rity in th e fo r m o f th e b ill, w h ic h i t can la te r sell i f i t w ish e s. Thus, w h ile th e b a n k is c o m m itte d to p ro v id in g th e fu n d s in itia lly , i t is n o t c o m m itte d to p r o v id in g th e fu n d s f o r th e f u ll te r m o f th e b ill. In a

bill acceptance facility,

th e b a n k agrees to accept

b ills d ra w n b y th e b o rro w e r u p to a sp e cifie d t o ta l a m o u n t. The c o m p a n y is th e n able to b o rro w elsew here in th e c a p ita l m a rk e t b y s e llin g b ills . T his is a re la tiv e ly easy ta s k because th e re is a re a d y m a rk e t f o r b a n k b ills . B ill fa c ilitie s are o f tw o basic type s. •

A

fully drawn bill facility

p ro v id e s a co m p a n y w ith a s p e c ifie d a m o u n t f o r a s p e c ifie d p e rio d . In

th is case th e co m p a n y has to b o rro w th e f u ll a m o u n t, w h ic h is p ro v id e d b y is s u in g a series o f b ills . N e w b ills are issu e d as th e e x is tin g b ills m a tu re — a process re fe rre d to as ‘r o llin g o v e r，a b i ll— u n t il

FULLY DRAWN BILL FACILITY bill facility in which the borrower must issue bills so that the full agreed amount is borrowed for the period of the facility

REVOLVING CREDIT BILL FACILITY bill facility in which the borrower can issue bills as required, up to the agreed limit

th e agreed p e rio d o f th e f a c ility exp ire s. The in te re s t ra te is re ca lc u la te d each tim e a n e w b ill is issued. F o r exa m ple, a 3 -y e a r fa c ilit y m a y be covered b y s ix 1 8 0 -d a y b ills . In som e in sta n ce s p a rtia l re p a y m e n t m a y be re q u ire d d u rin g th e p e rio d o f th e lo a n .

•

A revolving credit bill facility

d iffe rs fr o m a f u lly d ra w n f a c ilit y in t h a t th e c o m p a n y is p e rm itte d

to d ra w o n th e f a c ilit y as th e fu n d s are re q u ire d , p ro v id e d t h a t i t does n o t b o rro w m o re th a n th e agreed to t a l a m o u n t. In th is re sp e ct a re v o lv in g c re d it f a c ilit y is s im ila r to a b a n k o v e rd ra ft. W it h in the se b ro a d categories, m a n y v a ria tio n s are p o ssib le . F o r e xa m p le , som e b i ll fa c ilitie s f ix in advance th e in te re s t co st to th e b o rro w e r, w h ile o th e rs p ro v id e fu n d s a t th e c u rre n t m a rk e t rate, o r a t th e c u rre n t m a rk e t ra te su b je c t to an agreed m a x im u m ra te o r ‘cap’. G en erally, h o w e v e r，th e te r m a n d cost c o n d itio n s f o r b ill fa c ilitie s are as fo llo w s :

TERM: A c o m p a n y

issues a b ill to o b ta in a s h o r t- te rm lo a n . U s u a lly th e te rm o f a b ill is 30, 60, 90, 120

o r 1 8 0 days. O fte n , h o w e ve r, a c o m p a n y w ill w a n t g u a ra n te e d access to s h o r t- te rm fu n d in g , a n d w i ll seek a b ill f a c ility fo r, say, 3 years.

COSTS:

The co st o f a b ill fa c ility has th re e e le m e n ts. T hey are th e fees f o r e s ta b lis h in g a n d m a in ta in in g th e fa c ility , th e in te re s t cost a n d th e acceptance fee. The

first element o f

th e costs com p en sates

th e le n d e r f o r th e cost in c u rre d in e s ta b lis h in g a n d a d m in is te rin g th e fa c ility . T y p ic a lly , these fees are expressed as a pe rcen ta ge o f th e a m o u n t o f th e fa c ility . The

second element o f

th e costs

is th e in te re s t co st re p re s e n te d b y th e d iffe re n c e b e tw e e n th e b ills face va lu e a n d th e p ric e p a id b y th e d is c o u n te r. A t a n y g iv e n tim e , th e re is a m a rk e t-d e te rm in e d d is c o u n t ra te (expressed as a y ie ld ) a p p lica b le to b ills w ith th e sam e te r m to m a t u r ity a n d c re d it-w o rth in e s s .16 A lth o u g h a ll b ills t h a t have b e en accepted a n d /o r e n d o rse d b y a b a n k are n o r m a lly ca lle d b a n k b ills , th e re can be s lig h t d iffe re n c e s in y ie ld , d e p e n d in g o n th e c re d it r a tin g o f th e b a n k in v o lv e d . Y ie ld s in d ic a tiv e o f th o se a p p ly in g to b a n k b ills are s h o w n in Table 10 .5. The

third element o f

th e cost

o f a b ill f a c ilit y is th e acceptance fee. T his fee is th e a c c e p to rs r e tu r n f o r ta k in g on th e ris k s a sso cia te d w ith th e b ill fa c ility . The m a in r is k is t h a t th e c o m p a n y m a y d e fa u lt o n its o b lig a tio n s u n d e r th e fa c ility . The m a rg in cha rge d b y th e le n d e r depe nd s o n th e a m o u n t a n d te r m o f th e fa c ilit y a n d th e s e c u rity g iv e n b y th e b o rro w e r. F o r a b o rro w e r, th e re are a n u m b e r o f advan ta ge s in c h o o s in g b ill fin a n c e o v e r o th e r fo rm s o f s h o rt­ te r m d e b t. The m a jo r ad van ta ge is access to m a rk e t-b a s e d f u n d in g sources th a t, w it h o u t th e c re d itw o rth in e s s p ro v id e d b y acceptance, w o u ld n o t be ava ila ble. A n o th e r im p o r t a n t a d va n ta g e is th e v a rie ty o f b ill fa c ilitie s ava ila ble, w h ic h m eans t h a t b ill fu n d in g p ro v id e s f le x ib ilit y f o r th e b o rro w e r. H o w eve r,

15 A bill facility may also be offered by an investment bank or other financial institution. However, to simplify our discussion we will assume that the facility is offered by a bank. 16 Participants in the bill market, like participants in the commercial paper market, typically agree on a yield, which is then converted to a price using simple interest. For details, see Section 3.3.4.

C hapter ten S ources

〇卩

fin a n c e : debt

TABLE 10.5 Yields for 30-day, 90-day and 180-day bank accepted bills, 2000-13 3 0 - d a y y ie ld (% p .a .)

9 0 - d a y y ie ld (% p .a .)

1 8 0 - d a y y ie ld (% p .a .)

30 June 2000

6.15

6.17

6.23

30 June 2005

5.62

5.66

5.69

30 June 2006

5.87

5.97

6.09

29 June 2007

6.34

6.43

6.58

30 June 2008

7.59

7.80

7.97

30 June 2009

5.87

5.97

6.09

30 June 2010

4.71

4.89

4.97

30 June 2011

4.91

4.99

5.06

29 June 2012

3.59

3.54

3.49

28 June 2013

2.82

2.82

2.81

I D a te

I

Source: Table F I, Reserve Bank of Australia website, www.rba.gov.au.

fo r a b o rro w e r w it h a c re d it r a tin g e q u a l o r s u p e rio r to t h a t o f a b a n k th e re m a y be fe w i f a n y b e n e fits associated w it h o b ta in in g b a n k acceptance. Thus, f o r the se b o rro w e rs , c o m m e rc ia l p a p e r m a y be an a ttra c tiv e a lte rn a tiv e to b a n k b ills .

1 0 .5 .4 1 Debentures A d e b e n tu re is a lo n g -te rm d e b t s e c u rity th a t, in A u s tra lia , is u n iq u e to com p an ies. A d is tin g u is h in g fe a tu re o f m o s t d e b e n tu re s in A u s tra lia is t h a t th e lo a n is secured b y a charge o v e r ta n g ib le p ro p e rty o f th e b o rro w e r.17 O th e r fe a tu re s o f d e b e n tu re s u s u a lly in c lu d e th e fo llo w in g : •

th e in te re s t ra te payable b y th e b o rro w e r is fix e d a t th e tim e th e d e b e n tu re s are issued

•

th e te rm to m a t u r ity is fix e d a n d is u s u a lly in th e ran ge fr o m 1 ye a r to 5 years

•

p o te n tia l in v e s to rs m u s t be p ro v id e d w it h a p ro s p e c tu s

•

th e s e c u rity o ffe re d to d e b e n tu re h o ld e rs w ill be e ith e r a fix e d charge o v e r sp e cific assets o r a flo a tin g charge o ve r a p o o l o f assets

•

th e o w n e rs h ip o f d e b e n tu re s m a y be tra n s fe ra b le , so th e y can be lis te d o n an exchange such as

•

d e ta ils such as th e n a tu re o f th e s e c u rity ( i f an y) f o r th e d e b e n tu re s, re p o rtin g re q u ire m e n ts , o th e r

•

a tru s te e m u s t be a p p o in te d to p ro te c t th e in te re s ts o f d e b e n tu re h o ld e rs .18

th e ASX o b lig a tio n s o f th e is s u e r a n d th e rig h ts o f d e b e n tu re h o ld e rs m u s t be set o u t in a t r u s t deed

17 Section 9 of the C o rp o ratio n s A c t 2 0 0 1 states that a debenture *may (but need not) include a security interest over property of the body [the borrower] to secure payment of the money,. However, in practice, it appears that in Australia most debentures are secured over property. ASICs Money Smart website advises that, *The issuer [borrower] may give you ... security for repayment of your money. If that security is tangible property the notes can be called debentures* (see www.moneysmart. gov.au/investing/investments-paying-interest/unlisted-debentures-and-unsecured-notes). Note also that, traditionally, British (and Australian) terminology on this point is exactly the opposite of North American: in the former, debentures are typically secured against assets, whereas in the latter they are not secured (see www.oxforddictionaries.com/definition/ american_english/debenture). 18 For details on pricing debentures, see Section 4.4.

LEARNING OBJECTIVE 9 Identify and explain the features of the main types of long­ term debt securities

DEBENTURE a type of fixed interest security issued by a company, usually secured by a charge over tangible assets

feM i

B usiness finance

The im p o rta n c e o f d e b e n tu re s as a source o f fin a n c e f o r A u s tra lia n co m p a n ie s has d e c lin e d in th e pa st decade a n d o n ly a s m a ll n u m b e r o f d e b e n tu re issues are lis te d o n th e ASX. P u b lic issues o f de b e n tu re s are exp e n sive because o f th e costs in v o lv e d in p re p a rin g a p ro s p e c tu s a n d m a n y co m p a n ie s have fo u n d t h e ir d e b e n tu re t r u s t deed u n d u ly re s tric tiv e . M o s t co m p a n ie s are n o w able to o b ta in fix e d -in te re s t d e b t fin a n c e a t lo w e r c o st b y ta k in g o u t a v a ria b le -ra te b a n k lo a n a n d th e n e n te rin g in to an in te re s t ra te swap. T his m e c h a n is m is e x p la in e d in S e c tio n 1 7 .1 2 .2 . M a n y d e b e n tu re issues in A u s tra lia are u n lis te d a n d /o r have n o t b e en ra te d b y on e o f th e ra tin g agencies. C o n se q u e n tly, re lia b le a n d u p -to -d a te in fo r m a t io n o n p a r tic u la r d e b e n tu re issues has been d iff ic u lt to o b ta in . R e g u la tio n has m o s tly fo cu se d o n tw o aspects: d is c lo s u re o f in fo r m a t io n th r o u g h th e p ro s p e c tu s re q u ire m e n ts a n d m o n it o r in g o f p e rfo rm a n c e b y th e a p p o in te d tru s te e . In re c e n t years, th e re have b e e n a n u m b e r o f h ig h -p ro file fa ilu re s o f d e b e n tu re issu ers, p a r tic u la r ly th o s e t h a t o n -le n d th e fu n d s ra is e d th r o u g h a d e b e n tu re issue. O n e o f th e m o re n o ta b le fa ilu re s was t h a t o f B a n ksia F in a n c ia l G ro u p in 2 0 1 2 (see F in a n ce in A c tio n ). In F e b ru a ry 2 0 1 3 , th e A u s tra lia n S e c u ritie s a n d In v e s tm e n ts C o m m is s io n released a c o n s u lta tio n p a p e r t h a t p ro p o s e d s ig n ific a n tly t ig h t e r re g u la tio n o f d e b e n tu re issuers.

Finance in

ACTION

BA N KSIA^ LESSON: INVESTORS, YOU ARE ESSENTIALLY ALONE__________________________________________ T h e f a ilu r e o f B a n k s ia F in a n c ia l G r o u p in N o v e m b e r 2 0 1 2 r e ig n it e d d e b a te a b o u t th e r e g u la tio n o f d e b e n t u r e issu e s in A u s t r a lia . O f c o u rs e , o f its e lf a f a ilu r e d o e s n o t n e c e s s a r ily im p ly t h a t t ig h t e r r e g u la t io n is r e q u ir e d : in v e s tm e n t is r is k y a n d h a m - fis te d r e g u la t o r y a tte m p ts to r e d u c e r is k m a y in th e lo n g ru n d o m o r e h a r m th a n g o o d . B u t, a ll o th e r th in g s b e in g e q u a l, s im ila r r e g u la tio n s s h o u ld a p p ly in s im ila r c irc u m s ta n c e s . A c c o r d in g to f in a n c ia l jo u r n a lis t J o n a th a n S h a p ir o th e r e g u la t io n o f d e b e n tu r e s is a t o d d s w it h th e r e g u la t io n o f b a n k s . T h e f o llo w in g is a n e x c e r p t f r o m a n a r t ic le p u b lis h e d s o o n a f t e r th e B a n k s ia f a ilu r e w a s a n n o u n c e d . T h e y s a id it w o u ld n e v e r h a p p e n a g a in . T h e c o lla p s e o f p r o p e r t y f in a n c in g f ir m W e s t p o in t w a s b r a n d e d a 'n a t io n a l s h a m e 7 a n d s p a r k e d a r o y a l c o m m is s io n t h a t w a s m e a n t to o v e r h a u l th e lo c a l r e g u la t o r y f r a m e w o r k a n d p r e v e n t a r e p e a t. B u t it h a s h a p p e n e d a g a in . T h e c o lla p s e o f B a n k s ia F in a n c ia l G r o u p , w h ic h h a s le ft $ 6 5 0 m illio n o f fu n d s in je o p a r d y , is ir r e f u t a b le p r o o f t h a t m o n e y lo s t b y in v e s to rs in W e s t p o in t w a s la r g e ly in v a in . M o r e im p o r t a n tly , it is a t im e ly r e m in d e r t h a t in d iv id u a l in v e s to rs c a n n o t le a n o n th e r e g u la t o r to p r o t e c t th e m . T h e s ta r k e s t le s s o n fr o m th e c o lla p s e o f B a n k s ia — a n d s a d ly th e f a ilu r e s t h a t p r e c e d e d i t — is th e v a s t g u lf b e t w e e n h e a v ily r e g u la t e d b a n k s a n d u n lis te d , u n r a t e d in s titu tio n s t h a t e s s e n tia lly e n g a g e in b a n k - lik e a c t iv itie s . B a n k s ia 's b u s in e s s m o d e l w a s n o t d is s im ila r to t h a t o f a b a n k . It b o r r o w e d m o n e y fr o m th e p u b lic b y is s u in g d e b e n t u r e s a n d th e n le n t th e fu n d s to th e p u b lic b y f in a n c in g r e s id e n t ia l a n d c o m m e r c ia l m o r t g a g e s . B u t d e s p ite its b u s in e s s a n d u n lik e its n a m e , it w a s n o t e v e n c lo s e to b e in g a b a n k . B a n k s , o r r e g u la t e d a u t h o r is e d d e p o s it - ta k in g in s titu tio n s (A D Is ) a r e c a r e f u lly m o n it o r e d b y th e A u s t r a lia n P r u d e n tia l R e g u la tio n A u t h o r it y (A P R A ), w h ic h is ta s k e d w it h e n f o r c in g th e

B o n k in g A c f a n d p r o t e c t in g d e p o s it o r s 7 fu n d s . M o s t b a n k s m u s t h o ld $ 1 0 o f c a p it a l f o r e v e r y $ 1 0 0 o f lo a n s w r itt e n . B a n k s ia h a d le ss t h a n $ 3 . 6 0 f o r e v e r y $ 1 0 0 o f lo a n s . S o w h e n a r e v ie w o f th e lo a n b o o k r e v e a le d m o r e lo s s e s , it d i d n 't t a k e m u c h f o r d e b e n t u r e in v e s to r s to h a v e t h e ir fu n d s t h r e a t e n e d .

Source: 'Banksia's lesson: investors, you are essentially alone', Jonathan Shapiro, Australian Financial Review, 3 November 2012.

C hapter ten S ources

of fin a n c e : debt

1 0 .5 .5 1 Unsecured notes U n secu red n o te s are s im ila r to d e b e n tu re s , b u t d iffe r in t h a t h o ld e rs are u s u a lly u n se cu re d c re d ito rs w h o ra n k b e lo w a n y secured c re d ito rs f o r re p a y m e n t o f d e b t. H o w e ve r, in som e cases, d e sp ite t h e ir na m e, un secu red notes* m a y be secu red b y a charge o v e r shares o r o th e r in ta n g ib le assets. A re la te d d iffe re n c e is th a t a t r u s t deed f o r u n se cu re d n o te s w ill u s u a lly in c lu d e co ve n a n ts t h a t are less re s tric tiv e th a n th o se in a d e b e n tu re t r u s t deed. F ro m th e h o ld e r s p o in t o f vie w , th e re fo re , u n s e c u re d n o te s are a ris k ie r in v e s tm e n t th a n d e b e n tu re s. T o com p en sate f o r th e g re a te r r is k o f u n se cu re d n o te s , a c o m p a n y u s u a lly o ffe rs a h ig h e r in te re s t ra te o n u n s e c u re d n o te s th a n o n d e b e n tu re s. In c o n tra s t to a d e b e n tu re , w h e re th e in te re s t ra te is fix e d , th e in te re s t ra te o n a n o te m a y v a ry b y b e in g lin k e d to an in d ic a to r ra te such as th e b a n k -b ill sw ap ra te (BBSW ). N o te s o f th is ty p e are re fe rre d to as 'flo a tin g -ra te notes*. Som e flo a tin g -ra te n o te s are lis te d o n th e A u s tra lia n S e cu ritie s Exchange. M a n y o f these se cu ritie s have b e en issu e d b y fin a n c ia l c o rp o ra tio n s such as b a n ks a n d in s u ra n c e co m p a n ie s b u t issuers have also in c lu d e d O r ig in E nergy, C a lte x A u s tra lia a n d W o o lw o rth s .

1 0 .5 .6 1Corporate bonds In th e A u s tra lia n m a rk e t, th e te r m c o rp o ra te b o n d , g e n e ra lly re fe rs to lo n g -te rm d e b t s e c u ritie s w ith cou po n p a y m e n ts e ve ry 6 m o n th s based o n a d e fin e d ra te o f in te re s t, issu e d b y n o n -g o v e rn m e n t e n titie s in a m o u n ts o f a t le a st $ 5 0 0 0 0 0 p e r in v e s to r. In A u s tra lia , th e d is tin c tio n b e tw e e n a c o rp o ra te b o n d a n d a d e b e n tu re is s o m e w h a t b lu rre d , b u t a d e b e n tu re is u s u a lly secured b y a charge o v e r ta n g ib le assets o f th e b o rro w e r, w hereas a c o rp o ra te b o n d m a y o r m a y n o t be secu red .19 In a d d itio n , a d e b e n tu re o ffe rs a fix e d co u p o n rate, w hereas a c o rp o ra te b o n d m a y o ffe r a fix e d o r flo a tin g c o u p o n rate. U sually, b o n d s issu ed o n th e se te rm s are p lace d p riv a te ly , m o s tly w it h in s titu t io n a l in v e s to rs , a n d are n o t lis te d o n a s to c k exchange. Som e co m p a n ie s, in c lu d in g H e rita g e B a n k a n d P en ta g o n C a p ita l, have issued lo n g -te rm d e b t s e c u ritie s d e sig n e d to a p pe al to in d iv id u a l in v e s to rs . In ^re ta il1 c o rp o ra te b o n d issues, th e m in im u m in v e s tm e n t is m u c h s m a lle r, c o u p o n p a y m e n ts m a y be m ade q u a rte rly o r m o n th ly and th e se cu ritie s m a y be lis te d o n th e ASX. The co ve n a n ts used f o r c o rp o ra te b o n d s are u s u a lly less re s tric tiv e th a n th o se in a d e b e n tu re t r u s t deed. W h ile A u s tra lia n b a n ks fa v o u r lo a n s a n d s e c u ritie s w it h e x te n s iv e c o v e n a n t p ro te c tio n , fo re ig n b a n ks w ill co n sid e r d e b t w it h few , i f any, co ve n a n ts. T his so ca lle d c o v e n a n t-lig h t1 d e b t p la ye d an im p o r t a n t ro le in th e s tr u c tu r in g o f a n a tte m p t b y A ir lin e P a rtn e rs A u s tra lia (APA) to acq uire a n d p riv a tis e Q a n ta s A irw a y s (see F ina nce in A c tio n ).

APA USES CASH TO REDUCE RISKS IN QANTAS BID___________ A P A , a c o n s o r tiu m t h a t in c lu d e d M a c q u a r ie B a n k a n d T e xa s P a c ific , o f f e r e d to p a y $1 3 . 5 b illio n f o r Q a n ta s , f in a n c e d b y a b o u t $ 1 0 b illio n o f d e b t a n d th e re s t e q u ity . G iv e n t h a t Q a n ta s h a d n e t d e b t o f $ 4 . 8 b illio n , its d e b t w o u ld b e m o r e th a n d o u b le d , in c r e a s in g th e e x p e c te d re tu rn s , a n d ris k s , f o r e q u ity h o ld e rs . T h e le v e l o f d e b t in le v e r a g e d b u y o u t tr a n s a c tio n s is t y p ic a lly asse sse d b y c a lc u la t in g th e r a t io o f th e v a lu e o f d e b t to e a r n in g s b e f o r e in te re s t, ta x , d e p r e c ia t io n a n d a m o r tis a t io n (E B IT D A ). T h e f o llo w in g e x c e r p t o u tlin e s a n in n o v a t iv e a p p r o a c h u s e d to s tru c tu re th e f in a n c in g o f th e p r o p o s e d Q a n t a s p r iv a t is a tio n . R e c e n t le v e r a g e d b u y o u t t r a n s a c t io n s in A u s t r a lia h a v e b e e n s tru c k a t a d e b t-to -E B lT D A m u ltip le o f 7 . 5 tim e s . O f th a t, a b o u t 6 m u ltip le p o in ts is s e n io r d e b t a n d th e b a la n c e s u b o r d in a t e d .

continued

19 The Australian Securities and Investments Commission regards a debenture as a type of corporate bond, the main distinction being that 'To be called a debenture, a corporate bond must be secured against property. Corporate bonds generally may or may not be secured against property* (Australian Securities and Investments Commission, 2010, p. 6). In the US, corporate bonds are senior securities', whereas debentures are unsecured. Hence, in most cases, an Australian debenture would be called a corporate bond in the US, while an Australian corporate bond would be called a debenture in the US.

Finance in

ACTION

B usiness finance

continued G iv e n Q a n t a s h a s a m o r e v o la t ile e a r n in g s p r o f ile , le v e r a g e in th is p r iv a t is a t io n is n o t a s h ig h a t 6 . 4 tim e s E B IT D A . A p p ly i n g t h a t t y p ic a l L B O s tru c tu re w o u ld h a v e r e s u lte d in a s e n io r d e b t le v e l o f 5 . 2 tim e s a n d th e re s t s u b o r d in a t e d . T h e p r o b le m is t h a t s e n io r d e b t c o m e s w it h m y r ia d c o v e n a n ts th a t, if b r e a c h e d , c a n re s u lt in th e le n d e r s s e e k in g r e m e d ia l a c t io n , e v e n f o r e c lo s in g . A t y p ic a l c o v e n a n t w o u ld b e t h a t E B lT D A -to -in te re s t c o v e r c o u ld n o t f a ll b e lo w a s p e c if ie d le v e l. If a h ic c u p o c c u r s th e o w n e r s c a n q u ic k ly f in d th e m s e lv e s in a n a s ty s itu a tio n . B u t th is is th e a i r lin e in d u s tr y a n d th e re a r e a lw a y s t e m p o r a r y s h o c k s . It's n o t lik e th e b u s in e s s is in d a n g e r o f g o in g b r o k e . S o e s s e n t ia lly M a c q u a r ie h a d e n lis te d f iv e b a n k s to t r y a n d f it a s q u a r e p e g in to a r o u n d h o le . M o r g a n S ta n le y , w h ic h w a s n o t in v it e d to t e n d e r f o r th e d e b t p a c k a g e , h a d a s tro n g r e la t io n s h ip w it h T e x a s P a c ific a n d c o u ld s e e th e p r o b le m . S o it k n o c k e d o n th e d o o r to p r e s e n t a n a lt e r n a t iv e s tru c tu re — th e o n e u ltim a t e ly a d o p t e d . O f th e $ 1 0 b illio n in d e b t , h a lf w o u ld b e in th e f o r m o f t r a d a b le b o n d s b a c k e d b y a ir c r a f t le a s e s . T h e b a la n c e is a la y e r o f f ix e d a n d f lo a t in g - r a t e n o te s , d e n o m in a t e d in d if f e r e n t c u r r e n c ie s , a n d f in a lly , s u b o r d in a t e d d e b t . T h e b e a u ty is t h a t th e r e a r e n o c o v e n a n ts o n th e b o n d s , k n o w n a s e n h a n c e d e q u ip m e n t tru s t c e r t if ic a te s . T h e o n ly r e q u ir e m e n t is to m e e t th e $ 9 0 0 m illio n in a n n u a l in te r e s t p a y m e n ts . T h a t’s it. It’s a f a r s im p le r a n d m o r e s u ita b le f in a n c in g s tru c tu r e th a n s e n io r d e b t . To e n s u r e in te r e s t p a y m e n ts c a n a lw a y s b e m e t, A P A w i ll k e e p $ 2 b i lli o n in c a s h a s a b u ffe r . It a ls o h a s a $ 9 5 0 m illio n c r e d it lin e 'r e v o lv e r ', w h ic h a g a i n is f r e e o f th o s e a n n o y in g c o v e n a n ts . R ic k S c h ifte r o f T e x a s P a c ific w a s so a p p r e c ia t iv e o f th e w o r k M o r g a n S ta n le y in N e w Y o rk d i d t h a t h e s h ip p e d th e m t w o c a s e s o f B a r o s s a V a lle y E & E B la c k P e p p e r S h ir a z 2 0 0 1 . A t $ 7 0 a p o p it's a s m o k y a n d d u s ty , b u t b y a ll a c c o u n ts w o n d e r f u l, d r o p .

Source: 'Two cases of shiraz for innovative debt structuring7, Brett Clegg, Australian Financial Review, 15 December 2006. S ta tis tic s o n th e va lu e o f lo n g -te rm n o n -g o v e rn m e n t d e b t s e c u ritie s issu ed b y A u s tra lia n b o rro w e rs are s h o w n in Table 10 .6. Panel A sho w s th e s e c u ritie s issu ed in th e A u s tra lia n d o m e s tic m a rk e t to d o m e s tic in v e s to rs , w h ile Panel B covers s e c u ritie s issu ed in th e c a p ita l m a rk e ts o f o th e r c o u n trie s . The issuers o f the se s e c u ritie s are d iv id e d in to th re e categories:

banks, finance companies and other financial institutions b ‘non-financial corporations’ consisting of industrial and mining companies C issuers of asset-backed securities. a

A sse t-b a cke d se c u ritie s are m a rk e ta b le d e b t s e c u ritie s issu e d b y spe cia lise d e n titie s associated w ith fin a n c ia l in s titu tio n s , a n d the se s e c u ritie s are ba cked b y n o n -m a rk e ta b le fin a n c ia l assets such as m o rtg a g e lo an s a n d c re d it card receivables. In th e A u s tra lia n m a rk e t, m o s t o f the se issues have been backed b y re s id e n tia l m o rtg a g e s. W h e n asset-backed s e c u ritie s are c o m b in e d w it h th o s e issu ed b y b a n ks a n d o th e r fin a n c ia l c o rp o ra tio n s , i t is cle ar t h a t m o s t o f th e c o rp o ra te b o n d s issu e d b y A u s tra lia n b o rro w e rs are issu ed b y fin a n c ia l in s titu tio n s . B la ck e t al. (2 0 1 2 ) e s tim a te d t h a t in th e p e rio d J u ly 2 0 0 7 to D e cem b er 2 0 1 1 , th e f o u r m a jo r b a n ks a cco u n te d f o r a b o u t 6 0 p e r c e n t o f a ll p riv a te s e c to r asset-backed b o n d s, d e b e n tu re s a n d u n se cu re d b o n d s o n issue. The c o rp o ra te b o n d m a rk e t in A u s tr a lia has g ro w n r a p id ly sin ce 1 9 9 5 w h e n th e v a lu e o f lo n g ­ te r m n o n -g o v e rn m e n t d e b t s e c u ritie s o n issu e w as a b o u t $ 2 1 b illio n . A s s h o w n in T a b le 1 0 .6 , th e

BOND

m a rk e t re a ch e d $ 2 4 9 b illio n in J u n e 2 0 0 7 , b u t as n o te d a b o ve m o s t o f th e ‘c o rp o ra te ’ b o n d s are issu ed

debt security issued with a medium or long term to maturity by borrowers such as governments, state authorities and corporations in return for cash from investors

b y b a n k s a n d o th e r fin a n c ia l in s t it u t io n s ra th e r th a n b y n o n - fin a n c ia l c o m p a n ie s . The g r o w th ra te sin ce 2 0 0 7 has s lo w e d s o m e w h a t a n d as a t J u n e 2 0 1 3 s to o d a t ju s t o v e r $ 3 0 0 b illio n . I n M a y 2 0 1 0 , A S IC is s u e d R e g u la to ry G u id e 2 1 3

Facilitating debt raising to

e n co u ra g e th e d e v e lo p m e n t o f th e r e ta il

c o rp o ra te b o n d m a rk e t b y s im p lif y in g th e d is c lo s u re re q u ire m e n ts f o r V a n illa * b o n d s. B o n d s m a y be d e s c rib e d as V a n illa 1 i f th e y do n o t ha ve a n y u n u s u a l o r c o m p le x te rm s o r c o n d itio n s . A S IC d e fin e d th e m as u n s u b o rd in a te d , n o n - c o n v e r tib le b o n d s d e n o m in a te d in A u s tr a lia n d o lla rs w i t h a fix e d te r m o f 10 ye a rs o r less a n d th e p r in c ip a l re p a y a b le a t m a t u r ity , is s u e d a t th e sam e p ric e to a ll in v e s to rs

C hapter ten S ources

TABLE 10.6 Long-term non-government debt securities outstanding ($ billion) 1995- 2013

A Long-term non-government debt securities issued in Australia by Australian borrowers to Australian resident investors B a n ks a n d D a te

o th e r fin a n c ia l

N o n - fin a n c ia l

c o rp o ra tio n s

c o rp o ra tio n s

A sse 卜 backed

Total

June 1995

7.9

6.0

7.2

21.1

June 2000

19.4

17.3

24.5

61.2

June 2005

48.0

38.8

79.3

166.2

June 2006

64.0

42.3

98.9

205.3

June 2007

78.2

48.3

122.3

248.8

June 2008

99.4

45.4

111.5

256.3

June 2009

135.4

41.4

98.5

275.3

June 2010

172.1

40.6

80.6

293.3

June 2011

188.4

43.5

84.1

316.0

June 2012

187.3

45.3

86.1

318.7

June 2013

166.6

49.0

89.4

305.0

B Long-term non-government debt securities issued offshore by Australian borrowers B a n ks a n d D a te

o th e r fin a n c ia l

N o n - fin a n c ia l

c o rp o r a tio n s

c o rp o r a tio n s

A s s e t-b a c k e d

Total

June 1995

33.7

29.1

1.4

64.2

June 2000

72.3

33.6

20.1

125.9

June 2005

183.5

74.2

65.3

323.0

June 2006

206.3

77.2

72.3

355.7

June 2007

225.3

87.6

100.2

413.1

June 2008

262.8

90.4

68.4

421.5

June 2009

295.9

104.8

57.9

458.6

June 2010

355.8

114.5

35.3

505.6

June 2011

341.9

129.1

23.4

494.4

June 2012

331.6

148.2

17.7

497.6

June 2013

331.7

165.7

15.2

512.6

Source: Table D4, Reserve Bank of Australia website, www.rba.gov.au.

and paying interest on specified dates at e ither a fixed rate or a flo a tin g rate com prising a m arket indicator rate plus a fixed m argin. Nevertheless, i t appears th a t fu rth e r steps w ill be needed i f the retail corporate bond m arket is to grow.

of fin a n c e : debt

1

B usiness finance

The volume o f bonds issued offshore by Australian borrowers is considerably larger than the volume issued onshore and, as shown in Table 10.6, the largest Australian issuers o f bonds in offshore markets are financial institutio ns, o f which banks are the largest borrowers. Moreover, the value o f financial corporations* bonds on issue in offshore markets has typically been roughly double the value o f th eir domestic bonds. Issues by non-financial corporations have also grown significantly b u t are less than one-third o f the total. Issues o f asset-backed securities grew rapidly u n til 2007 b ut have since declined considerably, reflecting the effects o f the global financial crisis on the popularity o f securitisation. Some indication o f the reasons fo r issuing bonds offshore rather than domestically can be obtained by examining the characteristics o f issues made by Australian borrowers in the two markets. The main reason appears to be th a t offshore markets, particularly the US market, have greater capacity to absorb securities o f lower credit quality.20 For both the financial and the non-financial sectors, the credit ratings o f Australian domestic bond issues are higher, on average, than those o f offshore issues. As shown in Table 10.7, almost all Australian bond issuance has been lim ited to the three highest ratings o f AAA, AA and A.

TABLE 10.7 Australian corporate bond and debenture issuance: percentage of total issuance by rating R a tin g P e rio d

__A A A _

AA

A

BBB

1983-89

32

57

11

0

1990-92

22

70

8

0

1993-June 2007

28

46

22

3

July 2007-2011

30

45

19

7

Source: S. Black, J. Kirkwood, A. Rai & T. Williams, 'A history of Australian corporate bonds7, Research Discussion Paper No. 2012-09, Reserve Bank of Australia, December 2012.

FOREIGN BOND bond issued outside the borrower's country and denominated in the currency of the country in which it is issued

Eurobond medium- to long-term international bearer security sold in countries other than the country of the currency in which the bond is denominated

Issuing bonds in a variety o f offshore markets also provides a larger and more diversified funding base, which can be advantageous i f markets differ in terms o f the costs and availability o f funds. Financial intermediaries such as banks are known to prefer a diversified funding base. O ther reasons th a t have been suggested fo r issuing offshore include differences in te rm to m aturity, amounts borrowed and currency o f denom ination. However, these do n o t appear to be m ajor factors. For a sample o f domestic and offshore bond issues by Australian banks from 2001 to 2006, the m aturities o f both types ranged from 3 to 5 years. Larger issues are possible in offshore markets, b ut in practice domestic and offshore issues tend to be sim ilar in size. For the 2001 to 2006 sample, the average domestic issue by Australian banks was $304 m illio n while the average offshore issue was $356 m illion. M ost offshore issues are denominated in foreign currency, p rim a rily US dollars although there have been significant issues in euro and yen. Issuers almost invariably hedge against foreign currency risk, m ainly by swapping the foreign currency back in to Australian dollars.21 Therefore, w hile gaining access to a broader range o f investors may be im p orta nt, exposure to different currencies does n ot appear to be a m otivating factor. Comparisons o f the interest cost o f domestic bond issues and offshore issues, after allowing fo r the cost o f hedging, show th a t there is no systematic cost difference between the domestic and offshore markets. Bonds issued by an Australian borrower in a foreign country and denominated in the currency o f th a t country are known as foreign bonds. Examples include bonds denominated in US dollars and issued in the US domestic m arket by offshore borrowers and bonds denominated in yen and issuedin Jap an byo ffsh o re bo rro w e rs. Australian companies can also raise funds offshore by issuing Australian dollar Eurobonds. Eurobonds are medium - to long-term securities sold in countries other than the country o f the currency in which the bond is denominated. An Australian dollar Eurobond is a debt security denominated in Australian dollars b ut issued outside Australia w ith a view to attracting non-Australian investors.

20 For a more detailed discussion of this topic see Battellino (2002). Facts and statistics in the next two paragraphs are also drawn from Reserve Bank of Australia (August 2006). See also Black et al. (2010). 21 For further discussion of this process, see Section 17.12.3.

C hapter ten S ources

of f in a n c e : debt

10.6 Project finance Project finance is a technique th a t is commonly used to raise funds fo r m ajor m ining and natural resource projects, infrastructure such as power stations, pipelines and to ll roads, to u ris t resorts and other property developments.22 I t can also be used to fund the acquisition o f assets th a t w ill be used in large industrial operations. Partly because Australia has a large m ining sector, project finance has frequently been used in Australia.23 Project finance has been defined as:

A method of raising long-term debt financing for major projects through 'financial engineering, based on lending against the cash flow generated by the project alone; it depends on a detailed evaluation of a projects construction, operating and revenue risks, and their allocation between investors, lenders and other parties through contractual and other arrangements. (Yescombe, 2002, p. 1) This d efinition shows th a t an im p o rta n t feature o f project finance loans is th a t the lenders rely essentially on the cash flows o f a single project as the source o f the loan repayments. The projects involved are usually large and the loans required can exceed $1 billion. For example, Transurbans City Link to ll road project in M elbourne cost $1.7 billion , o f which $1.25 b illio n was provided by lenders. W ith such large projects it is usual fo r a syndicate o f lenders to provide funds so the credit risk is spread between them.

10.6.1 | The main features of project finance Each project is unique and there is no such th in g as Standard* project finance, b ut several features th a t are common to many project finance transactions can be identified. These include: •

• •

• •

•

•

The project is established as a special purpose legal e n tity whose sole business a ctivity is the project. This e n tity is the legal owner o f the project assets and is the borrow er in all project finance loans. The special purpose e n tity is usually a company b ut in some cases a partnership, u n it tru s t or unincorporated jo in t venture may be used. For sim plicity we w ill refer to this e n tity as the ‘project com pany' Project finance is usually raised to undertake a new project rather than a business th a t is already established. A high p roportion o f debt finance is used. In typical cases debt may provide 70 to 90 per cent o f the cost o f the project. The project sponsors who own equity in the project company provide the balance o f the funds. The lenders* decision on w hether to provide funds is based on the expected cash flows and assets o f the project rather than on the assets and financial positions o f the project sponsors. The debt finance is provided on a limited-recourse basis, which means th a t the project sponsors provide only lim ite d guarantees in relation to the project debt. Typically, these guarantees allow lenders to claim against the sponsors only u n til the project is constructed and becomes operational. Thereafter, the lenders rely entirely on the project s cash flows and assets. The main security fo r lenders is in the form o f intangible assets, such as the project company s contracts or rights to natural resources. I f the project company s tangible assets have to be sold follow ing default on the debt finance, th e ir m arket value is likely to be much lower than the outstanding debt. Project finance loans are generally fo r much longer terms than norm al corporate loans. However, the life o f a project is finite, and the loans m ust be repaid by the end o f th a t life. In contrast, lenders th a t provide corporate loans are concerned to see th a t the company has the capacity to pay interest on the loan but w ill assume th a t the company s debt is likely to be rolled over when it matures.

22 This section relies heavily on Yescombe (2002), Chapter 2. 23 For example, in 2012 Australian-based projects secured project finance of US$42 billion, representing more than 20 per cent of the years global total of US$195 billion (Australian Trade Commission, 2013).

LEARNING OBJECTIVE 10 Identify and explain the main features of project finance

B usiness finance

10.6.21 When is project finance a 什「active? In addition to the usual features o f project finance outlined above, the assessment and management o f risk is a v ita l p a rt o f any project finance transaction. Lenders m ust be confident n ot only th a t the project is technically sound b ut also th a t the project can be completed w ith in the budgeted capital cost and that its operation w ill generate sufficient cash flows to service the debt. I t follows th a t lenders need to evaluate carefully the term s o f any project contracts th a t may affect its construction and operating costs. They also need to ensure that, wherever possible, project risks fa ll on parties other than the project company. For example, i f the project involves construction and operation o f a power station, the lenders may require that a government a uth ority guarantees to purchase all o f the output. The process o f evaluating risks and negotiating suitable contracts can be slow, complex and costly, so the m argin th a t lenders charge over th e ir cost o f funds can be considerably higher than fo r norm al corporate loans. Therefore, any suggestion th a t project finance loans are 4cheap debt* is false. Despite the higher cost o f debt, project finance can be viable in cases where the operating cash flows are relatively predictable so the low risk o f the project allows a high p ro po rtio n o f debt to be used. High financial leverage can gear the rate o f return on equity to an attractive level, while the limited-recourse nature o f project debt reduces the risk exposure o f equity investors. I t is common fo r the original debt to be refinanced when the project reaches completion and many o f the original risks have been resolved. In some cases, refinancing p rio r to completion can achieve significant savings in interest costs (see Finance in Action).

Finance in

ACTION

REFINANCING OF CQNNECTEASrS DEBT FACILITIES_________ C o n n e c t E a s t G r o u p is e x p e c t e d t o a n n o u n c e a r e f in a n c in g o f its $ 2 . 1

b i l l i o n d e b t f a c il it ie s

t o d a y a m i d s p e c u la t io n t h a t t h e g r o u p , o w n e r o f th e E a s t lin k t o ll r o a d , is u p t o a y e a r a h e a d o f s c h e d u le o n t h e c o n s t r u c t io n t im e t a b le . T h e d e a l h a s im p r o v e d th e te rm s o f th e g r o u p 's f in a n c in g o n th e p r o je c t in s o u th -e a s t M e lb o u r n e . In te re s t o n d e b t d u r in g th e c o n s tr u c tio n p h a s e is s e t to f a ll b y 4 0 b a s is p o in ts to 1 1 0 b a s is p o in ts J ° ) It w i ll r e m a in a t th is le v e l f o r th e fir s t t w o y e a r s o f o p e r a t io n s o n c e th e r o a d h a s o p e n e d . It h a d b e e n s e t to in c r e a s e to 1 6 5 b a s is p o in ts d u r in g th is p e r io d . T h is is s e t t o s a v e 1 .3 c e n ts a u n it e a c h y e a r , w h ic h w i ll b e a v a ila b le to s u p p o r t d is tr ib u tio n s . T h is a m o u n t r e p r e s e n ts 2 0 p e r c e n t o f th e 6 . 5 c e n ts in d is t r ib u t io n s p a id b y th e g r o u p f o r th e y e a r to J u n e 3 0 . T h e r e f in a n c in g is th e f ir s t o f its k in d o n a g r e e n fie ld s to ll r o a d p r o je c t in A u s t r a lia a n d in v o lv e d a c o n s o r tiu m o f s e v e n b a n k s .

Source: 'ConnectEast may refinance debt facilities', Henry Byrne, Australian Financial Review, 21 December 2006, p. 36. In this article, the interest on debt is expressed as a margin over a benchmark rate such as the bank-bill swap rate.

In summary, project finance does n ot allow projects th a t should be rejected as uneconomic to become viable through ^financial magic*. However, through the use o f measures such as jo in t ventures to spread risk and careful contracting to allocate risks to parties who are best placed to bear them, m ajor projects that would be d iffic u lt fo r any single company to im plem ent can often go ahead.

LEARNING OBJECTIVE 11 Identify and explain the features of securities that have the characteristics of both debt and equity

4^^

10.7 Hybrids of debt and equity In this section we consider securities th a t have characteristics common to both debt and equity and are therefore regarded as hybrids. Australia has an active m arket in hybrid securities. Some hybrids are complex b ut m ost are based on a convertible note or a preference share. Because convertible notes are simpler, they are discussed first, followed by preference shares.

C hapter ten S ources

of fin a n c e : debt

10.7.1 | Convertible notes and convertible bonds Convertible notes and convertible bonds are usually unsecured debt th a t is issued fo r a fixed term at a fixed interest rate, w ith the additional feature th a t the holder has the rig h t to convert the note or bond to ordinary shares at a specified date(s). For sim plicity, in this section we refer to both types o f security as ^convertibles*. In effect, the purchaser o f a typical convertible acquires a fixed-interest security plus an option to purchase ordinary shares in the company at a specified conversion price. As a result, convertible holders gain from an increase in the company s share price. Assume th a t a company issues 10-year, 8 per cent convertibles w ith a face value o f $10, th a t at m a tu rity can be converted to shares at a conversion ratio o f 1 -fo r-l. The holder w ill convert i f the price o f the company s shares on the note s m a tu rity date is above $10. For example, i f the share price at th a t tim e is $11, the holder w ill make a gain o f $1 on each security by converting, rather than allowing the securities to be redeemed. I t is usual fo r convertible holders to be able to participate in new issues, such as rights issues and bonus issues, in the same ratio as if the securities had already been converted. I t is also usual fo r issuers to give holders the o p p o rtu n ity to convert the notes into shares immediately, i f there is a takeover offer fo r the issuing company. Investors accept lower interest rates on convertibles than they do on notes or bonds because the option inherent in a convertible is valuable. The conversion price can be set at an am ount th a t is greater than the current m arket price o f the company s shares because the option to convert w ill have a value, provided that there is some chance th a t the share price may eventually exceed the conversion price. Convertibles typically have terms o f up to 10 years, which make them attractive to issuers requiring long-term, fixed-rate debt finance. Because convertibles are unsecured they can be issued by companies whose existing assets are pledged as security fo r other loans. As long-term securities, convertibles are a natural investm ent fo r life insurance companies and superannuation funds, which have long-term liabilities. Convertibles can be issued to existing shareholders or by a placement to in s titu tio n s . Placements o f convertible notes by listed companies are restricted under ASX lis tin g rule 7.1, the *15 per cent rule', which provides th a t issues o f E q uity securities* w ith o u t shareholder approval are restricted to no more than 15 per cent o f a company s issued ordinary shares in any 12-m onth period. Since convertible notes are convertible in to o rd in a ry shares, they are defined as equity securities by the ASX. In February 2014, 185 issues o f convertible debt were listed on the ASX.24 These securities had been issued by 136 companies. The convertible fram ew ork allows scope fo r innovative security design, and some issues by Australian companies have been undated a nd /or subordinated. Undated convertibles can usually be converted to ordinary shares at any tim e during a specified period, which may be several years. I f a holder does n ot exercise the rig h t o f conversion by the final date, the convertibles become irredeemable or ‘perpetual’ debt. Therefore, such notes w ill generally be treated as equity fo r the purpose o f calculating balance sheet ratios used in loan agreements, b u t can be designed so th a t they w ill be treated as debt fo r tax purposes.

Why do companies issue convertibles? Convertibles may appear to be ‘cheap’ debt— the interest rates on convertible debt securities are lower than fo r straight debt, while they also allow companies to issue shares at a prem ium , over the current price. For example, a company th a t could borrow at an interest rate o f 8 per cent and whose current share price is $9 may issue a 5-year convertible w ith a coupon interest rate o f 6 per cent and a face value o f $10, convertible in to ordinary shares on a 1 -fo r-l basis. A m om ents reflection should show that there m ust be som ething wrong w ith this suggested explanation. I f convertibles really offer cheap finance*, they should be m uch more popular than they are. In a com petitive m arket, convertibles should be issued on terms th a t are fa ir fo r both issuers and investors, rather than being cheap fo r issuers and hence under-rewarding fo r the investors. The interest rate on a convertible debt w ill be lower than on

24 Most of these securities were described as convertible notes. Some were described as convertible bonds or convertible debentures. Convertible preference shares were excluded from this count.

CONVERTIBLE security issued for a fixed term, usually at a fixed interest rate, with the additional feature that the holder has the right to convert the security to ordinary shares on a specified future date or dates. Convertibles issued in Australia are usually called convertible notes but may be called convertible bonds

SWEETENED DEBT convertible which is predominantly debt but has some equity­ like features; typically has a low probability of being converted to equity

DELAYED EQUITY convertible which is predominantly equity but has some debt-like features; typically has a high probability of being converted to equity

otherwise equivalent debt sim ply because i t also provides an option to convert the security in to shares. This o ptio n is valuable, so its value is reflected in the lenders requiring a lower interest rate than they would on ordinary debt. Traditionally, tw o types o f convertible have been distinguished: those described as sw eetened debt and those described as delayed equity.25 This d istin ction plays an im p o rta n t role in explaining why companies issue convertibles. Sweetened debt is a convertible th a t is p rim a rily debt b u t also has a small component o f equity-like features. Delayed equity is a convertible th a t is p rim a rily equity b u t early in its life it has the debt-like characteristic o f paying interest. I f a convertible note specifies a high (low) conversion price, then there is a low (high) probability th a t subsequently it w ill be converted to equity and accordingly the security is considered debt-like (equity-like). N ot surprisingly, convertible issues identified as sweetened debt tend to have debt-like characteristics, while convertible issues identified as delayed equity tend to have equity-like characteristics (D utordoir & Van de Gucht, 2009). The decision to issue a new security can be thought o f as a two-stage process. In the firs t stage, the company decides whether it prefers to issue equity or debt. Straight equity issues and straight debt issues b oth involve costs fo r the issuing company. On the one hand, a straight equity issue may be interpreted by investors as a sign th a t the company s managers wish to sell new shares because, based on th e ir inside knowledge, they believe th a t the shares are currently overvalued. Issuing new equity may therefore be seen by investors as a negative signal, thus causing the m arket price o f the shares to fall. Such a company has an incentive to issue debt. On the other hand, a straight debt issue may significantly increase the p ro ba bility o f financial distress, causing the cost o f debt to be p ro hib itive ly high. Such a company has an incentive to issue equity. In the second stage, the company m ust choose between a straig ht security issue and a convertible security issue. I f the company rejects a straight equity issue in the firs t stage, then in the second stage it m ust choose between issuing straight debt and issuing convertible debt o f the sweetened debt variety. I f the company rejects a straight debt issue in the firs t stage, then in the second stage i t m ust choose between issuing straight equity and issuing convertible debt o f the delayed equity variety. W hy m ig h t sweetened debt impose lower costs on an issuer than straight debt? Suppose th a t a heavily indebted company issues more straight debt. Potential lenders may fear that, after the issue has been made, the company may take on very risky projects— in an extreme case, these projects may even have negative net present values— th a t benefit shareholders at the expense o f lenders. The reason is th a t i f the project succeeds, the shareholders keep nearly all the benefits b ut i f i t fails, nearly all the costs w ill be borne by the lenders because the shareholders have little to lose in the firs t place.26 Because o f this fear, lenders would demand a very high interest rate. A debt-like convertible issue mitigates this fear because, even i f the company does act as feared, the convertible holders w ill also benefit through the equity component o f th e ir securities. The optim al choice may therefore be to issue a debt-like convertible rather than straight debt. W hy m ig h t delayed equity impose lower costs on an issuer than straight equity? Suppose a company s managers genuinely believe th a t the company has a b rig h t future b ut the high cost o f issuing debt has caused them to prefer an equity issue. As explained above, potential investors may in te rp re t a new equity issue as signalling th a t the company has poor prospects. An equity-like convertible may help resolve this problem. I f the company managers* belief proves correct, the company w ill do well, so the share price w ill increase, the investors w ill convert and new equity w ill be issued. So, the company s managers achieve th e ir objective, albeit w ith a delay. But issuing a convertible w ill also m itigate the investors, concern because, in the m edium term , they w ill receive returns in the form o f interest. The optim al choice may therefore be to issue an equity-like convertible rather than straight equity. Evidence suggests th a t both the sweetened debt and the delayed equity interpretations have explanatory power. In the US, i t appears th a t convertible issues tend to be o f the delayed equity variety, although both varieties have been identified empirically. US issuers o f convertibles tend to be small, highgrow th high-risk companies, w ith correspondingly high debt issuance costs (Lewis, Rogalski & Seward, 1999). In Western Europe, nearly all convertible issues tend to be o f the sweetened debt variety. European issuers o f convertibles tend to be very large, mature and financially sound companies w ith high debt capacity (D utordoir & Van de Gucht, 2009).

25 An alternative term for delayed equity is ^back-door equity*. 26 For further discussion, see Section 12.7.1.

C hapter ten S ources

of fin a n c e : debt

10.7.21 Preference shares A preference share is a security th a t gives the holder preference over ordinary shareholders w ith respect to the payment o f dividends, and usually w ith respect to capital repayment in the event o f the company s liquidation. As a result, dividends cannot be paid to ordinary shareholders u n til preference dividends have been paid. In many instances the dividend is fixed fo r the life o f the preference share. The dividends on preference shares may be franked— th a t is, may have tax advantages fo r the investor. Alternatively, the terms o f the issue may specify th a t all dividends w ill be unfranked. The franking o f dividends is discussed in Chapter 11. W ith respect to capital repayment, preference shareholders may be entitled to fu ll repayment o f the am ount subscribed before any payment is made to ordinary shareholders, b u t they w ill rank after lenders and other creditors. In legal terms, preference shares, as the name implies, are a fo rm o f equity. But preference shareholders rank between creditors and ordinary shareholders and, while fixed dividends resemble fixed interest, preference share dividends can be le ft unpaid w ith o u t risking liquidation o f the company. In financial terms, therefore, preference shares have characteristics o f b oth debt and equity and hence are often described as hybrids o f debt and equity. Both the Corporations A ct and the lis tin g rules o f the Australian Securities Exchange require th a t the rights o f preference shareholders be stated fu lly in the company s co nstitu tion . A company th a t issues preference shares m ust abide by the provisions specified in its co n stitu tio n w ith respect to those shares.

PREFERENCE SHARES shares that rank before ordinary shares for the payment of dividends and, usually, in the event of liquidation of the issuing company. They often provide an entitlement to a fixed dividend

Traditional preference shares The characteristics o f preference shares can differ widely between issuers b ut traditionally, preference shares were cumulative, irredeemable, non-participating and non-voting. The meaning o f each o f these characteristics is now discussed.

C um ulative A company th a t issues cumulative preference shares is required to pay any accumulated preference dividends before a d istrib u tio n may be made to ordinary shareholders. For example, i f a company that has issued 1 m illio n 10 per cent preference shares at an issue price o f $1 fails to pay preference dividends fo r 2 years, it has accumulated an obligation to pay $200 000 in preference dividends.

Irred eem ab le Like ordinary shares, irredeemable preference shares are intended to be perpetual and have no m atu rity date. Redeemable preference sh ares are issued w ith a specified m atu rity (redemption) date and are therefore similar to debt. Redeemable preference shares are discussed below (see Modern preference shares).

N o n -p a rticip atin g The dividends paid on a non-participating preference share are restricted to the fixed dividend rate specified at the tim e the security is issued. I f the company grants preference shareholders the rig h t to participate in the d istrib u tio n o f p ro fit available to ordinary shareholders, preference shareholders may be entitled to a retu rn in excess o f the stated preference dividend rate. For example, a company may issue participating preference shares, which allow the holders to share in any p ro fit earned in excess o f a certain amount. As a result, holders o f participating preference shares can obtain a dividend in excess o f the stated preference dividend rate i f the company has a very profitable year.

N on -vo tin g Holders o f non-voting preference shares are n o t e n title d to vote at general meetings o f shareholders unless particular circumstances have arisen. For example, preference shareholders may be e ntitle d to vote i f the payments o f preference dividends are in arrears or i f there is a proposal to w ind up the company. Ignoring the cumulative nature o f trad ition al preference shares, these securities are simply perpetuities paying a fixed am ount per period. Hence, the pricing o f a non-cum ulative irredeemable

REDEEMABLE PREFERENCE SHARE a preference share that has a finite life

B usiness finance

preference share is an application o f the form ula fo r the present value o f an ordinary perpetuity, which is shown in Equation 10.2.27

10.2 where

P = the price o f the preference share D = the fixed dividend am ount payable per period r = required yield per period For example, i f a preference share pays a dividend o f $4 once per year, has just paid a dividend, and the required yield is 12.5 per cent per annum, then the price is $4/0.125 = $32. A more realistic example is provided in Example 10.4.

E xample 6

^

10.4

T o o w o o m b a R e so u rce s Ltd h a s o n issu e a n o n -c u m u la tiv e ir r e d e e m a b le p re fe r e n c e s h a re w ith a p a r v a lu e o f $ 1 0 a n d a f ix e d d iv id e n d ra te o f 1 2 p e r c e n t p e r a n n u m . T h e c u r r e n t y ie ld is 8 . 5 p e r c e n t p e r a n n u m . P re fe re n c e d iv id e n d s a r e p a id tw ic e e a c h y e a r. A p r e fe re n c e d iv id e n d h a s just b e e n p a id . W h a t is th e p ric e ?

SOLUTION F o llo w in g s ta n d a r d c o n v e n tio n , b e c a u s e d iv id e n d s a r e p a id tw ic e e a c h y e a r, th e a n n u a l ra te s a re h a lv e d , so th e d iv id e n d ra te is 6 p e r c e n t p e r h a lf-y e a r a n d th e r e q u ire d y ie ld is 4 . 2 5 p e r c e n t p e r h a lf-y e a r. T h e a m o u n t o f e a c h d iv id e n d is th e re fo re 0 . 0 6 x $ 1 0 = $ 0 . 6 0 p e r s h a re . U s in g E q u a tio n 1 0 .2 ,

th e p r ic e is:

_ $0.60 _ 0.0425 =$14.12 T he p r ic e o f th e p re fe re n c e s h a re is $ 1 4 . 1 2 .

Some trad ition al preference shares are s till listed on the ASX. For example, Webster Ltd, which describes its e lf as Australia’s fo u rth oldest business, has on issue nearly 400 000 cumulative irredeemable preference shares w ith a fixed dividend rate o f 9 per cent per annum (Webster, 2013). However, in the past tw o decades, many different form s o f preference shares have been issued in Australia. Some o f these modern developments are discussed next.

Modern preference shares

CONVERTING PREFERENCE SHARE a preference share that will automatically convert into an ordinary share on a specified date unless it is redeemed by the issuer prior to that date

M ost modern preference shares may be redeemed in one way or another. In m ost cases, these securities were designed to achieve advantages from an income taxation and/or a regulatory p o in t o f view. Many o f the m ajor issuers have been banks. In this section we describe three o f these securities: converting preference shares, reset preference shares and step-up preference shares.28

C o n v e rtin g p re fe re n ce sh a re s A converting preference sh are offers a promised dividend p rio r to a specified conversion date, at which tim e the preference shares autom atically convert to ordinary shares in the company.29 Since the conversion to ordinary shares is automatic, these converting preference shares differ fro m convertible preference shares, where the holder can exercise a choice. The conversion date fo r converting preference shares is typically 5 to 10 years from the date o f issue, w ith the issuer often having the option to enforce 27 For a derivation, see Section 3.6.3. 28 Two others are convertible preference shares and exchangeable preference shares. At the option of the holder, a convertible preference share can be converted into ordinary shares. An exchangeable preference share can be exchanged for a security issued by a subsidiary or affiliate of the issuer. 29 For a detailed discussion of converting preference shares and factors motivating their use, see Davis (1996).

4^^

C hapter ten S ources

early conversion. The num ber o f ordinary shares received by the holder o f each converting preference share is known as the conversion ratio, which maybe fixed at the tim e the shares are issued. For example, each preference share may convert in to one ordinary share. Alternatively, the conversion ratio may be expressed in terms o f the price o f the ordinary shares at the tim e o f the conversion. This conversion mechanism ensures th a t the holder receives at least a m inim um num ber o f ordinary shares at the date o f conversion. This m inim um num ber o f ordinary shares is usually set so th a t the value o f the ordinary shares received is at least equal to the issue price o f the hybrid. The effect o f arranging the conversion in this way is shown in Example 10.5.

E xample

of f in a n c e : debt

CONVERSION RATIO relationship that determines how many ordinary shares will be received in exchange for each converting security when the conversion occurs

10.5

In O c to b e r 2 0 1 4 , A B C Ltd is s u e d c o n v e r tin g p r e fe re n c e s h a re s w ith a fa c e v a lu e o f $ 2 0 w h ic h c o n v e rt to o r d in a r y s h a re s o n 3 0 O c to b e r 2 0 1 8 . A t th e d a te o f th e issu e, th e m a rk e t p r ic e o f A B C

6

o r d in a r y s h a re s w a s $ 7 . 5 0 . T h e te rm s o f th e issu e p r o v id e th a t th e c o n v e rs io n r a t io w ill b e d e te rm in e d b y d iv id in g $ 2 0 b y : a)

a n a m o u n t e q u a l to th e p r ic e o f A B C 's o r d in a r y s h a re s o n 3 0 O c to b e r 2 0 1 8 ; less 1 0 p e r c e n t; o r

b)

$20, w h ic h e v e r y ie ld s th e g r e a te r n u m b e r o f s h a re s . W h a t is th e c o n v e rs io n r a t io a n d th e v a lu e o f th e o r d in a r y s h a re s re c e iv e d in e x c h a n g e f o r e a c h

c o n v e rtin g p re fe re n c e s h a re , if th e o r d in a r y s h a re p r ic e o n 3 0 O c to b e r 2 0 1 8 is: i)

$ 8 .2 3

ii)

$ 1 7 .7 8

iii) $ 2 2 . 2 2 iv) $ 2 5 ?

SOLUTION i)

The a m o u n t s p e c ifie d in (a) a b o v e is e q u a l to $ 8 . 2 3 x 0 . 9 = $ 7 , 4 0 7 , so th e c o n v e rs io n r a t io w ill

ii)

The a m o u n t s p e c ifie d in (a) a b o v e is e q u a l to $ 1 7 . 7 8 x 0 . 9 = $ 1 6 , so th e c o n v e rs io n r a t io w ill b e

b e $ 2 0 / $ 7 . 4 0 7 = 2 . 7 . T h e v a lu e o f th e o r d in a r y s h a re s r e c e iv e d is 2 . 7 x $ 8 . 2 3 = $ 2 2 . 2 2 .

$ 2 0 / $ 1 6 = 1 . 2 5 . T h e v a lu e o f th e o r d in a r y s h a re s re c e iv e d is 1 . 2 5 x $ 1 7 . 7 8 = $ 2 2 . 2 2 . iii) The a m o u n t s p e c ifie d in (a) a b o v e is e q u a l to $ 2 2 . 2 2 x 0 . 9 = $ 2 0 . In th is c a s e , b o th (a) a n d (b) g iv e th e s a m e re s u lt— a c o n v e r s io n r a t io o f 1. T h e re fo re , th e v a lu e o f th e o r d in a r y s h a re s re c e iv e d is a g a in $ 2 2 . 2 2 . iv) S in c e th e o r d in a r y s h a re p r ic e is g r e a te r th a n $ 2 2 . 2 2 , (b) w ill g iv e a h ig h e r c o n v e rs io n r a tio , w h ic h w ill a g a in b e e q u a l to 1. T h e re fo re , th e v a lu e o f th e o r d in a r y s h a re s re c e iv e d is $ 2 5 . In s u m m a ry , th e resu lts s h o w th a t fo r a n y o r d in a r y s h a re p r ic e u p to $ 2 2 . 2 2 , e a c h p re fe re n c e s h a re w ill c o n v e r t to o r d in a r y s h a re s w orth $ 2 2 . 2 2 . G iv e n th e o r d in a r y s h a re p r ic e a t th e tim e o f th e issue ( $ 7 .5 0 ) , th is is b y f a r th e m o st lik e ly o u tc o m e . A lte rn a tiv e ly , if th e o r d in a r y s h a re p r ic e is g r e a te r th a n $ 2 2 . 2 2 , e a c h p re fe re n c e s h a re w ill c o n v e rt to o n e o r d in a r y s h a re w o r th , p e rh a p s , $ 2 5 . T h e re fo re , th e h o ld e r o f e a c h p r e fe re n c e s h a re is a s s u re d o f r e c e iv in g o r d in a r y s h a re s , w o r th a t least $ 2 2 . 2 2 a t th e tim e o f c o n v e rs io n . W h ile it is p o s s ib le th a t th e s h a re s re c e iv e d w ill b e w o r th m ore than $ 2 2 .2 2 , th e p r o b a b ilit y o f th is o u tc o m e is v e r y lo w .

R eset p re fe ren ce sh a re s Several companies, including banks and other financial institutions, have issued reset preference sh ares that were, at the time, classified as equity. Reset preference shares have no fixed repayment date and an in itia l dividend entitlem ent th a t may be a fixed rate or i t may be specified as a margin over a benchmark rate such as the 90-day bank b ill swap rate. The in itia l dividend applies fo r a specified period, typically 5 years. A t the end o f th a t period, the shares are usually re-marketed, w ith possible outcomes generally including redemption, conversion to ordinary shares or the setting o f a new dividend rate. In summary, reset preference shares provide issuers w ith a debt-like, essentially fixed-cost source o f funds fo r several years. I f they are n ot redeemed or converted to ordinary shares at the reset date, the reset mechanism should ensure th a t the subsequent dividend rate is in line w ith current interest rates.

RESET PREFERENCE SHARE a preference share where the dividend rate can be varied at specified intervals

4 ^^

Under International Financial Reporting Standards (IFRS), which were adopted in Australia in 2005, reset preference shares th a t had been classified as equity were reclassified as debt. This change was followed by an increase in the popularity o f perpetual step-up preference shares, which, under IFRS, can be classified as equity in a company s statement o f financial position.

S te p -u p p re fe ren ce sh a re s STEP-UP PREFERENCE SHARE a preference share where the dividend rate is reset at a higher rate on a specified date unless the securities have been re-marketed, redeemed or converted

The name used to id e n tify issues o f step-up preference sh ares (SPSs) w ill differ between issuers, b ut most issues have essentially the same m ain features. SPSs have no fixed repayment date and pay distributions based on a floating rate, usually set at a m argin over a benchmark interest rate u n til a specified step-up date. When th a t date is reached, the issuer has the rig h t to choose between tw o or more alternatives. These can include: • • •

re-m arketing the securities to establish a new m argin and to adjust certain other term s o f the securities redeeming the securities at face value converting the securities in to ordinary shares.

Following the step-up date, i f the securities have n ot been successfully re-marketed, redeemed or converted, the d istrib u tio n w ill be automatically increased (stepped up) to a higher margin. SPSs rank before ordinary shares, b ut after other preference shares fo r the payment o f d istributions and for payments in a w inding up o f the issuer.

Classification as debt or equity For tax and accounting purposes it is usually necessary to classify each financial instrum ent as either debt or equity. Traditionally, this classification has been based on the security s legal form . However, since 2001, Australian legislation has required th a t fo r tax purposes, a set o f detailed objective tests m ust be applied at the tim e a security is issued to determine whether it should be classified as either debt or equity. These tests are based on the economic substance o f the rights and obligations o f the parties rather than their legal form. Essentially, an interest in a company th a t provides contingent returns*— th a t is, where the returns depend on the economic performance o f the company— w ill generally be treated as equity fo r tax purposes, whereas an interest th a t provides ‘non-contingent returns’ w ill generally be treated as debt, provided th a t the value o f the returns is at least equal to the issue price. Under these rules, preference shares may be either debt or equity depending on th e ir individual characteristics. For example, preference shares th a t are redeemable at the issue price w ill be classified as debt, whereas perpetual non-cumulative preference shares w ill be classified as equity because the issuer is n o t required to repay the capital invested and payment o f dividends is contingent on the solvency o f the issuer. Similarly, converting preference shares w ill generally be considered as equity before conversion b ut i f the contingent component o f the returns is negligible they may be considered as debt. I f a p articular preference share is classified as debt, the ‘dividends’ paid to holders w ill be treated in the same way as interest payments fo r tax purposes. Therefore, the payments w ill be deductible fo r the issuer and fu lly taxable fo r the investor. Conversely, i f the share is classified as equity, the dividends w ill, like dividends on ordinary shares, be non-deductible b ut can be franked, in which case they w ill provide tax credits th a t can be used by resident shareholders.

W h y do companies issue preference shares? When the properties o f preference shares are compared w ith those o f ordinary shares and debt, three advantages can be identified.30 First, like debt, preference shares can be non-voting, so issuing preference shares allows a company to raise capital w ith o u t affecting the control o f ordinary shareholders. Second, unlike lenders, preference shareholders cannot force a company in to liquidation, so the advantage is that issuing preference shares does n ot cause the same increase in the risk o f corporate failure th a t would occur w ith greater borrowing. Third, some types o f preference shares are easier to value than ordinary shares because they usually pay a fixed dividend th a t is readily observable. Thus, new investors who are not well inform ed about a company s financial situation and its prospects may be prepared to buy preference shares even though they would be reluctant to buy ordinary shares issued by the same company. 30 The three advantages of preference shares outlined here are discussed in more detail in Baskin and Miranti (1997). In addition to these advantages, the tax treatment of preference shares can also be a significant factor.

4^^

C hapter ten S ources

of f in a n c e : debt

In th is c h a p te r, w e

c o m m e rc ia l p a p e r, th e p ro m is e is m a d e o n ly b y th e

c o n s id e r e d th e s o u rc e s o f d e b t

fin a n c e . T h e re a r e m a n y ty p e s o f d e b t, in c lu d in g lo a n s ,

b o r r o w e r , w h ile in a b ill o f e x c h a n g e th e re is a ls o a n

w h ic h a re n o n -m a rk e ta b le , a n d d e b t s e c u ritie s , w h ic h

a c c e p to r, w h o in th e u su a l c a s e re p a y s th e d e b t o n

te m p o ra ry

b e h a lf o f th e b o r r o w e r . B oth ty p e s o f s e c u rity c a n b e

tra n s fe r o f fu n d s w h ic h m u st b e r e p a id b y th e b o r r o w e r .

tr a d e d in s e c o n d a r y m a rk e ts . In th e se m a rk e ts , it is

•

B a n ks a n d o th e r f in a n c ia l in s titu tio n s o ffe r s e v e ra l

c o n v e n tio n a l f o r p a r tic ip a n ts to sell c o m m e r c ia l p a p e r

k in d s o f lo a n s . B a n ks o f f e r o v e rd ra fts , w h ic h

w ith o u t e n d o rs e m e n t b u t to sell b ills o f e x c h a n g e w ith

a re

m a rk e ta b le ,

b u t a ll ty p e s

a f le x ib le fo rm

o f f in a n c e

in v o lv e

in w h ic h

a

a re

e n d o rs e m e n t.

th e b o r r o w e r

issu e d

o f d e b t fu n d in g th a t is r e q u ire d fro m tim e to tim e .

b ill o f e x c h a n g e m a y b e issu e d a s p a r t o f a n o n g o in g

O th e r,

a rr a n g e m e n t k n o w n a s a b ill fa c ility .

m o re s p e c ia lis e d

fo rm s o f fin a n c e

in c lu d e

d e b to r fin a n c e , w h ic h uses a c o m p a n y ’s a c c o u n ts r e c e iv a b le as a b a s is fo r s h o rt-te rm in v e n to r y

lo a n s

and

b r id g in g

•

fin a n c e .

C o m p a n ie s c a n a ls o issu e lo n g -te rm d e b t s e c u ritie s , in c lu d in g d e b e n tu re s , u n s e c u re d n o te s a n d c o r p o r a te

f u n d in g , a n d B a n ks,

bonds.

P u b lic

issues

of

th e se

s e c u ritie s

a re

a

fin a n c ia l

r e la tiv e ly m in o r s o u rc e o f fin a n c e in th e A u s tr a lia n

in s titu tio n s a re o fte n in v o lv e d in o ffe r in g th e se fo rm s

m a rk e t, a n d c o m p a n ie s th a t re q u ire lo n g -te rm fix e d -

fin a n c e

c o m p a n ie s

and

o th e r

n o n -b a n k

ra te d e b t o fte n issu e s e c u ritie s in o ffs h o re m a rk e ts .

o f fin a n c e . D e b t w ith a te rm to m a tu rity o f m o re th a n 1 2 m o n th s is c la s s ifie d a s lo n g te rm . banks a n d

o th e r f in a n c ia l

Loan s fro m

in te r m e d ia r ie s

a re

•

P ro je c t fin a n c e is im p o r ta n t in th e A u s tr a lia n m a rk e t a n d it a llo w s la r g e n a tu ra l re s o u rc e a n d in fra s tru c tu re

th e

m o s t im p o r ta n t ty p e s o f lo n g -te rm d e b t fin a n c e fo r

p ro je c ts to b e fin a n c e d w ith a h ig h p r o p o r tio n o f

A u s tra lia n c o m p a n ie s . B a n k s p r o v id e v a r ia b le - r a te

d e b t. •

a n d fix e d -ra te te rm lo a n s . •

C o m m e r c ia l p a p e r is u s u a lly

u n d e r a p r o g r a m th a t m a y b e u n d e r w r itte n , a n d a

o b ta in s , a n d is c h a r g e d in te re s t o n , o n ly th e le v e l

C H A P T E R TENT R E V I W W

SUMMARY

A u s tr a lia n as

c o m p a n ie s c o n v e r tib le

a ls o n o te s

issu e h y b r id

such

C o m m e rc ia l p a p e r a n d b ills o f e x c h a n g e a r e s h o rt­

p r e fe re n c e

te rm d e b t s e c u ritie s . B oth ty p e s o f s e c u rity p ro m is e

s e c u ritie s is th a t th e y h a v e fe a tu re s o f b o th d e b t a n d

th e p a y m e n t o f a fix e d sum o n a s ta te d fu tu re d a te

e q u ity a n d

a n d a re s o ld o n a s im p le in te re s t b a s is . In th e c a s e o f

sh a re s in th e fu tu re .

s h a re s .

The

and

s e c u ritie s

A c o m p a n y c a n ra is e fu n d s b y is s u in g d e b t s e c u ritie s .

m a in

v a r io u s

ty p e s

fe a tu re

of

of

th e se

in s o m e c a s e s m a y b e c o m e o r d in a r y

KEY TERMS a c c e p to r (o r d ra w e e ) a t c a ll

292

282

b a n k b ill (o r b a n k a c c e p te d b ill) b ill a c c e p ta n c e fa c ility b ill d is c o u n t fa c ility b ill o f e x c h a n g e bond

E u ro b o n d fa c to r in g

c o n v e rs io n r a tio c o n v e rtib le

fin a n c ia l distre ss

279

279

flo o r - p la n ( o r w h o le s a le ) fin a n c e

303

c o u p o n p a y m e n ts

fo re ig n b o n d

306

in d ic a to r ra te

c re d it fo n c ie r lo a n

in te rm e d ia tio n 283

d e b to r fin a n c e w ith o u t re c o u rs e

283

m o r tg a g e

304

283

280

n o n -b a n k b ill o v e r d r a ft lim it

277

278

276

in v o ic e d is c o u n tin g

283

d e b to r fin a n c e w ith re c o u rs e

294

282

in te rb a n k c a sh ra te

286

295

284

300

fu lly d r a w n b ill fa c ility

290

277

d e la y e d e q u ity

290 283

fin a n c ia l ris k

307

c o n v e rtin g p re fe re n c e sh a re

d e b to r fin a n c e

290

292

300

fa c e v a lu e 284

276

292

e n d o rs e m e n t

c o m m e rc ia l p a p e r ( o r p ro m is s o ry n o te )

d e fa u lt

290

d ra w e r

294

294

298

d e b e n tu re

292

d is c o u n te r (o f c o m m e rc ia l p a p e r) d is in te r m e d ia tio n

293

292

b r id g in g fin a n c e

covenant

d is c o u n te r (o f a b ill o f e x c h a n g e )

293 282

p re fe re n c e sh a re s

305

309

B usiness finance

p r in c ip a l

277

se c u ritie s

re d e e m a b le p re fe re n c e s h a re re d is c o u n tin g

305

292

rese t p re fe re n c e s h a re

276

s te p -u p p re fe re n c e s h a re s u b o rd in a te d d e b t

307

re v o lv in g c re d it b ill fa c ility

294

s e c o n d a ry m a rk e t tra n s a c tio n

289

308

279

sw e e te n e d d e b t

304

s y n d ic a te d lo a n

287

u n s u b o rd in a te d d e b t

279

SELF-TEST PROBLEMS 1

W h a t is th e p r ic e o f a 1 8 0 - d a y b ill o f e x c h a n g e , w ith a fa c e v a lu e o f $ 5 0 0 0 0 0 , if th e y ie ld is 5 .5 0

2

pe r cent pe r annum ?

If th e p u rc h a s e r in th e p re v io u s p ro b le m sells th e b ill 6 0 d a y s la te r, a t w h ic h tim e it is p r ic e d to y ie ld 5 . 3 0 p e r c e n t p e r a n n u m , w h a t e ffe c tiv e a n n u a l in te re s t ra te h a s b e e n e a rn e d ?

Solutions to self-test problems are available in Appendix B.

tu

QUESTIONS

1

[L O 1] G o to th e w e b s ite o f th e R e se rve B a n k o f A u s tr a lia (w w w . r b a . g o v . a u ), fin d s ta tis tic a l ta b le s D 4 a n d

2

[L O 2 ]

D 8 a n d use th e m to u p d a te T a b le 1 0 . 1 . W h a t in fe re n c e s d o y o u d r a w fro m th e u p d a te d ta b le ?

A debt contract w ill always include specifications about cosh flows. O u t lin e th e fo rm s th a t th e se

s p e c ific a tio n s m a y ta k e . Id e n tify th e n a tu re o f o th e r s p e c ific a tio n s u s u a lly in c lu d e d in a d e b t c o n tra c t. 3

[L O 2 ] D is tin g u is h b e tw e e n : a)

s e c u re d d e b t a n d u n s e c u re d d e b t

b)

s u b o rd in a te d d e b t a n d u n s u b o rd in a te d d e b t

c)

d ir e c t a n d in d ir e c t d e b t fin a n c e .

The financial risk associated with borrowing involves two separate effects. O u tlin e th e s e e ffe c ts .

4

[L O 2

5

[L O 2 ] Lenders usually have little or no control over o company's operations but they have considerable potential control. E x p la in .

6

[L O 2 】 T he fo rm s o f s e c u rity a v a ila b le to c o m m e r c ia l le n d e rs in c lu d e a fix e d c h a r g e , a f lo a t in g c h a r g e a n d a n e g a tiv e p le d g e . W h a t a r e th e m a in s im ila r itie s b e tw e e n th e se th re e fo rm s o f s e c u rity ? W h a t a r e th e m a in d iffe re n c e s b e tw e e n th e m ?

7 8

[L O 3 ] D iscu ss th e fa c to rs th a t a ffe c t th e te rm s o f a b a n k o v e r d r a ft n e g o tia te d b y a b o r r o w e r . [L O 3 】 A

bank overdraft provides a company with a flexible source o f funds. D iscu ss th e s ig n ific a n c e o f th is

f le x ib ilit y fo r th e f in a n c ia l m a n a g e r a n d th e d iffic u ltie s it m a y c a u s e fo r th e b a n k . 9

[L O 3 ]

〇n /y

s m a // c o m p a n /e s e v e r n e e d b r / d g / n g f/n a n c e . D o y o u th in k th is s ta te m e n t is lik e ly to b e tru e o r

u n tru e ? W h y ? 10

[L O 3 ] D e s c rib e th e m a jo r ty p e s o f b a n k le n d in g o th e r th a n b a n k o v e r d r a ft.

11

[L 0 3 ,4

12

[L O 4 ] D is tin g u is h b e tw e e n in v o ic e d is c o u n tin g a n d f a c to r in g .

13

[L O 4 】D is tin g u is h b e tw e e n 'w it h re c o u rs e d e b t o r f in a n c e ’ a n d 'w it h o u t re c o u rs e d e b to r fin a n c e ’ .

14

[L 0 3 , 5 ] a)

】F ro m

th e v ie w p o in t o f th e b o r r o w e r , c o m p a r e a n d c o n tra s t d e b t o r f in a n c e a n d a b a n k o v e r d r a ft.

S e le c t o n e o f th e fo u r m a jo r A u s tra lia n b a n k s ( A N Z , C B A , N A B o r W e s tp a c ) a n d , fro m th e b a n k ’s w e b s ite , id e n tify th e ty p e s o f b u sin e ss lo a n s o ffe re d b y th e b a n k . R e co rd th e c u rre n t in te re s t ra te s o n the se bu sin ess lo a n s a n d o n o v e rd ra fts o ffe re d b y th e sa m e b a n k . E x p la in th e d iffe re n c e s b e tw e e n th e se ra te s,

b)

In J a n u a ry 2 0 0 8 , th e n F e d e ra l T re a s u re r W a y n e S w a n c ritic is e d a d e c is io n b y th e A N Z b a n k to lift in te re st ra te s o n v a r ia b le - r a te m o rtg a g e s b y 0 . 2 p e r c e n t. T he T re a s u re r s a id : ;W e b e lie v e th e rise is e x c e s s iv e , a n d

310

C hapter ten S ources

of f in a n c e : debt

th e fa llo u t fro m th e US s u b -p rim e [m o r tg a g e ] c ris is '. W h a t a s p e c ts o f th e ra te in c re a s e a n n o u n c e d b y th e A N Z b a n k w e r e u n u s u a l? E v a lu a te th e re a s o n s p u t f o r w a r d b y th e A N Z to ju s tify th e ra te in c re a s e . 15

[LO 5 ] W h a t a r e th e m a in te rm s o f th e t y p ic a l m o r tg a g e a g re e m e n t?

16

[L 0 5 ]

Voriable-rate term loons hove much greater flexibility than fixed-rote term loons. E x p la in .

17

[L O 5 ]

Bonk loons provide much greater flexibility than borrowing by issuing debt securities. D iscuss.

18

[LO 5 ] D e fin e a m o r tg a g e lo a n . W h a t a r e th e s im ila ritie s b e tw e e n a d e b e n tu r e a n d a m o r tg a g e lo a n ? H o w d o th e y d iffe r?

19

[LO 6 】W h a t a r e th e m a in d iffe re n c e s b e tw e e n s h o rt-te rm a n d lo n g -te rm d e b t s e c u ritie s ?

20

[ L 0 7 ] D e s c rib e th e m a in fe a tu re s o f c o m m e r c ia l p a p e r. W h y d o issues o f c o m m e r c ia l p a p e r g e n e r a lly

21

[L O 7, 8 ] H o w d o e s c o m m e r c ia l p a p e r d if f e r fro m a b ill o f e x c h a n g e ?

22

[L O 7, 8

in v o lv e la rg e -s c a le b o r r o w in g ?

F rom th e v ie w p o in t o f a p o te n tia l p u rc h a s e r, w h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f a

b a n k b ill c o m p a r e d w ith c o m m e r c ia l p a p e r ?

】W h a t

23

[L 0 7 , 8

24

[LO 8 ] D e s c rib e th e u s u a l ro le s o f th e d r a w e r , a c c e p to r a n d d is c o u n te r o f a b ill o f e x c h a n g e .

25

[LO 8 ] D is tin g u is h b e tw e e n b ill a c c e p ta n c e a n d b ill e n d o rs e m e n t.

26

[LO 8 】D is tin g u is h b e tw e e n a 'f u lly d r a w n b ill f a c ilit y ’ a n d a 'r e v o lv in g c r e d it b ill f a c ilit y ’ .

27

a r e th e a d v a n ta g e s o f is s u in g c o m m e r c ia l p a p e r ra th e r th a n b ills o f e x c h a n g e ?

[LO 8 ] In g rid d e p o s its $ 4 0 0 0 0 w ith a fu n d th a t in ve sts m a in ly in b a n k b ills a n d c o m m e r c ia l p a p e r. T h e n e x t d a y th e R e se rve B a n k o f A u s tr a lia a n n o u n c e s a n in c re a s e in th e c a s h ra te . T h re e d a y s la te r In g rid w ith d r a w s h e r d e p o s it a n d is s tu n n e d to fin d th a t she h a s lo s t m o n e y . I n te r e s t ra te s h a v e g o n e u p ! H o w c a n I h a v e lo s t m o n e y ? ' E n lig h te n her.

28

[ L 0 9 ] D iscu ss th e te rm 's e c u r ity 7 a s it re la te s to th e d iffe re n c e b e tw e e n d e b e n tu re s a n d u n s e c u re d n o te s .

29

[ L 0 9 ] W h a t a r e th e fu n c tio n s o f th e tru s te e a n d th e tru s t d e e d in a d e b e n tu re issue?

30

[ L 0 9 ] C o m m e n ta to rs h a v e s u g g e s te d th a t it w o u ld b e d e s ir a b le to e n c o u r a g e th e g r o w th o f th e r e ta il c o r p o r a te b o n d m a rk e t in A u s tr a lia . W h a t step s d o y o u th in k m ig h t b e u s e fu l in a c h ie v in g th is o b je c tiv e ?

31

[LO 1 0 ] O u tlin e th e m a in fe a tu re s o f p r o je c t fin a n c e . W h a t d is tin g u is h e s p r o je c t f in a n c e fro m o th e r ty p e s o f lo n g -te rm fin a n c e ? E x p la in w h y /c o m p le tio n , is o f c r itic a l im p o r ta n c e to th e p r o je c t s p o n s o rs a n d th e le n d e rs .

32

[LO ll]

It h a s b e e n s u g g e s te d th a t p r e fe re n c e s h a re s o ffe r a d v a n ta g e s o v e r o r d in a r y s h a re s a n d b o n d s in

th re e a re a s : (a) th e c o n tro l o f th e o r ig in a l s h a re h o ld e rs ; (b) th e a b ilit y o f r e la tiv e ly u n in fo r m e d in v e s to rs to v a lu e th e s e c u ritie s ; a n d (c) th e b a n k r u p tc y ris k o f th e c o m p a n y (B a skin & M ir a n t i 1 9 9 7 , p p . 1 5 1 - 7 ) . C o n s id e r e a c h o f the se th re e a re a s in tu rn a n d c o m p a r e th e issue o f n e w p re fe re n c e sh a re s w ith the a lte rn a tiv e s o f is s u in g n e w o r d in a r y sh a re s o r is s u in g n e w b o n d s .

In financial terms, traditional preference shores were very similar to debt but modern forms o f preference shares have many more equity-like features. D iscuss.

33

[LO ll]

34

[LO 1 1 J D is tin g u is h b e tw e e n s w e e te n e d d e b t a n d d e la y e d e q u ity .

35

[L O 1 1 ] O u t lin e th e tw o -s ta g e p r o c e d u r e th a t m a y b e u se d to d e c id e w h e th e r to issu e s tr a ig h t d e b t, s tr a ig h t e q u ity o r a c o n v e r tib le .

36

[LO 1 1 ] H y b r id s e c u ritie s m a y b e c la s s ifie d a s e ith e r d e b t o r e q u ity f o r ta x p u rp o s e s . W h a t is th e m a in c r ite r io n f o r th is c la s s ific a tio n ?

37

[LO 1 1 ] Id e n tify th e m a in d iffe re n c e s b e tw e e n a re se t p r e fe re n c e s h a re a n d a s te p -u p p r e fe re n c e s h a re . W h y h a v e re s e t p r e fe re n c e sh a re s b e e n la r g e ly r e p la c e d b y s te p -u p p r e fe re n c e s h a re s in A u s tra lia ?

PROBLEMS 1

Fixed-rate term loans [LO 5] S e a le x Ltd h a s a fix e d -ra te te rm lo a n o f $ 2 m illio n a t a n in te re s t ra te o f 8 . 7 5 p e r c e n t p e r a n n u m . T he c o m p a n y h a s e a rn in g s b e fo re in te re s t a n d ta x (EBIT) o f $ 1 . 4 m illio n p e r a n n u m . A c o v e n a n t in th e lo a n a g re e m e n t s p e c ifie s th a t EBIT m ust b e a t le a s t 3 . 5 tim e s g r e a te r th a n th e to ta l in te re s t p a id o n th e c o m p a n y 's d e b t. T he d ire c to rs o f S e a le x a re p la n n in g to ra is e a d d itio n a l d e b t b y b o r r o w in g a t a v a r ia b le ra te , in it ia lly 7 . 5 p e r c e n t p e r a n n u m . W h a t is th e m a x im u m a m o u n t th a t S e a le x c a n b o r r o w o n th e se te rm s?

CHAPTER TEN REVIEW

o v e r a n d a b o v e a n y th in g th a t c o u ld b e ju s tifie d b y th e in c re a s e in costs f lo w in g to th o se o r g a n is a tio n s fro m

Calculating annual repayments and interest rates [LO 5 】 C o m in c o Ltd n e e d s to b o r r o w a p p r o x im a te ly $ 2 m illio n to fin a n c e th e p u rc h a s e o f a g e m -s o rtin g m a c h in e fo r its d ia m o n d m in e . Its fin a n c ia l m a n a g e r is c o n s id e rin g th e f o llo w in g a lte rn a tiv e s : i)

C o m in c o 's b a n k w ill le n d $ 2 m illio n , r e p a y a b le in fo u r a n n u a l p a y m e n ts a t a n in te re s t ra te o f 8 . 5 p e r c e n t p ^ r annum .

ii)

T he e q u ip m e n t s u p p lie r ha s o ffe re d to fin a n c e th e g e m s o rte r w ith a n in itia l p a y m e n t o f $ 5 0 0 0 0 0 , fo llo w e d b y a n n u a l in s ta lm e n ts o f $ 4 6 0 0 0 0 a t th e e n d o f e a c h o f th e n e x t 4 y e a rs .

iii) A fin a n c e b r o k e r c a n a r r a n g e a $ 2 m illio n lo a n r e p a y a b le in a lu m p-sum p a y m e n t o f $ 2 7 6 1 5 1 3 in 4 y e a rs ' tim e . The b ro k e r w ill c h a r g e a n u p -fro n t fe e o f 1 p e r c e n t o f th e lo a n p r in c ip a l. a)

W h a t a re th e a n n u a l re p a y m e n ts o n th e b a n k lo a n ?

b)

W h a t is th e in te re s t ra te ( ig n o rin g th e u p -fro n t fee) o n th e fin a n c e b ro k e r's lo a n ?

c)

W h ic h o f th e th re e a lte rn a tiv e s p ro v id e s th e lo w e s t c o s t fin a n c e ?

Calculating price of commercial paper [LO 7] C a lc u la te th e p r ic e o f c o m m e rc ia l p a p e r w ith a fa c e v a lu e o f $1 m illio n a n d 1 8 0 d a y s to m a tu rity if th e y ie ld is 8 .9

pe r cent p e r annum .

Calculating yield on bill of exchange [LO 8] To ra is e $ 4 8 5 0 0 0 , a c o m p a n y d r a w s u p a b ill o f e x c h a n g e w ith a fa c e v a lu e o f $ 5 0 0 0 0 0 , p a y a b le in 1 8 0 d a y s . W h a t is th e im p lic it s im p le a n n u a l in te re s t ra te (y ie ld ) o n th e b ill? W h a t is th e im p lic it e ffe c tiv e a n n u a l in te re s t ra te o n th e b ill?

Calculating bill prices [LO 8] C a lc u la te th e b ill p ric e s n e e d e d to c o m p le te th e f o llo w in g ta b le . A s s u m e in e v e ry c a s e th a t th e fa c e v a lu e is $1 m illio n .

Yield = 5.1%

Yield = 5.2%

Yield = 5.3%

30 days 90 days 180 days

W h a t p a tte rn s a re th e re in th e ta b le ?

Bank bill prices and returns [LO 8] O n 8 M a r c h 2 0 1 4 , JDF Inve stm e nts Ltd p u rc h a s e d a b a n k b ill m a tu rin g o n 7 M a y 2 0 1 4 a t a n a n n u a l y ie ld o f 6 . 9 5 p e r c e n t p e r a n n u m . T he b ill h a d a fa c e v a lu e o f $ 1 m illio n . O n 2 3 M a r c h 2 0 1 4 , JDF s o ld th e b ill a t a y ie ld o f 6 . 8 0 p e r c e n t p e r a n n u m . C a lc u la te : a)

th e p u rc h a s e p r ic e p a id b y JDF

b)

th e s a le p r ic e re c e iv e d b y JDF

c)

th e d o lla r re tu rn e a rn e d b y JDF

d)

th e s im p le a n n u a l in te re s t ra te e a rn e d b y JDF

e)

th e e ffe c tiv e a n n u a l in te re s t ra te e a rn e d b y JDF.

Bank bill prices and returns [LO 8] A n in v e s to r b u y s a 9 0 - d a y b a n k b ill p r ic e d a t a y ie ld o f 1 2 . 5 5 p e r c e n t p e r a n n u m a n d sells it a w e e k la te r p ric e d a t a y ie ld o f 1 3 . 6 0 p e r c e n t p e r a n n u m . W h a t e ffe c tiv e a n n u a l in te re s t ra te h a s th e in v e s to r e a rn e d ? E x p la in y o u r resu lt.

Bank bill prices and returns [LO 8] A n in v e s to r b o u g h t a 9 0 - d a y b a n k b ill p r ic e d a t a y ie ld o f 7 . 4 5 p e r c e n t p e r a n n u m . T h re e w e e k s la te r, th e m a rk e t y ie ld o n th e b ill h a d fa lle n s lig h tly to 7 . 3 5 p e r c e n t p e r a n n u m . T he R B A th e n u n e x p e c te d ly a n n o u n c e d th a t it h a d re d u c e d th e ta r g e t c a s h ra te b y 0 . 5 p e r c e n t p e r a n n u m . A s a resu lt, sh o rt-te rm in te re s t ra te s a n d b ill y ie ld s r a p id ly a d ju s te d d o w n w a r d s a n d th e b ill's y ie ld fe ll to 7 . 0 5 p e r c e n t p e r a n n u m . T he in v e s to r then s o ld th e b ill. C a lc u la te th e e ffe c tiv e a n n u a l in te re s t ra te th e in v e s to r e a rn e d . W h a t e ffe c tiv e a n n u a l in te re s t ra te w o u ld th e in v e s to r h a v e e a rn e d if th e RBA h a d n o t a n n o u n c e d a n e w ta r g e t c a sh ra te ?

C hapter ten S ources

of f in a n c e : debt

a n d a fix e d d iv id e n d ra te o f 1 4 p e r c e n t p e r a n n u m . T he y ie ld is 9 . 8 p e r c e n t p e r a n n u m . P re fe re n c e d iv id e n d s a re p a id e v e ry 6 m o n th s. a)

W h a t is th e p r ic e if a p re fe re n c e d iv id e n d h a s just b e e n p a id ?

b)

H o w w o u ld y o u p ric e th e s h a re if th e m o st re c e n t p re fe re n c e d iv id e n d w a s p a id 2 m o n th s a g o ?

Converting preference shares [LO 11 ] XYZ Ltd c o n v e rtin g p re fe re n c e sh a re s h a v e a fa c e v a lu e o f $ 1 5 a n d a re d u e to c o n v e rt to o r d in a r y s h a re s on 31 J u ly 2 0 1 9 . E ach c o n v e rtin g p re fe re n c e sh a re w ill c o n v e rt to a n u m b e r o f o r d in a r y sh a re s th a t is d e te rm in e d b y d iv id in g $ 1 5 b y : i) ii)

a n a m o u n t e q u a l to th e p r ic e o f X Y Z o r d in a r y sh a re s o n 31 J u ly 2 0 1 9 , less 5 p e r ce n t; o r $15,

w h ic h e v e r y ie ld s th e g r e a te r n u m b e r o f o r d in a r y sh a re s. H o w m a n y o r d in a r y s h a re s w ill b e re c e iv e d b y th e h o ld e r o f o n e c o n v e rtin g p re fe re n c e s h a re if th e p r ic e o f a n X Y Z o r d in a r y s h a re is: a)

$5

b)

$ 7 .5 0

c)

$10

d)

$15

e)

$20?

CHAPTER TEN REVIEW

Pricing non-cumulative irredeemable preference shares [LO 11 ] T o w n s v ille T ra d e rs Ltd h a s o n issue a n o n -c u m u la tiv e irre d e e m a b le p re fe re n c e s h a re w ith a fa c e v a lu e o f $ 1 0

11 Analysis of conversion terms [LO 11 ] U s in g th e in fo rm a tio n in P ro b le m 1 0 , c a lc u la te th e v a lu e o f th e o r d in a r y sh a re s th a t w ill b e re c e iv e d o n c o n v e rs io n o f e a c h c o n v e rtin g p re fe re n c e s h a re in ca se s (a) to (e). B a se d o n y o u r results, s u g g e s t a n a lte rn a tiv e n a m e th a t d e s c rib e s th e n a tu re o f c o n v e rtin g p re fe re n c e sh a re s.

Ij REFERENCES

Australian Bureau of Statistics, Australian National Accounts, Financial Accounts, cat. no. 5 2 3 2 .0 , Table 27, September quarter 20 13 .

Cain, A. 'Factoring out the overdraft', Special report on small business cash flow, Australian Financial Review, 13 February 20 14 .

Australian Securities and Investments Commission, Debentures: Reform to Strengthen Regulation, Consultation Paper 199, February 20 1 3 .

Carew, E., Fast Money 4, Allen & Unwin, Sydney, 1998.

------- , Investing in Corporate Bonds?, O ctober 20 1 0 . Available at w w w .m o n e ysm a rt.g o v.a u /m e d ia /1 3 2 0 5 7 / investing-in-corporate-bonds.pdf. Australian Trade Commission, Data Alert, 2 4 January 2 0 1 3 . Baskin, J.B. & M iranti, P.J., A History of Corporate Finance, Cambridge University Press, 1997, pp. 1 5 1 -7 . Battellino, R., 'W h y do so many Australian borrowers issue bonds offshore?7, Reserve Bank of Australia Bulletin, December 2 0 0 2 , pp. 1 9 -2 4 . Black, S., Brassil, A. & Hack, M ., ’ Recent trends in Australian banks7 bond issuance7, Reserve Bonk of Australia Bulletin, March 20 10 , pp. 2 7 -3 3 .

Davis, K., 'Converting preference shares: an Australian capital structure innovation7, Accounting and Finance, November 1996, pp. 2 1 3 -2 8 . Debtor and Invoice Finance Association of Australia and N e w Zealand Inc., DIFA Update, December quarter 2 0 1 3 . Dutordoir, M . & Van de Gucht, L., 'W h y do Western European firms issue convertibles instead of straight debt or equity?', European Financial Management, June 20 09 , pp. 5 6 3 -8 3 . Fitzpatrick, P. & Hardaker, R., 'Finance company finance’，in R. Bruce, B. McKern, I. Pollard & M . Skully (eds), Handbook of Australian Corporate Finance, 5th edn7 Butterworths, Sydney, 1997. Hunt, B. & Terry, C .; Financial Institutions and Markets, 6th edn, Cengage, Australia, 2 0 1 1 .

-------, Kirkwood, J., Rai, A. & W illiam s, T., yA history of Australian corporate bonds', Research Discussion Paper No. 2 0 T2-09, Reserve Bank of Australia, December 20 1 2 .

Lewis, C .M ., Rogalski, RJ. & Seward, J.K., Is convertible debt a substitute for straight debt or for common equity ? ’， Financial Management, Autumn 1999, pp. 5 -2 7 .

Brown, A., Davies, M ., Fabbro, D. & Hanrick, T., 'Recent developments in banks' funding costs and lending rates ’， Reserve Bank of Australia Bulletin, M arch 2 0 1 0 , pp. 3 5 -4 4 .

Reserve Bank of Australia, Tables D2, D4, D7, D8, F I, F4 and F5, w w w .rba.gov.au.

Bruce, R., McKern, B., Pollard, I. & Skully, M . (eds), Handbook of Australian Corporate Finance, 5th edn, Butterworths, Sydney, 1997, Chapters 9, 13 and 14.

------- , 'The global financial environment', Financial Stability Review, September 2 0 1 0 , pp. 3 -1 4 . ------- , 'Central bank market operations', Bulletin, September 2 0 0 7 , pp. 1 9 -2 6 .

313

-------, 'Australian banks' global bond funding^ Bulletin, August 2 0 0 6 , pp. 1-6 .

Viney, C. & Phillips, P.; Financial Institutions, Instruments and Markets, 7th edn, M cG raw-H ill, Sydney, 2 0 1 2 .

-------, 'Australian financial markets', Bulletin, June 2 0 0 2 , pp.

Webster Ltd, Webster Ltd Annual Report 2012-13. Available at w w w .w ebsterltd.com .au/corporate/pdf/W ebster_Lim ited_ Annual_Report_2013.pdf.

6- 2 1 . Stock, K ."B illa b o n g ’s w ipeo ut—it wasn't just the board shorts', Bloomberg Businessweek, 18 July 2 0 1 3 . Available at www.businessweek.com /articles/201 3-07-1 8 / billabongs-wipeout-it-wasnt-just-the-board-shorts.

Yescombe, E.R., Principles of Project Finance, Academic Press, San Diego, 20 02 .

CHAPTER CONTENTS In tr o d u c t io n

316

Is p a y o u t p o lic y im p o r t a n t to

UJEI

s h a r e h o ld e r s ?

319

T r a n s a c tio n c o s ts a n d f lo t a t io n c o s ts

324

D iv id e n d s a n d ta x e s

325

A g e n c y c o s ts a n d c o r p o r a t e g o v e r n a n c e

335

B e h a v io u r a l fa c to r s a n d c a t e r in g t h e o r y

339

S h a re b u y b a c k s

339

D iv id e n d r e in v e s tm e n t p la n s a n d d iv id e n d

I n f o r m a tio n e ffe c ts a n d s ig n a llin g to in v e s to rs

e le c t io n s c h e m e s

346

P a y o u t p o lic y a n d c o m p a n y life c y c le

347

332

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

e x p la in w h y c a s h p a y m e n ts t o s h a r e h o ld e r s a r e im p o r t a n t a n d u n d e r s ta n d s o m e in s titu t io n a l fe a tu r e s o f d iv id e n d s a n d s h a r e b u y b a c k s

2

o u t lin e th e a r g u m e n t t h a t p a y o u t p o lic y is ir r e le v a n t t o s h a r e h o ld e r s 7 w e a lt h in a p e r fe c t c a p it a l m a r k e t w it h n o ta x e s

3

d e f in e th e fu ll p a y o u t p o lic y a n d e x p la in w h y it is im p o r t a n t t h a t c o m p a n ie s f o ll o w th is p o lic y

4

e x p la in h o w t r a n s a c t io n c o s ts a n d f lo t a t io n c o s ts m a y a f f e c t p a y o u t p o lic y

5

o u t lin e th e im p u t a t io n t a x s y s te m a n d e x p la in th e e ffe c ts o f im p u t a t io n a n d c a p it a l g a in s t a x o n re tu r n s to in v e s to rs

6

u n d e r s ta n d th e a r g u m e n t t h a t p a y o u t d e c is io n s m a y h a v e a r o le in p r o v id in g s ig n a ls to in v e s to rs

7

e x p la in th e w a y s in w h ic h a g e n c y c o s ts c a n b e r e la t e d to p a y o u t d e c is io n s

8

e x p la in b e h a v io u r a l f a c t o r s t h a t m a y a f f e c t p a y o u t p o lic y

9

u n d e r s ta n d th e n a tu r e o f s h a r e b u y b a c k s , d iv id e n d r e in v e s tm e n t p la n s a n d d iv id e n d e le c t io n s c h e m e s

10

e x p la in h o w p a y o u t p o lic y m a y c h a n g e a s a c o m p a n y m o v e s t h r o u g h its lif e c y c le .

a

B usiness finance

Introduction LEARNING OBJECTIVE 1 Explain why cash payments to shareholders are important and understand some institutional features of dividends and share buybacks

Many companies have never distributed any cash to shareholders, while others typically d istribute cash at least twice each year. Companies th a t d istribute cash to th e ir shareholders do so in two m ain ways: by the payment o f dividends and by repurchasing shares.1 Payout policy involves tw o fundam ental questions. First, a company s directors m ust decide how much cash, i f any, to pay to shareholders. Second, they must determ ine the form o f the payments— th a t is, should the payment be made as a dividend or through a share buyback? Alternatively, should the company pay dividends and repurchase shares?2 As discussed in Chapter 4, financial assets such as shares are valuable only because o f the benefits they provide in the form o f cash payouts. It is true that some companies have operated successfully fo r many years w ith o u t paying a dividend, while simultaneously th eir shareholders have experienced significant capital gains. The prim e example o f such a company is M icrosoft, which was founded in 1975, went public in 1986 and did n o t pay its first dividend u n til 2003. From 1986 to 2003, M icrosoft grew rapidly and its cash flows were retained to finance that growth. M icrosoft s firs t dividend was modest— 8 cents per share, followed by a dividend o f 16 cents per share in 2004, when it also announced plans to return up to $75 billion to investors through dividends and share repurchases, including $32 b illion paid as a special dividend o f $3 per share. Presumably, investors were w illing to hold the company s shares during the period 1986 to 2003 because they expected that eventually the company s growth would slow and it would start to return cash to investors through dividends and/or share repurchases. 'At the most basic level, investors supply capital to businesses only because they (or the people to whom they m ight sell th e ir securities) have a reasonable expectation o f eventually receiving payouts in one form or another* (De Angelo & De Angelo 2007, p. 12). Decisions on a company s payout policy should be consistent w ith the overall objective o f m axim ising shareholders’ wealth. However, payout decisions can involve several factors and the optim al policy may be fa r from obvious. For example, consider a profitable copper m ining company th a t has paid the same dividend each year fo r the last 5 years. Suppose th a t this year, the company s operating cash flow and p ro fit doubles because o f a large increase in the price o f copper. W hat payout decision w ill be best fo r shareholders? Should the extra cash be paid out, and i f so, should the company sim ply pay a larger dividend or should it repurchase shares? Should the company retain the extra cash and use i t to expand its exploration program? Should the extra cash be used firs t to repay debt w ith the dividend being increased only i f surplus cash remains after all existing loans have been repaid? These are only some o f the possibilities th a t may exist. This example shows th a t payout decisions are often related to other financial decisions. W hile, in practice, payout decisions should n ot be made in isolation, fo r the purpose o f analysing payout policy we need to isolate it from other financial decisions by holding constant both investm ent decisions and other financing decisions. In addition to determ ining the level and form o f payout, managers also need to consider issues such as the effects o f changing dividends and whether to adopt a dividend reinvestm ent plan. In Australia, companies th a t pay dividends usually make two dividend payments each year, so decisions on payouts need to be made frequently and a company s payout policy may need to be reviewed regularly. In this chapter we analyse payout policy and discuss the relevant empirical research. But firs t we describe briefly some in s titu tio n a l features o f dividends and share repurchases.

11.1.1 | Dividend declaration procedures Provided th a t the legal requirements and the exchange s listin g requirements are met, a company s dividend decisions are at the discretion o f its directors. In Australia, companies generally pay an interim dividend after the end o f the firs t h a lf o f the financial year and a final dividend after the company s Annual General Meeting. A company s Board o f Directors, when announcing a dividend, w ill specify a date, known as the ‘record date’，on which the company’s ‘books’ w ill dose fo r the purpose o f determ ining who is currently a shareholder, and hence entitled to receive the dividend. For shares listed on the Australian 1 2

4^^

See s. 6(1) of the Incom e T a x A s s e s s m e n t A c t 1 9 3 6 for a definition of what constitutes a dividend under the Act. Officially, the term share buyback is used in Australia while the term share (or stock) repurchase is more common in the US. In this chapter, the terms buyback and repurchase are used interchangeably.

C h a p te r

Securities Exchange (ASX), the rules o f the exchange specify an e x -d iv id e n d d a te , which is fo u r business days before the record date.3 Investors who purchase shares before the ex-dividend date buy the shares c u m -d ivid e n d and are entitled to receive the dividend. Those who purchase shares on or after the ex-dividend date are n o t e ntitled to receive the dividend.

Dividends are norm ally paid in cash, b u t many Australian companies have adopted dividend reinvestm ent plans th a t give shareholders the o ption o f using all or p art o f th e ir dividend to purchase additional shares in the company. These plans are discussed in Section 11.9. Dividends are sometimes given a designation such as special1to indicate th a t shareholders should n o t expect them to be repeated.

eueven

Payout

policy

EX-DIVIDEND DATE date on which a share begins trading ex-dividend. A share purchased ex-dividend does not include a right to the forthcoming dividend payment

CUM-DIVIDEND PERIOD period during which the purchaser of a share is qualified to receive a previously announced dividend. The cum-dividend period ends on the ex-dividend date

Historically, the Corporations A ct 2001 specified th a t a company s dividend may be paid only out o f profits, and m ust n ot be paid o ut o f capital.4 The purpose o f this restriction was to protect creditors by m aintaining a company s capital. Under amendments to the Corporations Act, which came in to effect on 28 June 2010, the profits test was replaced by new requirements th a t p ro h ib it a company from paying a dividend unless: • • •

the company s assets exceed its liabilities im m ediately before the dividend is declared and the excess is sufficient fo r the payment o f the dividend the payment o f the dividend is fa ir and reasonable to the company s shareholders as a whole the payment o f the dividend does n o t m aterially prejudice the company s a b ility to pay its creditors.

The new requirements are intended to focus on the solvency o f the company and mean th a t a company may be able to pay a dividend in the absence o f accounting profits. For example, a company w ith surplus cash may have recorded a net loss (in accounting terms) due to large non-cash expenses such as im pairm ent losses on property, plant and equipment. It could now pay a dividend provided the three requirements are met. Payments to shareholders may also be restricted by covenants in loan agreements. I f a company has additional classes o f shares such as preference shares, then any p rio rity rights to dividends m ust be observed. I f a share buyback causes a company to become insolvent, the directors may be personally liable for insolvent trading and the company s liquidator may seek a court order th a t the buyback transactions are void and the proceeds can be recovered from shareholders who sold. The im p u ta tio n ta x syste m allows companies to pay dividends th a t carry credits fo r income tax paid by the company. Such dividends are know n as fra n k e d d iv id e n d s and the tax credits can be used by resident shareholders to reduce th e ir income tax. I t is im p o rta n t to note th at, generally, the tax credits associated w ith franked dividends arise only from payment o f Australian company tax. New Zealand also operates an im p utatio n tax system and in 2003 the Australian and New Zealand im putation systems were extended to include companies resident in the other country. Companies th a t operate in both Australia and New Zealand (*trans-Tasman companies*) are now able to d istribu te both Australian and New Zealand tax credits to all shareholders. However, tax credits origin atin g in each country can be claimed only by residents o f th a t country. The operation o f the trans-Tasman im p utatio n rules is illustrated in Section 11.4.1. When a dividend is declared, the company m ust state the e xtent to w hich the dividend is franked. When a dividend is paid, th e company is required to provide each shareholder w ith a dividend statement. This statem ent shows the am ount o f the dividend and the date o f paym ent, the am ount o f any franked and unfranked parts o f the dividend and, i f the dividend is fu lly or p a rtia lly franked, 3

4

Many Australian companies choose a Friday as the record date, which means that the ex-dividend date will be the previous Monday. From the start of trading on the ex-dividend date to the close of trading on the record date there are in fact 5 days of trading. The trading period between the ex-dividend and record dates has been as long as 7 business days. It was reduced to 5 days following full adoption of electronic settlement and transfer procedures. See s. 254T, C o rp o ratio n s A c t 2 0 0 1 .

IMPUTATION TAX SYSTEM system under which investors in shares can use tax credits associated with franked dividends to offset their personal income tax. The system eliminates the double taxation inherent in the classical tax system

FRANKED DIVIDEND dividend paid out of Australian company profits on which company income tax has been paid and which carries a franking credit

B usiness finance

FRANKING CREDIT credit for Australian company tax paid, which, when distributed to shareholders, can be offset against their tax liability

WITHHOLDING TAX the tax deducted by a company from the dividend payable to a non-resident shareholder

TREASURY STOCK US term for a company’s own shares that have been repurchased and held rather than cancelled

the am ount o f the f r a n k i n g c r e d it . Where dividends are paid to non-residents, the company may be required to deduct w i t h h o l d i n g t a x , in w hich case the am ount o f any w ith h o ld in g tax deducted m ust also be shown. The im p utatio n system requires a franking account to be m aintained by each company. I f a company earns a pre-tax p ro fit o f $100 and pays company income tax o f $30, the credit to its franking account w ill be $30. W hen a franked dividend is paid, the franking account m ust be debited and the debit is equal to the franking credits attached to the dividend. Franked dividends received by resident companies are handled in the same way as dividends received by individuals and superannuation funds. Partnerships and trusts are n ot taxable entities and are therefore unable to use franking credits. However, any franking credits received by a partnership or tru s t can be passed on to the partners or beneficiaries, who can use them i f they are Australian residents.

W hile payment o f dividends is the most common way o f paying cash to shareholders, some countries allow companies to pay out cash by repurchasing or b u y in g back* th e ir own shares. The law may require th a t repurchased shares are cancelled or i t may allow the company to retain them as t r e a s u r y s to c k . In Australia, s. 259A o f the Corporations Act generally precludes a company from purchasing its own shares. However, exceptions to this general p ro hib itio n were introduced in 1989 and revised in 1995 to sim plify the procedures. Buybacks have since become routine fo r many companies. Five different types o f buybacks are specified in the legislation. Each type involves different legal form alities, but in general companies are able to repurchase up to 10 per cent o f th e ir ordinary shares in a 12-m onth period. This is often referred to as the 10/12 lim it. In each case, once the transfer o f ownership has been processed the shares m ust be cancelled. Further details o f the different types o f share buyback are as follows: a

Equal access buybacks. Offers are made to all ordinary shareholders to purchase the same percentage

o f the shares th a t they hold.5 The proposed buyback m ust be approved by shareholders passing an ordinary resolution only i f i t exceeds the 10/12 lim it, b Selective buybacks. In this case offers are made to only some o f the shareholders in a company. Because some shareholders could be disadvantaged, the procedural requirements are more stringent than fo r other types o f buyback. A selective buyback m ust be approved by shareholders either unanim ously or by a special resolution in which the selling shareholders and th e ir associates are unable to vote. C On-market buybacks. A listed company is able to buy back its shares in the ordinary course o f trading on the stock exchange. The Australian Securities and Investments Commission (ASIC) and the ASX m ust be n otified o f the proposed buyback, b u t shareholder approval via an ordinary resolution is required only i f the 10/12 lim it is exceeded. d Employee share scheme buybacks. A company may buy back shares held by or fo r employees who in itia lly acquired the shares through an employee share scheme. The procedural requirements are the same as fo r on-market buybacks. e Minimum holding buybacks. A listed company may buy back parcels o f shares th a t are smaller than a specified m inim um . No resolution is needed and the only legal requirem ent is th a t ASIC m ust be notified o f the cancellation o f the shares. Im portantly, the tax treatm ent depends on whether the buyback takes place on- or off-m arket. In the case o f an off-m arket buyback, the transaction can be structured so th a t p art o f the paym ent received by a shareholder is treated as a dividend fo r tax purposes. Any such dividend can be franked. An on-market buyback cannot include a dividend component and the whole am ount paid to the shareholder is treated as proceeds from the sale o f the shares. Accordingly, on-m arket buybacks are subject only to the capital gains tax provisions— th a t is, the tax treatm ent is the same as i f the shares were sold to a th ird party. There is another difference between regular dividends and share buybacks th a t can be im portant. A regular dividend affects taxes fo r all shareholders, b ut a share buyback w ill affect taxes only fo r 5

Off-market share buybacks take place under the equal access provisions. Section 257B of the C o rp o ratio n s A c t states that the company must offer to purchase the same percentage of the shares held by each shareholder. In practice, ASIC allows companies to invite shareholders to tender some or all of their shares.

C hapter eleven Payout

policy

shareholders who decide to sell and, at least fo r on-m arket buybacks, only i f the investor realises a capital gain. These differences mean th a t a share buyback can have tax advantages fo r shareholders. On-market buybacks are more common in Australia than off-m arket buybacks but, on average, the latter are larger so the total am ount o f capital returned to shareholders over tim e by each m ethod is similar. For example, during the 1996 to 2003 period, listed companies paid out a to ta l o f $10.5 b illion in 350 on-market share buybacks. Over the same period, $12.1 b illio n was paid out via 45 off-m arket buybacks (Brown 2007). D uring the 2007 calendar year, Australian listed companies returned about $12 b illio n to shareholders by repurchasing shares. But in 2008 and 2009, when companies and financial markets were affected by the global financial crisis, such repurchases declined to $4.6 b illio n and $2.1 billion, respectively. In 2010, 2011 and 2012 this decline was reversed, w ith repurchases being $16.0 billion, $13.0 b illio n and $8.6 b illio n respectively (ASX 2013, p. 3). The remainder o f the chapter consists o f nine main sections. First, we analyse the prim ary question: Is payout policy im portant to shareholders? Second, we discuss the effects o f transaction costs, flotation costs and behavioural factors. Third, we discuss the effects o f taxes, including both the taxation o f dividends and the taxation o f capital gains. Fourth, we discuss inform ation effects and signalling as reasons for the relevance of payout policy. Fifth, we discuss the role o f agency costs as a factor that influences payout decisions. Sixth, we discuss share repurchases as a way o f distributing cash to shareholders. Seventh, we cover behavioural factors and catering theory. Eighth, we discuss dividend reinvestment plans and dividend election schemes. Finally, we examine how a company s payout policy may evolve as the company moves through its life cycle.

Is payout policy im portant to shareholders? Before discussing reasons w hy payout policy may or may n ot be im p o rta n t to shareholders, we outline some o f the payout policies a company s directors m ight adopt.

11.2.1 | Alternative payout policies

LEARNING OBJECTIVE 2 Outline the argument that payout policy is irrelevant to shareholders7 wealth in a perfect capital market with no taxes

Payout policy involves two fundam ental questions. One is whether to pay any cash to shareholders and the other is the form o f the payment. In many cases a payment may be inappropriate— perhaps because the company has attractive investm ent opportunities and shareholders are expected to receive a greater benefit i f the company's cash is used to take up these opportunities instead o f paying it out now. I f cash is to be paid out, the directors m ust decide whether it w ill be paid as a dividend, or whether the company w ill repurchase some o f its shares or whether it w ill both pay a dividend and repurchase shares. We now outline three payout policies th a t m ig ht be adopted. For ease o f expression they are referred to as ‘dividend’ policies, but, in practice, the cash paid out could be w holly or p a rtly in the form o f a share buyback. Also, since these policies have a long h isto ry in many countries we continue to describe them by referring to dividends being paid from a company s profits.

Residual dividend policy One possibility is sim ply to treat dividends as a residual. A company th a t adopts this policy would pay out as dividends any profits that, in the opinion o f management, cannot be p rofitably invested. Alternatively, if the company s investm ent needs are greater than its p ro fit, then no dividend would be paid and extra finance would be raised externally. This policy can result in dividends fluctuating significantly from year to year.

Stable (or progressive) dividend policy A more popular policy is the stable dividend policy. Under this policy, management sets a target dividend-payout ratio — th a t is, a target p ro po rtio n o f annual p ro fit to be paid out as dividends. This target is such th a t dividends are related to the long-run difference between expected profits and expected investm ent needs. The am ount o f each dividend is changed only when this long-run difference changes. For example, the dividend per share w ill be increased if there is an increase in p ro fit th a t is regarded as

DIVIDEND-PAYOUT RATIO percentage of profit paid out to shareholders as dividends

PROGRESSIVE DIVIDEND POLICY

directors aim to steadily increase or at least m aintain the divide nd at each paym ent

sustainable, b ut it w ill n o t be changed in response to fluctuations in p ro fit th a t are believed to be only temporary. Similarly, i f p ro fit falls, the dividend per share w ill be m aintained unless the outlook fo r profits is so poor th a t the current dividend level is considered to be unsustainable. The aims o f a stable dividend p olicy are to reduce uncertainty fo r shareholders w hile providing them w ith a reliable income. Many companies th a t follow a policy o f this type refer to it as a progressive* dividend policy. There are tw o consequences o f a stable or progressive dividend policy. First, changes in dividends tend to lag behind changes in profits, and dividends are much less variable than profits. Second, the dividend-payout ratio may fluctuate dramatically. For example, i f p ro fit is unexpectedly high in a particular year, the dividend-payout ratio w ill fall.

Constant payout policy I f management is concerned to avoid fluctuations in payout ratio, then it could adopt a constant payout policyt whereby the dividend-payout ratio remains essentially the same each year.

1 1 .2 .2 1 Managers and payout decisions There is abundant empirical evidence th a t managers regard payout decisions as significant. In an im p o rta n t early study, L intner (1956) interviewed the managers o f 28 US companies and found that in most cases dividends were an ‘active decision variable， , and were seldom regarded purely as a residual or influenced significantly by financing requirements. He also found th a t m ost managers were reluctant to make changes in dividends th a t are likely to have to be reversed in the near future. In a much larger study, Brav, Graham, Harvey and Michaely (2005) surveyed 384 financial executives o f US companies and interview ed another 23 to fin d the factors th a t drive dividend and repurchase decisions. Their findings, some o f which are consistent w ith those o f Lintner, include:6 M aintaining the current level o f dividend per share is a high p rio rity and is o f sim ilar importance to investm ent decisions. Managers have a strong desire to avoid dividend cuts. External funds would be raised to finance planned investments before the dividend would be cut. b A part from the importance o f m aintaining the level o f dividend per share, payout policy is o f secondary concern. Managers see little reward fo r increasing dividends and w ill consider doing so only after investm ent and liq u id ity needs are met. c Dividends are ‘sticky’, inflexible and ‘smoothed’ over tim e relative to profits. Many companies that pay dividends would prefer th a t they did not. I f they could *start all over again* they would pay lower dividends and place greater emphasis on share repurchases, d In contrast to dividends, share repurchases are very flexible w ith no need fo r sm oothing. Repurchase decisions are made after investm ent decisions— th a t is, repurchases are made using the residual cash flow after investm ent spending. a

In some cases companies adopt a stated dividend policy. For example, the large resources companies BHP B illito n and Rio T into have both announced th a t they have adopted a progressive dividend policy. However, shareholders should be aware th a t when a company adopts such a policy, its directors are stating th e ir inten tion s rather than providing a guarantee th a t dividends w ill never fall (see Finance in Action). In other cases, a company may n ot explicitly state a dividend policy b ut investors may be able to infer that it is follow ing a particular policy by observing its payout record. The findings outlined above also show th a t there are significant differences between the factors th a t determ ine dividends and those th a t influence decisions to repurchase shares. In summary, there is evidence th a t managers treat some aspects o f payout decisions as being very im p orta nt. In contrast, a well-known analysis by M ille r and M odigliani (M M ) (1961) proved th a t under certain restrictive assumptions, dividend policy has no effect on shareholders’ wealth.

6

Brav et al. found that Lintners key finding that dividend policy is conservative still holds. That is, managers of companies that pay dividends are reluctant to cut them and non-payers are reluctant to initiate them because, once they do, they feel they will be locked in to maintaining dividend payments. Brav et al. identified two important differences relative to Lintner. First, managers target the dividend payout ratio less than they used to and give more prominence to the current level of dividend payments. Second, share repurchases have become an important form of payout and are favoured by managers because of their flexibility relative to dividends.

C hapter eleven Payout

DIVIDEND POLICY PROVIDES N O GUARANTEE FOR SHAREHOLDERS__________________________________________ Several companies have adopted a progressive dividend policy whereby it is intended that the dividend payout will increase in line with profits but not fall during economic downturns. Shareholders should be aware that this does not necessarily mean that the dividend income they receive will never decline. For example, in 2009 some companies reduced their dividends significantly with the intention that they would be able to resume a progressive dividend policy from the Vebased level7. In other cases, shareholders have suffered from the effects of exchange rate changes, as the following excerpts from an article by Barry FitzGerald explains. BHP Billiton stands alone among the global miners in being able to increase its dividend payment despite the damage being done to its December half profit from the now waning impact of the global financial crisis. But Australian shareholders w ill not be at the front of the line thanking the company for its generosity. W hile the interim dividend has been increased 2.4 per cent from 41 US cents to 42 US cents, it has gone backwards in Australian dollar terms by more than 25 per cent due to the impact of the strong Australian dollar. There were no apologies from BHP today for the haircut local shareholders will be taking on their dividends. It extolled the virtue of the group’s 'progressive’ dividend policy, another way of saying its intent is that dividends w ill always go onwards and upwards, albeit in the group’s 'functional’ currency—the battered US dollar. S o u rc e :

'B H P 's haircut for local investors', B a rry FitzG erald,

S y d n e y M o r n in g

H e r a ld ,

1 0 Fe b ru ary 2 0 1 0 .

1 1 .2 .3 1The irrelevance of payout policy The proposition th a t a company s dividend policy has no effect on shareholders' wealth was advanced by M M (1961).7 Their analysis demonstrated the irrelevance o f dividend policy under the follow ing assumptions:

a b C

The company has a given investm ent plan, and has determined how much o f the assets to be acquired w ill be financed by borrowing. There is a perfectly com petitive capital m arket, w ith no taxes, transaction costs, flo ta tio n costs or inform ation costs. Investors are rational so they always prefer more wealth to less and are equally satisfied w ith a given increase in wealth, regardless o f whether i t is in the form o f cash paid out or an increase in the value o f the shares they hold. To d e fin e d iv id e n d p o lic y , suppose t h a t a co m p a n y is to increase its d iv id e n d p a y m e n t. W it h th e

in v e s tm e n t p la n a n d th e b o rro w in g d e c is io n fix e d , th e e x tra fu n d s used to pa y th e h ig h e r d iv id e n d can be replaced fr o m o n ly one source: a n e w share issue. A lte rn a tiv e ly , suppose t h a t th e d iv id e n d is to be reduced. In th is case, th e re is o n ly one w a y t h a t th e s u rp lu s cash can be use d— t h a t is, to re p u rch a se som e shares. T here fore, in th e M M fra m e w o rk ,

dividend policy

in v o lv e s a tra d e -o ff b e tw e e n h ig h e r o r lo w e r

d iv id e n d s a n d is s u in g o r re p u rc h a s in g o rd in a ry shares. U s in g th is ap p ro a ch , M M p ro v e d t h a t d iv id e n d p o lic y is irre le v a n t to s h a re h o ld e rs ’ w e a lth . E xa m p le 11 .1 illu s tra te s th e a p p ro a ch t h a t M M used to p ro ve th a t d iv id e n d p o lic y is irre le v a n t.

Essentially, M M s argum ent is th a t the value o f a company depends only on its investments. The net cash that can be paid out to investors is a residual: the difference between profits and investment. This net payout consists o f cash paid o ut in dividends and share repurchases, less any cash raised by issuing shares. It follows th a t a company can adjust its payouts to any chosen level by m aking a corresponding adjustm ent 7

MM (1961) only considered dividends and their article does not mention share repurchases, probably because they were rare at the time. The MM analysis could be extended to include share repurchases and to show that, under their assumptions, the form in which cash is paid out has no effect on shareholders* wealth.

Finance in

ACTION

policy

Example 11.1 The ABC Company has 10000 shares on issue, with a market price of $1 1 each. Its statement of financial position ('balance sheet') in market values is shown in Table 11.1.

TABLE 11.1 ABC Company market value statement of financial position ($) Cash

15000

Debt

5000

Non-current assets

100000

Equity

110000

Total assets

115000

Value of company

115000

The $ 1 5 0 0 0 cash has been reserved for an investment opportunity that has not yet been taken up. Suppose that management decides instead to use the cash to pay a dividend of $15 000, and then issues more shares to new shareholders to replace the cash and proceed with the new investment. W hat is the effect of these transactions on the value of the existing shares and shareholders' wealth?

SOLUTION After the dividend and the share issue, the company still has the same assets, so that its value should still be $1 15000. The new shares should be worth the amount paid for them, $15000, so that the value of the original shares is: V a lu e o f o r ig in a l s h a r e s = v a lu e o f c o m p a n y - v a l u e o f d e b t - v a l u e o f n e w s h a re s

= $ 1 1 5 0 0 0 -$ 5 0 0 0 -$ 1 5 0 0 0 =$95 000

The original shareholders have suffered a capital loss of $15000, exactly offsetting the dividend of $ 15 000, which is now cash in their hands. By having the ABC Company pay a dividend, its original shareholders have converted part of their stake in the company into cash of $15000. Since the stake transferred to the new shareholders is also worth $15000, the net change in the wealth of the original shareholders is zero. Paying a dividend and then issuing new shares to replace the cash paid out involves a transfer of ownership between the 'old' and 'new' shareholders. Provided the terms of this transfer are fair, neither party gains nor loses—that is, the new shareholders receive shares that are worth the price paid for them and, for each dollar they receive in dividends, the old shareholders give up future dividends with a present value of $ 1, which reduces the value of their shares by $ 1.

to the num ber o f shares on issue. In a perfect capital m arket where the company s investm ents remain the same, these adjustments w ill have no effect on the net payout o f cash and no effect on company value. As shown in Example 11.1, paying out additional cash— $15 000 in th a t case— and then raising $15 000 by issuing additional shares is sim ply recycling cash and cannot affect shareholders* wealth. Now suppose that the ABC Company pays the $15 000 dividend and does n o t replace the cash by issuing more shares. In this case, paying the dividend is effectively a p artial liqu id atio n o f the company because its assets have been reduced by $15000 and the value o f its equity m ust fa ll to $110000 $15 000 = $95 000. The shareholders now have $15 000 cash in hand and have incurred a capital loss on th e ir shares o f $15 000. As a check, we can calculate th e ir wealth, which is $15 000 + $95 000 = $110 000: exactly the same as it was p rio r to the dividend. Alternatively, suppose th a t the company does n ot pay any dividend, but the shareholders w ant to raise $15 000 in cash. The shareholders can do this by selling p art o f th e ir holding to other investors— which is often referred to as creating a ‘homemade dividend’. A fte r these transactions, the original shareholders w ill again have cash o f $15 000 and the value o f th e ir rem aining shares m ust be equal to $110000 - $15 000 = $95 000. Clearly, the wealth o f the original shareholders is s till $110000. We can conclude th a t the p artial liquidation o f a company (by paying a dividend) cannot increase shareholders’ wealth because, in the absence o f taxes and transaction costs, shareholders can achieve the same result by liquidating p art o f th e ir holding.

C hapter eleven Payout

policy

Since the 1960s, m ost discussions o f payout policy have been based on the M M dividend irrelevance theorem. For example, empirical research has typically been based on the idea th a t i f dividend policy is im portant in practice, the reasons fo r its importance m ust relate to factors th a t M M s assumptions excluded from th e ir analysis. Accordingly, the large body o f research on dividend policy has m ainly examined whether the policies th a t companies adopt, and share price responses to dividend announcements, can be explained by m arket imperfections such as taxes, agency costs and the role th a t dividends may play in conveying inform a tion to investors. More than 40 years after the M M irrelevance theorem was published, De Angelo and De Angelo (2006) argued th a t i t is inadequate as a starting p o in t fo r understanding payout policy. De Angelo and De Angelo (DD) do n o t claim th a t the M M analysis is wrong; they accept th a t it is correct*, given the underlying assumptions. However, DD p o in t out th a t the M M analysis relies on an unstated but im p licit assumption that, in th e ir view, means th a t M M s irrelevance theorem is its e lf irrelevant. DD argue th a t the concept o f ‘fu ll payout’ is a more logical starting p o in t fo r discussion o f payout policy. The fu ll payout policy that DD advocate means th a t the fu ll present value o f a company s free cash flow should be paid o ut to shareholders. Free cash flows are defined as cash flows in excess o f those required to fund all available projects th a t have positive net present values. Their argument is explained in the next section.

To explain DDs criticism s o f M M , we use a sim plified version o f a numerical example provided by DD (2006). Suppose that an all-equity company undertakes a project w ith a net present value (NPV) of $10. The project generates free cash flow o f $1 per year in perpetuity and the required rate o f return is 10 per cent. The M M p ro of im p licitly assumes th a t a company w ill distribute all o f its free cash flow in every period. In this case, the company m ust distribute at least $1 per year. M M show th a t the company can distribute more than $1 per year by issuing more shares and d istrib u tin g the proceeds to shareholders. For example, i f the company s managers wish to pay a dividend o f $1.10 in a given year, the company sells shares w orth 10 cents to new shareholders and pays a dividend o f $1.10 to the old shareholders. DD point out th a t by issuing new shares and paying a higher dividend, the company is effectively carrying out financial interm ediation. In reality, cash o f 10 cents was transferred from new to old shareholders w ith the company only touching the cash fo r an instant. Accordingly, DD argue th a t the cash actually paid from the company s resources remains $1, so, in substance, its payout policy has n o t changed. M M s assumptions constrain a company to paying out all o f its free cash flow each year and this is an optimal payout policy. Clearly, i t is also true th a t paying higher dividends, financed by issuing more shares, cannot increase company value or shareholders* wealth. Hence, what M M did prove is th a t changing payout policy cannot add to the value created by a company s investment policy. However, DD argue that the M M approach does n ot prove that payout policy is irrelevant because company value can be changed if companies retain part o f th e ir free cash flow. To continue the numerical example, suppose th a t the company s managers decide to perm anently distribute only 99 cents per year. The 1 cent th a t is retained is invested in zero-NPV projects so the company s till has investments w ith an NPV o f $10, b ut the reduced payout means th a t the value o f its shares is only $9.90. In contrast to the outcomes envisaged by M M , the value lost through the suboptimal payout policy cannot be restored by investors selling some o f th e ir shares or borrowing against them to manufacture ‘homemade’ dividends. Given the distributions o f 99 cents per year, the m arket w ill value the shares at $9.90 and th a t is the price at which investors can sell or borrow against their shares. Thus, DD distinguish between ‘investm ent value’ and ‘d istribu tio n value’. Investment value is defined as the present value o f the free cash flow to the company generated by its investments. D istribution value is the present value o f the cash flow paid out to shareholders. These tw o values can be equal— but they w ill be equal only i f the company s payout policy is optimal. D istrib utio n value cannot be more than investment value b ut it w ill be less than investm ent value i f free cash flow is retained. In contrast to M M , DD conclude that both investm ent policy and payout policy are im portant. Their approach emphasises the importance o f a full payout policy. In summary, DD argue th a t managers have two im portant jobs. First, they are responsible fo r selecting good investm ent projects th a t generate profits and provide the capacity fo r cash to be paid out to investors. Second, they should ensure th a t over the life o f the enterprise, investors receive a d istribu tio n stream w ith the greatest possible present value. And so managers should th in k fu ll payout and n o t irrelevance when setting payout policy, (DD, 2007, p. 12).

L E A R N IN G O B JEC T IV E 3 Define the full payout policy a n d explain w h y it is important that c o m p an ie s follow this policy

FULL PAYOUT POLICY

distribution of the full present value of a c o m p a n y ’s free cash flow to shareholde rs

1 1 .2 .5 1 Payout policy in practice We have discussed tw o models o f payout policy, both o f which assume there is a perfect capital m arket w ith no taxes. First, the M M dividend irrelevance theorem suggests th a t any payout policy w ill do. Second, DD argue th a t M M relied on the im p lic it assumption th a t all o f a company s free cash flow is paid out and p o in t o ut th a t this is a critical requirem ent o f optim al payout policies. I f p a rt o f a company s free cash flow is never paid out, company value w ill be reduced, so DD support a fu ll payout policy. In the context o f a perfect or
Transaction costs and flotation costs L E A R N IN G O BJEC TIVE 4 Explain ho w

11.3.1 | Transaction costs

transaction costs and flotation costs m ay affect payout policy

DIVIDEND CLIENTELE

gro up of investors w h o c h o o se to invest in com panies that have dividend policies that meet their particular requirements

I f trading in shares does n ot involve any transaction costs, shareholders have the o p p o rtu n ity to effectively develop th e ir own payout policy w ith o u t incurring any costs. For example, i f an investor received a dividend th a t was n ot needed, the cash could be used to buy more shares in the company. Conversely, i f additional cash was needed, a shareholder could sell some shares to create a 'homemade1dividend. Thus, shareholders can create th e ir preferred cash flow stream th a t is independent o f the payouts made by the company. As De Angelo, De Angelo and Skinner (2009) p o in t out, provided the company eventually distributes fu ll value to investors, all shareholders 'w ill view each such dividend policy as equally valuable, regardless of the degree o f heterogeneity in th e ir preferences fo r immediate versus future payouts* (p. 203). In practice, shareholders who buy or sell shares to create a preferred cash flow stream w ill incur transaction costs such as brokerage fees, so investors who require income may prefer to hold shares th a t pay regular dividends. This is an example o f d iv id e n d c lie n te le s , which may develop when there are d ifferent classes o f investors w ith different preferences fo r current income— th a t is, a company w ill tend to attract a clientele o f investors who are suited by its dividend policy. Companies that do n ot pay dividends or pay only low or residual dividends would attract investors w ith adequate income from other sources. Such investors would reinvest any dividends they receive, b u t can avoid the transaction costs o f doing so by investing in companies th a t retain m ost or all o f th e ir profits. Conversely, companies that routinely pay high dividends would attract investors such as retirees, who require income from th e ir share p o rtfo lio to meet consumption needs. Thus, a stable dividend policy may reduce or elim inate the transaction costs th a t some shareholders would incur i f the company followed a residual dividend policy. However, th is does n ot necessarily mean th a t the stable policy w ill increase the m arket value o f the company s shares. I f transaction costs are the only im perfection th a t exists in a m arket, companies may compete to pay dividends to the clientele o f investors who wish to m inim ise transaction costs. This com petition among companies could result in an equilibrium , where the supply o f dividends is equal to investors1demand fo r cash payouts. As M M noted, i f such an equilibrium exists and the needs o f all investor clienteles are met, then one clientele is as good as another. In other words, there w ill be

C hapter eleven Payout

policy

no incentive fo r one more company to adopt a dividend policy designed to su it the needs o f a particular dividend clientele.

11.3 .2 | Flotation costs I f a company pays dividends and its retained profits are insufficient to meet its investm ent needs, then one solution is to raise funds externally. Alternatively, the company could increase the funds th a t are available internally by reducing or even elim inating its dividend. Under the M M assumption o f no flotation costs, shareholders would be indifferent between these alternatives. In practice, a company th a t raises funds externally w ill incur flo tatio n costs, which can be substantial. For example, i f a company needs $1 m illio n and flo ta tio n costs are 5 per cent, the company w ill need to issue shares w ith a value o f $1000 000/0.95 = $1 052 632 to raise a net $1 m illio n . Existing shareholders may incur an additional cost i f shares are issued to new shareholders when a company s management has confidential inform ation that indicates th a t the company s shares are undervalued.8 The existence o f flo ta tio n costs provides an incentive to preserve shareholders’ wealth by restricting dividends. Therefore, the best outcome fo r shareholders may be a residual dividend policy, where the company pays dividends only to the extent that it has profits which it cannot p ro fitab ly invest.

Dividends and taxes Taxes can either favour or penalise the payment o f dividends, depending on w hether the tax burden on profits distributed as dividends is greater or less than the tax burden on capital gains arising from retained profits. Under the classical ta x system , which applied in Australia u n til 30 June 1987, dividends were taxed in the hands o f an investor at the investors m arginal tax rate, whereas capital gains were either tax-free or taxed at lower rates than dividends. The classical tax system is s till used in some countries, including the US.9 Since dividends were paid from profits th a t were subject to company income tax, the classical tax system involved double taxation o f company profits. Therefore, from a purely tax view point, many investors were disadvantaged i f they received a dividend and would have preferred th a t companies retain profits, thus allowing investors to realise returns as tax-advantaged capital gains. Despite the apparent tax disadvantage o f paying dividends, many Australian companies did pay out a significant percentage o f th e ir profits as dividends. O f course, there may be a simple explanation: factors other than taxes affect payout decisions and, w ith share repurchases prohibited u n til 1989, payment o f dividends was the only way o f transferring cash from companies to th e ir shareholders. However, in the US, where share repurchases were legal and taxes favoured repurchases relative to dividends, the am ount o f cash paid out as dividends exceeded the value o f share repurchases each year u n til 1999. The additional tax burden on dividends suggested th a t the values o f US companies would probably increase i f cash was paid out by repurchasing shares instead o f paying dividends. This observation caused Black (1976) to conclude that the dividend policies o f US companies were a puzzle.

CLASSICAL TAX SYSTEM

tax system that operates in the U S a n d w hich operated in A ustralia until 3 0 June 1 9 8 7 ; under this system co m p a n y profits, a n d d ivid e nd s p a id from those profits, are taxed se p a ra te ly— that is, profit p a id a s a d ivid e n d is effectively taxed twice

11.4.1 I Dividends and the imputation tax system The imputation tax system th a t was introduced in July 1987 has im p o rta n t effects on the taxation o f dividends paid to investors in Australian companies. The basic in te n tio n o f the im p utatio n system is to eliminate the double taxation o f company profits, which is inherent in the classical tax system previously used in Australia. This in te n tio n is achieved by giving resident shareholders a credit fo r the Australian income tax paid by a company on its taxable income. The overall effect is th a t the p ro fit o f a company distributed as dividends is effectively taxed only at the investor level, b u t the tax is collected p rim a rily at the company level.

L E A R N IN G O B JEC TIVE 5 O utline the imputation tax system a n d e xp lain the effects of imputation a n d capital g a in s tax on returns to investors

8 9

The effects of this type of information asymmetry, which were analysed by Myers and Majluf (1984), are discussed in Section 12.9.2. The classical tax system is still used in the US and much of the empirical research on dividend policy is based on US data, so it is important to have an understanding of the classical tax system.

B usiness finance

The im p utatio n system operates as follows: a

b

c

Company income tax is assessed at the company income tax rate tc. Therefore, at the current company income tax rate o f 30 cents in the dollar, $100 o f company p ro fit w ill result in $30 being paid in company tax. I t is critic a l to understand th a t th is am ount o f $30 is therefore both p ro fit earned by the company and company tax paid. The im p u ta tio n system recognises this dual nature by adding $30 to the shareholder^ income and also givin g shareholders credit fo r $30 o f tax paid. Dividends paid out o f a company s after-tax p ro fit are referred to as franked dividends. In this case, the m axim um franked dividend th a t could be paid is $70. Each dollar o f franked dividend carries a franking credit equal to tc/ ( l - tc). Therefore, a franked dividend o f $70 w ill carry a franking credit o f $70 x 0.30/(1 - 0.30) = $30. Shareholders who receive a franked dividend o f $70 w ill include in th eir taxable income both the dividend received ($70) and the franking credit ($30). The shareholders’ taxable income is thus $100. Shareholders are then taxed at th e ir m arginal tax rate b u t are then allowed a tax credit in recognition o f the company tax paid. If, fo r example, the shareholders personal tax rate is 45 cents in the dollar, then th e ir tax lia b ility is 0.45 x $100 = $45, less the tax credit o f $30, so the net personal tax is $15. Therefore, the to ta l tax on the $100 company p ro fit is $45, o f which $30 was collected from the company and $15 fro m the shareholder.

The effects o f the im putation system on different types o f resident shareholders who receive a franked dividend paid from a company p ro fit o f $100 are shown in Table 11.2.

TABLE 11.2 Effects of dividend imputation on resident shareholders Medium-income individual

High-income individual

15

30

45

100

100

100

less Company tax ($)

30

30

30

Franked dividend ($)

70

70

70

0

15

70

55

Shareholder Marginal tax rate (%) Company p rofit ($)

Superannuation fund

Net shareholder tax ($) After-tax return ($)

85

•°) E xce ss franking credits a re refunded (that is, p a id in ca sh to the shareh old e r b y the tax authorities).

Table 11.2 shows tw o im p o rta n t features o f the im p utatio n system. First, a company s after-tax p ro fit paid out as franked dividends is effectively taxed only at the shareholders’ ‘personal’ tax rate. To pay a franked dividend o f $70 requires pre-tax company p ro fit o f $100 and i f this am ount were simply taxed at the shareholders* m arginal tax rate, the after-tax returns would be the same as those shown in the fin al row o f Table 11.2. Second, the after-tax retu rn from franked dividends does not depend on the company income tax rate, and company income tax can be regarded as a withholding tax against the personal tax liabilities o f shareholders. In other words, under im putation, payment o f company income tax is effectively a pre-payment o f personal tax. Under the im p utatio n system, it is only by payment o f franked dividends th a t credits fo r company tax paid can be transferred to investors, who can then use the credits to offset th e ir personal tax lia b ilitie s— th a t is, shareholders are unable to use tax credits u n til franked dividends are paid. Therefore, in an im putation system, the after-tax retu rn to shareholders depends heavily on the company s dividend policy. As discussed in Section 11.1.3, companies w ith operations in both Australia and New Zealand may elect to distribute Australian franking credits and New Zealand im putation credits to all shareholders. Such distributions have been allowed since 1 October 2003 and th eir effects are illustrated in Example 11.2.

C hapter eleven Payout

All Black Ltd is owned 70 per cent by New Zealand residents and 30 per cent by Australian residents. The company has operations in Australia where it pays A$ 100000 of company tax. It also pays company tax of N Z $200000. The resultant Australian franking credits and New Zealand imputation credits are fully distributed and both are attached to the same dividends. W hat are the tax credits that can be claimed by the Australian and New Zealand resident shareholders? How much of the tax credits cannot be utilised?

SOLUTION The Australian and New Zealand tax credits are distributed to all shareholders in proportion to their shareholdings in All Black Ltd. However, the tax credits from each country can be claimed only by residents of that country. Therefore, Australian resident shareholders will receive A $3000 0 in franking credits (30 per cent of the total Australian company tax of A$ 100000) and the remaining A $7000 0 will be distributed to New Zealand resident shareholders who are unable to use them. Similarly, New Zealand resident shareholders will receive imputation credits of N Z $140000 (70 per cent of the total New Zealand company tax of N Z$200000) and the remaining N Z$60000 will be distributed to Australian resident shareholders who are unable to use them.

So far we have focused on the taxation o f dividends, but, in practice, a significant pro po rtio n o f the returns to shareholders are in the form o f capital gains. Example 11.1 showed th a t payment o f dividends reduces the value o f shares and it follows th a t payment o f dividends reduces the potential fo r shareholders to incur capital gains tax. I f companies retain profits, the prices o f th e ir shares are likely to rise relative to those o f companies th a t d istribute p rofits, giving rise to capital gains tax liabilities fo r shareholders if and when the shares are sold.10 In Australia, capital gains tax applies only to gains on assets acquired on or after 20 September 1985, and is payable only when gains have been realised. The calculation o f capital gains tax can d iffer depending on whether the asset was purchased before or after 21 September 1999. However, provided th a t the asset has been held fo r at least 12 m onths, the m axim um rate o f capital gains tax fo r an individual w ill be h alf the marginal tax rate on the individuals ordinary* income. In the case o f superannuation funds, the maximum rate o f capital gains tax on long-term gains is 10 per cent compared w ith th e ir norm al income tax rate o f 15 per cent. The tim e value o f money means th a t the present value o f any capital gains tax payable is lower, the longer th a t realisation o f gains is delayed. Also, investors are able to choose the tim e at which assets are sold and may therefore be able to realise gains at times when th e ir m arginal tax rate is low. In summary, effective rates o f capital gains tax are likely to be low fo r many investors. However, where a capital gain arises from retention o f profits th a t have been taxed, any capital gains tax th a t is payable w ill be in addition to the tax already paid by the company. In other words, retention o f profits can involve double taxation: company income tax plus capital gains tax. Future capital gains tax can be reduced by the payment o f dividends, regardless o f whether the dividend is franked or unfranked. Unfranked dividends are taxed as ordinary income in the hands o f investors and carry no tax credits— in other words, the classical system o f taxation continues to apply to unfranked dividends. Given th a t the effective rate o f capital gains tax is likely to be less than an investors m arginal income tax rate, m ost investors are likely to prefer capital gains rather than unfranked dividends. As discussed in the next section, many investors w ill also have a tax-based preference fo r franked dividends rather than capital gains arising from retention o f taxed profits. The effects o f taxation on dividends and capital gains fo r the m ain classes o f investors in the Australian m arket are summarised in Table 11.3. Note th a t in relation to capital gains, the table shows details only o f capital gains tax applicable at the investor level— th a t is, tax in addition to any company tax paid on retained profits th a t underlie the capital gains. 10 Remember that share prices drop on the ex-dividend date. The significance of this drop in price is discussed in Section 11.4.4.

policy

TABLE 11.3 Taxation of dividends and capital gains Superannuation funds i

Resident individuals

Non-residents

Dividends

Dividend imputation effective from 1 July 1987. Franking credits can be offset against income tax on the shareholders’ income (including capital gains), but not against the Medicare levy. Excess franking credits are refunded from 1 July 2000.

Franked dividends received by a resident company are handled using the same gross-up and credit approach that applies to resident individuals and superannuation funds. Thus, franking credits received reduce the amount of company tax payable.

Introduction o f a 15% tax on earnings from 1 July 1988. Dividend imputation effective from that date. Excess franking credits are refunded from 1 July 2000.

W ithholding tax on dividends, applied from 1 July 1960. From 1 July 1987, franked dividends exempt from withholding tax. Unfranked dividends are subject to a 30% withholding tax or 15% i f covered by a double taxation treaty.

Capital gains

Assets acquired after 19 September 1985 are subject to capital gains tax. I f the asset is held for more than 1 year, it applies to the real component only u n til September 1999. On or after 21 September 1999, the amount o f any capital gain realised on an asset held for at least 12 months may be discounted by 50%.

Same as for resident individuals u ntil 20 September 1999. From 21 September 1999, the capital gain is included in the company’s taxable income. Discounting of gains does not apply to companies.

All assets disposed of after 1 July 1988 subject to capital gains tax at the rate o f 15%. If the asset is held for more than 1 year, it applies to the real component only u n til 20 September 1999. For capital gains realised on or after 21 September 1999 on assets held for at least 12 months, a discount o f 33 V3% is allowed.

Australian-related assets acquired after 19 September 1985 are subject to capital gains tax. Indexation for inflation applies to September 1999. For gains realised on or after 21 September 1999 discounting may apply. Exempt from Australian capital gains tax on shares in resident companies if the investor owns less than 10% of the company’s shares.

S o u rce :

This table is b a se d o n T. C allen, S. M o r lin g & J. Pleban, 'D iv id e n d s a n d taxation: a pre lim in ary investigation',

R e se a rc h

D is c u s s io n

M a s te r Tax G u id e

P aper

921

1,

E co n o m ic Research Departm ent, Reserve B a nk of A ustralia, p. 9, a n d updated b a se d on

2 0 0 4 , C C H A ustralia Ltd, Sydney.

1 1 .4 .3 1 Dividend policy with imputation and capital gains tax In Section 11.4.1 we showed that company profits paid out as franked dividends are effectively taxed once at the shareholders marginal tax rate. For example, company p ro fit distributed as franked dividends to an investor on the top marginal rate w ill be taxed at 45 per cent. For each $1 o f company taxable income, company tax o f 30 cents w ill be payable, leaving 70 cents th a t can be paid out as a franked dividend. An Australian resident receiving th a t dividend w ill be taxed on an income o f $1 (the dividend plus the franking credit o f 30 cents) and can claim the franking credit. W ith a marginal tax rate o f 45 per cent, the net tax payable by the investor w ill be 15 cents and the dividend income after all taxes w ill be $0.70 - $0.15 = $0.55. The alternative to payment o f dividends is retention o f profits, which, as discussed in Section 11.4.2, can involve double taxation: income tax paid by the company plus capital gains tax paid by the shareholder. Now suppose th a t the after-tax income o f 70 cents is instead retained by the company and the retained funds result in a capital gain o f 70 cents when the shares are sold. I f the date o f the sale is less than 1 year after the shares were purchased, the capital gain o f 70 cents w ill be taxed at 45 per cent, resulting in capital gains tax o f $0.70 x 0.45 = $0.315. Therefore, the shareholders after-tax income w ill be $0.70 - $0.315 = $0.385. Since this is much less than $0.55, it is clear th a t the Australian tax system provides a strong incentive fo r companies to pay the m axim um possible in franked dividends. I f the date o f the sale is more than 1 year after the shares were purchased, the taxable capital gain w ill be

C hapter eleven Payout

50 per cent o f 70 cents or 35 cents, so the capital gains tax w ill be $0.35 x 0.45 = $0.1575. In this case the net receipts w ill be $0.70 - $0.1575 = $0.5425, which is s till less, albeit only slightly so, than the income from p ro fit distributed as a franked dividend. However, as discussed in Section 11.4.2, effective rates o f capital gains tax can be lower than the rate we have used in this calculation. Thus, while the im putation system favours d istrib u tio n o f profits, the fact th a t long-term capital gains are taxed at lower rates than ordinary income reduces the incentive fo r d is trib u tio n and fo r some investors the effective rate of capital gains tax may be so low th a t they would prefer retention o f profits. Overall, the com bination o f the im putation system and capital gains tax means th a t investors could d iffer in th e ir preferences fo r dividend income and capital gains: shareholders w ith low (high) m arginal tax rates w ill tend to prefer companies th a t pay dividends (retain profits). Many Australian companies have significant operations offshore. Profits th a t are earned and taxed outside Australia cannot be paid to investors as franked dividends. Any dividends from these profits w ill be unfranked and therefore subject to tax at the shareholders’ marginal income tax rate. In general, shareholders can be divided in to three categories based on th e ir tax position: a

b c

Shareholders who are taxed at the same rate on ordinary income and capital gains. Investors in this category w ill be indifferent between payment o f unfranked dividends and retention o f profits, Shareholders who are taxed at a lower rate on capital gains than on ordinary income. Investors in this category w ill prefer retention o f profits rather than payment o f unfranked dividends, Shareholders who are taxed at a higher rate on capital gains than on ordinary income. Any investors in this category would prefer all profits to be distributed.

Under the Australian tax system, share traders who sell shares after holding them fo r less than 12 months would fall in to the firs t category. Investors who hold shares fo r more than 12 m onths are in the second category. I t is unlikely th a t any investors would fall into the th ird category. Therefore, many investors w ill have a tax-based preference fo r retention o f profits rather than unfranked dividends, some w ill be indifferent between these alternatives and none should prefer payment o f unfranked dividends. Pattenden and Twite (2008) examined the dividend policies o f a sample o f Australian companies over the period 1982 to 1997 to assess the effects o f the intro du ction o f the im p utatio n tax system in 1987. They found significant changes in both the magnitude and form o f dividends, which supports the argument th a t taxes have an im p o rta n t role in determ ining payout policies. Their study is broad in that they examined the d istrib u tio n o f tax credits across all types o f dividend payments. Accordingly, they measured gross dividend payouts defined as the sum o f all cash dividends, scrip dividends, bonus shares issued in lieu o f dividends and share repurchases. Investor demand fo r d is trib u tio n o f franking credits was expected to boost dividend payouts after the intro du ction o f the im p utatio n system, b ut corporate funding needs may well p ro m p t additional share issues to offset the additional payouts. Therefore, Pattenden and Twite also examined net dividend payouts defined as gross dividend payouts net o f cash raised by issuing shares through dividend reinvestm ent plans, rights issues, public issues and placements. In addition, they examined cases where companies began to pay dividends fo r the firs t tim e — known as dividend in itia tio n s— and also tested fo r changes in the v o la tility o f payouts. Consistent w ith investor demand fo r d istrib u tio n o f franking credits, Pattenden and Twite found that the introduction o f the im p utatio n tax system resulted in a higher frequency o f dividend in itia tio n s , increases in gross and net dividend payout, greater use o f dividend reinvestm ent plans and th a t the vo la tility o f the gross dividend payout increased. They also found th a t the effects o f the change in tax system differed across companies. For example, after the intro du ction o f the im p utatio n system, gross dividend payouts were higher fo r companies w ith a high effective Australian company tax rate and companies w ith a greater capacity to frank dividends were more likely to in itia te dividends. In summary, the im p utatio n system creates an incentive to distribute profits as dividends— b ut only to the extent th a t the dividends can be franked. Where a company has profits th a t could be d istributed as unfranked dividends, many investors w ill prefer th a t these profits be retained.

The argument th a t investors w ill prefer franking credits to be d istributed rather than retained assumes that these tax credits are valuable to investors. There is strong evidence to support this assumption. Much o f this evidence has been obtained by observing rates o f retu rn on shares on the ex-dividend day

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DIVIDEND DROP-OFF RATIO

ratio of the decline in the share price on the ex-dividend d a y to the divide nd per share

and by observing the dividen d d r o p -o ff ratio, which is the ratio o f the decline in the share price on the ex-dividend day to the dividend per share. The basis fo r this approach is straightforw ard. Suppose that shares in XYZ Ltd w ill begin trading on an ex-dividend basis tom orrow. W hat effect should this have on the share price? Investors who buy XYZ shares tom orrow are paying fo r an interest in the company s future net cash flows. Investors who bought XYZ shares today were buying essentially the same interest in future net cash flows, plus the dividend. Therefore, the drop-off in share price between today and tom orrow should reflect the value to investors o f the dividend. I f the dividend is franked, then the drop­ o ff in share price should reflect the combined value o f the cash dividend and the associated franking credit. Example 11.3 illustrates the effect o f franking credits on the ex-dividend drop-off.

Example 11.3 6

Norfolk Ltd shares have a closing price of $10.85 on 9 November 2015. On the next day they will begin trading on an ex-dividend basis. The dividend is 40 cents per share, fully franked at the company tax rate of 30 per cent. What is the expected ex-dividend share price?

SOLUTION Investors who buy Norfolk shares on 10 November are paying for an interest in the company's future net cash flows. Investors who bought the shares on 9 November were buying essentially the same interest in future net cash flows, plus the dividend. Since the dividend is fully franked, it carries a tax credit that is equal to (dividend x fc) /( l - tc) = ($0.40 x 0 .3 0 )/0 .7 0 = 17.14 cents. Therefore, if expectations of Norfolk's future cash flows remain unchanged, and if both the dividend and the tax credit are fully valued by investors, the ex-dividend drop-off should be 4 0 cents + 17.14 cents = 5 7 .1 4 cents, giving an expected ex-dividend share price of approximately $ 1 0 .2 8 .11 As shown in Example 11.3, the ex-dividend drop-off fo r franked dividends can be larger than the dividend because o f the value o f franking credits. There is clear evidence to support this claim in cases where companies pay large special dividends th a t are franked. In such cases, the share price fa ll on the ex-dividend date is typically more than the am ount o f the cash dividend. For example, in 1995 Energy Resources o f Australia Ltd (ERA) paid a special dividend o f $2.50 per share. The dividend was franked and carried a franking credit o f $1.56 per share.12 The ex-dividend date was 29 June 1995. The closing price o f ERA shares on 28 June was $6.86 and on 29 June the closing price was $3.10. Thus, based on daily closing prices, the ex-dividend drop-off was $3.76, which is considerably more than the cash dividend o f $2.50 and somewhat less than $4.06, w hich is the sum o f the cash dividend plus the franking credit. Several Australian studies o f large samples o f companies also provide evidence th a t franking credits are valuable. Bellamy (1994, p. 282) found th a t fo r each year in the period 1987-88 to 1991-92, the mean d ro p-off ratio fo r franked dividends exceeded th a t fo r unfranked dividends. For the whole period, the mean d ro p-off ratio fo r franked dividends was 0.89 compared w ith 0.66 fo r unfranked dividends. Brown and Clarke (1993) and Hathaway and Officer (2004) b oth studied the d ro p-off ratio and found th a t the m arket places a positive value on franking credits, b u t each study encountered difficulties in q ua ntifyin g th a t value. For example, when th e ir sample was restricted to large companies, Hathaway and Officer estimated th a t the value o f fran king credits was between 49 and 52 per cent o f th e ir face value. However, the results fo r small and medium-sized companies were erratic and unreliable— a problem th a t they a ttrib u te d to the fact th a t the shares o f many small companies do n o t always trade over the ex-dividend date period. A related problem is th a t in many cases the dividends (and the associated fran king credits) on ordinary shares are small relative to the share price and those prices can be quite volatile, which makes i t d iffic u lt to accurately q ua n tify the effect o f shares beginning to trade ex-dividend. In other words, w ith relatively small dividends and high price v o la tility, the Signal-to-noise ratio* is low in studies o f th is type. Feuerherdt, Gray and Hall (2010) address this problem by focusing 11 This result assumes that the tax rate on the grossed-up dividend is the same as the tax rate on capital gains. 12 At that time the company tax rate was 36 cents in the dollar, so a fully franked dividend of $2.50 would carry a tax credit of approximately $1.41. The larger tax credit for ERAs dividend reflects the fact that some of its tax credits were based on the company tax rate of 39 cents in the dollar, which applied previously. Other companies that paid similar special fully franked dividends include Joe White Makings Ltd and George Weston Foods Ltd. The case of ERAs special dividend is discussed by McDonald and Collibee (1996).

C hapter eleven Payout

on hybrid securities— preference shares— which have high dividend yields and prices th a t are relatively insensitive to m arket movements so the signal-to-noise ratio is much higher than fo r o rdinary shares. D uring the period they studied, the company tax rate was 30 cents in the dollar, so a fu lly franked $1 dividend carried a fran king credit o f 43 cents.13 Feuerherdt, Gray and Hall found th a t fo r all the securities they examined, the package o f a $1 dividend and the associated fran king credit had a value o f $1. Hence, i f cash dividends are fu lly valued by investors, they fin d th a t fran king credits do n o t affect share prices— which is consistent w ith security prices being set by non-resident investors who place no value on franking credits. Another problem in research o f this type is th a t the cum-dividend and ex-dividend prices are n ot simultaneous. The ex-dividend drop-off is typically measured from the close o f trading on the last day o f cum-dividend trading to the close o f trading on the follow ing day. Over a 24-hour period the share price may change significantly due to overall m arket movements or the arrival o f company or ind ustry inform ation. Therefore, ex-dividend drop-off ratios typically exhibit extreme variation. Walker and Partington (1999) overcame this problem by analysing data from 1 January 1995 to 1 March 1997, a period when the ASX allowed trading in cum-dividend shares after the official ex-dividend date. By observing essentially simultaneous trades in cum-dividend and ex-dividend shares they were able to observe an ‘instantaneous drop-off ra tio ’. For a sample o f 1015 trades covering 93 ex-dividend events they found th a t the average instantaneous drop-off ratio fo r fu lly franked dividends is 1.23. Therefore they concluded that a dollar o f franked dividends is w o rth significantly more than $1. Cannavan, Finn and Gray (2004) also id e n tify problems inherent in using the dividend drop-off approach to estimate the value o f franking credits. One problem is th a t efforts to separate the values o f cash dividends and the tax credits attached to them rely on the im p lic it assumption th a t the value of dividends is independent o f the degree o f franking. I f there are ‘im p utatio n clienteles’ where resident investors are attracted to companies paying fu lly franked dividends, this assumption may n o t be valid. Another problem is th a t dividend drop-off studies typically assume th a t the value o f tax credits remains the same over the sample period and is constant across companies in the sample. Cannavan, Finn and Gray avoid these problems by in fe rrin g the value o f tax credits from the relative prices o f individual share futures contracts and the prices o f the underlying shares. One advantage o f this approach is th a t a larger num ber o f observations can be used because it is n o t necessary to restrict the data to observations around the ex-dividend date. A nother advantage is th a t the value o f tax credits can be estimated separately fo r different types o f shares. For example, tax-paying resident investors w ill value all tax credits highly, b ut non-residents w ill value tax credits only i f they can in some way transfer tax credits to residents. Some schemes have been developed fo r m aking such transfers, b u t they can involve significant transaction costs, and the use o f such schemes may be w orthw hile only fo r highyielding shares w ith fu lly franked dividends. Hence, i f the m arginal investors in Australian shares are non-residents, then the m arket value o f tax credits may be related to the dividend yield. In an e ffo rt to restrict transfers o f tax credits between investors, the tax laws were amended in 1997 w ith the intro du ction o f a holding period rule, which provides th a t an investor can use a franking credit only i f the shares in the company are held at risk fo r at least 45 days around the date o f dividend entitlem ent. Cannavan, Finn and Gray found th a t p rio r to the 45-day rule, franking credits were valued at up to 50 per cent o f face value fo r high-yielding companies. A fte r the intro du ction o f the 45-day rule, they found no evidence o f franking credits having any value. These results are consistent w ith share prices in the Australian m arket being set by non-resident investors who were able to extract some value from franking credits distributed by large high-yielding companies p rio r to the intro du ction o f the 45-day rule. A fte r the intro du ction o f the rule, franking credits appear to be worthless in the hands o f non-resident investors. Beggs and Skeels (2006) examined the effects o f dividend im p utatio n on the ex-dividend share price drop from its inception to m id-2004. They addressed two more issues th a t complicate the use o f dividend drop-off ratios to estimate the value o f franking credits. First, the m arket value o f a dollar o f cash dividend may n o t be equal to the m arket value o f a dollar o f franking credit. Second, the values o f both cash dividends and franking credits could change over tim e and any such changes may be related to amendments to the tax regime such as the intro du ction o f the 45-day rule in 1997 and the refunding o f excess franking credits from 1 July 2000. Beggs and Skeels found th a t gross drop-off ratios— th a t is, the ex-dividend price drop divided by the cash dividend plus the franking credit— were significantly less 13 The franking credit is 43 cents because $1/(1 - 0.3) - $1 = $1.43 - $1 = 43 cents.

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than 1 over the whole period studied. W hen th e ir model was extended to provide separate estimates o f the cash drop-off ratio and the franking credit drop-off ratio fo r each financial year, they found th a t the cash drop-off ratio was generally close to 1 b ut the estimated value was significantly less than 1 in five o f the 18 years. In the case o f the franking credit drop-off ratio, its value was n ot significantly different from zero fo r much o f the period, which suggests th a t m arginal investors placed no value on franking credits. Im portantly, Beggs and Skeels found th a t the value o f franking credits was positive in the 2001 to 2004 period. This finding suggests th a t the intro du ction o f refunds fo r excess franking credits from 2000 caused a significant increase in the value o f franking credits to m arginal investors. As discussed in Chapter 14, the findings outlined above have im p o rta n t im plications fo r the debate on the effects o f im p utatio n on the cost o f capital fo r Australian companies. However, i t is im p o rta n t to note th a t the factor used to reflect the value o f franking credits when estim ating the cost o f capital under the im p utatio n tax system w ill n o t necessarily be the same as the value o f a dollar o f franking credits as discussed in this section. The studies discussed here provide estimates o f the value o f a dollar o f franking credits, given th a t those credits have been distributed. In contrast, as discussed in Section 14.5.4 the effective company tax rate used in estim ating the cost o f capital also depends on the extent to which franking credits are used to reduce personal taxes.14 This depends on a company s payout policy and on the a b ility o f shareholders to utilise franking credits. W hile a fu ll im putation tax system has the potential to ‘elim inate company tax’，Handley and Maheswaran (2008) analysed Australian Taxation Office data and found that, on average, only 67 per cent o f the franking credits distributed by Australian companies were used to reduce personal taxes over the period 1990 to 2000. The average u tilis a tio n rate increased to 81 per cent over 2001 to 2004. Under New Zealands im putation tax system, im putation credits are norm ally attached to cash dividends b ut can also be distributed via taxable stock dividends (bonus issues). Thus, there are taxable stock dividends w ith im putation credits attached and non-taxable stock dividends th a t do n ot carry im putation credits. This provides another setting fo r examining whether investors value im putation credits. Im putation credits cannot be used u n til they are distributed to shareholders. However, the value o f any such credits being stored by a company should be reflected in its share price. This argum ent implies that shareholders can realise the value o f undistributed im p utatio n credits at any tim e by sim ply selling th eir shares. Anderson, Cahan and Rose (2001) argue th a t taxable stock dividends d istributed by New Zealand companies have two advantages. First, shareholders can realise the tax benefits o f im p utatio n credits w ith o u t selling th e ir shares. Second, the present value o f the tax benefits is greater, the sooner they are distributed to investors. Therefore, i f im p utatio n credits are valuable to investors, the share price should increase when a company announces a taxable stock dividend. Moreover, the size o f this increase should exceed the size o f the reaction to the announcement o f a non-taxable stock dividend. Consistent w ith this expectation, Anderson, Cahan and Rose found th a t taxable stock dividends were associated w ith average abnormal returns o f 4.39 per cent over a 2-day announcement period, compared w ith 2.96 per cent fo r non-taxable stock dividends.

Information effects and signalling to investors L E A R N IN G O BJEC TIVE 6 Understand the argum ent that payout decisions m ay have a role in pro viding signals to investors

There is empirical evidence th a t share price changes around the tim e o f the announcement o f dividend changes and share repurchases are positively related to the change in payout (see Finance in Action at the end o f th is section). For example, i t is clear th a t announcements o f large increases in dividends are often followed im m ediately by increases in share prices, and th a t reductions in dividends can result in decreases in share prices.15 M ille r and M odigliani (1961, pp. 415-21) claimed th a t these facts do n o t invalidate th eir dividend irrelevance theorem. They m aintained th a t i t is n o t the dividend payments per se th a t determine the value o f a company, b ut the present and future cash flows from the company s investments. Managers w ill usually have better inform a tion about a company s prospects than outside shareholders and i f this inform a tion affects th e ir decisions about current dividend payments, then changes in dividends w ill 14 This point is emphasised by Hathaway and Officer (2004), pp. 6-7. 15 Studies that formally document these effects include Healy and Palepu (1988) and Balachandran, Krishnamurti, Theobold and Vidanapathirana (2012).

4^^

C hapter eleven Payout

convey management’s ‘inside’ info rm a tio n about future cash flows to the market. Thus, the announcement o f a change in dividends provides the occasion fo r a change in share price, b u t the change in dividends is not itse lf the cause o f the price change. In summary, M ille r and M odiglianis response was th a t the inform ation effect o f dividends can be consistent w ith th e ir irrelevance theorem. De Angelo and De Angelo dispute this approach and argue th a t the m arkets response to payout announcements can be explained w ith o u t invoking the idea th a t the m arket is really responding to inform ation about future earnings. They argue th a t payout policy does m atter_ th a t is, th a t the share market places a value on dividends— because investors value securities only fo r the payouts they are expected to provide (2006, p. 309). Therefore, it is logical th a t higher (lower) share prices follow the announcement o f higher (lower) payouts. I f dividend announcements do convey inform ation, it is possible th a t management deliberately uses dividend policy to signal inform a tion to investors.16 This argum ent relies on the existence o f inform ation asymmetry, whereby management has valuable inside inform a tion about the company. For example, management may be very confident about the success o f a new product it has launched. Could management not simply release a media statem ent telling everyone the good news? Yes it could— b ut would it be believed? A company m ig ht release such a statement even i f it were n o t true. How can management release inform a tion in a manner th a t w ill be believed? Dividends may provide a credible signal about a company’s ‘q uality’ because the payment o f dividends is evidence th a t the company generates sufficient cash to be able to pay dividends, and also provides inform a tion on managements expectations as to the company s future pro fitab ility. O ther companies, w ith less favourable prospects, th a t attem pt to im itate higher quality companies by increasing th e ir payout cannot do so w ith o u t increasing the risk o f being forced to cut th e ir dividend in the future. As noted earlier, there is clear evidence th a t changes in dividends appear to convey new inform ation about company value. Several US studies report th a t dividend increases (decreases) are associated w ith positive (negative) share price changes. For example, Grullon, Michaely and Swaminathan (2002) studied a large sample o f dividend changes o f at least 12.5 per cent over the period 1967 to 1993. They found that the average abnormal retu rn over a 3-day announcement period was 1.34 per cent (median 0.95 per cent) fo r dividend increases and -3.71 per cent (median -2.05 per cent) fo r dividend decreases. N ot surprisingly, dividend in itia tio n s (omissions) are associated w ith positive (negative) price changes that are larger than those th a t accompany dividend increases and decreases. Michaely, Thaler and Womack (1995) found average abnormal returns over a 3-day announcement period o f 3.4 per cent fo r dividend initiations and -7.0 per cent fo r omissions. Using Australian data from 1995 to 2008, Balachandran, Krishnam urti, Theobold and Vidanapathirana (2012) found th a t dividend reductions were associated w ith mean (median) abnormal returns o f -1 .7 per cent (3.4 per cent) over a 3-day period. Many studies focus on the relationship between current dividends and future earnings. For example, Healy and Palepu (1988) studied the p ro fit performance o f companies th a t in itia te d dividends and companies th a t om itted dividends. For th e ir sample o f companies th a t in itia te d dividends, earnings had increased rapidly p rio r to the dividend and continued to increase fo r the next 2 years. For companies that om itted dividends, earnings decreased in the year o f omission b ut then increased significantly in subsequent years— which is the opposite o f the prediction made by signalling models. Benartzi, Michaely and Thaler (1997) found th a t there is a strong correlation between increases in dividends and recent increases in p ro fit— th a t is, when dividends are increased, profits have already increased. However, they found little evidence th a t increases in dividends are followed by fu rth e r increases in p ro fit. In the 2 years follow ing dividend increases, they found th a t p ro fit changes are essentially unrelated to the dividend changes. In the case o f dividend decreases they found th a t profits tend to increase over the next 2 years. Hence, th e ir findings support the perverse result reported by Healy and Palepu. De Angelo, De Angelo and Skinner (1996) examined the dividend decisions made by managers o f 145 companies whose p ro fit declined after at least 9 consecutive years o f grow th in profits. The dividend decision in Year 0, the year th a t the record o f sustained p ro fit grow th was broken, could convey valuable inform ation to outsiders to help them assess whether the dow nturn was likely to be transient or persistent. The managers o f 99 o f the 145 companies increased dividends in Year 0, b u t De Angelo, De Angelo and Skinner found no evidence th a t these dividend increases were associated w ith favourable p ro fit surprises in the future. Also, the subsequent p ro fit performance o f the companies th a t increased dividends was 16 Signalling models are discussed by Miller (1987).

policy

B usiness finance

no better than th a t o f the companies th a t did n o t change th e ir dividends. Essentially, the study found virtu a lly no support fo r the n otio n th a t dividend decisions provide reliable signals about future p ro fit. The findings o f Grullon, Michaely and Swaminathan (2002) confirm the results from earlier studies. They examined the p ro fita b ility (measured by return on assets) o f companies 3 years before and 3 years after a change in dividends o f at least 12.5 per cent. They found th a t dividend-increasing companies move from a period o f increasing retu rn on assets before the dividend increase to a period o f declining return on assets after the increase. Moreover, companies th a t increased th e ir dividends the m ost experienced the greatest decline in p rofitability. Dividend decreases follow a period o f declining retu rn on assets, but after the dividend decrease, company p ro fita b ility tends to recover rather than decline further. A fte r reviewing the large body o f empirical evidence on the in fo rm a tio n signalling argument, Allen and M ichaely (2003) conclude that:
C hapter eleven Payout

policy

repurchase activity is inform ative about earnings quality. They find th a t it is, b u t repurchases provide a less credible signal than dividends— which is to be expected, since dividends represent a stronger com m itm ent to continue to d istribute cash to shareholders. As noted earlier, Brav, Graham, Harvey and Michaely (2005) surveyed and interviewed financial executives to determine the factors th a t are im p o rta n t in m aking payout decisions. They fin d th a t managers agree that both dividends and repurchases can convey inform a tion to investors. However, th eir responses to more detailed questions reveal little support fo r the signalling theories we have discussed. In particular, it is rare th a t managers view either type o f payout as a to ol th a t can be used to reveal private inform ation or to signal a company s q uality relative to competitors. Similarly, managers believe that dividends and repurchases are equally attractive to most in s titu tio n a l investors. Consequently, even companies th a t wish to attract in stitu tio n s as shareholders do n ot consciously use payout policy as an im p o rta n t tool to convince institutio ns to hold th e ir shares. Managers do, however, see a connection between risk reduction and dividend increases. M any hold views th a t are consistent w ith the ‘m a tu rity hypothesis’ proposed by GMS— that is, companies typically increase dividends when they become more mature and less risky. The next section discusses the role o f dividends in reducing agency costs. The signalling and agency cost arguments are related, b u t the way they are viewed differs depending on the underlying model th a t is adopted. I f the M ille r and M odigliani (M M ) dividend irrelevance theorem is used as the starting point, the signalling argument says th a t dividend changes convey news. A lternatively, the De Angelo and De Angelo (DD) fu ll payout model holds th a t dividends are im p orta nt, so it has no need to invoke the inform ation and signalling concepts to explain why share prices react to dividend-related announcements. In the case o f agency costs, there is no difference between the M M and DD approaches: in b oth cases the agency cost argument says th a t dividends are good news.

A N Z BANK AN N O U N CES INCREASED DIVIDEND_____________

Finance in

The signalling argument under the Miller and Modigliani (MM) analysis suggests that dividend changes convey news while the De Angelo and De Angelo (DD) model provides that dividend changes themselves affect company values. In the case of an individual announcement by a company concerning its dividend payout, it is not possible to differentiate between these explanations.

ACTION

N ews

n

AN Z Bank shares have surged to a record high after it vowed to give shareholders a bigger slice of future profits, raising investor hopes of even stronger returns across the sector. In a result that smashed market expectations, A N Z hiked the interim dividend by 1 1 per cent to 73 cents a share on Tuesday, and said it would lift the share of profits paid as dividends as it continued to cut costs and target growth across Asia. The $2 billion dividend payout was underpinned by a 10 per cent jump in half-year earnings to $3.1 8 billion, but is also a sign the bank is accumulating excess capital due to slow lending growth. Investors cheered the result, pushing A N Z shares up by 5.8 per cent, or $ 1 .74, to a new high of $31.84. Although analysts say bank dividend growth may soon cool off, A N Z chief executive Mike Smith signalled he expected further earnings growth, as its push to lift productivity still had more 'gas in the tank7. Helped by this earnings growth, the bank said it would lift its dividend payout ratio towards the upper end of its target range of 65 to 70 per cent. S o u rc e :

7A N Z su rge s o n profits p a yo u t', C la n c y Yeates,

S y d n e y M o r n in g

H e r a ld ,

3 0 A p ril 2 0 1 3 .

11.6 Agency costs and corporate governance We saw in Chapter 1 that, given the separation o f ownership and control o f companies, there can be conflicts o f interest between shareholders and managers resulting in agency costs. Shareholders are aware that these costs exist and may therefore impose restrictions on managers and give them incentives to make financing and investment decisions th a t are expected to increase shareholders’ wealth. Various authors have argued th a t paying higher dividends can reduce agency costs, b ut there is no single or generally agreed model o f how dividends achieve this outcome. D ifferent authors have suggested different mechanisms.

L E A R N IN G O B JEC TIVE 7 Exp lain the w a y s in w hich a g e n c y costs can be related to p ayout d ecisions

B usiness finance

One approach is based on the fact th a t higher dividends w ill force a company to raise capital externally more frequently than would otherwise be the case (Easterbrook 1984). Capital raising is accompanied by the provision o f in fo rm a tio n to investors, underw riters and other capital m arket agents, particularly potential new investors. As a result, investors w ill have the o p p o rtu n ity to scrutinise the company closely at a relatively low cost. The capital raising process provides an efficient mechanism fo r contributors o f new capital to m o n ito r the performance o f the managers. Existing shareholders also benefit from this process because managers who are subject to regular m o n itoring are more likely to act in shareholders’ interests than managers subject to less scrutiny. A nother approach focuses on the agency costs th a t are likely to arise when a company generates free cash flowSy which are defined as cash flows in excess o f those required to fund all available projects that have positive NPVs. Managers have incentives to achieve grow th because i t is likely th a t the larger the company, the greater w ill be th e ir power and remuneration. Therefore, managers o f companies w ith free cash flows are likely to retain cash and invest it in new projects, even i f the projects have negative NPVs. This problem is known as overinvestment. It follows th a t shareholders’ wealth w ill be increased i f managers com m it themselves to paying out this cash as dividends rather than retaining it w ith in the company (Jensen 1986).18 This argument provides another possible explanation fo r the positive m arket response to announcements o f dividend increases: investors welcome the higher payout m ainly because they believe th a t managers cannot be relied upon to invest retained funds profitably. This argument should be particularly strong fo r cash-rich companies in mature industries w ith few grow th opportunities. Lang and Litzenberger (1989) tested this hypothesis using a measure known as Tobins Q, which is the ratio o f the m arket value o f a company s assets to the estimated replacement cost o f those assets. I f a company is successful (unsuccessful) in ide ntifyin g investments w ith positive NPVs, its Q ratio should be greater (less) than one. For announcements o f dividend increases, Lang and Litzenberger found th a t low Q companies had larger share price increases than high Q companies. They interpreted this fin ding as being consistent w ith the free cash flow hypothesis. However, this interpretatio n was questioned by Denis, Denis and Sarin (1994) and Yoon and Starks (1995), who found th a t after controlling fo r the effects o f dividend yield and change in dividend yield, the m arket reaction to announcements o f dividend changes was n ot related to a company’s Q ratio. Lie (2000) undertook a direct exam ination o f the relationship between excess cash and payout policy in the context o f special dividends, increases in regular dividends and share repurchases. He found that in all three cases, companies m aking these payouts had higher cash holdings p rio r to the payout than others in the same industry. Lie also found th a t the m arket reaction to the announcement o f special dividends and share repurchases was positively related to the level o f cash relative to ind ustry norms. Moreover, this relationship was stronger fo r companies w ith poor investm ent o pportunities as indicated by th e ir having a Q ratio o f less than one. Lie concluded th a t shareholders1 wealth could be enhanced by d istrib u tin g cash and thereby restricting p otential overinvestment by managers. As discussed in the previous section, the findings o f Grullon, Michaely and Swaminathan (2002) are also consistent w ith the free cash flow hypothesis. In summary, evidence on the significance o f the free cash flow hypothesis is mixed, b u t most o f it is consistent w ith the argument th a t higher payouts can add value by reducing the p otential fo r management to overinvest. Similarly, it is n ot hard to fin d cases where investors welcome increased payouts because the higher payout indicates th a t management has changed its priorities. The response to an announcement by the Chairman o f Telstra Corporation in June 2004 is a good example (see Finance in A ction at the end o f this section).19 La Porta, Lopez-De-Silanes, Shleifer and Vishny (2000) outline and test two agency models o f dividends using legal protection o f shareholders as a proxy fo r agency problems between corporate insiders and outsiders. The ‘outcome model’ proposes th a t dividends are paid because effective legal protection allows outside shareholders to pressure corporate insiders to pay o ut cash, thus lim itin g the extent to which insiders can use company profits to benefit themselves.20 18

J e n s e n a r g u e s t h a t th e u s e o f d e b t fin a n c e w ill b e p a r t ic u la r ly e ffe c tiv e in r e d u c in g t h e s e a g e n c y c o s t s b e c a u s e se v e r e p e n a lt ie s a re a s s o c i a t e d w ith fa ilu r e to m e e t o b lig a t io n s to le n d e r s . C o m m it m e n t s t o p a y r e g u la r d iv id e n d s m a y h a v e a sim ila r , b u t le s s p r o n o u n c e d , e ffe c t b e c a u s e o f th e w e ll-k n o w n r e lu c ta n c e o f m a n a g e r s t o r e d u c e d iv id e n d s .

19

T h e e x a m p le o u t lin e d h e re is d is c u s s e d m o r e fu lly b y E a s t o n a n d H o w a r d ( 2 0 0 5 ).

20

T h is a r g u m e n t d o e s n o t re ly o n o u t s id e s h a r e h o ld e r s h a v in g a n y sp e c ific r ig h t to d iv id e n d s . R a th e r , th e a r g u m e n t is t h a t s h a r e h o ld e r s w h o h a v e th e m o re g e n e r a l r ig h t s to v o t e fo r d ir e c t o r s a n d to r e s is t o p p r e s s i o n a n d w e a lth e x p r o p r ia t io n w ill b e a b le to e x t r a c t d iv id e n d s fr o m c o m p a n ie s . F o r e x a m p le , s h a r e h o ld e r s m a y v o te fo r d ir e c t o r s w h o o ff e r b e t t e r d iv id e n d p o lic ie s

^^

4

o r m a y s u e c o m p a n ie s t h a t u s e r e s o u r c e s in w a y s t h a t b e n e fit o n ly th e in s id e r s .

Alternatively, dividends may be seen as a substitute fo r legal protection o f shareholders. This view is based on the need fo r companies to approach the capital markets to raise funds externally, at least occasionally. The substitute m oder proposes th a t insiders, who are interested in raising equity in the future, pay dividends to establish a reputation fo r favourable treatm ent o f outside shareholders. A good reputation w ill be o f greatest value in countries where legal protection o f m in o rity shareholders is weak and such shareholders have little to rely on apart from a company s reputation. La Porta, Lopez-De-Silanes, Shleifer and Vishny tested these models using a sample o f more than 4000 companies from 33 countries w ith different legal systems and different legal protection o f shareholders. Investor protection is generally stronger in common law countries such as the US, UK and Australia than i t is in civil law countries such as France, Spain and Japan. The outcome model has two testable predictions. First, if dividends are an outcome o f an effective system o f legal protection for investors, then dividends should be higher in countries where th a t protection is better. Second, fo r companies in these countries i t predicts a relationship between investm ent opportunities and dividends. High-growth companies should make lower payouts than low -grow th companies because shareholders who feel well protected w ill accept low payouts from companies w ith good investm ent opportunities. The alternative substitute model makes only one prediction: dividend payouts should be higher in countries where legal protection o f investors is weak. La Porta, Lopez-De-Silanes, Shleifer and Vishny found consistent support fo r the outcome model. Companies operating in countries where legal protection o f investors is better, pay higher dividends. This result is consistent w ith the outcome model and is the reverse o f the substitute models prediction. Also, in countries where investors are well protected, there is a relationship between dividends and growth. Companies th a t are growing more rapidly, as measured by grow th in sales, pay lower dividends than slowgrowth companies. This fin ding is consistent w ith the view th a t investors who are well protected legally are prepared to w ait fo r dividends provided th a t a company has good investm ent opportunities. Correia Da Silva, Goergen and Renneboog (2004) propose th a t dividend policy may be influenced by corporate governance regimes that, like investor protection, d iffer between countries. They define a corporate governance regime as *the amalgam o f mechanisms which ensure th a t the agent (the management o f a corporation) runs the company fo r the benefit o f one or m ultiple principals (shareholders, creditors, suppliers, clients, employees and other parties w ith whom the company conducts its business)1(p. 156). Corporate governance regimes may be m arket based or blockholder based. The market-based regime applies in countries such as the UK, the US and Australia and is characterised by diffuse ownership o f listed companies, the one-share-one-vote rule, an active m arket fo r corporate control and strong shareholder and creditor rights. In contrast, the blockholder system th a t is common in Europe involves the presence o f large blockholders, complex ownership structures such as cross-ownership between companies, frequent violations o f the one-share-one-vote rule and weak legal protection o f shareholders. Correia Da Silva, Goergen and Renneboog suggest th a t dividend policy may have different roles under these two regimes. For example, the greater concentration o f control th a t is inherent in the blockholder system may mean th a t there is less pressure on managers to com m it to paying high dividends as a way o f avoiding overinvestment. Also, dividends may be less im p o rta n t as a signal when control is more concentrated. As well as involving differences in the concentration o f control, the tw o regimes differ in terms o f the nature o f control. In market-based countries, m ost shares are held by financial in stitu tio n s b ut the holding o f each in s titu tio n in a given company is usually small. In European countries the m ain shareholder categories are families or individuals, corporations and, in the case o f Germany, banks. Banks are an im portant source o f finance fo r German companies and often hold significant voting stakes as well as being the main provider o f debt finance. Thus, the separation o f ownership and control th a t is the source o f many agency problems under the market-based regime is n o t an issue fo r many German companies. Correia Da Silva, Goergen and Renneboog examined the dividend policies o f German companies and compared th e ir findings w ith those from the existing body o f empirical research, m ost o f which has been conducted on companies operating under the market-based system. They found several differences between the dividend practices o f German companies compared w ith UK and US companies. First, German companies pay out a lower p roportion o f th e ir cash flows. Second, w hile the dividends per share o f UK and US companies are relatively sm ooth over tim e w ith frequent small adjustments, the dividends per share o f German companies exhibit less frequent b ut larger changes. In particular, German companies frequently reduce or o m it dividends i f they incur a loss, b u t quickly revert to the payout p rio r to the reduction or omission once p ro fita b ility is restored. These findings contrast w ith L in tn e rs (1956) prediction th a t managers w ill only make dividend changes th a t they believe w ill n ot have to be reversed

B usiness finance

in the short run. In other words, the blockholder regime o f corporate governance appears to provide companies w ith greater fle x ib ility in terms o f th e ir dividend policies. A nother im p o rta n t result is that bank ownership o f the vo ting equity o f German companies is associated w ith a lower level o f dividends and a greater propensity to o m it the dividend when p ro fit falls. Thus, direct control by a bank can be seen as reducing agency costs. In summary, the legal protection o f investors th a t was stressed by La Porta, Lopez-De-Silanes, Shleifer and Vishny may n o t be the m ost im p o rta n t factor th a t explains differences in dividend policy between countries. O ther differences between corporate governance regimes, such as the concentration and nature o f control, are also im p o rta n t and the evidence from Correia Da Silva, Goergen and Renneboogs study is consistent w ith the view th a t control is a substitute fo r dividends as a mechanism fo r m on itoring management and reducing agency costs.

Finance in

ACTION

AGENCY COSTS AT TELSTRA__________________________________ The market reaction to the announcement in June 2004 of a new capital management strategy for Telstra Corporation provides an excellent illustration of the role that payout policy can play in alleviating investors' concerns about the use of free cash flows. Telstra, Australia's largest telecommunications company, had been strongly criticised in previous years over its strategy of growth by acquisition. This strategy—regarded by critics as poorly executed —led to investments in Asia and technology-related investments that resulted in write­ downs of more than $2 billion. A failed attempt to merge its directories business with media company John Fairfax Holdings also attracted criticism, split the Telstra board and contributed to the resignation in April 2 0 0 4 of former chairman, Bob Mansfield. The Fairfax plan had been put forward by Mansfield together with [then] Telstra CEO, Dr Ziggy Switkowski. 〇n 21 June 2 0 0 4 , the new chairman of Telstra released a statement on capital management which included the following: The Telstra Board o f Directors has undertaken with management its review o f the Company's strategy os port o f the annual budget and planning process. The operating strategy o f Telstra has been reaffirmed and new capital settings have been established. The Company expects future cosh flows from operations to remain robust. Accordingly, the Board has adopted the following capital management policies from the 2 0 0 4 -0 5 year: • The Board's policy w ill be to declare ordinary dividends o f around 80 per cent o f normal profits offer tax. • The Board expects to return $ 1 .5 billion to shareholders each year for the next three years through special dividends o n d /o r shore buybacks, subject to maintaining the Board’s target balance sheet ratios. • The Board notes that offer appropriate capital expenditures and the proposed capital returns to shareholders, the company w ill have sufficient balance sheet capacity to support well targeted acquisitions o f moderate scale and which satisfy strict financial criteria [emphasis added]. Analysts noted that the higher cash payout would result in higher financial leverage and the announcement sparked a credit downgrade by rating agencies such as Standard & Poor's. Telstra shares jumped by 4.6 per cent in response to the announcement to a nine-month high of $5.02. Peter M organ, director of fund manager 4 52 Capital, said: 'This is a step in the right direction. If they have excess capital, they should be returning it to shareholders. W hat the market has been concerned about is that their acquisitions so far have been disappointing’ . Other commentators pointed to the significance of the Board's commitment to an 80 per cent payout ratio in comparison to the previous commitment to distribute at least 60 per cent of profits. S o u rc e :

A d a p te d from Telstra M e d ia Release, 'Statem ent from M r John Ralph, C h a irm a n of the B oard , Telstra C o rp o ratio n

on the matter o f C a p ita l M a n a g e m e n t ’， O ffice of the C o m p a n y Secretary, 21 June 2 0 0 4 .

C hapter eleven Payout

policy

Behavioural factors and catering theory As we discussed in Section 11.2.3, the M odigliani and M ille r analysis assumes th a t capital markets are perfectly competitive. It also assumes th a t investors are rational and th a t they are equally satisfied w ith a given increase in wealth, regardless o f whether it is in the form o f dividends or an increase in the value of the shares they hold. Baker and W urgler (2004a, 2004b) present and test a theory th a t relaxes these assumptions. This theory has three foundations. First, it is assumed th a t n ot all investors are rational and th a t sometimes investors prefer dividends to increases in the value o f th e ir shares and sometimes they prefer increases in the value o f th e ir shares to dividends. Second, i t is assumed th a t i f investors are sometimes w illing to pay more to invest in companies th a t pay higher dividends th a t the process o f arbitrage, as discussed in Section 1.5.7, w ill fa il to prevent these companies having higher prices than those th a t do not pay dividends. Third, managers cater to this investor demand by paying dividends when investors place higher value on dividends, and not paying dividends when investors place higher value on increases in the value o f th e ir shares. It is from these foundations th a t c a te rin g th e o ry is derived: the theory that managers cater to changes over tim e in investor demand fo r dividends. To test this theory, Baker and W urgler (2004a) examine whether the market-wide rate o f companies in itia tin g or o m ittin g to pay dividends depends on the presence o f a so-called ‘dividend prem ium ’ in share prices. A company’s dividend premium is measured as a ratio given by the m arket value o f its shares divided by the book value o f its shares. The market-wide dividend premium is the difference between the average o f this ratio fo r companies paying dividends and those n o t paying dividends. Baker and W urgler argue that this m arket-wide dividend prem ium is due to investors being w illin g to pay more to hold payers than non-payers. They also argue th a t i f a dividend prem ium is present it w ill lead to a difference between the future share returns o f dividend-paying and non-dividend-paying companies. Specifically, they argue that i f demand fo r dividends is high this w ill lead to the share prices o f dividend-paying companies being overpriced, and hence th e ir future returns to be relatively low. Using US data from 1963 to 2000 they fin d th a t m arket-wide dividend initia tion s are higher in years following years in which the m arket-to-book ratio fo r dividend-paying companies is higher than fo r non-dividend-paying companies. They also find th a t increases in market-wide dividend in itia tio n s are followed by years in which shares in dividend-paying companies underperform shares in non-dividend­ paying companies. Sim ilarly they find th a t market-wide dividend omissions are high in years follow ing years in which the m arket-to-book ratio fo r dividend-paying companies is low relative to th a t fo r non­ dividend-paying companies. Further, they fin d th a t increases in market-wide dividend omissions are followed by years in which shares in dividend-paying companies outperform shares in non-dividend­ paying companies. These results suggest th a t dividends are relevant to share prices, and th a t managers cater to changes over tim e in investor demand in order to maximise the current share price. However, Hoberg and Prabhala (2009) have cast doubt on these findings by showing th a t the relationship between the so-called dividend prem ium and companies paying dividends may be due to risk— a factor th a t Baker and W urgler ignored. Hoberg and Prabhala argue th a t riskier companies adopt more conservative payout policies to avoid the potential o f needing to cut dividends. And as was discussed in Section 7.7, some studies suggest th a t companies w ith lower m arket-to-book ratios may be riskier. Therefore they argue th a t the difference between the m arket-to-book ratios o f dividend-paying and non­ dividend-paying companies may be due to risk differences and th a t this in tu rn leads to differences in future returns. As economy-wide risk varies over tim e so does this relationship between risk and return. When Hoberg and Prabhala control fo r this risk factor they fin d no residual relationship between the so-called dividend prem ium and companies1propensity to pay dividends.

11.8 Share buybacks Most cash paid out to the shareholders o f Australian companies is distributed as dividends. As discussed in Section 11.1.4, changes to the Corporations Act in 1989 and 1995 mean th a t companies can also pay cash to shareholders by repurchasing shares. This m ethod o f d istrib u tin g cash has grown rapidly since

L E A R N IN G O B JEC TIVE 8 Explain behavioural factors that m ay affect payout policy

CATERING THEORY theory that suggests that m a n a g e rs cater to c h a n g e s ove r time in investor d e m an d for d ivid e nd s

L E A R N IN G O B JEC T IV E 9 U nde rstand the nature of share buybacks, d ivid e n d reinvestment p la ns a n d d ivide nd election schem es

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4

B usiness finance

1995. In the 1995 financial year, share repurchases by listed companies totalled $770 m illio n (Renton 2000, p. 38) and, as noted in Section 11.1.4, the to ta l peaked at about $16 b illio n in 2010. Rapid growth in share repurchases since the 1990s appears to be a global phenomenon. M any other countries that previously prohibited share repurchases, such as Germany and Japan, also introduced provisions that allow companies to repurchase shares. Share repurchases also grew dramatically in countries like the US, Canada and the UK where repurchases had long been perm itted. For example, between 1985 and 1996, the value o f open-market repurchase programs announced by US industrial companies increased by 750 per cent from $15.4 b illio n to $113 billion , while aggregate dividends increased by a factor o f ju s t over two during the same period (Jagannathan, Stephens & Weisbach 2000, p. 356). In 1999, fo r the firs t tim e in history, and again in 2000, US ind ustria l companies distributed more cash to investors through share repurchases than through cash dividends (G rullon & Michaely 2004, p. 651).

I f there are no taxes or other imperfections, repurchasing shares is effectively the same as paying a cash dividend. Accordingly, many o f the factors th a t may explain why companies repurchase shares are the same as those th a t may explain why they pay dividends. For example, i f the agency costs o f free cash flow can be reduced by paying dividends, they can also be reduced by repurchasing shares. In terms o f a company s assets and operations, the end result o f taking surplus cash out o f the company should be the same, regardless o f the m ethod used to pay out the cash. Indeed, G rullon and Michaely (2004) report th a t th e ir analysis ‘indicates strong sim ilarities between companies th a t increase dividends and those th a t use open-market share repurchases, (p. 653). In b oth cases, p ro fita b ility does n o t increase and risk and the cost o f capital decline. They conclude th a t these and other sim ilarities suggest th a t Sim ilar factors m otivate companies to repurchase shares in the open m arket and to increase dividends* (p. 654). However, the m ethod o f payment can matter. For example, suppose th a t managers are more reluctant to cut dividends than they are to cancel share repurchase programs. I t follows th a t dividends may be better in controlling agency costs because they represent a stronger com m itm ent to continue paying out cash. Similarly, dividends and share repurchases may both be used as signals o f a managers expectations b ut the in fo rm a tio n conveyed to investors may be different. In particular, an increase in dividends is likely to signal a more perm anent increase in cash flows than a one-off share repurchase. In this section we discuss several factors th a t may influence the decision to retu rn cash to shareholders by repurchasing shares and review empirical evidence on the effects o f share repurchases.

Improved perform ance measures Company announcements o f share buybacks and reports in the financial press often m ention th a t the buyback is expected to have a favourable effect on performance measures, particula rly earnings per share (EPS) and net assets per share. Focusing on the effects on EPS may reflect an assumption th a t the m arket w ill react mechanically to increases in EPS by increasing the share price. This 4EPS-based* rationale fo r buybacks raises tw o m ain issues. First, to repurchase shares a company m ust use cash th a t could have been invested elsewhere. Therefore, unless the buyback is financed by borrowing, the company w ill have fewer assets after the buyback. I f the assets were being used efficiently, earnings w ill also be lower so EPS w ill increase only if the decrease in earnings is less, in percentage terms, than the decrease in the num ber o f shares on issue. I f the company has surplus cash th a t i t cannot invest profitably, then using the cash to repurchase shares should certainly increase EPS. However, the real source o f any gain to investors is the more efficient use o f resources, n o t some magical reaction to the higher EPS. Second, a share buyback reduces the company s equity and increases its financial leverage, particularly if the buyback is financed by borrowing. Higher leverage means higher risk for shareholders and this w ill tend to reduce the share price and hence lower the price-earnings (P/E) ratio. In summary, i f the only reason for a share buyback is that it is expected to increase EPS, the probability that the share price w ill increase is low.

Signalling and undervaluation As discussed in Section 11.5, managers are likely to have better in fo rm a tio n about a company s true value than outside investors and may use changes in dividends to convey info rm a tio n to investors. Arguably,

share repurchases may serve a sim ilar purpose. In the case o f share repurchases, there are tw o versions o f the signalling hypothesis. The firs t version is th a t the announcement o f a share repurchase could provide new inform ation: managers expect th a t earnings and cash flows w ill be higher in the future. The second version is th a t managers may use repurchases to indicate th a t they disagree w ith the m arkets valuation o f the company based on existing public inform ation. Several studies, including Comment and Jarrell (1991), fin d negative abnormal returns in the m onths p rio r to the announcement o f open-market repurchase programs. This fin ding suggests th a t managers make repurchase announcements at times when they believe th a t the shares are undervalued. Early studies, such as Bartov (1991), found support fo r the firs t version o f the signalling hypothesis in that there is some evidence o f earnings grow th follow ing repurchases. However, the findings o f a more recent and comprehensive study (Grullon & Michaely 2004) are inconsistent w ith the hypothesis that repurchases signal good news about future earnings. This study found a significant decline in operating p ro fit as a percentage o f to ta l assets over the 3 years follow ing the announcement o f a repurchase program. I t also found th a t analysts revise th e ir forecasts o f earnings per share downwards after these announcements are made. Managers who believe th a t th e ir company s shares are undervalued could tr y to signal th a t belief by increasing dividends or repurchasing shares. Any share price increase follow ing an increase in dividends accrues proportionately to all current shareholders. In contrast, i f the share price appreciates follow ing a repurchase, then insiders and any other shareholders who do n o t sell w ill benefit disproportionately. This difference suggests th a t perceived undervaluation may lead managers to favour repurchases rather than dividend increases. To examine the u ndervaluation version o f the signalling hypothesis, Ikenberry, Lakonishok and Vermaelen (1995) analysed share returns fo r a period o f 4 years fo llo w in g repurchase announcements by more th an 1200 US companies. For the whole sample they found excess returns o f more than 12 per cent over the 4-year period. Excess returns were measured relative to a benchm ark p o rtfo lio form ed on the basis o f company size and book-to-m arket ratio. This overall result is consistent w ith the p ossibility th a t companies are undervalued, on average, at the tim e repurchases are announced. Ikenberry, Lakonishok and Vermaelen also found th a t excess returns over the 4-year period were strongly related to the book-to-m arket ratio. For companies w ith the lowest book-to-m arket ratio (gla m o u r1 stocks), the average excess re tu rn was slig h tly negative, w hile fo r those w ith the highest book-to-m arket ratio (Value* stocks), the average excess re tu rn was extrem ely high. The sample contained companies w ith a wide range o f book-to-m arket ratios and was n o t s ig n ifica n tly biased towards value stocks. In summary, the results suggest th a t some groups o f companies are fa irly priced at the tim e o f repurchase announcements, b u t in other cases managers do appear to be indicating th a t th e ir company is undervalued.

Resource allocation and agency costs The share m arket plays an im p o rta n t role in allocating capital between competing investm ent opportunities. Profitable companies w ith good investm ent opportunities should experience increases in share price th a t make it easier to raise capital. Conversely, i f a company has run out o f positive NPV investments, then any surplus capital should be returned to shareholders, who are then free to invest it elsewhere. I f share repurchases are part o f this process o f resource allocation in the capital market, then repurchases should be associated w ith reduced investm ent opportunities. The empirical evidence is consistent w ith this suggestion. US companies th a t repurchase shares via tender offers do, on average, have smaller asset bases after the repurchase transactions. Similarly, US companies subsequently make lower capital expenditures after open m arket repurchases (Nohel & Tarhan 1998). G rullon and Michaely (2004) found th a t any changes in p ro fita b ility in the years after share repurchase are negative rather than positive. Like Nohel and Tarhan, they found th a t companies that repurchase th e ir shares subsequently decrease th e ir investments. G rullon and Michaely conclude that repurchase announcements are viewed positively by investors because they are related to a reduction in the agency costs o f free cash flow. In summary, there is evidence th a t share repurchases are im p o rta n t in allowing capital to be released from declining sectors o f the economy and reallocated to sectors where the investm ent opportunities are better.

B usiness finance

Financial flexibility Jagannathan, Stephens and Weisbach (2000) propose th a t the choice between dividends and repurchases is influenced by financial flexibility. As suggested by Lintner, managers prefer to increase dividends regularly and tr y to avoid decreasing them. Therefore, dividends are effectively an ongoing comm itment, whereas repurchases do n o t im p lic itly com m it the company to future payouts. In other words, repurchases preserve financial fle x ib ility relative to dividends. Jagannathan, Stephens and Weisbach test the hypothesis th a t repurchases are used to distribute cash flows th a t are likely to be temporary, while dividends are used to distribute perm anent cash flows. The results o f th e ir tests support this hypothesis. For example, they found th a t companies w ith higher operating cash flows are more likely to increase dividends, while companies w ith higher non-operating cash flows are more likely to increase repurchases. Guay and H arford (2000) address the same issue using a different m ethodology and reach the same conclusion: the permanence* o f an increase in cash flows is an im p o rta n t factor th a t influences the choice between paying out the extra cash by increasing dividends and m aking a share repurchase.

Employee share options Another factor that can influence the choice between dividends and repurchases is the existence o f employee share options. Employees, particularly senior managers, may receive p art o f th e ir remuneration in the form o f call options on the company s shares. The existence o f these options is likely to favour repurchases relative to dividends because dividends and share repurchases have different effects on the prices o f options on shares. As discussed in Section 18.2.5, the value o f a call o ption is negatively related to future dividends on the underlying share because the price o f a share is expected to fall on each ex-dividend date. In contrast, repurchasing shares at the m arket price should n o t affect the share price or the value o f call options held by managers. Fenn and Liang (2001) examined this issue and found that option holdings by management are strongly related to the composition o f payouts. Management share options induce a substitution o f repurchases fo r dividends.

Dividend substitution The dividend substitution hypothesis proposes th a t share repurchases and payment o f dividends are sim ply alternative ways o f d istrib u tin g company profits to shareholders. For example, i f a company reports higher earnings and m aintains the same dividend b u t also announces a share repurchase, then the repurchase may be seen as a substitute fo r dividends. One im p o rta n t difference between share repurchases and dividends involves the tax treatm ent o f investors* income. Under m ost tax systems (including Australia’s), long-term capital gains are taxed less heavily than ordinary income. Even i f the m arginal tax rates applicable to capital gains and dividends are the same, investors are likely to prefer capital gains because they are able to defer the realisation o f gains and the payment o f taxes. Therefore, the rapid grow th o f share repurchases may reflect, at least in part, a tax-driven substitution o f repurchases fo r dividends. Fama and French (2001) reported th a t the p ro po rtio n o f US companies paying cash dividends fell fro m 67 per cent in 1978 to 21 per cent in 1999. Their analysis suggests th a t the decision to pay dividends is influenced by three characteristics: a

b c

p ro fita b ility investm ent o pportunities size.

Companies th a t are larger and more profitable are more likely to pay dividends, w hile dividends are less likely fo r companies w ith more investm ent opportunities. The decline in the p ro p o rtio n o f companies th a t pay dividends is due in p art to the listing o f very large numbers o f small growth* companies th a t make large investm ent outlays and have yet to pay any dividends. However, after controlling fo r company characteristics, Fama and French (2001) also found a significant decline in the likelihood that a company pays dividends. In other words, the perceived benefits o f paying dividends appear to have declined over tim e, leading to an increase in the relative p opularity o f share repurchase. They found that m ost repurchases are made by companies th a t also pay dividends and conclude that: *the large share repurchases o f 1993-98 are m ostly due to an increase in the desired payout ratios o f dividend payers, which they are reluctant to satisfy w ith cash dividends* (p. 39).

C hapter eleven Payout

policy

Grullon and Michaely (2002) reported several findings which indicate th a t US companies have gradually substituted share repurchases fo r dividends. The dividend-payout ratios o f US companies declined in the 1980s and 1990s b ut the to ta l payout ratio did not decline over th a t period. Also, companies th a t initia ted cash payouts favoured repurchases over dividends. The pro po rtio n o f companies in itia tin g distributions through repurchases rather than dividends increased from 27 per cent in 1973 to 81 per cent in 1998. They also found that, since the mid-1980s, established dividend-paying companies rely more on share repurchases than dividends to increase th e ir cash payouts. Finally, they found evidence th a t investors view repurchases as a substitute fo r dividends. In particular, they found th a t the m arket reaction to dividend decreases— which is generally negative— is not significantly different from zero i f the company has repurchased shares in the recent past. Grinstein and Michaely (2005) tested the argument presented by Brennan and Ih a k o r (1990) th a t repurchases are likely to be higher fo r those companies w ith large in s titu tio n a l shareholdings. This argument is based on the premise th a t less inform ed individual investors are likely to avoid companies that repurchase shares because they have less knowledge than in s titu tio n a l investors as to when to participate by selling shares back to the company. Grinstein and Michaely did fin d th a t repurchases are higher fo r those companies w ith large in stitu tio n a l holdings and th a t in s titu tio n a l holdings increase after repurchases. However, they found th a t increases in in s titu tio n a l holdings did n o t lead to higher repurchases. Skinner (2008) also finds strong evidence th a t since share repurchases firs t became significant in the US in the early 1980s they have increasingly been substituted fo r dividends. For example, in the case o f companies th a t pay annual dividends and make regular repurchases, the relationship between earnings and dividends becomes weaker from 1980 to 2005, b u t repurchases adjust quickly to changes in earnings, which is consistent w ith the greater fle x ib ility o f repurchases. Companies in this category have generally been paying dividends fo r many years (or decades) and Skinner argues th a t they continue to do so because o f th e ir h is to ry — given the w ell-known reluctance to cut dividends, these companies are essentially forced to continue paying them. In the case o f companies w ith no significant dividend history which make repurchases either regularly or occasionally, Skinner again finds th a t earnings are increasingly im p o rta n t in explaining repurchases over the period o f his study. He argues th a t newer companies w ith o u t a dividend h isto ry are unlikely to in itia te dividends once they are in a position to commence payouts and th a t dividends may eventually disappear in the US.

1 1 .8 .2 1 Share repurchases in Australia As in the US and other countries, the factors discussed in the previous section may be im p o rta n t in m otivating the management o f an Australian company to repurchase some o f its shares. In addition, as noted in Section 11.1.4, in Australia an off-m arket share buyback can be structured to include a franked dividend and this feature can have significant tax advantages fo r resident investors, p articularly those w ith a low m arginal tax rate such as superannuation funds (see Finance in Action).

Finance

W Q O LW O R TH ^ 2010 OFF-MARKET SHARE BUYBACK

in

The share buyback completed in October 2010 by Woolworths Ltd (W O W ) is typical of the off-market buybacks conducted by several large Australian companies. Two important features of such buybacks are that the buyback price includes a significant fully franked dividend component as well as a capital component, and that the buyback price is determined by a tender process. In August 2 010, W oolworths announced that it intended to buy back up to $7 0 0 million worth of shares. Shareholders who chose to participate in the buyback were invited to select a tender discount from seven discounts of 8 per cent to 14 per cent inclusive to the Market Price — which was defined as the volume weighted average price of W O W shares traded on the ASX over the five trading days up to and including the closing date for tenders (8 October). The closing price of W O W shares on 25 August 2 0 1 0 (the last trading day before details of the buyback were announced) was $ 26.90 . All shares bought through the buyback were bought continued

ACTION

News

n=.

B usiness finance

continued

at the same price, the buyback price, which was determined through the tender process. Tenders were accepted only if the shareholder's tender discount was equal to or greater than the buyback discount. Shareholders could also choose to make a 'Final Price Tender’，in which case they would receive the buyback price but there was no assurance that successful tenders would be accepted in full because the company had the right to apply a scale back if the number of shares tendered exceeded the number it was prepared to buy. Therefore, the success of each tender depended on the shareholder’s tender discount, the size and discount of tenders lodged by other shareholders, and the total number of tenders the company accepted. In summary, shareholders who decided to tender their shares faced uncertainty about the number of their shares that might be bought back and about the price they would receive. The buyback price had two components: a capital component of $ 3 .08 and a fully franked dividend component, which made up the balance of the price. The capital gains tax consequences of participating in the buyback are complicated by the fact that the Australian Taxation Office determines a 'tax value7 for the shares. In the case of the W O W buyback, the tax value was determined by adjusting the pre-announcement average price of $ 2 6 .3 6 to reflect any change in the S&P/ASX 20 0 Index between 26 August and 8 October. In its advice to shareholders, W oolworths assumed that the tax value would be $27. For capital gains tax purposes, Australian resident individual and superannuation entity shareholders would be deemed to have disposed of each share for the capital proceeds of $3.08 plus any amount by which the tax value exceeded the buyback price. The estimated effects of participating in the buyback for resident individuals are shown in Table 1 1.4. The calculations assume a buyback price of $ 23.22 , so the fully franked dividend component is $ 2 0 .1 4 with franking credits of $8.63, giving assessable income of $ 2 8 .7 7 per share.

TABLE 11.4 Estimated effects of W O W buyback for resident individuals Marginal tax rate (i)

16.5%

31.5%

38.5%

46.5%

$20.14

$20.14

$20.14

$20.14

$8.63

$8.63

$8.63

$8.63

Assessable income (ii) + (iii) = (iv)

$28.77

$28.77

$28.77

$28.77

Tax on assessable income (i) x (iv) = (v)

($4.75)

($9.06)

($11.08)

($13.38)

Dividend component Dividend (ii) Franking credit (iii)

Proceeds net of tax (iv) - (v)

Capital component—proceeds net of tax ⑹ Total after-tax proceeds (°l

$24.02

$19.71

$17.69

$15.39

$3.75

$4.36

$4.65

$4.97

$27.77

$24.07

$22.34

$20.36

The p ro ce e d s net of tax are equal to the capital com p one nt of the b u y b a c k price ($ 3 .0 8 ) plus tax sa v in g s ra n g in g

from 6 7 cents to $ 1 . 8 9 . Details of the capital g a in s tax calculations a re not sh o w n since the am ounts are small a n d the capital g a in s tax co n se q u e n c e s of participating in the b u y b a c k d e p e n d o n the sh a re h o ld e r's cost b a se (assum ed to be $ 1 5 ), the length of time the sh ares are held a n d the sh a re h o ld e rs' ability to utilise capital losses to offset capital g a in s derived from other assets. S o u rc e :

W o o lw o rth s Limited,

O ff-M a r k e t B u y -B a ck

B o o k le t

Se pte m ber 2 0 1 0 , p. 25 .

Table 1 1.4 shows that the value of the buyback was greater the lower the shareholder's marginal tax rate. Moreover, for shareholders on low marginal tax rates, the total after-tax proceeds could be greater than the buyback price—assumed to be $ 2 3 .2 2 . This comes about because, for these shareholders, the franking credit attached to the dividend component is greater than the personal tax on the dividend. It is clear that shareholders with low marginal tax rates would determine pricing of the buyback. Since the market price of the shares was

about $27, high tax rate investors who wished to sell W O W shares were better off selling on market rather than through the buyback. On 1 1 October 2010, W O W announced that the buyback price was $25.62, reflecting a buyback discount of 14 per cent. The buyback price consisted of a capital component of $3.08 and a fully franked dividend of $22.54 per share. The tax value of the shares bought back was $28.54 ($2.92 more than the buyback price) so for capital gains tax purposes the deemed disposal price of each share was $3.08 + $2.92 = $6. Woolworths returned $704 million to shareholders through the buyback and successful tenders were scaled back by 88.2 per cent. Research on share buybacks in Australia has focused on two issues: the m otivations fo r buybacks and the market response when a buyback is announced. In both cases there are good reasons to expect that the results may differ between buybacks o f different types. For example, managers m ight use an on-market buyback to signal their belief that a company is undervalued. In the case o f off-market buybacks, the consideration for the repurchased shares is often less than the current m arket price so a buyback o f that type is unlikely to be effective as a way o f signalling undervaluation. A study o f the stated m otivations for 67 buybacks over the period 1990 to 1995 found that the m otivations differed depending on the type o f buyback. The main motivations for on-market buybacks were to signal managements perception o f the true value o f the company and to improve financial performance. Selective buybacks were used m ainly to remove specific shareholders from the share register, while equal access (off-market) buybacks were viewed prim arily as an alternative to dividends (M itchell & Robinson 1999). Brown and Norman (2010) identified the largest 75 Australian industrial companies in 1997 and found that from 1997 to 2007, 36 o f these companies made 23 off-market and 86 on-market share buybacks. The off-market buybacks were typically larger than the on-market buybacks. The average transaction size was $742.9 m illion (9.5 per cent o f the company s shares) for off-market buybacks and $219.6 m illion (3.3 per cent o f the company s shares) fo r on-market buybacks. In addition to being favoured fo r larger buybacks, Brown and Norman found that an off-market buyback is more likely to be chosen when a company has accumulated excess franking credits and when a company is generating larger free cash flows. They conclude that the incentive to distribute accumulated franking credits ‘is a major m otivation fo r undertaking an off-market buyback in Australia’ （p. 780). Moreover, their results support the view th a t franking credits are valuable to participating shareholders because they are w illing to sell their shares at less than the market price to obtain the franking credits that are usually distributed through an off-market buyback. Finally, Brown and Norman found that the market-to-book ratio is significantly lower fo r companies making on-market buybacks, which suggests that they are favoured as a way o f signalling undervaluation. This result is consistent w ith the findings o f M itchell and Dharmawan (2007), whose comprehensive study o f on-market buybacks concluded that under the transparent buyback regime in Australia, signalling o f undervaluation is one o f the strongest incentives fo r on-market buybacks. Otchere and Ross (2002) note that ASX Listing Rules require that companies undertaking on-market buybacks must give a reason for the transaction. They studied 132 Australian on-market buybacks announced between January 1991 and July 1999 where the stated reason was ‘undervaluation, o f the company’s shares. These announcements were associated w ith abnormal returns averaging in excess o f 4 per cent while industry rivals recorded smaller but still significant abnormal returns. Thus, it appears that these announcements conveyed value-relevant inform ation that was not just company-specific b ut related to the industry as a whole. Balachandran and Faff (2004) found that during the period 1996 to 1999, announcements o f on-market buybacks were associated w ith mean abnormal returns o f 2.72 per cent over a 3-day period. Brown (2007) studied off-m arket share buybacks between January 1996 and December 2003 and found that abnormal returns on the announcement date were small b u t significant, averaging around 1.2 per cent. She argues th a t signalling is unlikely to explain the positive m arket reaction which she suggests is more likely to be a response to the d istrib u tio n o f franking credits. Brown also documents a ‘dram atic’ increase in trading volume on the announcement date and finds th a t trading volumes remain elevated, on average, over the next 3 days. This tem porary increase in trading volume is a ttrib uted to demand fo r the shares from superannuation funds and other low tax rate investors who value the franking credits th a t are often distributed through off-m arket buybacks.21 21

T w e n ty o f th e 2 8 b u y b a c k s in B r o w n s s a m p le in c lu d e d a d iv id e n d c o m p o n e n t . T h e s a m p le s iz e is lim ite d b e c a u s e s h a r e b u y b a c k s w ere rare in A u s t r a lia u n t il th e la w s g o v e r n in g t h e m w e re lib e r a lis e d in D e c e m b e r 1 9 9 5 , a n d th e s t u d y p e r io d fin is h e s in D e c e m b e r 2 0 0 3 p r io r t o th e J a n u a r y 2 0 0 4 c h a n g e s in th e c a lc u la tio n o f t h e c a p it a l g a i n s t a x lia b ility fo r sh a r e h o ld e r s p a r t ic ip a t in g in e q u a l a c c e s s s h a r e b u y b a c k s.

Dividend reinvestment plans and dividend election schemes

DIVIDEND REINVESTMENT PLAN (DRP) arrangem ent m a d e b y a co m p a n y that giv e s shareholders an option of reinvesting all or part of their d ivide nds in additional sh ares in the com pany, usually at a small discount from market price

DIVIDEND ELECTION SCHEME arrangem ent m ade by a co m p a n y that gives shareh olde rs the option of receiving their d ivid e n d s in one or more of a num ber of forms

As discussed in Section 11.4.3, most resident investors w ill prefer th a t Australian companies distribute franking credits by paying the m axim um possible franked dividends. However, sim ply m axim ising the payout o f franked dividends is unlikely to be an optim al dividend policy, because companies th a t pay substantially increased dividends may be in danger o f run nin g short o f cash to finance new investments. This problem has been addressed through dividend reinvestm ent plans. These plans and dividend election schemes are discussed in this section. Dividend reinvestm ent plans (DRPs) were introduced by some Australian companies in the early 1980s. They offer shareholders the option o f using all or p art o f th e ir dividends to buy additional shares. W hile shareholders have always had this option, DRPs enable shareholders to purchase additional shares w ith o u t incu rring brokerage. In addition, the shares can sometimes be obtained at a discount. The discount may be from 1.5 to 10 per cent o f the current m arket price, depending on the company, w ith 2.5 per cent being a typical choice. However, many companies offer no discount at all. Where a discount applies, i t benefits shareholders taking up the new shares at the expense o f those who do not. As a result, there is an incentive fo r shareholders to jo in dividend reinvestment plans th a t offer discounts. The incentive to increase payouts under the im p utatio n system has undoubtedly contributed to the popularity o f DRPs. In 2013, over 160 Australian listed companies used DRPs. Clearly, a company that responds to the demand fo r franked dividends by increasing its payout may ru n short o f cash. Management could respond by m aking additional rights issues or share placements to replace the extra cash paid out as dividends. However, as discussed in Section 9.6, these measures can be slow and involve significant transaction costs. The adoption o f a DRP can be a more attractive and less costly solution. A DRP does n ot require a prospectus or other disclosure document provided the shares issued are fu lly paid. Where a shareholder chooses to reinvest a franked dividend, the company pays out no cash, b ut franking credits are s till transferred to the shareholder. The evidence suggests th a t DRPs are well received by shareholders. Exam ination o f daily share returns has shown that, p rio r to im putation, there was little m arket reaction when a company announced th a t it was introducing a DRP. However, after the intro du ction o f im putation, such announcements were associated w ith a significant positive m arket response, particularly in the period after 1 July 1988, when im putation was extended to superannuation funds and other in s titu tio n a l investors (Chan, McColough & Skully 1993). Several companies have found th a t dividend reinvestm ent has been so popular w ith investors that the company has accumulated surplus cash th a t it is unable to invest profitably. I f this occurs, a possible response is to make dividend reinvestm ent less attractive by reducing or elim inating the discount at which shares are offered under the DRP. Also, some companies have imposed lim its on participation in DRPs. For example, each shareholder may be allowed to participate in the DRP fo r a m axim um o f 10000 shares. A nother response is to suspend the company s DRP u n til its investm ent opportunities improve, b ut suspension o f a DRP may n o t be popular w ith shareholders. In May 1996, Lend Lease Corporation announced an innovative solution which allowed shareholders to reinvest th e ir dividends while avoiding the possibility o f the company accumulating surplus cash. The solution was simple: after each dividend Lend Lease would buy back shares at the m arket price so th a t the net num ber o f issued shares remains unchanged. O ther large companies have since adopted the same approach. DRPs are the most popular o f the various dividend-related plans in the Australian market. Some companies also operate a dividend election scheme, which offers shareholders the option o f receiving th e ir dividends in one or more o f a number o f forms. The popularity o f dividend election schemes increased considerably following the introduction o f the im putation system, although subsequent legislative changes have reduced their tax effectiveness. As well as fu lly franked dividends, the options could include unfranked dividends (at a higher rate than the franked dividends), dividends paid by an overseas subsidiary, or bonus shares issued in lieu o f dividends. These schemes were designed to make a company s shares attractive to different classes o f shareholders and to enable franking credits to be streamed* to those shareholders who could use them most effectively. For example, fu lly franked dividends appeal to superannuation funds and resident individuals in low personal income tax brackets. Higher unfranked dividends appeal to non-residents

C hapter eleven Payout

policy

who cannot use franking credits. Bonus shares issued instead o f a dividend are not treated as a dividend for tax purposes and cannot carry franking credits. But fo r capital gains tax purposes, they are deemed to be acquired at the same tim e as the original holding. Further, if the original holding was purchased before the introduction o f capital gains tax on 20 September 1985, they are not subject to capital gains tax and the bonus shares inherit their tax-free status. Bonus shares may also be attractive to overseas and resident investors who do not pay Australian income tax and are therefore unable to use franking credits. The use o f dividend election schemes to stream, franking credits to particular classes o f investors has now been restricted.22 Despite the restrictions, some companies have retained th e ir dividend election scheme, b u t typically the choice o f dividend substitutes is now confined to bonus shares and dividends paid by an overseas subsidiary. These choices are offered through separate plans, typically called bonus share plans and overseas dividend plans. Overseas dividend plans can be attractive to non-resident shareholders in Australian companies w ith overseas subsidiaries. For example, shareholders who reside in the UK m ight elect to receive dividends paid by a UK subsidiary o f an Australian company instead o f dividends from the Australian parent company. The dividends could then carry a tax credit th a t the shareholders can use to offset th e ir tax liabilities in the UK.

Payout policy and com pany life cycle In this section we draw on the theories and empirical evidence discussed earlier in the chapter to outline a model th a t w ill help financial managers to develop payout policies fo r individual companies. Given that payout decisions can be influenced by many factors, including a company’s investm ent opportunities, taxes, inform a tion effects, signalling, agency costs and transaction costs, i t is unrealistic to expect that any single model can provide a complete explanation o f payout policy. However, i f a model is to be useful it should be able to explain im p o rta n t empirical findings, including the follow ing:23 a

b

C

d e

f g

Aggregate payouts (dividends plus share repurchases) are massive and have increased steadily in real terms over the years. Dividends tend to be paid by mature companies whose retained earnings far exceed th e ir contributed equity, and n o t by early-stage companies, which are largely financed by capital infusions. Companies pay dividends on an ongoing basis and avoid accumulating large cash balances. Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts o f taxes on these dividends. The market reacts positively to announcements o f repurchase and dividend increases, and negatively to announcements o f dividend decreases. Unexpected dividend changes are o f little help in forecasting future earnings surprises. Once they initia te regular dividends, managers are reluctant to cut or o m it them.

De Angelo and De Angelo (DD) (2007) argue th a t th e ir fu ll payout approach is a more prom ising foundation fo r a model o f payout policy than the M ille r and M odigliani (M M ) dividend irrelevance theorem. For example, authors who adopt the M M theorem find i t puzzling (see Black 1976) th a t dividends are as common and large as they are in countries such as the US where the classical tax system typically means th a t dividends are taxed more heavily than capital gains. A ttem pts to explain the empirical findings using inform a tion asymmetry and signalling have m et w ith lim ite d success. As noted in Section 11.5, changes in dividends are o f little i f any help in forecasting future earnings. Moreover, signalling theory predicts th a t a company w ill pay dividends when outside investors fin d it particularly d ifficu lt to assess the company s prospects. This suggests th a t young, small companies w ith good grow th prospects that are n ot fu lly recognised by investors would fin d signalling valuable. However, few such companies 22

T h e s c h e m e s a re s t ill a llo w e d , b u t t h e ir t a x e ffe c t iv e n e s s h a s g e n e r a lly b e e n e lim in a te d . F r o m 1 J u l y 1 9 9 0 , a c o m p a n y m u s t d e b it it s fr a n k in g a c c o u n t i f a n u n fr a n k e d o r p a r t ly fr a n k e d d iv id e n d is p a i d t o a s h a r e h o ld e r a s a s u b s t it u t e f o r a fr a n k e d d iv id e n d . S im ilarly , th e fr a n k in g a c c o u n t m u s t b e d e b ite d i f ta x - e x e m p t b o n u s s h a r e s a r e is s u e d a s a s u b s t it u t e fo r a fr a n k e d d iv id e n d .

23

T h e se a re n o t th e o n ly e m p ir ic a l o b s e r v a t io n s o n p a y o u t p o lic ie s t h a t m a y b e r e g a r d e d a s im p o r t a n t . I t e m s (d ) a n d (e) o n o u r lis t h a v e b e e n s e le c te d fr o m a t o t a l o f s ix o b s e r v a t io n s p r e s e n t e d b y A llen a n d M ic h a e ly ( 2 0 0 3 ) . T h e o t h e r fiv e it e m s a r e fr o m a fu r t h e r 1 0 p r e s e n t e d b y D e A n g e lo a n d D e A n g e lo ( 2 0 0 7 ) .

L E A R N IN G O B JEC T IV E 10 Exp lain h o w payout p o lic y m ay c h a n g e a s a c o m p a n y m oves through its life cycle

pay dividends. In fact, dividends are m ostly paid by large, profitable, mature companies th a t have less info rm a tio n asymm etry than smaller growth* companies. DD argue th a t a theory o f payout policy should be based on the principle th a t shares have value only fo r the payouts delivered to th e ir holders. Therefore, the cash flows generated by a company s assets m ust be converted into cash distributions to make shareholders as well o ff as possible. W hile an optim al payout policy w ill deliver the fu ll value o f a company s free cash flow to shareholders, the fu ll payout model is silent on the tim in g o f the payments. DD suggest th a t the tim e profile o f a company s payouts w ill depend on a trade-off between the advantages o f internal capital, such as savings in flo ta tio n costs, and the disadvantages o f retaining cash. In th e ir view, the m ain disadvantage o f retention is the agency problems th a t can develop w ith free cash flow. Further, the balance between the advantages o f interna l capital and the disadvantages o f retaining cash w ill change as the investm ent o pportunities available to the company change. In other words, the fu ll payout approach leads naturally to a life-cycle theory o f payout policy. DD were n ot the firs t to suggest a life-cycle theory o f payout policy. Clearly, the life-cycle approach is consistent w ith the concept, discussed in Section 11.5, th a t cash payouts w ill typicaQy increase as a company matures and its investm ent opportunities shrink. Similarly, Lease et al. (2000) pointed out that a company s payout policy may need to change as it moves through its life cycle. For example, when a new business w ith good growth prospects is started, capital requirements w ill generally be large and access to the capital markets w ill be restricted because outsiders know little about the company. Therefore, payment o f dividends is usually not practical at this stage. Subsequently, the company may experience rapid growth and begin to raise more external funds by borrow ing and by m aking share issues. Despite large investment needs, the company may start to pay modest dividends to establish a track record o f payouts and to increase its appeal to in stitu tio n a l investors, some o f which may be restricted to investing only in dividend-paying shares. When the company reaches m aturity, positive NPV projects are harder to find, the ownership o f the founders w ill have been diluted by successive capital raisings and agency problems are likely to arise. A t this stage companies generate ample amounts o f cash, which should be paid out through dividends and share buybacks unless it can be invested profitably by the company. For companies in mature stages o f the life cycle, payouts to shareholders become more im p o rta n t because the agency costs o f free cash flow would be large i f they allowed large amounts o f cash to accumulate w ith in the company. Tests carried out by De Angelo, De Angelo and Stulz (DDS) (2006) supported a life-cycle theory o f dividends, which, as they note, is essentially a theory o f how the trade-off between the benefits and costs o f retention evolves as a company moves through its life cycle. W hile the benefits o f retention (such as saving flo ta tio n costs and reducing personal taxes) are well accepted in the literature as being large enough to influence payout decisions, there is less agreement about the significance o f factors th a t are supposed to m otivate the managers o f mature companies to distribute cash. This difference has probably arisen because factors such as the agency costs o f free cash flow are much harder to measure than the costs o f issuing securities and the effects on share prices o f new issue announcements. To provide some, adm ittedly indirect, evidence on the economic magnitude o f the effects o f excess retention, DDS selected the 25 largest, long-standing dividend-paying industrial companies in the US as at 2002, and projected how th e ir financial structures would appear at th a t tim e i f these companies had n o t paid any dividends over the period 1950 to 2002, while keeping th e ir investm ent outlays unchanged. Collectively, at the end o f 2002, the 25 companies held cash o f $157 b illion and had a long-term debt o f $639 billion. Measured in 2002 dollars, these companies paid an estimated $1.6 trillio n in dividends over the period 1950 to 2002. I f that cash had instead been retained, the cash holdings o f tdiese companies in 2002 would have totalled almost $1.8 trillio n and the median company s cash holding would have equalled 51 per cent o f total assets. Alternatively, these companies could have repaid all th eir long-term debt and increased their cash balances by about $1 trillio n . DDS concluded that: *Most likely, the payouts we observe reflect direct or indirect pressure to pay out cash from stockholders concerned that managers m ight use the ample discretion provided by enormous cash balances and triv ia l debt obligations to make self-serving decisions that h u rt stockholders’ （2006, p. 252). M ost o f the 25 companies that DDS examined are mature companies in stable industries and th eir behaviour seems consistent w ith the life-cycle theory in which companies pay dividends when the costs o f retaining free cash flow (mainly agency costs) exceed the benefits o f retention. However, DDS p o in t out that the large payouts typically made by mature companies w ith ample cash flows can also be explained w itho ut invoking the agency costs o f free cash flow as an im portant factor. An alternative explanation is that the managers o f these 25 companies may have paid substantial dividends simply because they wished to maximise stockholder wealth, and they recognised that shares have value only to the extent that stockholders eventually receive distributions from the firm* (2006, p. 252).

C hapter eleven Payout

policy

In this chapter we have discussed dividend and share repurchase decisions with an emphasis on the central issue of the effects of payout decisions on the wealth of shareholders. • When dividend policy is defined as the trade-off between: • retaining profit, and • paying dividends and making share issues to replace the cash paid out, it can be shown that dividend policy does not affect shareholders7wealth in a perfect capital market with no taxes. This approach emphasises the importance of investment decisions in determining company value and shareholders' wealth. • The 'dividend irrelevance' theorem has been challenged as a basis for understanding payout decisions and the alternative 'full payout’ approach is based on the principle that shares have value only for the payouts delivered to shareholders. This approach maintains that as well as making the right investment decisions, managers should ensure that the full present value of a company's free cash flows is paid out to shareholders. • Taxes, agency costs and information effects are the main imperfections that may cause a relationship to exist between payout policy and shareholders' wealth. • While the payment of dividends is the most common way of distributing cash to shareholders, companies can also distribute cash by repurchasing shares. • A dividend will have tax effects for virtually all shareholders, but a share buyback will affect taxes paid by only the shareholders who sell. In many countries share repurchases grew more rapidly than dividends during the 1990s and this trend has also occurred in Australia since 1995. • Dividend decisions are important under the imputation tax system because franking credits, which are valuable to Australian resident taxpayers, can be distributed to shareholders only by payment of franked dividends. Many listed companies have increased their dividend payouts substantially, while others have initiated dividends since imputation was introduced. However, maximising the payout of franked

•

•

•

•

•

dividends could leave the company short of cash and may not suit all shareholders. These problems are addressed by dividend reinvestment plans and dividend election schemes, respectively. • Share repurchases are more flexible than dividends, because once a company initiates dividend payments, investors expect the payments to be maintained and, preferably, increased over time. A change in tax policy that favours capital gains relative to dividends occurred in Australia in 1999. Following this change, most resident investors will prefer that dividends paid by Australian companies are franked. Where a company has profits that can be distributed only as unfranked dividends, many investors are likely to prefer that these profits are retained rather than distributed. There is evidence that dividends and share repurchases have a valuable role in reducing agency costs. In particular, the results of recent studies support the argument that distributing free cash flows to shareholders increases their wealth by reducing the potential for managers to overinvest. Announcements of share repurchases and changes in dividends can have significant effects on share prices. W hile there is no doubt that changes in payouts often convey information to the market, the traditional argument that such changes act as signals of future cash flows is not supported by the evidence. Rather, higher payouts are associated with lower cash flows, shrinking investment opportunities and lower risk. The characteristics of companies that repurchase shares are similar to those of companies that increase dividends. There is some evidence that companies cater to investors' changing preferences for dividends compared with increases in the value of the shares they hold. However, there is also evidence that this apparent finding may be due to changes in risk over time—changes in risk that result in changes in payout policy. The full payout approach leads to a life-cycle theory of payout policy, which proposes that payouts will be determined by a trade-off between the benefits and costs of retaining cash. This trade-off will evolve as a company moves through its life cycle.

CHAPTER ELEVEN REVIEW

SUMMARY

KEY TERMS catering theory 339 classical tax system 325 cum-dividend period 317

dividend clientele 324 dividend drop-off ratio 330 dividend election scheme 346

349

dividend-payout ratio 319 dividend reinvestment plan (DRP) ex-dividend date 317 franked dividend 317 franking credit 31 8

346

full payout policy 323 imputation tax system 317 progressive dividend policy 320 treasury stock 318 withholding tax 318

QUESTIONS 1

[LO 1] Define the following terms: a) ex-dividend date b) franked dividend c) dividend reinvestment plan d) dividend drop-off ratio e) overseas dividend plan f) franking account g) free cash flow h) full payout policy i) progressive dividend policy.

2

[LO 3】It has been argued that company managers should adopt a 'full payout policy’ . W hy is the adoption of this policy considered to be so important?

3

[LO 3 】Dividends and shore repurchases must be important because investors w ill value a share only for the cosh payouts it is expected to provide. Do you agree? Explain your answer.

4

[LO 3] Distinguish between 'investment value7 and 'distribution value'. W hy is the distribution value concept

5

[LO 4 】W hat reasons are there to suppose that there is a dividend-clientele effect? Does the empirical evidence support the existence of such an effect? If such an effect exists, does this mean that a company can influence its market value by changing its dividend policy? Why, or why not?

6

[LO 1, 2, 5] Are the following statements true or false?

important?

a) A company can pay a dividend only if it is currently earning profits. b) In Australia, dividends and capital gains are taxed at the same rate for individual investors. c) The residual dividend policy is used by most companies. d) The imputation system involves personal tax being collected at the company level. e) To Australian resident investors, a dollar of franked dividends is worth more than a dollar of unfranked dividends. f) 7

8

According to the Miller and Modigliani dividend irrelevance theorem, an unmanaged (residual) dividend policy is no better or worse than a carefully designed, managed policy.

[LO 5 】Dividends are taxed at a lower rate than capital gains. This suggests that companies should have high dividend-poyout ratios. Discuss this statement, giving special attention to its appropriateness in the Australian tax environment. [LO 4, 5] Explain the likely effects on dividend-payout ratios of each of the following: a) The imputation tax system is modified to allow investors only partial (50 per cent) credit for company tax b) Personal income (but not capital gains) tax rates are increased. c) Capital gains tax is abolished. d) Interest rates increase substantially. e) Company profitability increases. f) Prospectus requirements are tightened, increasing the costs of share issues.

C hapter eleven Payout

[LO 5] Under the imputation tax system, there is on optim al dividend p olicy for a ll Australian companies: always p ay the maximum possible franked dividend, given the balance in the franking account. Discuss this statement.

10 [L0 4 ,6 ] Some companies have investment opportunities well in excess of the earnings available to finance them but they still insist on paying dividends. Why? 11

[LO 4, 6 There is evidence to suggest that dividends have a more stable pattern than earnings. What reasons can you suggest for management adopting a policy of paying a stable dividend in the face of fluctuating earnings?

12 [1 0 4 ,6 】When dividends ore taxed more heavily than capital gains and there are transaction costs, a company that pays dividends and subsequently makes a rights issue is behoving illogicolly. Discuss this statement. 13 [LO A, 6] Usually the Board of Directors increases dividend per share only slowly in response to rising profits, and is even more reluctant to decrease dividend per share than to increase it. Give reasons for this behaviour pattern. Is this behaviour more likely to be observed under an imputation tax system than under a classical tax system? Why, or why not? 14 [LO 5, 6] Explain how the following circumstances could affect a company’s dividend policy: a) The company issues cumulative preference shares carrying an entitlement to fully franked dividends. b) The company receives a large unexpected fully franked dividend from another company. c) Owing to continued losses, retained profits have been reduced to almost zero. d) A large US investor recently acquired 40 per cent of the company’s shares.

CHAPTER ELEVEN REVIEW

9

policy

e) The exploration division of the company has confirmed that several ore deposits are economically viable and ready for development into mines. 15 [LO 6] Allen and M ichoely (2003) conclude that if company managers do use dividends to signal, %e signal is not about future growth in earnings or cash flow s\ Outline evidence that supports this conclusion. If Allen and Michaely are correct, how can the usual market responses to announcements of changes in dividends be explained? 16 [LO 6】The 'maturity hypothesis' has been proposed as an explanation for the nature of the information conveyed by dividend changes. Outline the key aspects of this hypothesis. 17

[LO 7】The payment of dividends is said to have a role in reducing agency costs. Outline the ways in which the payment of dividends can limit the extent of agency problems.

18 [LO 7] Dividends and control moy be substitute mechanisms for monitoring management. Explain. 19 [LO 2, A, 6, 7 In an article titled 'BP should resist slashing dividend7 [W all Street Journal, 9 June 2010), Liam Denning noted that UK-based oil company BP was under pressure to reduce or omit dividends on its ordinary shares as a result of a major oil spill from one of its exploration wells in the Gulf of Mexico. Subsequently, BP announced that it would omit some of its quarterly dividend payments. Carefully examine why the reduction in, or omission of, BP's dividends may harm its shareholders. 20

[LO 8] Explain what is meant by catering theory and explain the importance of incorporating risk into tests of this theory.

21

[LO 9] The imputation system encourages payment o f high dividends. Companies that do so may be left short o f cosh. Comment on this statement.

22

[L0 7, 10] The nature o f the investment opportunities available to a company is likely to hove an important influence on dividend decisions. Discuss.

23

[[〇 ]〇 ]

A company's payout policy can be expected to change over time as the company moves through its life cycle. Explain the life-cycle theory of payout policy.

PROBLEMS 1

Analysing dividend policy [LO 1] As noted in Section 1 1.2.2, investors may attempt to infer a company’s dividend policy by observing its profits, dividends and payout ratio over time. Data collected from the annual reports of the listed company Cabcharge Australia Limited are shown in the following table. 351

B usiness finance

Year to 30 June

Profit after tax ($m)

Dividend per share (cents)

Dividend payout ratio (%)

2002

16.1

10.0

68.9

2003

20.3

12.0

66.8

20 04

23.1

13.75

66.7

2005

27.8

17.0

68.7

2006

38.0

23.0

67.9

20 07

51.8

30.0

68.0

2 0 08

59.0

34.0

68.5

2009

61.4

34.0

66.7

2010

57.6

34.0

71.0

2011

46.1

30.0

70.5

2012

60.0

35.0

74.3

2013

60.6

30.0

71.6

a) Based on the dividend payout ratio data for the period 2002 to 2009, how would you describe Cabcharge’s dividend policy? b) When the figures for 2010 to 2013 are included, how might your inferences about the company's dividend policy change? Give reasons. 2

Dividend payment policy [LO 4 】

The Dromana Dredging Company has asked your advice on its dividend policy. There has been only a small change in earnings and dividends over the years and the company's share price has also been relatively stable during the same period. It has been suggested that the company should expand its activities from dredging into providing services for offshore oil exploration companies. To undertake the proposed expansion activity the company intends to make a rights issue. As the expansion is expected to average approximately 25 per cent return on investment each year, it is not expected that there will be any difficulty in convincing shareholders to take up their rights. Below are data on earnings, dividends and share prices for the years 2011-14 and the expected figures for 2015.

Dromana Dredging Company: data for 2011-14 and expected figures for 2015 ($) 2011

2012

2013

2014

2015

Earnings p e r share

0.40

0.42

0.44

0.43

0.44

Cash available p e r share

0.60

0.67

0.67

0.66

0.66

D iv id e n d per share

0.20

0.20

0.22

0.22

?

Average m a rk e t price o f o rd in a ry shares

4.00

4.10

4.40

4.35

4.40

Make a recommendation on the dividend payment for 2015. Give reasons. 3

Ex-dividend share price drop [LO 5]

Dribnor Ltd has announced a fully franked dividend of $1 per share. The company tax rate is 30 per cent. By how much should the share price fall on the ex-dividend date if: a) franking credits are of no value b) franking credits are fully valued?

352

C hapter eleven Payout

policy

Information effects of dividends [LO 6] Examine the daily share price behaviour of any company in the 4-week period before and after its most recent change in cash dividends. What conclusions can you draw from the movements in the share price? Share buybacks and earnings per share [LO 9] Share buybacks are sometimes motivated by the desire to increase earnings per share. Falcon Ltd recorded an operating profit of $2 million in the last financial year. It has 4 million shares on issue and the market price of the shares is $5 each. Falcon announces that it will repurchase 10 per cent of each shareholder's shares at $5 per share. a) Calculate Falcon's price-earnings ratio before the buyback. b) An observer comments as follows: 'Falcon's buyback should boost its earnings per share from 50 cents to 55 cents, so with the price-earnings ratio remaining the same, the share price should increase'. i) If the observer's argument is correct, what will Falcon's share price be after the buyback? itically evaluate the observer's argument.

CHAPTER ELEVEN REVIEW

Dividend payment policy [LO 4, 5, 6] The Wrex Manufacturing Company has a history of rapid growth, with a rate of return on assets of about 20 per cent per annum. For the past 5 years its dividend-payout ratio has been approximately 60 per cent. A high payout has been justified on the grounds that the company is operated in the shareholders7 interests and dividends paid by the company have a beneficial effect on the company's share price. What factors would you take into consideration when deciding on the appropriate dividend policy for the company? Is the current dividend policy justified?

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Benartzi, S.; Michaely, R. & Thaler, Rw ;Do changes in dividends signal the future or the past?\ Journal of Finance, July 19 97 , pp. 1 0 0 7 -3 4 .

------ , & Michaely, R., 'Payout policy', in G. Constantinides, M. Harris & R. Stulz (eds), Handbook of the Economics of Finance, Elsevier North Holland, Amsterdam, 20 03 .

Black, F.; 'The dividend puzzle', Journal of Portfolio Management, W inter 1976, pp. 5 -8 .

Anderson, H., Cahan, S. & Rose, L , 'Stock dividend announcement effects in an imputation tax environment’， Journal of Business Finance and Accounting, June-July 2 0 0 1 ; pp. 6 5 3 -6 9 . Australian Securities Exchange, Australian Cash Equity Market, ASX, Sydney, 2 0 1 3 . Available at ww w.asx.com . au/docum ents/resources/australian_cash_equity_ market.pdf. Baker, M. & W urgler, J., 'A catering theory of dividends ’，

Journal of Finance, June 2 0 0 4 a , pp. 1 1 2 5 -6 5 . ------ , & -------〆Appearing and disappearing dividends: the link to catering incentives,/ Journal of Financial Economics, August 2 0 0 4 b , pp. 2 7 1 -8 8 . Balachandran, B., Krishnamurti, C., Theobold, M . & Vidnapathiana, B., 'Dividend reductions, the timing of dividend payments and information content', Journal of Corporate Finance, December 201 2, pp. 12 3 2 -4 7 . Bartov, E., 'Open-market stock repurchases as signals for earnings and risk changes', Journal of Accounting and Economics, September 1991, pp. 2 7 5 -9 4 . Beggs, D. & Skeels, C .; 'M arket arbitrage of cash dividends and franking credits', The Economic Record, September 20 06 , pp. 2 3 9 -5 2 . Bellamy, D., 'Evidence of imputation clienteles in the Australian equity market7, Asia Pacific Journal of Management, O ctober 1994, pp. 2 7 5 -8 7 .

Brav, A., Graham , J., Harvey, C. & Michaely, R., 'Payout policy in the 21 st century', Journal of Financial Economics, September 2 0 0 5 , pp. 4 8 3 -5 2 7 . Brennan, M . & Thakor, A., 'Shareholder preferences and dividend policy', Journal of Finance, September 1990, pp. 9 9 3 -1 0 1 8 . Brown, C., 'The announcement effects of off-market share repurchases in Australia7, Australian Journal of Management, December 2 0 0 7 , p p .3 6 9 -8 5 . ------ , & Norm an, D., 'M anagem ent choice of buyback method: Australian evidence', Accounting and Finance, December 2 0 1 0 , pp. 7 6 7 -8 2 . Brown, P. & Clarke, A ., T h e ex-dividend d a y behaviour o f Australian share prices before and after dividend im putation^ Australian Journal o f Management, June 1993, pp. 1 -4 0 . Cannavan, D., Finn, F. & Gray, S., 'The value of imputation tax credits in Australia^, Journal of Financial Economics, April 2 0 0 4 , pp. 1 6 7 -9 7 . Chan, K., M cColough, D. & Skully, M ., 'Australian tax changes and dividend reinvestment announcement effects: a pre- and post-imputation study', Australian Journal of Management, June 1993, pp. 4 1 -6 2 . Comment, R. & Jarrell, G., The relative signalling pow er of Dutch-auction and fixed-price self-tender offers and openmarket share repurchases7, Journal of Finance, September 1991, pp. 1 2 4 3 -7 1 .

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Correia Da Silva, L., Goergen, M . & Renneboog, L., Dividend Policy and Corporate Governance, O xford University Press, O xford, 20 04 .

Hoberg, G. & Prabhala, N.R., 'Disappearing dividends, catering, and risk', Review of Financial Studies, January 2 0 0 9 , pp. 7 9 -1 16.

De Angelo, H. & De Angelo, L., The irrelevance of the M M dividend irrelevance theorem,/ Journal of Financial Economics, February 2 0 0 6 , pp. 2 9 3 -3 1 5 .

Ikenberry, D., Lakonishok, J. & Vermaelen, T., 'M arket underreaction to open market share repurchases7, Journal of Financial Economics, O ctober-N ovem ber 1995, pp. 1 8 1 -2 0 8 .

------ , -------, 'Payout policy pedagogy: w hat matters and w hy7, European Financial Management, January 2007, pp. 1 1 -2 7 . -------, -------, & Skinner, D., 'Reversal of fortune, dividend signaling and the disappearance of sustained earnings growth', Journal of Financial Economics, March 1996, pp. 3 4 1 -7 1 .

------, ------ , & -------, 'C orporate payout policy', Foundations and Trends in Finance, 2 0 0 9 , vol. 3, issue 2 -3 , pp. 9 5 -2 8 7 . -------, -------, & Stulz, R., 'Dividend policy and the e a rn e d / contributed capital mix: a test of the life-cycle theory7, Journal of Financial Economics, August 2 0 0 6 , pp. 2 2 7 -5 4 . Denis, D., Denis, D. & Sarin, A., 'The information content of dividend changes: cash flow signaling, overinvestment and dividend clienteles7, Journal of Financial and Quantitative Analysis, December 1994, pp. 5 6 7 -8 7 . Easterbrook, F., T w o agency-cost explanations of dividends',

American Economic Review, September 1984, pp. 6 5 0 -9 . Easton, S. & Howard, P.; 'Agency costs at Telstra: a case study', Australian Economic Review, 2005, vol. 38, no. 2, pp. 2 2 9 -3 2 . Fama, E. & French, K., 'Disappearing dividends: changing firm characteristics or lower propensity to pay?7, Journal of Financial Economics, A pril 2 0 0 1 , pp. 3 -4 3 . Fenn, G. & Liang, N ., 'Corporate payout policy and managerial stock incentives', Journal of Financial Economics, April 2 0 0 1 ; pp. 4 5 -7 2 . Feuerherdt, C., Gray, S. & H a ll, 丄 ，'The value of imputation tax credits on Australian hybrid securities', International Review of Finance, September 2 0 1 0 , pp. 3 6 5 -4 0 1 . Grinstein, Y. & Michaely, R., 'Institutional holdings and payout policy', Journal of Finance, June 20 05 , pp. 1 3 8 9 -4 2 6 . Grullon, G. & Michaely, R., 'Dividends, share repurchases and the substitution hypothesis7, Journal of Finance, August 2 0 0 2 , pp. 1 6 4 9 -8 4 .

Jagannathan, M ., Stephens, C. & W eisbach, M ., 'Financial flexibility and the choice between dividends and stock repurchases,/ Journal of Financial Economics, September 2 0 0 0 , pp. 3 5 5 -8 4 . Jensen, M ., 'Agency costs of free cash flow, corporate finance and takeovers', American Economic Review, M a y 1986, pp. 3 2 3 -9 . La Porta, R., Lopez-De-Silanes, F., Shleifer, A. & Vishny, Rw 'Agency problems and dividend policies around the w orld', Journal of Finance, February 2 0 0 0 , pp. 1 -3 3 . Lang, L. & Litzenberger, R., 'Dividend announcements: cash flow signaling vs. free cash flow hypothesis', Journal of Financial Economics, 1989, pp. 1 8 1 -9 2 . Lease, R_, John, K., Kalay, A., Loewenstein, U. & S a rig , 〇 . ， Dividend Policy: Its Impact on Firm Value, Harvard Business School Press, Boston, 2 0 0 0 . Lie, E., 'Excess funds and agency problems: an empirical study of incremental cash disbursements,/ Review of Financial Studies, Spring 2 0 0 0 , pp. 2 1 9 -4 8 . Lintner, J., 'Distribution of incomes of corporations among dividends, retained earnings and taxes', American Economic Review, M a y 19 56 , pp. 9 7 -1 13. M cDonald, RJ. & Collibee, P .,'G ivin g credit where it’s due: unlocking value from franking credits^ JASSA, July-September 1996, pp. 1 2 -1 7 . Marsh, T. & M erton, R.; 'Dividend behavior for the aggregate stock market', Journal of Business, January 1987, pp. 1 -4 0 . Michaely, R., Thaler, R. & W omack, K., 'Price reactions to dividend initiations and omissions: overreaction or drift?', Journal of Finance, June 1995, pp. 5 7 3 -6 0 8 . M iller, M ., 'The informational content of dividends ’， in J. Bossons, R. Dornbusch & S. Fischer (eds),

Macroeconomics: Essays in Honor of Franco Modigliani, MIT Press, Boston, 1987, pp. 3 7 -5 8 .

------ , -------, The information content o f share repurchase programs,/ Journal of Finance, April 2 0 0 4 , pp. 6 5 1 -8 0 .

M iller, M . & M odigliani, F., 'Dividend policy, growth and the valuation of shares', Journal of Business, O ctober 1961, pp. 41 1-3 3.

------ , -------, & Swaminathan, B., 'Are dividend changes a sign of firm maturity?7, Journal of Business, July 2 0 0 2 , pp. 3 8 7 -4 2 4 .

Mitchell, J.D. & Dharmawan, G.V., 'Incentives for on-market buy-backs: evidence from a transparent buy-back regime7, Journal of Corporate Finance, M arch 2 0 0 7 , pp. 1 4 6 -6 9 .

Guay, VV. & Harford, J., 'The cash-flow performance and information content of dividend increases versus repurchases', Journal of Financial Economics, September 20 0 0 , pp. 3 8 5 -4 1 5 .

-------, & Robinson, 'M otivations of Australian listed companies effecting share buy-backs', ABACUS, February 1999, pp. 9 1 -1 19.

Handley, J. & M ahesw aran, K., 'A measure of the efficacy of the Australian imputation tax system,/ The Economic Record, March 2 0 0 8 , pp. 8 2 -9 4 . Hathaway, N . & Officer, R.; The value o f imputation tax credits: 2 0 0 4 update', Capital Research Pty Ltd, Melbourne, November 2 0 0 4 , www.capitalresearch.com .au. Healy, P. & Palepu, K., ’Earnings information conveyed by dividend initiations and omissions,/ Journal of Financial Economics, September 1988, pp. 1 4 9 -7 5 .

Myers, S. & M ajluf, N w 'C orporate financing and investment decisions when firms have information that investors do not have7, Journal of Financial Economics, June 1984, pp. 1 8 7 -2 2 1 . Nohel, T. & Tarhan, V., 'Share repurchases and firm performance: new evidence on the agency costs of free cash flo w ', Journal of Financial Economics, August 1998, pp. 1 8 7 -2 2 2 . Otchere, I. & Ross, M ., 'D o share buy-back announcements convey firm-specific or industry-wide information? A test of the

C hapter eleven Payout

Pattenden, K. & Twite, G., 'Taxes and dividend policy under alternative tax regimes', Journal of Corporate Finance, February 20 0 8 , pp. 1 -1 6 . Renton, N. (ed.), Australian Dividend Handbook and Contact Directory, 2 0 0 0 -2 0 0 1 edn, Information Australia, Melbourne. Skinner, D., 'The evolving relation between earnings, dividends and stock repurchases,/ Journal of Financial Economics, March 2 0 0 8 , pp. 5 8 2 -6 0 9 .

-------; & Soltes, E.; ;W h a t do dividends tell us about earnings quality?', Review of Accounting Studies, M arch 2 0 1 1 , pp. 1 -2 8 . Walker, S. & Partington, G w The value o f dividends: evidence from cum-dividend trading in the ex-dividend period', >Accounf/ng anc/ 尸/nance, November 1999, pp. 2Z5—96. W oolworths Limited, Off-Market Buy-Back Booklet, W oolworths Limited, Sydney, September 2 0 1 0 , p. 25. Yoon, P. & Starks, L., 'Signaling, investment opportunities and dividend announcements7, Review of Financial Studies, W inter 1995, pp. 9 9 5 -1 0 1 8 .

CHAPTER ELEVEN REVIEW

undervaluation hypothesis', International Review of Financial Analysis, 2 0 0 2 , pp. 5 1 1 -3 1 .

policy

355

CHAPTER CONTENTS 12.1

Introduction

3 57

112.6

The costs of financial distress

3 77

12.2

The effects of financial leverage

3 57

112.7

Agency costs

379

12.3

The M odigliani and M iller analysis (no tax case)

| 12.8 361

Optimal capital structure: the static trade-off theory

381

The effects of taxes on capital structure under a classical tax system

369

Capital structure with information asymmetry

382

The effects of taxes on capital structure under an imputation tax system

374

12.4

12.5

1

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

4 ^^

explain the effects o f financial leverage and distinguish between business risk and financial risk

2

understand the 'capital structure irrelevance' theory of M odigliani and M iller

3

explain how tax may influence capital structure decisions

4

explain how the costs of financial distress may influence capital structure decisions

5

explain how agency costs may influence capital structure decisions

6

understand the concept of an optimal capital structure based on a trade-off between the benefits and costs of using debt

7

explain the 'pecking order' theory of capital structure.

C hapter twelve Principles

of capital structure

Introduction In C h ap te rs 9 an d 10 w e o u tlin e d th e sources o f fu n d s t h a t m a y be used to fin a n c e a co m p a n y s o p e ra tio n s . The m ix o f sources o f fu n d s use d b y a c o m p a n y is called its c a p ita l s tru c tu re . The tw o basic sources are d e b t1 an d e q u ity, so th a t, in p ra c tic e , a c o m p a n y s

capital structu re

ty p ic a lly re fe rs to th e m ix o f d e b t

a n d e q u ity th a t i t uses to fin a n c e its a c tiv itie s . T w o m a jo r q u e s tio n s are c o n sid e re d in th is cha pter. The f ir s t is: H o w does a c o m p a n y ’s c a p ita l s tru c tu re a ffe c t its ris k ? The s econd is: H o w does a c o m p a n y ’s c a p ita l s tru c tu re a ffe c t its m a rk e t value?

CAPITAL STRUCTURE

mix of debt and equity finance used by a company

The fu n d a m e n ta l source o f a c o m p a n y s value is th e s tre a m o f n e t cash flo w s g e n e ra te d b y its assets. This stre a m is u s u a lly re fe rre d to as th e c o m p a n y s n e t o p e ra tin g cash flow s* o r e a rn in g s b e fo re in te re s t and tax* (E B IT ).2 The c a p ita l s tru c tu re a d o p te d b y a c o m p a n y d iv id e s th is stre a m b e tw e e n d iffe re n t classes o f in ve sto rs. I f a c o m p a n y is fin a n c e d e n tire ly b y e q u ity a n d th e re is n o c o m p a n y ta x , th e n a ll o f th is s tre a m is available to p ro v id e in c o m e to sh a re h o ld e rs. I f a c o m p a n y also b o rro w s fu n d s , th e le n d e rs have f ir s t cla im on th e n e t o p e ra tin g cash flo w s an d sh a re h o ld e rs are e n title d to th e re s id u a l cash flo w s t h a t re m a in a fte r th e le nd ers have been pa id . T h ere fore, i f a co m p a n y has a g iv e n set o f assets, th e n a s k in g w h e th e r th e re is an

optim al capital structu re

f o r th e co m p a n y a m o u n ts to a s k in g w h e th e r th e v a lu e o f th e s tre a m o f n e t

o p e ra tin g cash flo w s depends o n h o w i t is d iv id e d b e tw e e n p a y m e n ts to le n d e rs a n d sha reh old ers. Does th e va lu e o f a c o m p a n y s s tre a m o f n e t o p e ra tin g cash flo w s d e p e n d o n h o w th is s tre a m is d iv id e d be tw ee n le n d e rs a n d sh a re h o ld e rs? T his q u e s tio n so u n d s s im p le , b u t th e a n sw e r can be e ith e r s im p le o r

OPTIM AL CAPITAL STRUCTURE

the capital structure that maximises a company's value

com p le x, d e p e n d in g o n th e a p p ro a ch used to f in d th e answ er. The M o d ig lia n i a n d M ille r a n a lysis o f c a p ita l s tru c tu re ( w ith o u t ta x ), w h ic h w e discuss in th is ch a p te r, p ro v id e s a s im p le a n sw e r— no. B u t th is a n sw e r is reached u n d e r a set o f r e s tric tiv e a s s u m p tio n s . W h e n the se a s s u m p tio n s are relaxe d, th e a n sw e r is n o t as s im p le — a c o m p a n y s c a p ita l s tru c tu re m a y a ffe c t its v a lu e f o r several reasons, in c lu d in g taxes, th e costs o f fin a n c ia l d istre ss, agency costs a n d in fo r m a tio n a s y m m e trie s . C a p ita l s tru c tu re in v o lv e s m a n y issues, an d, as a re s u lt, o u r d is c u s s io n o f i t is d iv id e d in to tw o c ha pters. In th is c h a p te r w e discuss th e p rin c ip le s o f c a p ita l s tru c tu re . In C h a p te r 13 w e discuss e m p iric a l evidence on th e v a lid ity o f th o s e p rin c ip le s a n d th e m a in fa c to rs t h a t m an ag ers s h o u ld c o n s id e r in m a k in g c a p ita l s tru c tu re decisions.

12.2 The effects of financial leverage A ll com p an ies are su b je c t to

b u sin ess risk.

W h e n th e m a n a g e m e n t o f a c o m p a n y decides to e n te r a

p a rtic u la r lin e o f bu sin ess, i t k n o w s t h a t th e re are ris k s in v o lv e d . F o r e xa m p le , n e w c o m p e tito rs m a y em erge, te c h n o lo g y m a y change in u n e x p e c te d w ays, n e w g o v e rn m e n t re g u la tio n s m a y be in tro d u c e d o r consum ers* ta ste s m a y change. These a n d o th e r fa c to rs c o n trib u te to a c o m p a n y s b u sin ess ris k , w h ic h w ill be re fle c te d in changes in th e co m p a n y s n e t o p e ra tin g cash flo w s . I f a c o m p a n y is fin a n c e d e n tire ly b y shares— t h a t is, i t has n o d e b t— th e n bu sin ess r is k is th e sole cause o f v a ria tio n s in th e r e tu r n to sh a re h o ld e rs. B u t i f a c o m p a n y is fin a n c e d p a r tly b y d e b t, th e sh a re h o ld e rs

LEARNING OBJECTIVE 1 Explain the effects of financial leverage and distinguish between business risk and financial risk

are exposed to a second sou rce o f r is k called fin a n c ia l ris k . T h is ty p e o f r is k re s u lts fr o m th e fa c t t h a t th e p a y m e n ts p ro m is e d to le n d e rs m u s t be m ade, even i f th e co m p a n y s u ffe rs a se rio u s d e c lin e in it s n e t o p e ra tin g cash flo w s .3 T h e re fo re , th e m o re d e b t th e c o m p a n y has, th e g re a te r is th e fin a n c ia l r is k face d b y its sha reh old ers.

1

F o r e a s e o f e x p o s it io n , w e u s e t h e t e r m 'd e b t' to r e fe r to a ll f o r m s o f fin a n c e t h a t p r o d u c e a r a t e o f r e t u r n t h a t i s fix e d , o r v a r ie s in a c c o rd a n c e w ith s p e c if ie d r u le s. H e n c e , ^ e b t ' in c lu d e s in t e r e s t - b e a r in g lo a n s , m a r k e ta b le fix e d a n d v a r ia b le in t e r e s t r a te s e c u r it ie s , le a s e fin a n c e a n d s o m e t y p e s o f p r e fe r e n c e s h a r e s .

2

C o m p a n y n e t o p e r a t in g c a sh flo w s a re a ls o o f t e n r e fe r r e d to a s n e t o p e r a t in g in c o m e *, b u t in g e n e r a l w e r e s e r v e t h e te r m m c o m e * fo r c a sh flo w s to in v e s t o r s . In th e e x a m p le s in t h is c h a p te r , b e fo r e - t a x n e t o p e r a t in g c a sh flo w s a r e a s s u m e d to r e m a in c o n s t a n t in p e rp e tu ity . T h is a s s u m p t io n im p lie s t h a t th e c o m p a n y k e e p s th e s a m e a s s e t s in p la c e a t all t im e s . T h ere fo re, th e b e fo r e - t a x n e t o p e r a t in g c a s h flo w s m u s t b e n e t o f th e in v e s t m e n t r e q u ir e d e a c h y e a r to r e p la c e a s s e t s t h a t d e te r io r a te t h r o u g h u s e o r o b s o le sc e n c e . D e d u c t in g t h is in v e s t m e n t is th e s a m e , in p r in c ip le , a s d e d u c t in g d e p r e c ia tio n to d e te r m in e th e *e a r n in g s , o r p ro fit* t h a t c a n b e d is t r ib u t e d w h ile m a in t a in in g c a p it a l in ta c t. T h e r e fo r e , w e u s e th e t e r m s *n et o p e r a t in g c a sh flo w s* a n d e a r n in g s b e fo r e in t e r e s t a n d t a x ' in te r c h a n g e a b ly .

3

I f a c o m p a n y is u n a b le to m e e t i t s o b lig a t io n s to le n d e r s , th e y c a n ta k e c o n tr o l o f th e c o m p a n y , a n d t h is a c tio n m a y r e s u lt in i t s liq u id a tio n .

BUSINESS RISK

variability of future net cash flows attributed to the nature of the company’s operations. It is the risk shareholders face if the company has no debt

FINANCIAL LEVERAGE

W h y , th e n , do co m p a n ie s b o rro w , i f b o rro w in g in v o lv e s e x tra ris k ? The rea son is t h a t b y b o rro w in g ,

( g e a r in g )

a c o m p a n y m a y be able to increase th e ra te o f r e tu r n e a rn e d b y its sh a re h o ld e rs. T his e ffe c t is k n o w n as

the effect of company debt on the returns earned by shareholders. Financial leverage is measured by ratios such as the debtequity ratio and the ratio of debt to total assets

financial leverage,

or

gearing.

I f th e ra te o f r e tu r n o n a co m p a n y s assets is g re a te r th a n th e in te re s t

ra te o n it s d e b t, b o rro w in g w ill increase th e ra te o f r e tu r n to sh a re h o ld e rs. B u t i f th e ra te o f r e tu r n o n a c o m p a n y s assets is less th a n th e in te re s t ra te o n its d e b t, b o rro w in g w ill decrease th e ra te o f r e tu r n to sh a re h o ld e rs. Thus b o rro w in g increases th e v a r ia b ility in th e ra te o f r e tu r n e a rn e d b y s h a re h o ld e rs — th a t is, fin a n c ia l leverage exposes sh a re h o ld e rs to fin a n c ia l ris k . A h ig h p r o p o r tio n o f d e b t m ea ns t h a t a sm a ll pe rce n ta g e change in th e r e tu r n o n a c o m p a n y s assets w ill g e n e ra te a la rg e p e rcen ta ge change in th e p r o fit a va ila b le to sh a re h o ld e rs. M o s t d ire c to rs o f com p an ies are w e ll aw are o f th e re la tio n s h ip b e tw e e n b o rro w in g a n d r e tu r n s — f o r exa m ple, a p a r tic u la r ly cle a r s ta te m e n t a p pe ared in th e 2 0 1 2 a n n u a l re p o rt o f C abcharge A u s tra lia L td (see F ina nce in A c tio n ).

Finance in

ACTION

N ews

n

=

CAPITAL MANAGEMENT AT CABCHARGE AUSTRALIA LTD Many company annual reports provide statements about the company's approach to capital management—that is, to issues such as the company's debt-equity ratio. The 2012 annual report of Cabcharge Australia Ltd included the following statements of Board policy: The Board's policy is to maintain a strong capital base so as to maintain investor, creditor and market confidence and to sustain future development of the business. The Board of Directors monitors the return on capital, which the Group defines as net operating income divided by total shareholders' equity. The Board of Directors also monitors the level of dividends to ordinary shareholders. The Board seeks to maintain a balance between the higher returns that might be possible with higher levels of borrowings and the advantages and security afforded by a sound capital position. The G roup’s target is to achieve a return exceeding its cost of capital; during the year ended 3 0 June 201 2 the return was 4 3 .4 per cent (201 1: 33.3%). In comparison, the weighted average interest expense on interest-bearing borrowings (excluding liabilities with imputed interest) was 6.2 per cent (201 1: 5.7%). Source: Cabcharge Australia Ltd, Annual Report 2012, p. 65. Table 12 .1 p re se n ts tw o m easures o f leverage t h a t w e have ca lcu la te d fr o m p u b lic ly a va ila ble da ta f o r 13 lis te d A u s tra lia n com p an ies. The n u m e ra to r o f each m ea sure is th e b o o k va lu e o f n e t d e b t d e fin e d as in te re s t-b e a rin g lia b ilitie s (o r b o rro w in g s ) less cash a n d assets v e ry s im ila r to cash. Ide ally, w e w o u ld have use d m a rk e t values ra th e r th a n b o o k values b u t c o rp o ra te d e b t is o fte n in th e f o r m o f lo a n s th a t are n o t tra d e d , so w e w ere u n a b le to ca lcu la te th e m a rk e t v a lu e o f d e b t. The d e n o m in a to r o f th e f ir s t r a tio is th e b o o k va lu e o f d e b t p lu s th e m a rk e t va lu e o f th e c o m p a n y s shares (also k n o w n as it s e q u ity ). Because th e m a rk e t va lu e o f e q u ity re fle c ts th e co m p a n y s e xp ected f u tu r e cash flo w s , th is ra tio s h o u ld be a g o o d in d ic a to r o f a c o m p a n y s a b ility to m e e t its in te re s t p a y m e n ts in th e

future. The

d e n o m in a to r

o f th e seco nd r a tio is th e b o o k v a lu e o f th e co m p a n y s assets. T his ra tio is u s u a lly n o t a p a r tic u la r ly g o od m easure o f a c o m p a n y s a b ility to m e e t e ith e r c u rre n t o r fu tu r e in te re s t p a y m e n ts . R a th e r, i t re fle c ts th e e x te n t to w h ic h a c o m p a n y has used d e b t in th e

past to

fin a n c e th e a c q u is itio n o f n e w assets.

Table 12 .1 sho w s t h a t leverage va rie s s ig n ific a n tly b e tw e e n c o m p a n ie s. D iffe re n c e s in leverage can be re la te d to in d u s tr y m e m b e rs h ip a n d asset typ e . F o r exa m p le , D a v id Jon es, w h ic h is a re ta ile r, re lie s m u c h less o n d e b t fin a n c e th a n A m c o r, a p a c k a g in g m a n u fa c tu re r, a n d Q an ta s, an a irlin e . In th is c h a p te r a n d in C h a p te r 13 w e discuss th e fa c to rs t h a t m a y e x p la in w h y som e co m p a n ie s re ly m o re h e a v ily o n d e b t fin a n c e th a n o th e rs . To illu s tra te th e c a lc u la tio n a n d in te r p r e ta tio n o f d e b t- e q u ity ra tio s , sup po se W o o d la n d s L td has e q u ity o f $ 10 m illio n , d e b t o f $8 m illio n a n d assets o f $ 1 8 m illio n . Its c a p ita l s tru c tu re can be s u m m a ris e d b y its d e b t- e q u ity ra tio , w h ic h is 0.8. Suppose t h a t W o o d la n d s th e n b o rro w s $5 m illio n to b u y a n e w fa c to ry . I t s t ill has e q u ity o f $ 1 0 m illio n , b u t its d e b t is n o w $ 1 3 m illio n a n d it s assets have g ro w n to $ 2 3 m illio n . Its d e b t- e q u ity ra tio is n o w 1.3. N o te t h a t W o o d la n d s has s im u lta n e o u s ly cha ng ed b o th its d e b t- e q u ity ra tio a n d its assets— t h a t is, i t has s im u lta n e o u s ly ch a ng ed b o th its c a p ita l s tru c tu re a n d its in v e s tm e n t p o lic y . W h ile m a n y co m p a n ie s fr e q u e n tly m ake such s im u lta n e o u s d e cisio n s, w h e n we e xa m in e th e effects o f a change in c a p ita l s tru c tu re w e ne ed to h o ld e v e ry th in g else c o n s ta n t. N a tu ra lly , ‘e v e ry th in g else’ in c lu d e s th e c o m p a n y ’s in v e s tm e n t p o lic y . T his o u tc o m e c o u ld be a ch ie ve d b y a c o m p a n y

C hapter twelve Principles

TABLE 12.1 Leverage ratios of Australian listed «companies Company

Debt/(debt + MVE)

Debt/book value of assets %

A m cor

3 1 .9

2 4 .5

BH P B illiton

2 1 .1

2 3 .7

2 .0

5 .4

2 6 .8

2 4 .1

D avid J o n e s

7 .0

5 .7

D ulu xG roup

3 2 .4

1 5 .9

F airfa x M edia

3 .5

8 .2

H ills H oldin gs

0 .8

1 .6

O rica

3 0 .2

2 0 .2

Q an tas

1 6 .1

5 1 .8

T elstra

3 2 .7

1 7 .5

5 .2

5 .4

1 0 .3

8 .8

B lu eSco pe Stee l C ab ch arge A u stra lia

T re asu ry W ine E s ta te s W esfarm ers

l〇) MVE = market value of equity on the company's balance date. Debt is the book value of debt as at balance date. Balance date is 3 0 June 2 0 1 3 , except for David Jones (27 July 2 0 1 3 ), DuluxGroup (30 September 20 1 2 ) and Orica (30 September 2 012). Source: Compiled from company annual reports and end-of-year share prices on the ASX.

b o rr o w in g m o n e y to f u n d th e r e p u r c h a s e o f s o m e o f i t s s h a r e s . W e u s e t h is a p p r o a c h in E x a m p le 1 2 .1 , w h ich i llu s t r a t e s th e e ffe c ts o f le v e r a g e o n s h a r e h o ld e r s . E x a m p le 1 2 .1 i llu s t r a t e s tw o im p o r t a n t e f f e c t s o f fin a n c ia l le v e r a g e . F ir s t , it s h o w s t h a t w h e n a c o m p a n y b o r r o w s , th e

expected rate of return on equity is increased. I f th e

e x p e c t e d e a r n in g s b e fo r e in t e r e s t

o f $ 3 0 0 0 0 0 p e r a n n u m a r e m a in t a in e d , th e p r o p o s e d c a p it a l s t r u c t u r e r e s u lt s in a n in c r e a s e in th e e x p e c te d r a te o f r e t u r n o n e q u it y f r o m 1 5 p e r c e n t to 1 8 p e r c e n t p e r a n n u m . T h ere is a c o r r e s p o n d in g c h a n g e in e x p e c t e d e a r n in g s p e r s h a r e (E P S ), w h ic h in c r e a s e s fr o m 3 0 c e n t s to 3 6 c e n t s . S e c o n d , w h e n a c o m p a n y b o r r o w s , th e

variability of returns to shareholders is increased. I f increases th e r a te o f r e t u r n

$ 4 0 0 0 0 0 p e r a n n u m , th e p r o p o s e d s t r u c t u r e

e a r n in g s b e fo r e in t e r e s t a re o n e q u it y f r o m 2 0 p e r c e n t

to 2 8 p e r c e n t p e r a n n u m , b u t i f e a r n in g s b e fo r e i n t e r e s t a r e o n ly $ 2 0 0 0 0 0 p e r a n n u m , th e p r o p o s e d stru ctu re

decreases th e

r a te o f r e tu r n o n e q u it y fr o m 1 0 p e r c e n t to 8 p e r c e n t p e r a n n u m . Th e e f f e c t s o f

th e a lte r n a tiv e c a p it a l s t r u c t u r e s o n th e r e t u r n s to s h a r e h o ld e r s a r e s h o w n in F ig u r e 1 2 .1 . W ith th e e x is tin g a ll- e q u ity c a p it a l s t r u c t u r e , th e r a te o f r e tu r n o n e q u it y is , b y d e fin itio n , a lw a y s e q u a l to th e r a te o f r e t u r n o n D r i b n o r s a s s e t s . U n d e r th e p r o p o s e d s t r u c t u r e , t h is r e m a in s t r u e o n ly w h e n th e r a te o f r e tu r n o n D r i b n o r s a s s e t s is e q u a l t o th e i n t e r e s t r a t e p a id o n i t s d e b t , w h ic h is 1 2 p e r c e n t. I f th e r a te o f r e t u r n o n a s s e t s i s g r e a t e r th a n 1 2 p e r c e n t, th e le v e re d s t r u c t u r e r e s u lt s in a h ig h e r r a te o f r e tu r n o n e q u ity t h a n th e a ll- e q u ity s t r u c t u r e . I f th e r a te o f r e tu r n o n a s s e t s is l e s s th a n 1 2 p e r c e n t, th e le v e re d s t r u c t u r e r e s u lt s in a lo w e r r a te o f r e t u r n o n e q u ity . In o t h e r w o r d s , fr o m th e v ie w p o in t o f th e s h a r e h o ld e r s , le v e r a g e a p p lie s in b o t h d ir e c tio n s : it t u r n s a g o o d y e a r in t o a n e v e n b e t t e r o n e b u t it t u r n s a b a d y e a r in t o a n e v e n w o r se o n e . Th e e ffe c t o f le v e r a g e in c r e a t in g fin a n c ia l r i s k is s h o w n c le a r ly b y th e d iffe r e n t s lo p e s o f th e tw o lin e s in F ig u r e 1 2 .1 . In s u m m a r y , th e c h o ic e o f c a p it a l s t r u c t u r e fo r D r ib n o r in v o lv e s a t r a d e - o f f b e tw e e n r is k a n d e x p e c t e d re tu rn . C learly , a n y v a lid a n a ly s is o f t h is c h o ic e m u s t c o n s id e r

both f a c t o r s :

th e fin a n c ia l m a n a g e r s h o u ld

n o t d e te r m in e a t a r g e t d e b t - e q u it y r a t io b a s e d o n ly o n th e e x p e c t e d le v e l o f E P S o r th e r a t e o f r e t u r n o n e q u ity . P r o v id e d t h a t th e e x p e c t e d r a t e o f r e t u r n o n a s s e t s is g r e a t e r t h a n th e in t e r e s t r a te o n d e b t,

of capital structure

Exam ple

12.1

Dribnor Ltd is currently unlevered—that is; it has not borrowed—and has an issued capital of 1 million shares that have a market price of $2 each. Dribnor's expected earnings are $300 0 0 0 per annum and the market value of its assets is $2 million. There are no taxes and all earnings available to ordinary shareholders are paid out as dividends. Ron Peacock, who is Dribnor's financial manager, is considering whether the company should borrow $1 million at an interest rate of 1 2 per cent per annum, and use the borrowed money to repurchase 5 0 0 0 0 0 shares at their market price of $2 each. If this proposal is implemented, Dribnor's capital structure will be different—it will have some debt— but its assets and earnings before interest will be the same. W hile Dribnor's expected earnings before interest are $30 0 0 0 0 per annum, it is not certain that these earnings will be achieved, and Ron wishes to analyse the effects if earnings increase to $ 4 000 00 per annum or decrease to $200000 per annum. Ron also wishes to analyse the effect if earnings are $240 0 0 0 per annum, because, in that event, the rate of return on assets would be 12 per cent per annum, which is the same as the interest rate on debt.

SOLUTION The results of Ron’s calculations are shown in Table 12.2.

TABLE 12.2 Effect of leverage on returns to Dribnor shareholders E a r n in g s b e fo re in te r e s t ($)

200000

240000

300000

400000

R ate o f re tu rn on a s s e t s (%)

10

12

15

20

N u m b e r o f sh a re s (m illion )

1 .0

1.0

1 .0

1 .0

E a r n in g s p e r sh a re (c en ts)

20

24

30

40

R a te o f re tu rn o n e q u ity

10

12

15

20

0 .5

0 .5

0 .5

0 .5

120000

120000

120000

120000

80000

120000

180000

280000

16

24

36

56

8

12

18

28

E x is tin g c a p ita l stru c tu re (1 0 0 % eq uity )

( % ) ⑷

P ro p o se d c a p ita l stru c tu re (5 0 % equity, 5 0 % d e b t) N u m b e r o f sh a re s (m illion ) In te r e st o n d e b t ($) E a r n in g s availab le to o rd in ary sh a re h o ld e rs ($) E a r n in g s p e r sh a re (c en ts) R a te o f re tu rn on eq u ity

( % ) ⑹

Rate of return on equity = Earnings per share (cents)/Market price per share. The market price per share is $2.

in c r e a s in g th e d e b t - e q u it y r a tio w ill a lw a y s in c r e a s e b o t h e x p e c t e d E P S a n d th e e x p e c t e d r a te o f r e tu r n o n e q u ity . B u t t h e s e e x p e c t e d b e n e f it s c o m e a t th e p ric e o f in c r e a s e d fin a n c ia l r isk . W e h a v e s h o w n t h a t fin a n c ia l le v e r a g e in c r e a s e s b o t h e x p e c t e d r e t u r n a n d r i s k f o r s h a r e h o ld e r s . H o w e v e r, w e h a v e n o t y e t c o n s id e r e d th e m o s t i m p o r t a n t q u e s t io n : Is th e in c r e a s e in e x p e c t e d r e tu r n e n o u g h t o c o m p e n s a t e s h a r e h o ld e r s f o r th e in c r e a s e in r is k ? I f i t is j u s t e n o u g h to c o m p e n s a t e (b u t n o m o r e ), th e n th e v a lu e o f th e c o m p a n y w ill b e u n c h a n g e d b y le v e r a g e . B u t i f i t m o r e (le s s ) t h a n c o m p e n s a t e s , th e n th e v a lu e o f th e c o m p a n y w ill b e h ig h e r (lo w e r). A r ig o r o u s a n a ly s is o f t h is q u e s t io n b y M o d ig lia n i a n d M ille r (1 9 5 8 ) s h o w e d t h a t , in a p e r f e c t c a p it a l m a r k e t w ith n o t a x e s , th e h ig h e r e x p e c t e d r e tu r n is j u s t e n o u g h to c o m p e n s a t e f o r t h e h ig h e r r is k — n o m o r e a n d n o l e s s . T h e r e fo re , th e v a lu e o f th e c o m p a n y is n e ith e r in c r e a s e d n o r d e c r e a s e d b y le v e r a g e ; c a p it a l s t r u c t u r e is t h u s ir r e le v a n t to c o m p a n y v a lu e . T h eir a n a ly s is i s c o n s id e r e d in th e n e x t s e c tio n .

C hapter twelve Principles

of capital structure

Figure 12.1 The effect of leverage on returns

proposed structure (50% equity, 50% debt) / t

UJnJjo^oa xllnb uo a)

Qj

10 12

20

30

Rate of return on assets [%)

12.3 The M o d ig lia n i and M ille r analysis (no tax case) 12.3.1 | M odigliani and Miller's Proposition 1 M o d ig lia n i a n d M ille r (M M ) (1 9 5 8 ) a n a ly s e d th e e ffe c t o f c a p it a l s t r u c t u r e o n c o m p a n y v a lu e b a s e d o n a s e t o f r e s tr ic tiv e a s s u m p t i o n s . The m o s t i m p o r t a n t a s s u m p t i o n s a re :

a

S e c u r itie s is s u e d b y c o m p a n ie s a r e t r a d e d in a

p erfect capital m arket;

t h is is a f r ic t io n le s s m a r k e t

in w h ic h th e re a r e n o t r a n s a c t io n c o s t s a n d n o b a r r ie r s to th e fr e e flo w o f in f o r m a t io n . 丨

T h ere a re n o t a x e s .

C

C o m p a n ie s a n d in d iv id u a ls c a n b o r r o w a t th e s a m e in t e r e s t ra te .

d

T h ere a re n o c o s t s a s s o c i a t e d w ith th e liq u id a t io n o r r e o r g a n is a t io n o f a c o m p a n y in fin a n c ia l difficu lty .

e

C o m p a n ie s h a v e a fix e d in v e s t m e n t p o lic y s o t h a t in v e s t m e n t d e c is io n s a r e n o t a f f e c t e d b y fin a n c in g d e c is io n s . G iv e n th e s e a s s u m p t i o n s , M M p r o v e d t h a t th e v a lu e o f a c o m p a n y is i n d e p e n d e n t o f i t s c a p ita l

s tr u c tu r e . T h ey c o n c lu d e d t h a t i f a c o m p a n y h a s a g iv e n in v e s t m e n t p o lic y , t h e n c h a n g in g i t s r a t io o f d e b t to e q u ity w ill c h a n g e th e w a y in w h ic h i t s n e t o p e r a t in g c a s h flo w s a r e d iv id e d b e tw e e n le n d e r s a n d s h a r e h o ld e r s , b u t w ill n o t c h a n g e th e t o t a l v a lu e o f th e c a s h flo w s. T h e r e fo re , th e v a lu e o f th e c o m p a n y w ill n o t c h a n g e . T h is i s th e ir n o w - f a m o u s P r o p o s it io n 1. C learly , in m o s t c a s e s , t h e s e a s s u m p t i o n s a r e n o t r e a lis tic . F o r e x a m p le , M M s a s s u m p t i o n s e x c lu d e ta x e s a n d d e f a u lt c o s t s . B u t t h i s d o e s n o t m e a n t h a t t h e ir a n a ly s is is u s e l e s s . O n e o f th e g r e a t v ir t u e s o f M M s a n a ly s is is t h a t b y im p lic a t io n it p o in t s th e w a y fo r w a r d . I f c a p it a l s t r u c t u r e d o e s in f a c t m a t t e r a t l e a s t a l it t le — a s m o s t p e o p le b e lie v e — th e n it m u s t m a t t e r f o r r e a s o n s t h a t M M e x c lu d e d fr o m th e ir a n a ly s is . W e d is c u s s t h is is s u e f u r t h e r in S e c t io n 1 2 .3 .4 . P r o p o s itio n 1 c a n b e p r o v e d in m a n y d iffe r e n t w a y s. Th e p r o o f p r o v id e d b y M M i s b a s e d o n th e id e a t h a t in v e s t o r s c a n c r e a te h o m em ad e lev e rage a s a n a lte r n a tiv e to c o r p o r a t e le v e r a g e . S u p p o s e t h a t w e c o u ld o b s e r v e tw o c o m p a n ie s , U a n d L , w h ic h a r e e q u iv a le n t, e x c e p t t h a t U h a s n o d e b t w h ile L h a s d e b t — t h a t

LEARNING OBJECTIVE 2 Understand the 'capital structure irrelevance7theory of Modigliani and Miller PERFECT CAPITAL MARKET

frictionless capital market in which there are no transaction costs and no barriers to the free flow of information

is , U is u n le v e r e d , w h ile L is le v e re d . S u p p o s e , c o n t r a r y t o P r o p o s it io n 1, t h a t th e m a r k e t v a lu e o f L (w h ich w e d e n o t e VL) e x c e e d s th e m a r k e t v a lu e o f U (w h ich w e d e n o t e

). T h en a s h a r e h o ld e r in L s h o u ld se ll h is

s h a r e s in L a n d , b y b o r r o w in g m o n e y , w ill b e a b le t o s t r u c t u r e a n in v e s t m e n t in U t h a t p r o d u c e s : 1

a h ig h e r r e t u r n a t th e s a m e r is k

2

th e s a m e r e t u r n a t a lo w e r r is k

3

th e s a m e r e t u r n a t th e s a m e r i s k f o r a lo w e r in v e s t m e n t o u tla y . T h a t is , i f VL > Vv t h e n all th r e e o f t h e s e s t r a t e g ie s a r e a v a ila b le t o a s h a r e h o ld e r in L . T h is i s illu s t r a t e d in E x a m p le 1 2 .2 .

Exam ple

12.2

Suppose we observe two companies, U and L, which are equivalent except for their capital structure. Both companies produce net operating cash flows (N C F ) of $11 000 a year. The market value of the levered company, L, is VL = $105000, comprised of debt, DL, whose market value is $2500 0 and equity, EL, whose market value is $80000. The market value of the unlevered company, U, is Vu = $1000 00, which by definition is comprised only of equity (that is, E j = $100000). The interest rate for both companies (and all investors) is 4 per cent per annum. Consider an investor who owns 1 per cent of the shares in L. The market value of his shareholding is 0.01 x $ 8 000 0 = $800. a) W hat is the investor's return and risk? b) How could the investor achieve: i)

a higher return at the same risk?

ii) the same return at a lower risk? iii) the same return at the same risk and also have money left over?

SOLUTION a) The investor's return is: Return = 0.01 x net income of L

= 0.01 x (NCF-interest expense) = 0 .0 1 x ($ 11 0 0 0 - 0 .0 4 x $25 000) = 0.01 x $ 1 0 0 0 0

=$100

The investor’s risk is measured by L’s debt-equity ratio: Risk = L’ s debt- equity ratio _ $25 0 0 0 _ $8 0 0 0 0 = 0 .3 1 2 5

b) Recognising that, according to MM, the shares in L are overvalued because VL > VUf the investor first sells his shares in L for $800. i) How to achieve a higher return at the same risk. The investor borrows $250 at 4 per cent and invests the whole sum ($800 + $250 = $1050) in shares of company U. Because the total market value of all shares in U is $ 100 000, he must now own 1.05 per cent of the shares of U. Hence, the return on this shareholding is 1.05 per cent of the net operating cash flows of U. The return on this investment is: Return = return on shares - interest on debt = 0 .0 1 0 5 x $11 0 0 0 - 0 . 0 4 x $ 2 5 0 = $ 1 1 5 .5 0 - $ 1 0 .0 0 = $ 1 0 5 .5 0

> $100

C hapter twelve Principles

The risk of this investment is: Risk = investor’ s de bt-eq uity ratio

= $250 = $800 = 0.3125

Thus, the investor has achieved a higher return ($105.50) at the same risk (0.3125). ii) How to achieve the same return at a lower risk. The investor borrows $171.43 at 4 per cent and invests the whole sum ($800 + $171.43 = $971.43) in shares of company U. Therefore he owns 0.971 43 per cent of the shares of U. The return on this investment is: Return = return on shares —interest on debt

= 0.0097143 x $11 0 0 0 -0 .0 4 x $171.43 = $10 6.8 6 -$ 6.8 6 =$100

The risk of this investment is: Risk = investor’ s de bt-eq uity ratio

$171.43 ~

$800

= 0.2143 <0.3125

Thus, the investor has achieved the same return ($100) at a lower risk (0.2143). iii) How to achieve the same return at the same risk and also have money left over. The investor retains $41.71 of the $800, leaving $758.29, then borrows $236.97 and invests the whole sum ($758.29 + $236.97 = $995.26) in shares of company U. Therefore he owns 0.995 26 per cent of the shares of U. The return on this investment is: Return = return on shares - interest on debt

=0.0099526 x $11 0 0 0 -0 .0 4 x $236.97 = $ 1 0 9 .4 8 -$ 9 .4 8 =$100

The risk of this investment is: Risk = investor’ s de bt-eq uity ratio

$236.97 —$758.29 = 0.3125

Thus, the investor has achieved the same return ($100) at the same risk (0.3125), and the investor also has some money ($41.71) to spend or to invest elsewhere. For a risk-averse investor all of these strategies produce a better outcome than if they continued to hold the shares in company L. It can be proved algebraically th a t the results in Example 12.2 hold in all cases where the value o f the levered company is greater than the value o f the unlevered company. As an example, we provide the algebraic p ro of fo r achieving a higher retu rn at the same risk.

Notation E l = market value o f the equity (shares) o f company L

D l = market value o f the debt o f company L VL = m arket value o f company L = + DL Ev = m arket value o f the equity o f company U Vu = m arket value o f company U = EV r = interest rate on debt

of capital structure

NCF = net operating cash flow (the same fo r b oth companies) p = the percentage o f the shares o f company L th a t the investor owns The value o f the shares held by the investor is L = p x EL. The retu rn on these shares is the proportion, p} o f the net income o f company L. That is, Return = p (N C F - rD i)

^

The risk is measured by the debt-equity ratio o f company L, which is The investor borrows an amount, A, such th a t his personal d ebt-equity ratio equals the debt-equity ratio o f company L. That is, A is chosen such that:

PEl

El

Therefore v4 = p x D i ， The am ount to be invested in U shares is therefore:

pEL + pDL = p(EL + Dl ) = pVL vVj

Therefore, the proportion o f U shares on issue owned by the investor is - — . vu

Thus the return on this investm ent is: New return = return on shares - interest on debt pX l

x

NCF- r

x

pDi

Hence, the difference between the new retu rn and the previous retu rn is: Difference in return = new return - previous return ^

x

NCF-prDL -p(N C F-rD L)

J

Vu

p x NCF x

(竞 .

> 0 if VL >Vu =

pDl

= 〇L

Investor’s deb t-e q uity ratio = ----PEl El PEl Therefore, the investor has achieved a higher retu rn at the same risk. Example 12.2 shows th a t i f the value o f the levered company exceeds the value o f the unlevered company, an investor in the levered company should sell her shares and instead borrow money and invest in the shares o f the unlevered company. This action w ill be profitable fo r as long as the value o f the levered company remains greater than the value o f the unlevered company. I f enough investors undertake sim ilar transactions, there w ill be downward pressure on the price o f L shares (because there are many sellers) and upward pressure on the price o f U shares (because there are many buyers). E quilibrium w ill be restored when security prices have adjusted to the p o in t where the m arket values o f the tw o companies are equal. W hat happens i f the opposite o f Example 12.2 arises— th a t is, i f the value o f the levered company is less than the value o f the unlevered company? In th a t case, an investor in U shares should sell these shares and buy shares in L. O f course, this action w ill increase the investors risk because L has borrowed whereas U has not. However, this risk can be offset by the investor also lending money. In effect, the investor can undo the effect o f corporate leverage. The central mechanism in M M s p ro of is the substitu ta bility between corporate debt and personal debt. I f a levered company is overvalued, an investor in th a t company s shares can replicate his risk and return by investing instead in the shares o f an unlevered company and adjusting the d ebt-equity ratio by borrow ing personally. Hence, leverage does n ot add value to a levered company because, by borrowing, the levered company is n o t doing anything th a t its shareholders cannot do fo r themselves. Therefore, there is no reason fo r investors to pay a prem ium fo r the shares o f levered companies. Similarly, i f an unlevered company is overvalued, an investor in th a t company s shares can replicate his risk and return by investing instead in the shares o f a levered company and adjusting his d ebt-equity ratio (to zero) by lending personally. Leverage neither adds to, n o r subtracts from , the value o f a company. Proposition 1 is a law o f conservation o f value. A company is a collection o f assets th a t generates a stream o f net operating cash flows, which are then divided between different suppliers o f finance. Proposition 1

C hapter twelve Principles

says that the value o f a set o f assets remains the same, regardless o f how the net operating cash flows generated by the assets are divided between different classes o f investors. I f this law is breached then investors can earn immediate profits w ith no risk. The process o f taking advantage o f such an o p p ortu nity is called arbitrage, which should ensure th a t perfect substitutes w ill n ot sell at different prices in the same m arket at the same tim e. In the context o f the M M analysis, tw o companies w ith the same assets, but different capital structures, are perfect substitutes. I f th e ir m arket values are n o t the same, investors w ill enter the m arket to take advantage o f the arbitrage o p p o rtu n ity and, in doing so, w ill force the values o f the two companies to be the same. It is sometimes argued that the arbitrage process employed by M M is unrealistic because company leverage and personal leverage are not perfect substitutes. For example, individual borrowers often pay higher interest rates and higher transaction costs than companies. Although true, this observation has little substance as a criticism because the particular arbitrage procedure used by M M is not the only way to prove their proposition. Another way, which uses a different arbitrage procedure, is shown in Example 12.3.

of capital structure

ARBITRAGE

simultaneous transactions in different markets that result in an immediate risk-free profit

Example 12.3 This example again compares Company L and Company U using the information provided in Example 12.2. Recall that both companies have net operating cash flows of $1 1 000 a year. Company U has no debt and the market value of its equity is $100000. Company L has borrowed $25000 at an interest rate of 4 per cent per annum and the market value of its equity is $80000. Hence, contrary to MM, the market value of L, which is $80000 + $25000 = $105000, exceeds the market value of U, which is $100000. If an investor owns 1 per cent of L—that is, 1 per cent of its shares and 1 per cent of its debt—what is the market value of the investment and what is the annual return on the investment?

SOLUTION The market value of this investment is: Equity: 1% x $ 8 000 0 = $ 800 Debt: l% x $ 2 5 0 0 0 = $ 250 Total market value: $1050 The annual return produced by this investment is: Equity: 1% x ($ 1 1 000 - 0.04 x $25 000) = $100 Debt: 0.04 x $250 = $10 Total annual return: $110 The investor can arbitrage this situation by first selling his portfolio of the debt and equity of company L for its market value of $1050. The investor then retains $50, and invests the remaining $ 1000 in U's shares. This shareholding represents 1 per cent of the equity of company U and hence entitles the investor to 1 per cent of the net operating cash flows generated by company U—that is, the annual return on this investment is 0.01 x $11 000 = $110. Therefore, the investor's return is $110 —the same as before—but the investor also has $50 left over to consume or to invest elsewhere. Clearly, the difference between the values of the two companies could not persist and the actions of investors selling L’s securities and buying U's shares would quickly establish an equilibrium in which their values would be exactly the same. In summary, M M s Proposition 1 states th a t a change in the company s capital structure sim ply changes the way in which the net operating cash flows generated by the assets are divided between shareholders and lenders. Regardless o f how they are divided, th e ir to ta l size remains the same. Therefore, the value o f the company s assets remains the same. Because the company s securities represent claims against those assets, the to ta l m arket value o f the securities also remains the same. To illustrate this w ith an everyday analogy, we cannot change the size o f a cake sim ply by slicing it up in a different way!

12 .3 .2 1M odigliani and M iller’s Proposition 2 Proposition 1 focuses on dollar values— in particular, it states th a t the dollar value o f a company is independent o f the company s capital structure. Proposition 2 focuses on a company s cost o f capital, which is the required rate o f retu rn on the company s securities. Proposition 2 states th a t a company s

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1

B usiness fikance

weighted average cost o f capital is independent o f the company s capital structure. In short, Proposition 2 is like retelling the story o f Proposition 1 b ut in a different language. I f a company s net operating cash flows are constant in perpetuity, then the expected rate o f return on the company s assets, k〇iis sim ply the expected net operating cash flows per annum divided by the m arket value o f the company, V. That is: 念

o=

annual net operating cash flows V

ran

Consider an investor who owns all o f a company s shares and has also provided all o f its debt finance. As discussed in Chapter 7, the expected rate o f retu rn on a p o rtfo lio is a weighted average o f the expected rates o f re tu rn on the assets in the p ortfolio. Therefore, in this case, the investors expected rate o f return is a weighted average o f the rates o f retu rn on the company s equity and the company s debt, where the weights are the proportions o f equity and debt in the company s capital structure. Because this investor has provided all o f the company s equity capital and all o f its debt capital, the investor is entitled to all o f the net operating cash flows generated by the company s assets. Hence, the investors expected rate o f retu rn is equal to k〇 . Therefore, the expected rate o f retu rn on the company s assets is:

*。=

(

x

i )

12.2

where k 〇 = expected rate o f retu rn on assets (or weighted average cost o f capital) ke = expected rate o f retu rn on equity (or cost o f equity capital) kd = expected rate o f return on debt (or cost o f debt capital) E = the m arket value o f the company s equity capital D = the market value o f the company s debt capital V = E + D = the to ta l m arket value o f the company The alternative terms used to describe the variables ke and kd may need to be explained. Investors w ill purchase a security only i f the expected rate o f retu rn on the security is at least equal to the m inim um rate o f retu rn th a t the investor requires or demands. The rates o f retu rn received by investors m ust be provided by the issuers o f securities, and, from the issuers view point, the rate o f retu rn required by investors is effectively a cost— typically referred to as a cost o f capital. Similarly, the expected rate o f return on a p o rtfo lio o f all the securities issued by a company, as calculated in Equation 12.2, is often referred to as the weighted average cost o f capital. The weighted average cost o f capital is typically used as the discount rate when estim ating the net present value (NPV) o f projects th a t are o f the same risk as the company s existing assets. The weighted average cost o f capital is discussed in detail in Chapter 14. Equation 12.2 can be rearranged to show how the cost o f equity capital, kei is affected by the use of debt finance. This gives: ke = k 〇 + (k 〇 - kd)

12.3

Equation 12.3 is M M s Proposition 2, which shows that fo r a levered company the cost o f equity capital consists o f two components. The first component is /c〇. I f a company had no debt (D = 0), then Equation 12.3 tells us th a t fo r this company, ke = k〇 . That is, k 〇 is equal to the rate o f return required by shareholders on a company th a t has no debt. I f a company has no debt, it has no financial risk, but i t w ill have business risk. So, in Equation 12.2, k0 can be interpreted as the rate o f return required because o f the company s business risk. The second component is an increment fo r financial risk and is proportional to the company s debtDEFAULT RISK

the chance that a borrower will fail to meet obligations to pay interest and principal as promised

equity ratio, ~ and also depends on the difference between k〇 and kd一 which m ust be positive. I f a company can always borrow w ith no defau lt risk, the cost o f debt, kdi w ill rem ain constant as the company s d ebt-equity ratio increases, and the relationship between the cost o f equity capital and the deb t-e q uity ratio w ill be linear. Proposition 2 fo r the case o f default-free debt is shown in Figure 12.2. Propositions 1 and 2 may appear contradictory. Proposition 1 says th a t shareholders w ill be indifferent to borrow ing by a company. But Proposition 2 says th a t borrow ing by a company increases a shareholders expected rate o f return. W hy would a shareholder be ind iffe re nt to getting a higher expected rate o f return? The answer is th a t because o f the financial risk associated w ith borrow ing, the shareholders* required rate o f return also increases exactly in line w ith the increase in th e ir expected rate o f return. The extra expected rate o f retu rn is just enough— no more and no less— to compensate fo r the extra financial risk. Therefore, borrow ing by a company has no effect on its shareholders’ wealth.

C hapter twelve Principles

Figure 12.2 Modigliani and Miller's Proposition 2 with default-free debt

How can the weighted average cost stay the same when the cost o f one component (equity) has risen and the cost o f the other component (debt) has stayed the same? W hy doesn^ the average increase? The answer is th a t when a company changes its capital structure, the securities m arket reacts by also changing the m arket value o f the company’s debt and the m arket value o f the company’s equity. Therefore, the weights, which are market-value weights, also change. Here is a hypothetical num erical example where the company s debt is default-free and the interest rate is always 4.5 per cent. The company is considering three alternative capital structures.

Low leverage (80 per cent equity and 20 per cent debt) The cost o f equity capital (ke) is 11.125 per cent. So k0 = 0.8 x 11.125% + 0.2 x 4.5% = 9.8%

Medium leverage (60 per cent equity and 40 per cent debt) The cost o f equity capital (ke) is 13.33 per cent. So k0 = 0.6 x 13.33% + 0.4 x 4.5% = 9.8%

High leverage (20 per cent equity and 80 per cent debt) The cost o f equity capital (ke) is 31 per cent. So k0 = 0.2 x 31% + 0.8 x 4.5% = 9.8% In each case, the cost o f debt remains at 4.5 per cent b ut the cost o f equity increases as more debt is issued. As required, the weights always sum to 1, b ut the weighted average remains at 9.8 per cent. This outcome is not the result o f assuming default-free debt. In practice, there is always some risk th a t a corporate borrower w ill default. For many large companies this risk is very small b u t i t is never zero. Therefore, as a company borrows more, i t w ill have to pay higher interest rates. But this does n o t mean that the weighted average cost o f capital m ust increase as borrow ing increases. Here is a simple numerical example o f what could happen:

Low leverage (80 per cent equity and 20 per cent debt) The cost o f equity capital (ke) is 11.1 per cent. The cost o f debt capital (kd) is 4.6 per cent. So k 〇 = 0.8 x 11.1% + 0.2 x 4.6% = 9.8%

Medium leverage (60 per cent equity and 40 per cent debt) The cost o f equity capital (ke) is 13 per cent. The cost o f debt capital (kd) is 5 per cent. So k0 = 0.6 x 13% + 0.4 x 5% = 9.8%

High leverage (20 per cent equity and 80 per cent debt) The cost o f equity capital (ke) is 25 per cent. The cost o f debt capital (kd) is 6 per cent. So k0 = 0.2 x 25% + 0.8 x 6% = 9.8%

of capital structure

In each case, the cost o f debt and the cost o f equity increase as more debt is issued. As required, the weights always sum to 1, b u t the weighted average remains at 9.8 per cent. While Proposition 1 is a law o f conservation o f value, Proposition 2 is a law o f conservation o f risk. Assume that a company is able to borrow w ith no risk o f default. When the company borrows, it transfers a risk-free cash flow stream to lenders. The business risk associated w ith the company s assets, and therefore w ith its net cash flows, remains the same regardless o f its capital structure. Under the assumption o f risk-free debt, this risk w ill affect only shareholders. While increasing the amount o f debt does not change the total risk to which shareholders are exposed, it concentrates that risk on a smaller amount o f equity capital. Therefore, borrowing increases the risk per dollar o f equity. Because shareholders are assumed to be risk averse, they respond by requiring a higher rate o f return. But perfect capital markets do not provide something for nothing: the increased expected rate o f return is just enough— no more and no less— to compensate for the extra risk. Because lenders rank ahead o f shareholders in the division o f net operating cash flows, the required rate o f retu rn on a company s debt is always less than the required rate o f retu rn on its equity. This has led some people to believe th a t debt is cheaper1than equity from the view point o f the company as a whole. Proposition 2 highlights the error in this belief. Example 12.4 provides an illustration.

Example 12.4 Consider again Example 12.1, in which Dribnor Ltd is financed solely by equity and its shareholders require a rate of return of 15 per cent per annum. This rate reflects the risk of Dribnor's assets. Dribnor can borrow at an interest rate of 12 per cent per annum. Suppose that Dribnor borrows $1 million and uses these funds to repurchase shares. W hat will happen to Dribnor's cost of equity capital? What will happen to its weighted average cost of capital?

SOLUTION We can answer the first question using Proposition 2 as shown in Equation 12.3: k e

=

k 〇 +

[k 〇 - k

d )

= 0 .1 5 + ( 0 . 1 5 - 0 . 1 2 )

⑴

= 0 .1 8 or 18% per annum

Dribnor's weighted average cost of capital can be calculated using Equation 12.2:

= 0 .1 8 x 0.5 + 0 .1 2 x 0.5 0 .1 5 or 15% per annum

The introduction of debt finance has not changed Dribnor's weighted average cost of capital of 15 per cent, despite the fact that the interest rate on debt is only 12 per cent. The reason is that the borrowing causes the cost of equity capital to increase to a level that exactly offsets the effect of the apparently cheaper debt. In other words, the interest cost of debt is only its explicit cos\. The financial risk created by borrowing increases the cost of equity capital, and this increase is an im plicit cost associated with the debt.

1 2 .3 . 3 !M odigliani and Miller's Proposition 3 M M s Proposition 3 states th a t the appropriate discount rate fo r a particular investm ent proposal is independent o f how the proposal is to be financed. The appropriate discount rate depends on the features o f the investm ent proposal— in particular, its riskiness. W hether the investing company obtains the funds by borrowing, or by issuing shares, or both, has no effect on the appropriate discount rate. This im plication is consistent w ith the irrelevance o f the financing decision as stated in Proposition 1. Taken together, the M M propositions m aintain that in a perfect capital market w ith no taxes, it is only the investment decision that is im portant in the pursuit o f wealth maximisation. The financing decision is o f no consequence. Therefore, investment decisions can be completely separated from financing decisions.

C hapter twelve Principles

of capital structure

1 2 .3 .4 1 W hy is the M M analysis important? We have given considerable space to an explanation o f the M M analysis. This should n ot be taken to im ply that we regard the M M analysis as providing a complete description o f the effects o f financing decisions. Clearly, it cannot do so because im p o rta n t factors such as taxes have so far been ignored. So why is the M M analysis so im portant? There are two reasons. The firs t is th a t it helps us to ask the rig h t questions about financing decisions. In particular, as M ille r (1988) later observed, showing w hat doesn't m atter can also show, by im plication, w hat does.4 By m aking the assumptions they did, M M excluded from th e ir analysis a num ber o f factors th a t could be im p orta nt. These factors include company taxes, personal taxes and default (and the associated costs o f liquidating a b ankrupt company). By im plication, i f capital structure does in fact matter, then taxes and default risk could be good places to look fo r the reasons why i t matters. The second reason, which is related to the first, is th a t an understanding o f the M M propositions helps to distinguish between logical and illogical reasons fo r particular financing decisions. For example, it may be suggested th a t companies should use at least some debt finance because debt is cheaper* than equity. Using the M M analysis, we can state th a t i f this reason is based on the observation that interest rates are lower than required rates o f retu rn on equity, then th a t reason is illogical. But a logical reason might be th a t there is a tax advantage to using debt rather than equity. The basic M M analysis th a t we have presented envisages only two sources o f finance: debt and equity. In practice, there are many other sources o f finance, including preference shares, leases and hire-purchase agreements. Furtherm ore, debt may be short term or long term , it can be denominated in different currencies such as US dollars, euro or yen, and some types o f debt and preference shares can be convertible into ordinary shares. But the fundam ental M M message is th a t any com bination o f finance sources is as good as any other. No m atter how many sources o f finance are used, the resulting capital structure is just another way o f dividing the net operating cash flows between the people who have contributed the capital that sustains the company s operations. We now tu rn to a discussion o f some o f the factors th a t M M o m itted from th e ir basic analysis.

The effects of taxes on capital structure under a classical tax system M M excluded company tax and personal tax from th e ir basic analysis. However, they were well aware that company tax m ight be an im p o rta n t factor and extended th e ir analysis to include company tax. There are two main types o f company tax systems. Under the classical tax system, which applies in the US, and to foreign companies operating in Australia, companies and th e ir shareholders are taxed independently. That is, fo r tax purposes, a company is an e n tity d istin ct from the shareholders who own it. Under an imputation tax system, which is used in many countries, including Australia, Canada and New Zealand, the taxation o f companies and shareholders is integrated. We begin by considering the effects o f company tax under the classical tax system. The effects o f personal taxes are discussed in Sections 12.4.2 to 12.4.4. The effects o f taxes under an im putation tax system are discussed in Section 12.5.

LEARNING OBJECTIVE 3 Explain how tax may influence capital structure decisions

12.4.1 | Company income tax M M extended th e ir original no-tax analysis to incorporate the effect o f company income tax under the classical system.5 Company p ro fit is taxed after allowing a deduction fo r interest on debt, which means that borrowing causes a significant reduction in company tax and a corresponding increase in the after­ tax net cash flows to investors. The tax savings associated w ith debt are shown in Example 12.5, which is based on the same data as Example 12.1.

4

In o th e r w o r d s, if fin a n c in g d e c is io n s a re im p o r t a n t , th e r e a s o n s f o r t h e ir im p o r t a n c e m u s t b e r e la t e d t o th e f a c t o r s t h a t M M e x c lu d e d th r o u g h t h e ir a s s u m p t io n s . H o w e v e r, it d o e s n o t n e c e s sa r ily fo llo w t h a t a ll s u c h f a c t o r s w ill c a u s e a d e p a r t u r e fr o m M M s c o n c lu s io n s . A s M y e r s ( 2 0 0 3 , p. 2 2 1 ) c o m m e n t e d , p e r h a p s M ille r s h o u ld h a v e s a i d *w h at m ay m a tte r ".

5

The o r ig in a l M o d ig lia n i a n d M ille r ( 1 9 5 8 ) a rtic le in c lu d e d th e e ffe c t o f t a x s a v in g s o n in t e r e s t , b u t v a lu e d th e s a v in g s in c o rre c tly . T h e e rr o r w a s r e c tifie d in M o d ig lia n i a n d M ille r ( 1 9 6 3 ).

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Example 12.5 Dribnor Ltd is subject to company income tax at the rate of 30 cents in the dollar and interest on debt is tax deductible. W hat is the effect of borrowing $1 million at 12 per cent per annum on the after-tax net cash flows to investors?

SOLUTION The two capital structures proposed for Dribnor Ltd are compared in Table 12.3, assuming that earnings before interest and tax are $3000 00 per annum. Table 12.3 shows that by borrowing $1 million, Dribnor increases its after-tax cash flow by $ 3 6 0 0 0 per annum. This increase is equal to the annual tax savings on interest, which is calculated by multiplying the annual interest payment, I, by the company income tax rate, tc. That is: A nn ua l tax savings on interest = fc x / = 0 .3 0 x $ 1 2 0 0 0 0 = $ 3 6 0 0 0 per annum

TABLE 12.3 The effects of borrowing and company tax on cash flows 100% equity

Equity and debt of $1 million

300000

300000

Interest on debt ($)

—

120000

Taxable income ($)

300000

180000

Company income tax ($) (tax rate, tc = 0.30)

90000

54000

After-tax company income ($)

210000

126000

After-tax cash flow available to investors (shareholders and lenders) ($)⑷

210000

246000

Increase in after-tax cash flow available to investors ($)

—

Capital structure Earnings before interest and tax ($)

36 000

(°l Earnings before interest and tax less company income tax

W hat is the effect o f these tax savings on the value o f the company? Since the annual after-tax cash flow increases by an am ount equal to the annual tax savings on interest, i t follows th a t the m arket value o f a levered company, VD m ust be equal to the value o f an equivalent unlevered company, VU} plus the present value (PV) o f the tax savings on interest. That is: VL = Vu

(PVof tax saving on interest)

12.4

W hat is the appropriate risk-adjusted discount rate to apply to the tax savings? Assuming th a t the tax savings are just as risky as the interest payments on debt, the appropriate discount rate is sim ply the cost o f debt, kd. I f the annual interest payment remains constant in perpetuity, Equation 12.4 becomes: VL = VU + ^ kd

12.5

In th is case the annual interest payment, I, is equal to the cost o f debt, kdi m u ltip lie d by the value o f debt, D. M aking these substitutions, Equation 12.5 can be rew ritten as follows: VL = V u + t^ kd = Vy + tcD

12.6

C hapter twelve Principles

of capital structure

Equations 12.4 to 12.6 express M M s Proposition 1, m odified to incorporate the effects o f company tax. Note th a t i f there is no company tax, then tc = 0, and Equation 12.6 becomes VL = VUf which is M M s no-tax result. Equation 12.6 implies th a t a levered company is always w o rth more than an equivalent unlevered company. Moreover, the more i t borrows, the greater is its debt, D, and the more its value increases. I f the company tax rate is 30 per cent, then, according to Equation 12.6, company value increases by 30 cents for every dollar o f debt in a company s capital structure. In Section 12.3.1 we summarised Proposition 1 in the no-tax case using the analogy o f slicing a cake: slicing a cake in a different way does n ot change the size o f the cake. Introducing company tax is analogous to cutting the cake into three slices instead o f tw o— there is now a slice fo r the government as well as slices fo r the shareholders and lenders. Saving company tax by borrow ing is equivalent to increasing the size o f the shareholders’ slice by reducing the size o f the government’s slice. The main im plication o f Proposition 1 w ith company tax is clear b ut extreme: a company should borrow so much th a t its company tax b ill is reduced to zero. In practice, very few companies use such extremely high levels o f debt. This fact indicates th a t while debt may have some advantages when there is company tax to be paid, there m ust also be other factors th a t offset these advantages. One im p o rta n t factor th a t can do so is income tax payable by individuals, which we refer to as personal taxes.6

1 2 .4 .2 1 Company tax and personal tax In practice, the company tax system and the personal tax system interact in complex ways. A lthough we cannot provide a complete analysis here, we can capture the m ain features by considering a simplified case. This case is presented in Example 12.6. Exam ple

12.6

In 2012-13, Nowra Ltd had earnings before interest and tax of $2500 00 and its interest expense was $100000. All its lenders and shareholders are individuals. The company operates under a classical tax system. All companies are taxed at the rate of 30 per cent on company income, while all individuals are taxed at the rate of 40 per cent on interest income and 25 per cent on income from shares. How much tax does the government collect?

SOLUTION Table 12.4 sets out the calculations.

TABLE 12.4 Taxes collected from Nowra Ltd, its lenders and shareholders Amount ($)

Tax paid ($)

Type of tax and tax rate

Earnings before interest and tax (EBIT)

250000

—

_

less Interest

100000

Earnings after interest, before tax

150000

Income and expenses

less Company tax Earnings available to shareholders

40 000 —

Personal tax (40%) _

45 000

45 000

Company tax (30%)

105000

26250

Personal tax (25%)

Total tax collected

111250

As shown in Table 12.4, the government collects tax of $11 1 250, of which $ 4500 0 is company tax and $ 6 6 2 5 0 is personal tax. Consider $100 o f Nowras earnings before interest and tax. I f this $100 is paid to one o f the lenders as interest, then the government collects $40 in tax from the lender, and the lender keeps $60. I f this

6

Th e t e r m p e r s o n a l ta x e s* is w id e ly u s e d in th e fin a n c e lit e r a t u r e to r e fe r t o t a x e s p a id a t th e in v e s t o r le v e l. S u c h t a x e s in c lu d e th e in c o m e t a x p a id b y s u p e r a n n u a t io n fu n d s a s w e ll a s t h a t p a id b y in d iv id u a l in v e s t o r s , b u t to b e c o n s is t e n t w ith th e lite r a tu r e w e w ill u s e th e t e r m p e r s o n a l t a x e s.

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$100 is n o t paid to a lender, then i t form s p art o f earnings after interest and w ill be subject to company tax. The government w ill collect $30 in company tax, leaving $70 to be passed on to a shareholder. But the shareholder m ust pay 25 per cent o f the $70 in personal tax, which is 0.25 x $70 = $17.50. The shareholder therefore receives $70 - $17.50 = $52.50. This is summarised in Table 12.5. The table also shows the general case in which the company tax rate is tc, the personal tax rate on interest income is tp and the personal tax rate on income from shares is ts.

TABLE 12.5 Effect of taxes on the income of lenders and shareholders Lenders Source of finance

Nowra Ltd

Shareholders

General case

Nowra Ltd

General case

Earnings before interest and tax (EBIT) 衝

100

100

Company tax ($)

N il

0

30

100

Earnings after company tax ($)

100

100

70

100(1 - tc)

Personal tax ($)

40

100

17.50

100(1- t c) x t s

Net income after all taxes ($)

60

100(1- t p)

52.50

100 (1 - g a - g

100

100 I

X

tp

X

tc

tc is the company income tax rate. tp is the personal tax rate on interest income. ts is the personal tax rate on income from shares.

Therefore, as shown in the b ottom line o f Table 12.5, the preferred source o f finance depends on a comparison between (1 - t ) and (1 - tc) ( l - ts). W ith personal taxes and company tax, the effect o f debt on company value becomes: Vl = v u +

D (1-^)

12.7

where D = the m arket value o f debt Equation 12.7 can be used to consider tw o special cases. Special case No. 1: Suppose th a t the personal tax rate on interest income is equal to the personal tax rate on income from shares— th a t is, = ts. In this case, Equation 12.7 simplifies to: =〜 + … ， which is M M s result when they include company tax in th e ir analysis (Equation 12.6). In o ther words, personal taxes do n o t affect the company tax savings associated w ith debt, provided th a t the personal tax rates on income from debt and equity are the same. Special case No. 2: Suppose th a t (1 - tp) is equal to (1 - tc) ( l - ts), which means th a t the overall tax burdens on debt and equity are the same. In this case, Equation 12.7 simplifies to: VL = V。 — th a t is, the effects o f company tax and personal taxes offset each other exactly, so changing a company s capital structure w ill n o t affect its value. This result is the same as M M s no-tax case. How likely are these special cases to arise in practice? In m ost classical tax systems Special case No. 1 is unlikely to arise because capital gains are often taxed at a lower rate than ordinary income. Typically, interest income is regarded as ordinary income and hence is taxed at the fu ll personal tax rate, tp. Income from shares w ill usually consist p a rtly o f dividends, which are taxed at the fu ll rate, and p artly o f capital gains, which are taxed at a lower rate. So the overall tax rate on shareholders’ income, ts, is less than the fu ll rate, tp. But Special case No. 2— or something very sim ilar— is quite likely to arise. Suppose th a t the company tax rate, tc, is 0.30 and an investor has a personal tax rate o f 0.45 on interest and dividends but the tax rate on capital gains is 0.10.7 Also assume th a t dividends make up one-third o f the return to equity while capital gains make up tw o-thirds. For this investor, tp = 0.45 and ts = 0.45 x 1/3 + 0.1 x 2/3 = 0.217.

7

A c a p it a l g a in s t a x r a te o f 1 0 p e r c e n t m a y s e e m low . F o r e x a m p le , in A u st r a lia , c a p it a l g a i n s a r e fr e q u e n tly t a x e d a t h a lf th e rate o n o r d in a r y in c o m e , w h ich in t h is e x a m p le w o u ld b e 2 2 .5 p e r c e n t. H o w e v e r, c a p ita l g a i n s t a x is u su a lly n o t p a y a b le u n til th e s h a r e s a re s o ld , w h ich m a y n o t o c c u r u n til m a n y y e a r s a f t e r th e s h a r e s w ere b o u g h t. B e c a u se o f th e t im e v a lu e o f m o n e y , th is d e fe r r a l o f t a x p a y a b le b e n e fits th e t a x p a y e r a n d m a y w ell im p ly t h a t th e e ffe c tiv e c a p ita l g a i n s t a x r a te is a s lo w a s 1 0 p e r ce n t.

C hapter twelve Principles

The after-tax retu rn from debt w ill be $100 x (1 - 0.45) = $55 and from equity i t w ill be $100 x (1 - 0.3) x (1 - 0.217) = $54.81. These returns are almost identical, which suggests th a t it is possible fo r the effect o f personal taxes to offset the effect o f company tax, provided th a t the personal tax rate on equity returns is significantly lower than the personal tax rate on interest. This outcome is possible i f capital gains are tax-free or are taxed at a lower rate than ordinary income— a situation th a t frequently arises in practice. One complication th a t we have n ot considered is the fact th a t personal tax rates d iffer between investors. The effects o f taxes and th e ir im plications fo r capital structure decisions when different investors have different personal tax rates were analysed form ally by M ille r (1977). This analysis is presented in the next section.

To outline M ille r s analysis o f the effects o f debt and taxes under the classical tax system, we assume that all the income received by shareholders is in the form o f unrealised capital gains, so the personal tax rate on shareholders1 income, ts, is zero. Suppose th a t all companies were financed entirely by equity. That situation cannot persist because there would be a strong incentive fo r companies to reduce company tax by borrowing. This means th a t some investors w ill have to switch from holding shares to holding debt. Tax-exempt investors should readily move from holding shares to holding debt because they would pay no tax in either case. The in itia l impact o f the change from all-equity financing would be to reduce to ta l taxes, because company tax is being reduced w ith o u t any increase in personal tax. When tax-exempt investors have been satisfied, companies th a t wish to borrow w ill have to persuade taxable investors to purchase debt. The interest rate offered to potential lenders m ust therefore increase, in order to attract investors w ith higher and higher m arginal personal income tax rates, tp. Companies can afford to persuade investors to switch from holding shares to holding debt, provided that the company tax saved by issuing the additional debt is greater than the personal tax payable by the lender (remember that ts = 0). Companies should be able to do this if the investors marginal tax rate is less than the company tax rate. But it should not be tax effective for investors on marginal tax rates greater than the company tax rate to become lenders: the personal tax paid on interest would be greater than the company tax saved. Therefore, the migration of investors from equity to debt should stop when, for the marginal investor, t is equal to If the tax rate o f the marginal investor is lower than the company tax rate, then there would be an incentive for companies to reduce overall taxes by increased borrowing. However, companies cannot afford to pay interest rates that are high enough to attract investors whose tax rate is higher than the company tax rate. The logical result is an equilibrium in which there is no incentive for companies to borrow either more or less. M ille rs analysis has three m ain im plications. Two are: 1 There is an optim al d ebt-equity ratio fo r the corporate sector as a whole, and this optim al d ebtequity ratio w ill depend on the company income tax rate and on the funds available to investors who are subject to different tax rates. 2 The securities issued by different companies w ill appeal to different types o f investors. For example, tax-exempt investors should invest only in debt securities, while investors subject to marginal personal income tax rates greater than the company income tax rate should invest only in shares. Therefore, companies w ith different capital structures w ill attract different investor clienteles, but, according to M ille r (1977), one clientele is as good as the other'. Consequently, in equilibrium there is no optim al debt-equity ratio for an individual company. An analogy may help to explain these two im plications. Suppose th a t 20 per cent o f cars use diesel fuel and 80 per cent use petrol. Cars o f both types are distributed evenly across a city. Then, i f the city has 10 000 fuel bowsers, we would expect about 20 per cent (2000) would deliver diesel fuel and about 80 per cent (8000) would deliver petrol, because th a t is how to ta l fuel demand is organised. But there is no reason fo r any individual service station to allocate its bowsers in those proportions. D ifferent service stations could have different proportions o f diesel and petrol bowsers, w ith little or no effect on the volume o f fuel they sell. The th ird im plication is: 3

The shareholders o f levered companies end up receiving no benefit from the company tax savings on debt because the saving is passed on to lenders in the form o f a higher interest rate on debt— th a t is, companies are effectively required to compensate the lenders fo r the additional personal tax payable

of capital structure

on interest income. The compensation is paid in the form o f an interest rate th a t is higher than it would be i f personal income taxes did n o t exist. M ille rs analysis is valuable in explaining empirical observations such as the fact th a t the average d ebt-equity ratio o f US companies did n o t increase substantially from the 1920s to the 1970s, despite an almost five-fold increase in the company income tax rate during th a t period. M ille rs explanation is that personal income tax rates increased in a sim ilar manner, thereby offsetting what would otherwise have been a strong incentive fo r companies to issue more debt.

12 .4 .4 1The scope of M iller’s analysis M ille r proposed th a t the effects o f personal and company taxes can exactly offset each other, im plying th a t an individual company s value is independent o f its capital structure, even though there is an optim al deb t-e q uity ratio fo r the corporate sector as a whole. His analysis is im p o rta n t in h ig hligh tin g the need to consider personal tax as well as company tax when analysing the effects o f borrow ing on company value. However, M ille rs analysis relied on some sim plifying assumptions. An im p o rta n t assumption is th a t the effective company income tax rate is the same fo r all companies. Suppose th a t the tax rate fo r all companies equals the sta tu tory rate, which is, say, 30 per cent. A profitable company th a t has borrowed w ill save 30 cents o f company tax fo r every dollar o f interest paid. However, n ot all companies make profits all the tim e. I f a company makes a loss, the am ount o f the loss is carried forward as a deduction against later years’ taxable income. Therefore, fo r a loss-making company, the present value o f the tax savings on an additional dollar o f interest w ill be less than 30 cents. Moreover, as De Angelo and Masulis (1980) have pointed out, borrow ing is n ot the only way fo r companies to save tax. For example, depreciation on many assets can be claimed as a tax deduction, and the larger a company s deductions fo r depreciation and other non-debt items, the smaller is any advantage associated w ith saving company tax by borrowing. In other words, non-debt tax deductions are a substitute fo r interest as a tax deduction. W ith uncertain future interest tax savings and non-debt tax deductions, debt may be more valuable fo r some companies than it is fo r others. The companies whose shareholders w ill benefit most from corporate borrow ing w ill be those best able to use the tax deductions generated by the interest paid on debt. In other words, borrow ing by a company can add value i f the company tax saved by borrow ing is greater than the additional personal tax paid; this is m ost likely fo r companies w ith profits that are large and stable. Conversely, fo r companies w ith low profits and p articularly those w ith accumulated losses being carried forward, borrow ing can reduce company value and shareholders1wealth because borrowing increases the personal tax payable on interest received and hence increases to ta l taxes. It should also be noted th a t in discussing the lim ita tio n s o f M ille rs analysis we have n ot yet allowed fo r the fact that interest may n ot be the only cost incurred when a company borrows. O ther costs include the costs o f financial distress and agency costs. M ille r recognised th a t in principle these costs are relevant to capital structure decisions. However, he argued th a t in practice they are too small to have a significant effect on company value. We discuss these costs in Sections 12.6 and 12.7. In summary, his analysis is im p o rta n t in that i t shows th a t the effects o f personal and corporate taxes tend to be offsetting, and can be exactly offsetting i f the personal tax rate on interest income is significantly greater than the personal tax rate on income from shares.

12.5 The effects of taxes on capital structure LEARNING OBJECTIVE 3 Explain how tax may influence capital structure decisions

under an imputation tax system 12.5.1 | W hat is an imputation tax system? In Chapter 11 we provided a detailed discussion o f the im putation tax system th a t operates in Australia. In this section we therefore provide only a b rie f summary. Since 1987, Australian-owned companies operating in Australia have been taxed under an im putation system. The hallm ark o f an im putation system is th a t company taxes and personal taxes are integrated. Look again at Table 12.4, which sets out

C hapter twelve Principles

of capital structure

the amount o f tax collected fro m Nowra Ltd under a classical tax system. Note that, although the highest tax rate in this example is 40 per cent, Nowras earnings before interest and tax (EBIT) o f $250 000 has generated tax collections o f $111 250— equivalent to a tax rate o f 44.5 per cent. This high im plied tax rate arises because the classical system taxes company income in the hands o f the company and then taxes it again when th a t income is passed on to the company s shareholders as a dividend. Critics o f the classical system describe this outcome as ‘double taxation’. An im p utatio n system is designed to elim inate this feature o f the classical tax system. Its operation is illustrated in Example 12.7.

Exam ple

12.7

In 2013-14, as in the previous year, Nowra Ltd had earnings before interest and tax (EBIT) of $250000 and its interest expense was $1000 00. All its lenders and shareholders are individuals resident in Australia. The company now operates under an imputation system. In this tax system, all companies are taxed at the rate of 30 per cent on company income, while all individuals are taxed at the rate of 40 per cent on interest income and 40 per cent on dividends. Nowra;s dividend policy is to pay out all its after-tax income in dividends. How much tax does the government collect?

SOLUTION Table 12.6 sets out the calculations.

TABLE 12.6 Taxes collected from Nowra Ltd, its lenders and shareholders Income and expenses

Amount ($)

Earnings before interest and tax (EBIT)

250000

less Interest

100000

Earnings after interest, before tax

150000

less Company tax

45 000

Earnings available to shareholders

105000

Franked dividend

105000

plus Franking credit1 Shareholders’ taxable income

Type of tax and tax rate

40000

Personal tax (40%)

45000

Company tax (30%)

15 000

Personal tax

45000 150000

Shareholders’ gross tax liability (at 40%)

60000

less Franking credit

45000

Shareholders’ net tax payable

15 000

Total tax collected

i Tax paid ($)

100000

1The calculation of the franking credit is: franking credit = ~ ~ ~ x franked dividend

= 2 ^ 2 x $105000 0.70 =$45 000

Given Nowras dividend policy, the government has collected tax o f $100 000 from Nowras earnings o f $250 000— equivalent to a tax rate o f 40 per cent. This tax rate is, o f course, equal to the personal tax rate levied on interest and dividend income. The im p utatio n system is intended to produce this outcome.

4^^

B usiness finance

1 2 .5 .2 1The effects of tax on capital structure decisions under an imputation tax system To compare the effects o f taxes on debt and equity under an im putation tax system, consider a dollar o f EBIT and th in k o f the company s capital structure as determ ining whether this dollar is paid out as interest to lenders or used to provide a retu rn to shareholders. The return to shareholders could be in the form o f either dividends or capital gains, depending on whether p ro fit is d istributed or retained by the company. As discussed in Chapter 11, i f Australian company tax has been paid, then most resident shareholders w ill benefit i f profits are distributed as franked dividends rather than retained. The after-tax returns to lenders and shareholders from a dollar o f EBIT used to pay interest or franked dividends are shown in Table 12.7.

TABLE 12.7 After-tax returns to investors under an imputation tax system Lenders

Shareholders

EBIT ($)

1

Company income tax ($)

0

Income after company tax ($)

1

Franking credit ($)

0

Investors’ taxable income ($)

1

1 - tc + tc = 1 (grossed-up dividend)

fp

(tp - tc) (gross personal tax less tax credit)

Net personal tax ($) Income after all taxes ($)

a - 〜）

1

(1 - tc) (franked dividend)

( i - g - (tp- tc) = ( i - tp)

I f the dollar o f EBIT is used to pay interest to lenders, then company tax is zero because interest paid is tax deductible fo r the company. Interest received is taxable in the hands o f lenders at the personal tax rate, tpi so th a t the lender s net income after all taxes is $(1 - t ). Alternatively, i f the dollar o f EBIT is used to provide a retu rn to shareholders, then the company w ill have to pay tax o f $tc w hich leaves after­ tax p ro fit o f $(1 - tc). This p ro fit can be used to pay a franked dividend o f $(1 - tc) carrying a franking credit o f $tc. The shareholder w ill then be taxed on the grossed-up dividend ($1), which means that, after allowing fo r the franking credit, net personal tax w ill be $(tp - tc). Finally, the shareholders income after all taxes w ill be the cash dividend, $(1 - tc), less net personal tax, $(tp - tc) — th a t is, the shareholder’s after-tax income is $(1 - tc) - $(tp- tc) = $ ( l - t p). W hile the calculation o f shareholders, after-tax income under im p utatio n may seem complex, the end result is simple: income distributed as franked dividends to resident shareholders is effectively taxed only once, at the shareholders’ personal tax rate. As shown in Table 12.6, interest paid to lenders is also taxed only once at the lenders* personal tax rate. Thus, the im p o rta n t result is that, fo r any given investor, the overall tax burden is the same fo r both debt and equity. In other words, in this case the im putation tax system is neutral between debt and equity. I f n e u tra lity is achieved, we are back to M M s Proposition 1 in the original no-tax case: the choice o f capital structure does n o t affect a company s value. In showing th a t the im p utatio n tax system can be neutral we have assumed th a t all profits are distributed as franked dividends. O ther results may be possible i f profits are retained. In Australia in 2013-14 the income tax rate payable by companies was 30 per cent. A ll companies face the same rate— — it does n o t vary w ith company income. However, the income tax rate payable by individuals depends on the ind ivid ua ls taxable income. Thus different individuals pay different income tax rates. In 2013-14 the top m arginal tax rate fo r personal income, excluding the Medicare levy, was 45 per cent. Consider an investor on this rate. This investors after-tax retu rn from a dollar o f EBIT paid out as interest w ill be $(1 - 0.45) = $0.55. Alternatively, i f this investor receives a capital gain o f $1, the tax law provides th a t at m ost only h a lf this am ount (50 cents) is subject to tax i f the gain is realised after a period o f more than 12 m onths. Effectively, the income tax rate is halved; in this case, the rate would be = 22.5 per cent. I f the same investor holds shares in a company th a t retains all profits and provides returns only as capital gains, then the after-tax retu rn w ill be (1 - tc) (1 - tg) = (1 - 0.30) (1 - 0.225) = 0.5425.

C hapter twelve Principles

of capital structure

The after-tax return from equity (0.5425) is only slightly lower than the after-tax retu rn from debt (0.55). However, this analysis understates the attractiveness o f the investm ent in equity. W hile it is true th a t this investor w ill pay a tax rate o f 22.5 per cent on a capital gain, this tax does not have to be paid until the shares are sold. Therefore, i f the investor keeps the shares for, say, 10 years before selling them, the payment o f the capital gains tax is deferred fo r 10 years. Taking in to account the tim e value o f money, this is equivalent to a reduction in the capital gains tax rate. In this case, an investm ent in shares is more attractive than an investm ent in debt. The im plication is th a t fo r this investor, the tax system is not neutral, but the bias favours equity rather than debt as a source o f company finance. To state this in another way, fo r a company to borrow from investors in the top tax bracket, the interest rate needed to attract such investors would have to be so high th a t company value would be reduced. In summary, the Australian im p utatio n tax system does n o t favour the use o f debt finance by companies. The system is either neutral or biased towards equity, depending on the investors marginal tax rate. Therefore, we arrive at essentially the same conclusion as M iller: borrow ing w ill n o t add value because the interest rate paid w ill reflect personal tax rates on interest th a t are equal to or higher than the overall tax rates on equity returns. W hile this conclusion is essentially the same as M ille rs , the reason is different. M ille r s argument relied on m arket equilibrium , whereas in the case o f the Australian tax system it is the structure o f the system th a t ensures th a t i t is either neutral o r biased towards equity. The designers o f the im p utatio n tax system had as one o f th e ir m ain objectives the removal o f any taxrelated bias towards the use o f debt finance by companies. Our analysis indicates th a t this objective should be achieved in the case o f companies th a t are w holly owned by Australian resident investors. However, taxes can s till be an im p o rta n t influence on financing decisions fo r many companies. For example, overseas investors in Australian companies are outside the im p utatio n tax system and are effectively s till taxed under the classical system. Consequently, debt may have tax advantages fo r Australian companies w ith a large overseas ownership.

fhe costs of financial distress The costs o f financial distress may also cause a company s value to depend on its capital structure. We first outline the nature o f financial distress. The effects o f direct bankruptcy costs are then discussed in Section 12.6.1. Indirect costs o f financial distress are discussed in Section 12.6.2. A company is said to be in a state o f financial d istress when it has d ifficu lty m eeting its comm itm ents to lenders. In serious cases, financial distress may lead to the liquidation o f the company. Alternatively, an adm inistrator or receiver-manager may be appointed by the lenders— this may lead either to eventual liquidation or to control reverting to shareholders i f the company trades out o f its difficulties. In less serious cases o f financial distress, a company may trade out o f its difficulties w ith o u t resorting to form al measures such as receivership. In other, even less serious cases, a company may meet all its comm itments but the mere possibility o f financial difficulties can change peoples behaviour. For example, suppliers may demand cash on delivery i f the customer is rum oured to be facing financial difficulties. Therefore, we can distinguish between costs associated w ith a form al transfer o f control to lenders, th a t is, bankruptcy costs, and indirect costs o f financial distress, which can affect companies whose problems are less serious.8

LEARNING OBJECTIVE 4 Explain how the costs of financial distress may influence capital structure decisions FINAN C IAL DISTRESS

situation where a company’s financial obligations cannot be met, or can be met only with difficulty BANKRUPTCY COSTS

12.6.1 I Bankruptcy costs In Section 12.2 we explained th a t any borrow ing by a company creates financial risk fo r its shareholders. This is true even i f the d eb t-e q uity ratio is so low th a t there is no risk o f default. M M s analysis shows that financial risk increases the cost o f equity capital b ut has no effect on the weighted average cost o f capital or on a company’s m arket value. Increasing a company s deb t-e q uity ratio increases financial risk and also increases a separate but related risk: the risk th a t the company w ill default on its debt. W hen there is some p robability o f default, debt is described as ‘risky’. M M ’s Proposition 1 holds even i f debt is risky: a company’s m arket value is 8

S tr ic t ly s p e a k in g , th e te rm b a n k r u p t c y ' in A u s t r a lia a p p lie s o n ly t o th e in so lv e n c y o f in d iv id u a ls . W h e n a c o m p a n y fa ils to m e e t it s fin a n c ia l o b lig a t io n s , it s c r e d it o r s h a v e a n u m b e r o f o p t io n s , s u c h a s s e e k in g th e a p p o in t m e n t o f a rec e iv e r, a r e c e iv e r - m a n a g e r o r a liq u id a to r . W e u s e th e t e r m ‘b a n k r u p t c y ， to d e s c r ib e th e s t a t u s o f s u c h c o m p a n ie s b e c a u s e o f it s w id e sp r e a d u s e in th e fin a n c e lit e r a t u r e .

direct and indirect costs associated with financial difficulty that leads to control of a company being transferred to lenders

B usiness finance

n ot affected by its d ebt-equity ratio. This conclusion also relies on the assumption that, while default is possible, there are no costs associated w ith default— th a t is, bankruptcy costs are assumed to be zero.9 In practice, there are both direct costs o f bankruptcy and indirect costs o f financial distress, and these costs w ill affect companies th a t issue risky debt. The direct costs are out-of-pocket costs associated w ith receivership or liquidation and consist m ainly o f fees paid to parties such as lawyers, accountants and liquidators. Indirect costs relate to factors such as the effects o f lost sales, reduced operating efficiency and the cost o f managerial tim e devoted to attempts to avert failure. When a company issues risky debt there is some probability th a t the company w ill subsequently default, in which case direct bankruptcy costs w ill be incurred. Therefore, by issuing risky debt, a company gives outsiders (lawyers, accountants, liquidators, and so on) a potential claim against its assets, which m ust decrease the value o f the company to its shareholders and/or its lenders. Where debt finance offers both benefits (such as tax savings) and the possibility o f bankruptcy costs, the value o f a company can be w ritte n as follows:

Value of a company = value of an equivalent all-equity financed company + present value of the benefits of debt - present value of expected bankruptcy costs The present value o f expected bankruptcy costs w ill be positively related to both the probability o f bankruptcy and the present value o f costs incurred i f bankruptcy does occur. The p robability o f bankruptcy w ill depend on the company s business risk and on its financial leverage, b u t at any given level o f business risk, the higher the company s leverage, the higher w ill be the probability o f bankruptcy. Therefore, the present value o f expected bankruptcy costs w ill increase as a company s d ebt-equity ratio increases. Hence, on this view, the decision to borrow involves a trade-off between the advantage o f tax savings and the disadvantage o f expected bankruptcy costs. Bankruptcy costs would n o t concern shareholders i f they were borne entirely by other parties such as lenders. When a company is liquidated, it is rare fo r shareholders to receive any return. In other words, the company s equity is usually worthless and any proceeds from the sale o f assets w ill be distributed to lenders. The costs incurred in adm inistering the liquidation, therefore, reduce the pool o f funds available fo r distribu tio n to lenders. However, before they lend money, potential lenders should realise th a t they w ill suffer in the event o f liquidation and respond by demanding a higher interest rate on th eir loans. Consequently, while lenders w ill bear realised liquidation costs, the expected costs are likely to be borne by shareholders. Therefore, expected bankruptcy costs decrease both company value and shareholders’ wealth.

As noted above, the indirect costs o f financial distress relate to factors such as the effects o f lost sales, reduced operating efficiency and the cost o f managerial tim e devoted to attem pts to avert failure. The basic problem is th a t the threat o f corporate bankruptcy provides incentives fo r managers and other stakeholders such as customers, suppliers and employees to behave in ways th a t can disrup t a company s operating activities and thus decrease its value. For example, i f a company is experiencing financial difficulties, managers are likely to pay less a tte ntio n to issues such as product quality and employee safety. Clearly, i f product quality falls and this fall is easily noticed by customers, sales and revenue w ill be lost. I f product quality is im p orta nt, b ut d iffic u lt to assess, the mere perception th a t a company s product quality is likely to suffer because o f financial difficulties can deter customers. For example, travellers are likely to be w ary o f financially insecure airlines because o f fears th a t safety may be im paired by inadequate maintenance. Therefore, it can be im p o rta n t fo r companies to m aintain an image o f low risk. Restricting the level o f debt is one way o f restricting a company s overall risk. Titm an (1984) points out th a t shareholders and lenders are n o t the only parties who can suffer i f a company liquidates or w ithdraws vo lu n ta rily from a particular line o f business. Titm an argues th a t expected future costs imposed on parties such as employees and customers w ill affect

9

T h e a s s u m p t io n o f n o c o s t s a s s o c ia t e d w ith d e f a u lt d o e s n o t m e a n t h a t t h e r e a r e n o lo s s e s in c u r r e d b y in v e s t o r s . T y p ically , b o t h le n d e r s a n d s h a r e h o ld e r s w ill in c u r lo s s e s b e c a u s e t h e v a lu e o f th e c o m p a n y s a s s e t s h a s d e c lin e d . T h is d e c lin e c a u s e s th e c o m p a n y t o d e f a u lt b u t i f th e r e a r e n o c o s t s a s s o c ia t e d w ith d e f a u lt , th e t o t a l , a lb e it re d u c e d , v a lu e o f t h e a s s e t s is a v a ila b le f o r d is t r ib u t io n to in v e s t o r s . T h e re fo r e , in v e s t o r s d o n o t s u ff e r a d d it io n a l lo s s e s a s a r e s u lt o f d e fa u lt .

C hapter twelve Principles

of capital structure

shareholders* wealth. For example, suppose th a t a machinery m anufacturer is considered likely to liquidate. Customers w ill expect problems in obtaining spare parts and service, so the price they are prepared to pay fo r the company s products w ill fall. Sales, profits and share price would be greater if the company could assure customers and other stakeholders th a t i t is very u nlikely to liquidate. Titm an suggests th a t the choice o f capital structure can, in effect, help to provide this assurance. By borrow ing less, a company decreases the p robability o f liquidation and hence improves the terms on which it trades w ith customers and other parties. Conversely, fo r companies th a t borrow, the adverse effect on the company’s current terms o f trade is p art o f the cost o f borrowing. T itm ans model has the testable im plication th a t companies such as car manufacturers and computer manufacturers, whose liquidation would impose large costs on customers and other associates, w ill adopt capital structures th a t feature relatively low levels o f debt. Empirical evidence on this issue is presented in Chapter 13. In addition to its adverse effects on sales, a company s risk o f financial distress can also increase its operating costs and its financing costs. For example, a greater risk o f financial distress w ill mean that it is harder to attract and retain skilled employees. Similarly, it can im pair a company s a bility to borrow and to obtain trade credit.

12.7 A gency costs Companies enter in to contractual relationships w ith various parties, including managers, shareholders, lenders, customers and suppliers. These relationships may involve agency costs, which arise from the potential fo r conflicts o f interest between the parties. In this section, we discuss the m ajor ways in which agency costs can affect financing decisions. The relevant costs include those associated w ith conflicts o f interest between lenders and shareholders, and the incentive effects o f debt. Equity finance also has agency costs because there can be conflicts o f interest between shareholders and managers.

12.7.1 I Conflicts of interest between lenders and shareholders When a company borrows, the lenders may fear th a t managers w ill make decisions th a t w ill transfer wealth from them to shareholders. This conflict o f interest is one type o f agency problem. The follow ing examples illustrate the p otential fo r such conflicts o f interest (Myers 1977; Sm ith & Warner 1979). •

•

•

•

Claim dilution. A company may issue new debt th a t ranks equally w ith, or has a higher ranking than, its existing debt. I f the proceeds from the issue are used to pay dividends, the to ta l assets o f the company are m aintained and the only change is in the company s d ebt-equity ratio. However, the holders o f the old debt now have a less secure claim on the company s assets and therefore th eir investment has become riskier. Accordingly, the m arket value o f th e ir loans decreases. Unless the value o f the company also decreases because o f the new debt, wealth is transferred from the holders o f the old debt to shareholders. DzWend payout. I f a company significantly increases its dividend payout, it decreases the company’s assets and therefore increases the riskiness o f its debt. Again, this results in a wealth transfer from lenders to shareholders. Further, the incentives fo r managers to increase a company s dividends become greater when the company is facing financial distress. In this case, the dividend payout provides a means fo r the shareholders to receive returns th a t otherwise are likely to go to the lenders on liquidation o f the company. Asset substitution. When a company borrows, it has a greater incentive to undertake risky investments, especially i f the m arket value o f its shares is very low. In fact, this incentive can be so strong th a t a company may undertake a high-risk investm ent even i f the investm ent has a negative net present value. The reason is th a t i f the investm ent proves successful, m ost o f the benefits w ill flow to shareholders, b ut if the investm ent fails, m ost o f the costs w ill be borne by lenders. Therefore, at the tim e the investm ent is undertaken, the to ta l value o f the company w ill decrease (because the investm ent has a negative net present value), b u t the value o f the shares w ill increase and the value o f the debt w ill fall. Again there is a transfer o f wealth from lenders to shareholders. Underinvestment. A company may reject proposed low -risk investments that have a positive net present value. If a company s debt is very risky, it may not be in the interest o f shareholders to contribute additional capital to finance profitable new investments. While undertaking the investments would

LEARNING OBJECTIVE 5 Explain how agency costs may influence capital structure decisions

B usiness finance

increase company value, shareholders can still lose because the risk o f the debt w ill fall and its value w ill increase. The amount o f this increase can be greater than the net present value o f the investments. Lenders should realise th a t th e ir wealth may be eroded by managers’ decisions made in the best interests o f the company s shareholders. Lenders would be expected to attem pt to protect themselves against such behaviour by managers. The more the company borrows, the greater is the need to seek such protection. One response by lenders is to require a higher interest rate on debt than would otherwise be the case, in order to compensate them fo r the losses they may suffer. This imposes costs on the company th a t w ill be borne largely by shareholders. Lenders may also protect themselves by requiring covenants to be included in loan agreements. Examples o f covenants are restrictions on issuing additional debt, particularly debt th a t has a higher ranking; restrictions on the disposal o f assets; a lim ita tio n on the payment o f dividends; lim ita tion s on the types o f investments the company can undertake; and requirements th a t the company m aintain specific financial ratios.10 The fact th a t these types o f covenants have been in existence fo r many years suggests th a t lenders are well aware o f th e ir need fo r protection. Covenants affect the value o f the company and shareholders’ wealth in tw o ways: a

b

M o n ito rin g w ill be required to ensure th a t the covenants are n ot breached, There may be o p p o rtu n ity costs in cases where the covenants are too restrictive and prevent managers from im plem enting value-maximising decisions. For example, covenants designed to prevent the company undertaking high-risk projects w ith negative net present values may also result in some profitable, high-risk projects being forgone.

Conflicts of interest between shareholders and company managers The agency costs discussed in Section 12.7.1 relate only to debt b ut there can also be agency costs associated w ith equity. These costs arise when a company's shares are owned by outside1investors rather than by ‘insiders’ such as top-level managers. To see this, consider a company owned entirely by an entrepreneur who also manages its operations. In this case, there are no agency costs o f equity because one person both owns and controls the company. Many companies are clearly too large to be structured in this way and equity capital is provided by shareholders who have little or no involvem ent in the company s operations. Instead, managers are employed to control the day-to-day operations o f the company. W ith this separation o f ownership and control there can be conflicts o f interest between shareholders and managers. For example, managers are unlikely to be as m otivated as an entrepreneur to w ork hard, strive fo r m axim um efficiency and search actively fo r profitable investm ent opportunities. The agency costs o f equity can be reduced by measures th a t align the objectives o f managers w ith those o f shareholders. These measures include employee share ownership schemes and the inclusion o f options on the company s shares as p art o f the rem uneration o f top-level managers. I f these measures are effective, this prom pts the question: Would it be efficient to elim inate the costs associated w ith the separation o f ownership and control by having a company s equity capital provided only by its managers? The answer is generally no, fo r two m ain reasons. First, while the owner-manager structure (rather than the employee-manager structure) is preferred fo r many small businesses, there are few individuals who have the combination o f wealth and skills to both own and manage a very large company. Second, while having an owner-manager has advantages in terms o f agency costs, it has disadvantages in terms o f risk bearing. As discussed in Chapter 7, investors can reduce risk by diversification and it is easy for them to diversify by combining the shares o f many companies in a p ortfo lio . Diversification can eliminate company-specific or unsystematic risk, and investors w ill require compensation only fo r bearing systematic risk th a t cannot be removed by diversification. In other words, the existence o f a stock m arket allows companies to raise equity capital on terms th a t reflect the benefits o f diversification. But where a company s manager is also one o f its shareholders, the manager is u nlikely to reap the fu ll benefits o f 10

S m it h a n d W a r n e r ( 1 9 7 9 ) . In a d d it io n , th e la w m a y lim it t h e b e h a v io u r o f m a n a g e r s . F o r e x a m p le , u n d e r A u s t r a lia n law , a c o m p a n y c a n p a y a d iv id e n d o n ly i f t h r e e c o n d it io n s a r e m e t . T h e se a r e : (i) th e c o m p a n y 's a s s e t s m u s t e x c e e d i t s lia b ilitie s im m e d ia t e ly b e fo r e th e d iv id e n d is d e c la r e d a n d th e e x c e s s m u s t b e s u ffic ie n t t o p a y th e d iv id e n d ; (ii) i t m u s t b e fa ir a n d r e a s o n a b le to th e s h a r e h o ld e r s ; a n d (iii) i t m u s t n o t m a t e r ia lly p r e ju d ic e th e c o m p a n y ’s a b ilit y to p a y i t s c r e d it o r s.

C hapter twelve Principles

diversification. As an employee, the managers wealth is linked to some extent to the fortunes o f the company. For example, managers generally develop skills and knowledge th a t are company-specific— that is, they have skills and knowledge th a t are valuable in th e ir current employment, b ut are o f less value elsewhere. Therefore, managers would require a higher rate o f retu rn on th e ir investm ent than outside, investors. In other words, managers would charge* more fo r bearing risk than outside investors, who can diversify. Consequently, the owner-manager structure is n o t efficient from the view point o f risk bearing. Jensen (1986) outlines an im p o rta n t application o f agency theory to capital structure decisions. This application is based on the concept o f *free cash flow*, which Jensen defines as the cash flow in excess o f that required to fund all projects that have positive net present values. Consider, fo r example, a highly profitable company in a declining industry. Because the company is profitable, it w ill generate positive net operating cash flows, b u t because the in d u stry is declining, it w ill have few new investm ent projects that have a positive net present value. Hence, it has large free cash flows. Managers have considerable discretion in deciding how to use free cash flows and Jensen argues th a t managers w ill be tempted to use free cash flows in ways th a t benefit them rather than the shareholders. For example, managers may invest in new projects or takeovers th a t increase th e ir command over resources, even though these investments have negative net present values. Similarly, having free cash flows may allow managers to avoid making hard decisions, such as retrenching surplus employees and adapting to rapidly changing technology. The upshot is th a t the company becomes less efficient and the interests o f shareholders are damaged. One way to reduce the agency costs o f free cash flows is through the paym ent o f dividends or by buying back shares. Jensen argues th a t shareholders’ wealth should be increased i f managers com m it to paying out this cash as dividends or to buying back shares rather than retaining the cash w ith in the company. However, promises to continue to pay high dividends or to buy back shares are weak because shareholders cannot enforce them. But i f a company borrows, i t is obliged to make agreed payments o f interest and repayments o f principal to the lender. Thus, debt has a control effect* whereby managers are forced to pay out cash because the penalties fo r default are severe. Jensen argues th a t the control effect o f debt w ill be im p o rta n t in companies th a t generate large net operating cash flows b ut have low growth prospects. Such companies can be expected to have higher financial leverage than others. He acknowledges th a t high leverage can be dangerous b u t also believes th a t it can add value in cases where companies generate large free cash flows.

O ptim al capital structure: the static trade-off theory Debt offers a company advantages, which include the tax d eductibility o f interest, b ut also disadvantages, which include increased costs o f financial distress. Therefore, there is the possibility o f a trade-off between the advantages and the disadvantages o f debt, leading to an optim al capital structure.11 I f an all-equity company decides to issue a small am ount o f debt, it is likely th a t the probability o f financial distress w ill be increased only negligibly. Under a classical tax system, the resulting tax savings are therefore likely to outweigh the very small increase in expected costs o f financial distress. Consequently, the value o f the company w ill increase. However, as the pro po rtio n o f debt is fu rth e r increased, the probability o f financial distress also increases and hence the expected costs o f financial distress also increase. A t some point, the higher costs w ill equal the higher tax savings. A t th a t point, the optim al d ebt-equity ratio has been reached. I f the deb t-e q uity ratio is increased s till fu rthe r, the value o f the company starts to decrease. This is illustrated in Figure 12.3. The static trade-off th eory outlined here has been a popular way o f reconciling observed capital structures w ith the M M analysis (w ith company income tax). There are several reasons fo r suggesting that the static trade-off theory provides an over-sim plified view o f the relationship between capital structure and company value. These reasons include the following: •

M ille r has argued th a t when both corporate and personal taxes are considered, the net effect o f taxes on company value can be zero.*1 3 7 9

11

S e v e r a l a u t h o r s h a v e d is c u s s e d o p t im a l c a p it a l s t r u c t u r e t h e o r ie s o f t h is ty p e . S e e , fo r e x a m p le , K r a u s a n d L itz e n b e r g e i ( 1 9 7 3 ) a n d S c o t t ( 1 9 7 6 ).

of capital structure

FREE CASH FLOW cash flow in excess of that required to fund all projects that have positive net present values

m LEARNING OBJECTIVE 6 Understand the concept of an optimal capital structure based on a trade-off between the benefits and costs of using debt

STATIC TRADE-OFF THEORY theory that proposes that companies have an optimal capital structure based on a trade-off between the benefits and costs of using debt

Rgure 12.3 The static trade-off theory of capital structure

•

The im p u ta tio n tax system has the p otential to be neutral between debt and equity as sources o f company finance. In cases where it is not neutral, the system is biased towards equity, n ot debt. There is evidence th a t the direct costs o f bankruptcy are small relative to company value (Warner 1977; Pham & Chow 1987, Weiss 1990; Andrade & Kaplan 1998).12 Companies used debt finance long before there were income taxes, which suggests th a t there must be advantages o f debt that are not related to income tax. The main such advantage probably involves agency costs. As discussed in Section 12.7.2, debt can be valuable in reducing the agency costs o f equity.

• •

W hile the static trade-off theory has significant lim ita tion s, its central message may s till be valid: there are both advantages and disadvantages o f debt, which can give rise to an optim al capital structure consisting o f a com bination o f different types o f finance. Therefore, despite its lim ita tion s, the static trade­ o ff theory is useful in th a t it can help managers to focus on some o f the factors th a t can be im p o rta n t in financing decisions.

12.9 C apital structure with inform ation fk

：

LEARNING OBJECTIVE 7 Explain the 'pecking order’ theory of capital structure

asymmetry 12.9.1 | Pecking order theory In a landm ark study, Donaldson (1961) carried out an extensive survey to fin d out how the capital structures o f US companies were actually established. His m ain findings can be summarised as follows: a

b

12

Managers prefer to use internal finance rather than raise funds externally by borrow ing or issuing shares. D ividend-payout ratios are set based on companies, expected future cash flows and expected investm ent opportunities. The aim is to ensure th a t there are sufficient internal funds to meet a company’s capital expenditure needs under ‘norm al’ conditions, b ut managers are also reluctant to make sudden changes in dividends— th a t is, dividend policy is ‘sticky’. W a rn e r e s t im a t e d t h a t t h e d ir e c t b a n k r u p t c y c o s t s in c u r r e d b y a s a m p le o f b a ile d * U S r a ilr o a d c o m p a n ie s a v e r a g e d o n ly 5 .3 p e r c e n t o f th e m a r k e t v a lu e o f th e ir a s s e t s . T h is fig u re fa lls t o 1 p e r c e n t i f c o m p a n y v a lu e is m e a s u r e d 7 y e a r s b e fo r e b a n k r u p tc y . W e iss e s t i m a t e s t h a t d ir e c t c o s t s fo r la r g e fin a n c ia lly d i s t r e s s e d fir m s a r e o n a v e r a g e 2 .8 p e r c e n t o f th e b o o k v a lu e o f a s s e t s . P h a m a n d C h o w r e p o r t e d d ir e c t b a n k r u p t c y c o s t s a v e r a g in g 3 .6 p e r c e n t o f c o m p a n y v a lu e a t th e d a t e o f b a n k r u p t c y fo r a s a m p le o f A u s t r a lia n c o m p a n ie s . W h e n th e p r o b a b ilit y o f fa ilu r e is a ls o t a k e n in t o a c c o u n t , it a p p e a r s t h a t e x p e c te d d ire c t b a n k r u p t c y c o s t s w o u ld b e v e r y sm a ll.

C hapter twelve Principles

c

d

of capital structure

W ith a sticky dividend policy and unexpected changes in both cash flows and investm ent opportunities, a company may or may n o t be able to finance all o f its capital expenditure internally. In periods when the funds available interna lly are greater than the company s investm ent needs, it may pay o ff debt, invest in marketable securities or increase dividends. Conversely, i f the funds available interna lly are insufficient to meet the company s investm ent needs, i t may ru n down its cash, sell marketable securities and, i f fu rth e r funds are needed, raise funds externally, If external funds are needed, borrow ing is preferred. A new issue o f ordinary shares is a last resort.

In summary, Donaldson observed th a t companies tend to follow a hierarchy or pecking order o f financing sources. The pecking order is: internal finance— in essence, retained earnings b external funds raised by borrow ing c external funds raised by issuing hybrid securities, such as convertible notes and preference shares d external funds raised by issuing ordinary shares. a

Donaldsons pecking order roughly corresponds to the transaction costs o f raising new capital. For example, internal finance usually imposes lower transaction costs than external finance. Therefore, the pecking order could perhaps be explained by a desire to m inim ise the transaction costs o f raising finance. According to Myers (1984), info rm a tio n asymm etry provides another explanation. In the follow ing sections, we explain how in fo rm a tio n asymmetry may influence capital structure decisions.

1 2 .9 .2 1 Information asymmetry and the undervaluation of a company’s assets Inform ation asymmetry exists when company managers have more info rm a tio n about th e ir companies1 asset values and prospects than outside investors. I f managers have in fo rm a tio n th a t the share m arket does not have, then the managers should have a more accurate idea than the share m arket o f the company s *true value*. Sometimes the managers may know th a t the company is w o rth more than its m arket value, while at other times the managers may know th a t the company is w o rth less than its m arket value. In this section we consider the case where the managers know th a t the share m arket has undervalued a company’s assets. Suppose th a t Alpha Books Ltd has on issue 100 000 o rdinary shares w ith a m arket price o f $4.50 each, but the company’s managers know th a t the ‘tru e ’ value o f the company’s assets is greater than the share m arket believes— the ‘tru e ’ value o f a share is $5. In the long term , perhaps when more inform ation is publicly available, the share m arket w ill also value the shares at $5 each. But in the short term, there is in fo rm a tio n asym m etry between the managers and the share m arket. Suppose fu rth e r that Alpha Books also has an investm ent o p p o rtu n ity th a t requires an outlay o f $200 000, which w ill have to be financed externally, and which has an NPV o f $17 000. The existence o f this investm ent o p p ortu nity is n o t know n to outsiders and is n o t reflected in the current share price. Hence, there is a second in fo rm a tio n asym m etry between the managers and the share m arket. But when the m arket is inform ed o f the new investm ent, the share price w ill respond positively to th is inform a tion . Should Alpha Books make the new investment? I f so, should the investm ent be made before or after the share m arket learns the true value o f the company s existing assets? And should the investm ent be financed by issuing new shares or by issuing new debt? To answer these questions, we consider the fo u r scenarios shown in Table 12.8.

TABLE 12.8 Alternative information and financing scenarios for Alpha Books Ltd Time that the investment announcement is made

Financing method New share issue

New debt issue

Before the share market learns the true value of the existing assets

Scenario 1

Scenario 3

After the share market learns the true value of the existing assets

Scenario 2

Scenario 4

PECKING ORDER THEORY

theory that proposes that companies follow a hierarchy of financing sources in which internal funds are preferred and, if external funds are needed, borrowing is preferred to issuing riskier securities

B usiness finance

W e n o w analyse each o f the se scen arios. F o r ease o f e x p re ssio n w e use ‘s h o rt t e r m ’ to m e a n th e p e rio d b e fo re th e share m a rk e t le a rn s th e tru e v a lu e o f th e e x is tin g assets. W e use ‘lo n g te r m ’ to m e a n th e p e rio d a fte r th e share m a rk e t le a rn s th e tru e va lu e o f th e e x is tin g assets.

Scenario 1: Investment announcement made before the share market learns the true value of the existing assets; new shares are issued In itia lly , th e share p ric e is $ 4 .5 0 , so th e n u m b e r o f n e w shares to be issu ed is $ 2 0 0 0 0 0 /$ 4 .5 0 = 4 4 4 4 4 . A f te r th e n e w in v e s tm e n t is a n n o u n ce d , a n d th e n e w shares are issued, th e share p ric e in th e s h o rt te rm w ill be: n P q =

$450 0 0 0 + $200 0 0 0 + $17 000 ^ -------------------------------------------- = $ 4 .b z 144 444

H a d th e n e w in v e s tm e n t n o t b e en m ade, th e share p ric e w o u ld have re m a in e d a t $ 4 .5 0 , so in th e s h o rt te r m th e s h a re h o ld e rs g a in 12 cen ts p e r share. In th e lo n g te rm th e share m a rk e t le a rn s th e tru e value o f th e e x is tin g assets a n d th e share p ric e w ill be: n

Pi =

$500 000 + $200 000 + $ 17 000 -----------------------------------------------------------------------------------------------

=

^ $4.96

144 444 H a d th e n e w in v e s tm e n t n o t been m ade, th e share p ric e w o u ld have been $ 5 .0 0 , so in th e lo n g te rm th e s h a re h o ld e rs lose 4 cen ts p e r share. T h e re fo re , th e ‘n e w ’ sh a re h o ld e rs — th o se w h o b o u g h t th e n e w shares a t $ 4 .5 0 each— w ill g a in b o th in th e s h o rt te r m a n d th e lo n g te rm , because b o th $ 4 .6 2 a n d $ 4 .9 6 exceed $ 4 .5 0 . The
Scenario 2: Investment announcement made after the share market learns the true value of the existing assets; new shares are issued In th e s h o rt te r m th e share p ric e re m a in s a t $ 4 .5 0 . In th e lo n g te rm , th e share m a rk e t le a rn s th e tru e va lu e o f th e e x is tin g assets a n d th e share p ric e increases fr o m $ 4 .5 0 to $5 .00. T h ere fore, th e n u m b e r o f n e w shares to be issu ed is $ 2 0 0 0 0 0 /$ 5 .0 0 = 4 0 0 0 0 . A f te r th e n e w in v e s tm e n t is a n n o u n c e d , a n d th e n e w shares are issued, th e share p ric e w ill be:

Pl =

$500 000 + $200 000 + $17 000

= $ 5 .1 2

140 000

In t h is scen ario, b o th th e n e w s h a re h o ld e rs a n d th e o ld s h a re h o ld e rs g a in in th e lo n g te r m b y 12 cents p e r share.

Scenario 3: Investment announcement made before the share market learns the true value of the existing assets; new debt is issued I f th e c o m p a n y b o rro w s to fin a n c e th e p ro je c t, a ll th e b e n e fit o f th e p o s itiv e N P V w ill go to th e c u rre n t sh a re h o ld e rs. A f te r th e n e w in v e s tm e n t is a n n o u n ce d , a n d th e n e w d e b t is issued, th e sha re p ric e w ill be:

Ps

$450 000 + $17 000

$4.67

In th e s h o rt te r m th e sh a re h o ld e rs g a in b y 1 7 ce n ts p e r share. I n th e lo n g te r m th e share m a rk e t le arn s th e tru e v a lu e o f th e e x is tin g assets, a n d th e share p ric e w ill be:

Pl

4^ ^

$500 000 + $17 000

100 000

$5.17

C hapter twelve Principles

〇卩

capital structure

H ad th e n e w in v e s tm e n t n o t be en m ade, th e share p ric e w o u ld have b e en $ 5 .0 0 , so in th e lo n g te rm th e sh a re h o ld e rs g a in b y 17 ce n ts p e r share.

Scenario 4: Investment announcement made after the share market learns the true value of the existing assets; new debt is issued In th e s h o rt te rm , th e share p ric e re m a in s a t $ 4 .5 0 . In th e lo n g te rm th e share m a rk e t le a rn s th e tru e value o f th e e x is tin g assets a n d th e share p ric e increases fr o m $ 4 .5 0 to $ 5 .0 0 . A f te r th e n e w in v e s tm e n t is a n no un ced, a n d th e n e w d e b t is issued, th e share p ric e w ill be: D

Jr T —

$500 0 0 0 + $17 000

100 000

— IpO • L l

In th is scen ario th e sh a re h o ld e rs g a in in th e lo n g te rm b y 17 ce n ts p e r share. In s u m m a ry,

without the new investment,

th e s h o r t- te rm o u tc o m e is a share p ric e o f $ 4 .5 0 w h ile th e

lo n g -te rm o u tc o m e is a share p ric e o f $ 5 .0 0 .

With the new investment,

th e s h o r t- te rm a n d lo n g -te rm

ou tcom es are th o se s h o w n in T able 12.9.

TABLE 12.9 Share price outcomes of alternative information and financing scenarios for Alpha Books Ltd F in a n c in g m e th o d T im e th a t th e in v e s tm e n t a n n o u n c e m e n t

N e w s h a re issue

N e w d e b t issue

Scenario 1

Scenario 3

is m a d e

Before the share m a rk e t learns th e tru e value o f the e x is tin g assets

Share price in the s h o rt te rm :

Share price in th e s h o rt te rm :

$4.62

$4.67

Share price in the lo n g te rm :

Share price in th e lo n g te rm :

$4.96

$5.17 Scenario 4

Scenario 2

A fte r the share m a rk e t learns th e tru e value o f th e e xistin g assets

Share price in th e s h o rt te rm :

Share price in th e s h o rt term :

$4.50

$4.50

Share price in th e lo n g te rm :

Share price in th e lo n g term :

$5.12

$5.17

C o m p a rin g th e fo u r scenarios, th e cle ar w in n e r is S cen ario 3, in w h ic h th e n e w in v e s tm e n t p ro je c t s h o u ld be accepted im m e d ia te ly , a n d s h o u ld be fin a n c e d b y d e b t. S cen ario 3 p ro d u ce s th e h ig h e s t share p rice in th e s h o rt te r m ($ 4 .6 7 ) a n d th e e q u a l h ig h e s t share p ric e in th e lo n g te r m ($ 5 .1 7 ). The w o rs t o u tco m e in th e lo n g te r m is c le a rly S cenario 1, in w h ic h th e n e w in v e s tm e n t is u n d e rta k e n im m e d ia te ly a n d is fin a n c e d b y shares. In t h is exa m ple, S cenario 1 is so ba d t h a t in th e lo n g te r m th e s h a re h o ld e rs lose as a re s u lt o f u n d e rta k in g an in v e s tm e n t w it h a p o s itiv e NPV.

1 2 .9 .3 1 Information asymmetry and the overvaluation of a company's assets N o w co n s id e r a d iffe re n t s itu a tio n . The c u rre n t share p ric e o f A lp h a B ooks is $ 4 .5 0 a n d th e re is n o ne w in v e s tm e n t o p p o rtu n ity . M a n a g e m e n t has in fo r m a tio n t h a t im p lie s t h a t th e share p ric e s h o u ld be o n ly $3 .50. In th e s h o rt te rm th e share m a rk e t does n o t have th is in fo r m a tio n b u t w ill le a rn o f i t in th e lo n g te rm . M a n a g e m e n t decides to issue 50 0 0 0 n e w shares w h ile th e m a rk e t p ric e is s t ill $ 4 .5 0 a n d w ill use th e cash raised ($ 2 2 5 0 0 0 ) to re p a y d e b t. In th e s h o rt te rm , th is changes th e c a p ita l s tru c tu re b u t n o t th e

4^ ^

B usiness finance

va lu e o f th e com p an y. In th e lo n g te rm , w h e n th e share m a rk e t le a rn s th e tru e va lu e o f th e c o m p a n y s assets, th e share p ric e w ill be:

Pl =

$350 000 + $225 000

= $ 3 .8 3

150 000

W h ile th is p ric e is less th a n th e p re v io u s p ric e o f $ 4 .5 0 , i t is

more th a n

$ 3 .5 0 , w h ic h th e share p rice

w o u ld have been h a d th e n e w share issue n o t be en m ade. H a v in g n e w s h a re h o ld e rs p a y m o re th a n th e shares are w o r th c u s h io n s th e im p a c t o f th e bad ne w s o n th e o ld sh a re h o ld e rs.

I n fo r m a tio n a s y m m e try can cause th e share m a rk e t to u n d e rv a lu e o r to o v e rv a lu e a com p an y. I f a c o m p a n y s m an ag ers b e lie ve t h a t its shares are u n d e rv a lu e d , th e y w ill p re fe r to b o rro w . I f th e y be lie ve t h a t th e shares are o ve rv a lu e d , th e y w ill p re fe r to issue n e w shares. H o w e ve r, w h ile o u ts id e in v e s to rs are n o t as w e ll in fo rm e d as m an ag ers, th e y u n d e rs ta n d m a n a g e rs’ m o tiv e s . T h ere fore, th e sha re m a rk e t m a y see th e a n n o u n c e m e n t o f a n e w share issue as evidence t h a t th e co m p a n y s m a n a g e rs k n o w b a d new s t h a t is n o t y e t k n o w n to o u ts id e rs . C o n se q u e n tly, th e share p ric e w ill decrease w h e n a n e w share issue is a n n o u n c e d . T his p o s s ib ility p ro v id e s a n o th e r rea son w h y n e w share issues ra n k v e ry lo w in th e p e c k in g o rd er. The m a in im p lic a tio n f o r c o m p a n y m an ag ers is t h a t th e re are ad van ta ge s in r e s tr ic tin g fin a n c ia l leverage so t h a t a c o m p a n y w ill be able to b o rro w a t s h o rt n o tic e i f a p ro fita b le in v e s tm e n t o p p o r tu n ity arises. To see th is , suppose t h a t a c o m p a n y is so h ig h ly le v e re d t h a t a n y u n e x p e c te d ne ed f o r fu n d s can be m e t o n ly b y is s u in g shares. The a n n o u n c e m e n t o f a share issue w ill cause th e c o m p a n y s share p ric e to fa ll, u n le ss th e m a n a g e rs succeed in c o n v in c in g in v e s to rs t h a t th e y are n o t co n c e a lin g adverse in fo r m a tio n . B u t f a ilin g to m ake an issue w i ll m e a n t h a t a p ro fita b le in v e s tm e n t o p p o r tu n it y m u s t be fo rg o n e . This cho ice b e tw e e n tw o u n a ttra c tiv e a lte rn a tiv e s can be a vo id e d b y m a in ta in in g Reserve b o r r o w in g c a p a c ity ’ o r ‘fin a n c ia l sla c k ’. In t u r n , th is can be a ch ie ve d b y r e s tr ic tin g d e b t to a m o d e ra te le vel, h o ld in g m a rk e ta b le s e c u ritie s t h a t can be s o ld to p ro v id e cash a n d /o r a rra n g in g lin e s o f c re d it w ith u n u s e d b o r r o w in g lim its . A n im p o r t a n t d iffe re n c e b e tw e e n th e p e c k in g o rd e r th e o r y a n d th e s ta tic tra d e -o ff th e o ry is t h a t th e p e c k in g o rd e r th e o ry does n o t re ly o n th e c o n ce p t o f a ta rg e t d e b t- e q u ity ra tio .13 In ste a d , a c o m p a n y s o b se rve d c a p ita l s tru c tu re w ill s im p ly re fle c t th e h is to r y o f it s c a p ita l re q u ire m e n ts . F o r exa m ple, suppose t h a t a co m p a n y en jo ys e x c e p tio n a l p r o fita b ility , w h ic h re s u lts in a s u b s ta n tia l increase in its share p rice . T here fore, in m a rk e t va lu e te rm s , th e c o m p a n y s d e b t- e q u ity ra tio w ill have decreased. A c c o rd in g to th e s ta tic tra d e -o ff th e o ry , i f a co m p a n y s o p tim a l c a p ita l s tru c tu re has n o t changed, th e n th e c o m p a n y s n e x t c a p ita l ra is in g s h o u ld be d e b t, to m o ve b a ck to w a rd s th e ta rg e t d e b t- e q u ity ra tio . H o w e ve r, th e p e c k in g o rd e r th e o r y suggests o th e rw is e . Ind e e d , because o f th e co m p a n y s e x c e p tio n a l p r o fita b ility , i t m a y n o t ne ed to raise e x te rn a l fu n d s a t all. T h e re fo re , p ro fita b le co m p a n ie s w ill te n d to have lo w d e b t- e q u ity ra tio s because o f th e a v a ila b ility o f in te r n a l fu n d s . Less p ro fita b le co m p a n ie s in th e sam e in d u s tr y w ill have h ig h e r d e b t- e q u ity ra tio s because th e y g e n e ra te fe w e r fu n d s in te r n a lly a n d because d e b t is f ir s t on th e p e c k in g o rd e r o f e x te rn a l sources o f fu n d s .

13 Note that internal equity and external equity are at opposite ends of the pecking order.

C hapter twelve Principles

of capital structure

ra te o f

c la im a g a in s t its a sse ts, w h ic h re d u c e s th e v a lu e o f

re tu rn to s h a re h o ld e rs , b u t a ls o in c re a s e s th e ris k

th e c o m p a n y to in v e s to rs . D ir e c t b a n k r u p tc y co sts

o f th e ir re tu rn s . T h e se e ffe c ts a r e o ffs e ttin g , a n d in

a p p e a r to b e s m a ll a s a

a p e rfe c t c a p it a l m a rk e t w ith

v a lu e , b u t f in a n c ia l d is tre s s c a n a ls o in v o lv e v a r io u s

F in a n c ia l le v e r a g e in c re a s e s th e e x p e c te d

a

c o m p a n y 's

c a p it a l

n o ta x e s , c h a n g in g

s tru c tu re

does

not

p r o p o r tio n

o f com pany

in d ir e c t costs.

change

c o m p a n y v a lu e o r s h a r e h o ld e r s 7 w e a lth . U n d e r th e se

A g e n c y co sts m a y a ls o in flu e n c e c a p it a l s tru c tu re

c o n d itio n s ,

ir r e le v a n t b e c a u s e

d e c is io n s . T h e se c o sts a r is e b e c a u s e th e re m a y b e

c h a n g in g it s im p ly c h a n g e s th e w a y in w h ic h th e

c o n flic ts o f in te re s t b e tw e e n le n d e rs a n d s h a re h o ld e rs

s tre a m

a n d b e c a u s e th e re m a y a ls o b e c o n flic ts o f in te re s t

of

c a p it a l net

s tru c tu re

o p e r a tin g

is

cash

flo w s

is

d iv id e d

b e tw e e n d iffe r e n t c la s s e s o f in v e s to rs . In a p e r fe c t

b e tw e e n

c a p ita l

T he la tte r c a s e m a y b e p a r tic u la r ly s e v e re w h e r e a

m a rk e t,

d iv id in g

th is c a s h

f lo w

s tre a m

is

s h a re h o ld e rs

and

com pany

m a n a g e rs .

co stle ss a n d c a n n o t c h a n g e its to ta l v a lu e .

c o m p a n y h a s a la r g e fre e c a s h flo w . Je n se n su g g e s ts

W h e n th e p e rfe c t c a p it a l m a rk e t a s s u m p tio n s a r e

th a t, in th e s e c a s e s , d e b t m a y b e a u se fu l w a y to

re la x e d , s e v e ra l fa c to rs c o u ld m a k e c a p it a l s tru c tu re

c o n tro l th e b e h a v io u r o f m a n a g e rs .

im p o rta n t. T hese fa c to rs in c lu d e c o m p a n y in c o m e

•

ta x ,

p e rs o n a l

in c o m e

ta x ,

th e

co sts

of

T he

s ta tic

s h o u ld

fin a n c ia l

tr a d e - o ff t h e o r y

be

expanded

d is a d v a n ta g e s o f m o re d e b t. T h is p o in t is th e

com pany

v a lu e

if th e

com pany

debt

w h e re

•

s a v e d b y b o r r o w in g

m o re

th a t d e b t

p o in t

th e

in c re a s e

of

th e

d is tre s s , a g e n c y co sts a n d in fo r m a tio n a s y m m e try . W h e n th e re a re in c o m e ta x e s , d e b t f in a n c e c a n

a d v a n ta g e s

s u g g e s ts

u n til

ju s t e q u a l

th e

o p tim a l c a p it a l s tru c tu re .

ta x •

is g r e a te r th a n th e e x tra

T he

p e c k in g

p e rs o n a l ta x p a id . W h ile th is is p o s s ib le fo r a t

r a is in g

le a s t s o m e c o m p a n ie s

o rd e r’

u n d e r th e c la s s ic a l ta x

o rd e r

fin a n c e , in

w h ic h by

th e o ry

m a n a g e rs in te rn a l

d e b t,

h y b r id

p ro p o s e s f o llo w

fu n d s

a

a re

th a t,

in

'p e c k in g p r e fe r r e d ,

s yste m , th e im p u ta tio n ta x system is d e s ig n e d to

fo llo w e d

re m o v e a n y ta x a d v a n ta g e s o f d e b t.

as a la s t re s o rt, a n e w issu e o f o r d in a r y s h a re s .

s e c u ritie s a n d

D e b t is s u e d b y c o m p a n ie s is ris k y in th a t th e re is

In fo rm a tio n

to

a n d in v e s to rs m a y h e lp to e x p la in th e p e c k in g

re c e iv e rs h ip o r liq u id a tio n . T h e se o u tc o m e s in v o lv e

o rd e r. A c c o r d in g to th e p e c k in g o r d e r a p p r o a c h ,

d ir e c t

a

o f d e fa u lt,

b a n k r u p tc y

co sts,

w h ic h

la r g e ly

in

can th e

le a d fo rm

of

a s y m m e trie s b e tw e e n

th e n ,

so m e

p r o b a b ilit y

c o m p a n y 's

d e b t - e q u it y

r a t io

CHAPTER TWELVW REVIEW

SUMMARY

m anagem ent

w ill v a r y

over

tim e , d e p e n d in g o n its n e e d s fo r e x te rn a l fin a n c e .

fee s p a id to in s o lv e n c y s p e c ia lis ts . T h e re fo re , a n y c o m p a n y th a t b o r r o w s is g iv in g o u ts id e rs a p o te n tia l

KEY TERMS a r b itr a g e

fin a n c ia l le v e ra g e ( g e a rin g )

365

b a n k ru p tc y costs bu siness ris k

357

366

fin a n c ia l distre ss

fre e ca sh f lo w

377

358

38 1

o p tim a l c a p ita l s tru c tu re

357

c a p ita l s tru c tu re d e fa u lt ris k

377

p e c k in g o r d e r th e o r y

357

383

p e rfe c t c a p ita l m a rk e t

36 1

s ta tic t r a d e - o ff th e o r y

381

SELF-TEST PROBLEMS B a rry T o d d , a n e n tre p re n e u r, is p la n n in g to e s ta b lis h a n in la n d fis h fa rm . T he to ta l c o s t o f th e n e c e s s a ry e a rth m o v in g , c o n s tru c tio n o f p o n d s a n d in s ta lla tio n o f p u m p s is e s tim a te d to b e $1 m illio n . T h re e p o s s ib le fin a n c in g p la n s a r e b e in g c o n s id e r e d . T h e se a r e a s fo llo w s : a)

e q u ity o f $1 m illio n

b)

e q u ity o f $ 7 5 0 0 0 0 a n d a b a n k lo a n o f $ 2 5 0 0 0 0

c)

e q u ity o f $ 2 5 0 0 0 0 a n d a b a n k lo a n o f $ 7 5 0 0 0 0 .

387

T he in te re s t ra te o n th e lo a n s w ill b e 1 0 p e r c e n t p e r a n n u m . B a r r y is u n c e rta in a b o u t th e re tu rn s fro m fish fa r m in g a n d w is h e s to a n a ly s e th e e ffe cts o f th e a lte rn a tiv e fin a n c in g p la n s o n th e ra te o f re tu rn o n his in v e stm e n t. P re p a re a ta b le s h o w in g th e ra te o f re tu rn o n B a rry 's in v e s tm e n t f o r e a c h fin a n c in g p la n if th e a n n u a l n e t o p e r a tin g c a s h flo w s g e n e ra te d b y th e fish fa rm a re $ 0 , $ 1 0 0 0 0 0 a n d $ 2 0 0 0 0 0 . T he e ffe cts o f ta x e s m a y b e ig n o r e d . C o m m e n t o n th e results. 2

Emu F a rm s Ltd h a s assets w ith a m a rk e t v a lu e o f $ 1 . 5 m illio n . Its c a p it a l s tru c tu re c o n s is ts o f e q u ity , p lus a lo a n o f $ 5 0 0 0 0 0 a t a n in te re s t ra te o f 8 p e r c e n t p e r a n n u m . T h e c o m p a n y 's c o s t o f e q u ity h a s b e e n e s tim a te d a t 2 1 . 5 p e r c e n t a n d its m a n a g e r is c o n s id e r in g a p r o p o s a l to b o r r o w a fu rth e r $ 2 5 0 0 0 0 , w h ic h w o u ld b e u se d to b u y b a c k s h a re s . T h e in te re s t ra te o n th e n e w lo a n is a ls o 8 p e r c e n t p e r a n n u m .

3

a)

U se M M 's P ro p o s itio n 2 to c a lc u la te th e e ffe c t o f th e in c re a s e in le v e ra g e o n th e c o s t o f e q u ity .

b)

C a lc u la te th e c o m p a n y 's w e ig h te d a v e r a g e c o s t o f c a p ita l b e fo re a n d a fte r th e in c re a s e in le v e ra g e .

C o s m ic Press Ltd is a ll- e q u ity fin a n c e d a n d is e x p e c te d to g e n e r a te n e t o p e r a tin g c a s h flo w s o f $ 6 0 0 0 0 0 p e r a n n u m . T h e c o m p a n y in c o m e ta x ra te is 3 0 p e r c e n t. C o s m ic 's s h a re h o ld e rs e x p e c t a 1 5 p e r c e n t ra te o f re tu rn (a fte r c o m p a n y ta x ). a)

W h a t is C o s m ic 's v a lu e ?

b)

If th e c o m p a n y b o r r o w s $1 m illio n a t a n in te re s t ra te o f 1 0 p e r ce n t: i) W h a t is C o s m ic 's a fte r-ta x o p e r a tin g c a s h flo w ? ii) W h a t is C o s m ic 's v a lu e a c c o r d in g to M M 's P ro p o s itio n 1 (w ith c o m p a n y ta x)?

Solutions to self-test problems are available in Appendix B.

tu 1

QUESTIONS

[L O 1] W h a t a r e th e p o te n tia l a d v a n ta g e s a n d d is a d v a n ta g e s to a c o m p a n y ’s s h a re h o ld e rs if th e c o m p a n y in c re a s e s th e p r o p o r tio n o f d e b t in its c a p it a l stru c tu re ?

2

[L O 1] D is tin g u is h b e tw e e n b u s in e s s ris k , f in a n c ia l ris k a n d d e fa u lt risk.

3

[L O 2 】 a)

O u tlin e th e M o d ig lia n i a n d M ille r v a lu a tio n p ro p o s itio n s . S p e c ify th e a s s u m p tio n s o n w h ic h th e ir p r o p ­ o s itio n s a re b a s e d .

b)

M odigliani and Miller's Propositions 1 and 2 are contradictory. Shareholders cannot be indifferent to the use o f debt when it increases the expected rate o f return on their investment. C o m m e n t o n th is s ta te m e n t.

2] Alternative proofs o f the M M propositions show that it is not necessary to assume the operation o f arbitrage involving personal borrow ing for the propositions to hold. D iscu ss th is s ta te m e n t.

4

[L O

5

[L O 3 ] O u tlin e M ille r 's a r g u m e n t th a t th e ta x a d v a n ta g e s o f d e b t a r e r e d u c e d o r c o m p le te ly o ffs e t o n c e p e rs o n a l ta x e s a r e in c lu d e d in th e a n a ly s is . H o w a p p r o p r ia t e is M ille r 's a n a ly s is , g iv e n th e A u s tr a lia n ta x system ?

6

[L O 3 】 M ille r 's a n a ly s is a ss u m e s th a t a c o m p a n y c a n fu lly u tilis e th e ta x d e d u c tio n s g e n e r a te d b y in te re s t p a y m e n ts o n d e b t. Is th is a s s u m p tio n lik e ly to b e tru e fo r a ll c o m p a n ie s ? G iv e re a s o n s .

7

[L O 3 ] A n

investor w ill wish to invest in a company because o f its capital structure. D iscu ss th is s ta te m e n t.

8

[L O 4 】O u tlin e th e s ig n ific a n c e o f b a n k r u p tc y co sts in th e c a p it a l s tru c tu re d e b a te .

9

[L O 3 , 4 ] C o m m e n t o n th e f o llo w in g s ta te m e n ts :

10

a)

The Australian imputation tax system is neutral in the sense that there is no bias towards the use o f either debt or equity.

b)

Costs o f financial distress w ill be borne entirely by lenders.

c)

Evidence such os that provided by Warner, Weiss, and Pham and Chow indicates that the costs o f financial distress ore too small to have any effect on capital structure decisions.

Managers, when pursuing the objective o f maximising the value o f the company to its shareholders, may moke decisions that ore not in the lenders' best interest. E x p la in w h y th is s ta te m e n t m a y b e tru e , a n d

[L O 5 ]

g iv e e x a m p le s o f d e c is io n s th a t m a y le a d to a tr a n s fe r o f w e a lth fro m le n d e rs to s h a re h o ld e rs .

C hapter twelve Principles

[LO 5 ] W h a t a r e a g e n c y co sts? O f w h a t s ig n ific a n c e a r e th e y in c a p it a l s tru c tu re d e c is io n s ?

12

[LO 6 ] C r itic a lly e v a lu a te th e f o llo w in g s ta te m e n ts:

13

a)

It is obvious that companies should use os much debt as possible. It is cheaper than equity and the interest is tax deductible os well.

b)

The probability o f financial distress should be negligible for companies with a low proportion o f debt. Therefore, a low proportion o f debt should not have any noticeable effect on the cost o f equity.

[LO 7 ] T he p e c k in g o r d e r t h e o r y p la c e s n e w s h a re issues a t th e b o tto m o f th e p e c k in g o rd e r. W h y ?

CA

PROBLEMS

1

E ffect o f le v e ra g e [L O 1 ]

A n e n tre p re n e u r is p la n n in g to e s ta b lis h a c o m p a n y w ith $ 5 0 m illio n in assets a n d is in v e s tig a tin g th re e p o s s ib le c a p ita l structure s fo r th e c o m p a n y : (i) n o d e b t; (ii) 2 0 p e r c e n t d e b t; a n d (iii) 5 0 p e r c e n t d e b t. T he in te re s t ra te o n th e d e b t is 1 0 p e r c e n t p e r a n n u m . T h e e n tre p re n e u r b e lie v e s th a t th e a n n u a l e a r n in g s b e fo re in te re s t a n d ta x w ill b e $ 2 . 5 m illio n in a p o o r y e a r, $ 5 m illio n in a n a v e r a g e y e a r a n d $ 1 0 m illio n in a g o o d y e a r. a) b)

C o m p le te th e ta b le b e lo w . P lot th e results fo r th e th re e c a p ita l stru ctu re s to g e th e r o n th e o n e d ia g r a m , w ith re tu rn o n assets (RoA) on

OHAPTEH TWELVE REVIEW

11

of capital structure

th e h o r iz o n ta l a x is a n d re tu rn o n e q u ity (RoE) o n th e v e rtic a l a x is . C o m m e n t. C a p ita l s tru c tu re (i)

C a p ita l s tru c tu re (ii)

C a p ita l s tru c tu re (iii)

Assets D e b t/ Assets D ebt ($) E q u ity ($) EBIT ($)

$2.5m

$5 .0m

$10.0m

$2.5m

$5.0m

$10.0m

$2.5m

$5.0m

$1 0.0m

In te re st ($) N et incom e ($) RoA

( % ) ⑷

RoE (%)W ^R o A (Return on Assets) = EBIT/Assets (where EBIT means earnings before interest and tax). ^RoE (Return on Equity) = Net income/Equity. 2

E ffe ct o f le v e ra g e [LO 1 ] a)

C a lc u la te th e ra te o f re tu rn a v a ila b le to s h a re h o ld e rs f o r a c o m p a n y fin a n c in g $1 m illio n o f asse ts w ith th e fo llo w in g th re e a rra n g e m e n ts : i) a ll e q u ity ii) 5 0 p e r c e n t e q u ity , a n d 5 0 p e r c e n t d e b t a t a n in te re s t ra te o f 1 2 p e r c e n t p e r a n n u m iii) 2 5 p e r c e n t e q u ity , a n d 7 5 p e r c e n t d e b t a t a n in te re s t ra te o f 1 2 p e r c e n t p e r a n n u m . T he assets a re e x p e c te d to g e n e ra te e a rn in g s b e fo re in te re s t o f $ 1 5 0 0 0 0 p e r a n n u m in p e rp e tu ity .

b)

In te rp re t y o u r a n s w e r, a n d e x p la in w h a t e ffe c t a c h a n g e in th e p e rp e tu a l e a rn in g s stre a m m ig h t h a v e o n th e ra te o f re tu rn a v a ila b le to s h a re h o ld e rs .

389

Debt^-equity ratio and arbitrage [LO 2] R o c k m e lo n Pty Ltd a n d C a n ta lo u p e Pty Ltd a re tw o id e n tic a l c o m p a n ie s w ith e x p e c te d e a rn in g s b e fo re in te re st o f $ 1 . 5 m illio n p e r a n n u m . T he o n ly d iffe re n c e b e tw e e n th e tw o c o m p a n ie s is th a t R o ck m e lo n h a s issu ed d e b t s e c u ritie s to fin a n c e th e id e n tic a l a c tiv itie s th a t C a n ta lo u p e h a s fin a n c e d w ith e q u ity se c u ritie s a lo n e . T h e re a re n o ta x e s. D e ta ils o f th e tw o c o m p a n ie s a re as fo llo w s :

Item

R o ck m e lo n Pty Ltd

C a n ta lo u p e Pty Ltd

M a rk e t value o f e q u ity ($)

6000000

8000000

M a rk e t value o f d e bt ($)

4000000

—

N u m b e r o f shares issued

6000000

5 000000

Cost o f de bt (kd)

0.08

—

C h e e W e n g o w n s 6 0 0 0 0 0 sh a re s in R o c k m e lo n Pty Ltd. a)

W h a t is th e c u rre n t m a rk e t v a lu e o f C h e e W e n g 's sh a re s, a n d w h a t is h is in c o m e fro m R o c k m e lo n Pty Ltd?

b)

S h o w h o w C h e e W e n g c a n o b ta in a n id e n tic a l in c o m e w ith a lo w e r n e t o u tla y .

DebN-equity rafio and arbitrage [LO 2] L a n c e lo t Ltd a n d U n iv e rs a l Ltd o p e ra te u n d e r th e c o n d itio n s a s s u m e d b y M o d ig lia n i a n d M ille r in th e ir a n a ly s is w ith o u t ta x . T he tw o c o m p a n ie s a re id e n tic a l e x c e p t fo r th e ir c a p ita l stru ctu re s. B oth c o m p a n ie s h a v e a n n u a l n e t o p e r a tin g c a s h flo w s o f $ 5 0 0 0 0 0 . T h e m a rk e t v a lu e o f L a n c e lo t's d e b t is $ 2 m illio n . T h e in te re s t ra te is 9 p e r c e n t p e r a n n u m . L a n c e lo t ha s 3 . 2 m illio n sh a re s o n issue; th e ir c u rre n t m a rk e t p r ic e is 5 9 ce n ts p e r s h a re . U n iv e rs a l h a s n o d e b t. It h a s 1 .5 m illio n sh a re s o n issue; th e ir c u rre n t m a rk e t p r ic e is $ 2 . 4 5 p e r sh a re . H a ro ld o w n s 2 0 0 0 0 0 sh a re s in L a n ce lo t. a)

W h a t is th e m a rk e t v a lu e o f H a ro ld 's in v e stm e n t? W h a t is th e c u rre n t re tu rn o n his in ve stm e n t? W h a t is th e ris k o f his in ve stm e n t, as m e a s u re d b y th e d e b t - e q u it y ra tio ?

b)

S h o w H a r o ld th a t e a c h o f th e fo llo w in g th re e s tra te g ie s is a n a r b itr a g e : i) S ell th e 2 0 0 0 0 0 sh a re s in L a n c e lo t. B o r r o w $1 2 5 0 0 0 a n d in v e s t th e w h o le p ro c e e d s in U n iv e rs a l sh a re s. ii) Sell th e 2 0 0 0 0 0 sh a re s in L a n ce lo t. B o rro w $ 8 5 6 7 2 a n d in ve st th e w h o le p ro c e e d s in U n iv e rs a l sh a re s. iii) Sell th e 2 0 0 0 0 0 sh a re s in L a n ce lo t. S p e n d $ 9 7 9 8 . B o r r o w $1 1 4 6 1 9 , a d d th is to th e r e m a in in g c a s h , a n d in v e s t th e w h o le p ro c e e d s in U n iv e rs a l sh a re s.

Debl^-equity rafio and arbitrage (harder) [LO 2] Le vity Ltd a n d U n ic o rn Ltd o p e ra te u n d e r th e c o n d itio n s a ss u m e d b y M o d ig lia n i a n d M ille r in th e ir a n a ly s is w ith o u t ta x . T he tw o c o m p a n ie s a re id e n tic a l e x c e p t fo r th e ir c a p ita l structure s. B oth c o m p a n ie s h a v e a n n u a l n e t o p e r a tin g c a s h flo w s o f $ 1 0 m illio n . T he m a rk e t v a lu e o f Le vity's d e b t is $ 3 0 m illio n . T he in te re s t ra te is 7 . 5 p e r c e n t p e r a n n u m . Le vity ha s 1 .2 5 m illio n sh a re s o n issu e; th e ir c u rre n t m a rk e t p ric e is $ 2 0 . 4 8 p e r sh a re . U n ic o rn h a s n o d e b t. It ha s 4 0 m illio n sh a re s o n issu e; th e ir c u rre n t m a rk e t p ric e is $ 1 . 3 0 p e r s h a re . Je s s ic a o w n s 1 0 0 0 0 sh a re s in Levity. a)

W h a t is th e m a rk e t v a lu e o f J e ssica 's in ve stm e n t? W h a t is th e c u rre n t re tu rn o n h e r in v e s tm e n t? W h a t is the ris k o f h e r in v e s tm e n t, a s m e a s u re d b y th e d e b t - e q u it y ra tio ?

b)

S h o w Je ssica th a t e a c h o f th e fo llo w in g s tra te g ie s is a n a r b itr a g e : i) To a c h ie v e a h ig h e r re tu rn a t th e sa m e risk, firs t sell th e 1 0 0 0 0 sh a re s in Levity, th e n b o r r o w $ 2 4 0 0 0 0 a n d in v e s t th e w h o le p ro c e e d s in U n ic o rn sh a re s. ii) To a c h ie v e th e sa m e re tu rn a t a lo w e r risk, firs t sell th e 1 0 0 0 0 sh a re s in Levity, th e n b o r r o w $ 1 9 2 7 8 7 a n d in v e s t th e w h o le p ro c e e d s in U n ic o rn sh a re s.

c)

W h a t w o u ld Jessica n e e d to d o to a c h ie v e a n in v e s tm e n t in U n ic o rn th a t h a s th e s a m e re tu rn a n d risk as h e r c u rre n t in v e s tm e n t b u t a ls o le a v e s c a sh le ft o v e r to s p e n d ?

C hapter twelve Principles

Increasing income by arbitrage [LO 2 】 Q u a r r io n B o o k s Ltd a n d C o c k a tie l B o o ks Ltd a re id e n tic a l in e v e ry re s p e c t e x c e p t th a t Q u a r r io n h a s n o d e b t w h ile C o c k a tie l h a s a $ 2 m illio n lo a n a t a n in te re s t ra te o f 8 p e r c e n t. T h e re a r e n o ta x e s . T h e v a lu a tio n o f th e tw o c o m p a n ie s is as fo llo w s : Item

Q u a r r io n B oo ks

700000

Earnings be fore in te re s t ($)

less

In te re s t on lo a n ($)

equals

Incom e available to o rd in a ry

C o c k a tie l B o o ks

1

700000 160000

700000

540000

0.14

0.16

5 000000

3375000

shareholders ($)

divided by

Cost o f e q u ity (ke)

equals

M a rk e t value o f e q u ity ($)

plus

M a rk e t value o f debt ($)

equals

T otal m a rke t value ($)

2000000 5 000000

5 375 000

J a n e o w n s $ 1 0 0 0 0 w o r th o f C o c k a tie l s h a re s. S h o w th e p ro c e s s a n d th e a m o u n t b y w h ic h J a n e c o u ld in c re a s e h e r in c o m e b y th e use o f a r b itr a g e .

7

Increasing income without increasing risk [LO 2]

CHAPTER TWELVmHEVIEW

6

of capital structure

The f o llo w in g in fo rm a tio n re la te s to tw o c o m p a n ie s w ith th e s a m e b u sin e ss risk. T h e re a r e n o ta xe s. P a rra m a tta Pet F o o d

P e n rith Pet F o o d

Earnings before in te re s t ($)

10000

10000

M a rke t value o f debt ($)

50000

—

kd {%)

4

—

ke (%)

12

10

66666

100000

116666

100000

Item

M a rke t value o f e q u ity ($) T otal m a rke t value ($)

A c c o r d in g to M o d ig lia n i a n d M ille r , th e to ta l m a rk e t v a lu e o f th e tw o c o m p a n ie s s h o u ld b e th e sa m e , irre s p e c tiv e o f th e m e th o d s u se d to fin a n c e th e ir in ve stm e n ts. S u p p o s e y o u h o ld 1 p e r c e n t o f th e sh a re s in P a rra m a tta Pet F o o d . S h o w th e p ro c e s s a n d th e a m o u n t b y w h ic h y o u c o u ld in c re a s e y o u r in c o m e w ith o u t in c re a s in g y o u r risk.

8

Effect of company tax [LO 3] T he f o llo w in g in fo rm a tio n re la te s to C e e l Ltd, a s s u m in g tw o d iffe re n t c a p ita l stru ctu re s. T he v a lu a tio n in th e ta b le b e lo w a s su m e s th a t th e re is n o c o m p a n y ta x a n d n o p e rs o n a l ta x . F in a n c e d b y E q u ity a n d 10% Item

Earnings be fore in te re s t ($)

less

In te re s t o n lo a n ($)

equals

Earnings available to o rd in a ry shareholders ($)

divided by

Cost o f e q u ity (ke)

equals

M a rk e t value o f e q u ity ($)

plus

M a rk e t value o f lo a n ($)

equals

T o ta l m a rke t value o f com pany ($)

A ll e q u ity

600000

lo a n

600000 150000

—

600000

450000

0.15

0.18

4000000

2 500000

—

1500000

4000000

4000000

‘ 391

B usiness finance

T he g o v e rn m e n t th e n in tro d u c e s c o m p a n y ta x a t th e ra te o f 3 0 cen ts in th e d o lla r. A s s u m in g th a t th e re a re still n o p e rs o n a l ta x e s , c a lc u la te th e to ta l m a rk e t v a lu e o f th e c o m p a n y fo r b o th c a p ita l structures. C o m m e n t o n y o u r fin d in g s .

9

Information asymmetry and capital structure [LO 7 】 S o p h ie P h a rm a c e u tic a ls Ltd h a s 9 . 6 m illio n o r d in a r y sh a re s o n issue. T he c u rre n t m a rk e t p ric e is $ 1 2 . 5 0 p e r s h a re . H o w e v e r, th e c o m p a n y m a n a g e r k n o w s th a t th e results o f so m e re c e n t d ru g tests h a v e b e e n re m a r k a b ly e n c o u r a g in g , so th a t th e 'tr u e 7 v a lu e o f th e sh a re s is $ 1 3 . U n fo rtu n a te ly , b e c a u s e o f c o n fid e n tia l p a te n t issues, S o p h ie P h a rm a c e u tic a ls c a n n o t y e t a n n o u n c e the se test results. In a d d itio n , S o p h ie P h a rm a c e u tic a ls ha s a p r o p e r ty in v e s tm e n t o p p o r tu n ity th a t re q u ire s a n o u tla y o f $ 1 5 m illio n a n d h a s a n e t p re s e n t v a lu e o f $ 2 . 5 m illio n . A t p re s e n t, S o p h ie P h a rm a c e u tic a ls ha s little s p a re c a s h o r m a rk e ta b le assets, so if th is in v e s tm e n t is to b e m a d e it w ill n e e d to b e fin a n c e d fro m e x te rn a l so u rce s. T he e x is te n c e o f th is o p p o r tu n ity is n o t k n o w n to o u ts id e rs a n d is n o t re fle c te d in th e c u rre n t s h a re p ric e . S h o u ld S o p h ie P h a rm a c e u tic a ls m a k e th e n e w in v e s tm e n t? If so , s h o u ld th e in v e s tm e n t b e m a d e b e fo re o r a fte r th e s h a re m a rk e t le a rn s th e tru e v a lu e o f the c o m p a n y 's e x is tin g assets? S h o u ld th e in v e s tm e n t b e fin a n c e d b y is s u in g n e w sh a re s o r b y is s u in g n e w d e b t?

REFERENCES Andrade, G. & Kaplan, S., 'How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed', Journal of Finance, October 1998, pp. 1443-93. De Angelo, H. & Masulis, R., 'Optimal capital structure under corporate and personal taxation', Journal of Financial Economics, March 1980, pp. 3-29. Donaldson, G., Corporate Debt Capacity, Graduate School of Business Administration, Harvard University, Boston, 1961. Jensen, M., 'Agency costs of free cash flow, corporate finance and takeovers', American Economic Review, May 1986, pp. 323- 9. Kraus, A. & Litzenberger, R., 'A state-preference model of optimal financial leverage', Journal of Finance, September 1973, pp. 911-22. Miller, M .; 'Debt and taxes', Journal of Finance, May 1977, pp. 261-75. ------, 'The Modigliani-Miller propositions after thirty years7, Journal of Economic Perspectives, Fall 1988, pp. 99-120. Modigliani, F. & Miller, M., 'The cost of capital, corporation finance and the theory of investment^ American Economic Review, June 1958, pp. 261-97. ------, ------ , 'Corporate income taxes and the cost of capital: a correction,/ American Economic Review, June 1963, pp. 433-43. Myers, S., 'Determinants of corporate borrowing', Journal of Finonciol Economics, November 1977, pp. 147-75.

392

------, 'The capital structure puzzle', Journal of Finance, July 1984, pp. 575- 92. ------, 'Financing of corporations', in G. Constantinides, M. Harris & R. Stulz (eds), Handbook of the Economics of Finance, Elsevier North Holland, Amsterdam, 2003. Myers, S. & Majluf, N w "Corporate financing and investment decisions when firms have information that investors do not have7, Journal of Financial Economics, June 1984, pp. 187-221. Pham, T. & Chow, D., 'Some estimates of direct and indirect bankruptcy costs in Australia: September 1978-May 1983', Australian Journal of Management, June 1987, pp. 75-95. Scott, J., yA theory of optimal capital structure7, Bell Journal of Economics, Spring 1976, pp. 33-54. Smith, C. & Warner, J., 'On financial contracting: an analysis of bond covenants', Journal of Financial Economics, June 1979, pp. 117-61. Titman, S., The effect of capital structure on a firm's liquidation decision7, Journal of Financial Economics, March 1984, pp. 137-51. Warner, J., 'Bankruptcy costs: some evidence7, Journal of Finance, May 1977, pp. 337-47. Weiss, l., 'Bankruptcy resolution: direct costs and violation of priority of claims', Journal of Financial Economics, October 1990, pp. 285-314.

▼ CHAPTER CONTENTS ICT1

In tr o d u c t io n

394

13.4

F in a n c in g a s a m a r k e tin g p r o b le m

408

13.2

E v id e n c e o n c a p it a l s tru c tu re

395

13.5

D e te r m in in g a f in a n c in g s tr a te g y

409

13.3

A s s e s s in g th e t h e o r ie s o f c a p it a l s tru c tu re

406

LEARNING OBJECTIVES

^

A f te r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

o u t lin e e m p ir ic a l e v id e n c e f r o m r e c e n t s tu d ie s o f c a p it a l s tru c tu re

2

a s s e s s th e im p lic a t io n s o f th e e v id e n c e f o r th e s ta tic t r a d e - o f f a n d p e c k in g o r d e r th e o r ie s

3

e x p la in h o w f in a n c in g c a n b e v ie w e d a s a m a r k e tin g p r o b le m

4

o u t lin e th e m a in fa c t o r s t h a t f in a n c ia l m a n a g e r s s h o u ld c o n s id e r w h e n d e t e r m in in g a c o m p a n y ’s f in a n c in g s tra te g y .

(

B usiness finance

Introduction In Chapter 12 we outlined theories o f capital structure, beginning w ith the M odigliani and M ille r (MM ) analysis in the absence o f taxes. This analysis implies th a t in a perfect capital market, all capital structure decisions are u nim portant. W hile th a t conclusion is valid under th e ir assumptions, one positive message from the M M analysis is th a t i f capital structure is in fact im p orta nt, then the reasons fo r its importance m ust relate to factors th a t M M excluded by th e ir assumptions. These factors include taxes, the costs of financial distress, agency costs and differences in the inform a tion available to managers and investors. These other factors have provided the foundation fo r alternative theories o f capital structure. The static trade-off theoryy outlined in Section 12.8, proposes that there is an optim al capital structure that maximises the value o f a company. Companies w ill borrow u n til the advantages o f additional debt are exactly equal to the disadvantages o f additional debt. The advantages o f additional debt include the tax savings th a t may be made because interest paid is tax deductible. The disadvantages o f additional debt include the expected costs o f financial distress th a t w ill arise i f the company is unable to pay the interest th a t it owes. In Section 12.7.2 we outlined Jensens analysis o f the agency costs o f free cash flows. We noted th a t profitable companies in mature industries are likely to generate large free cash flows and managers may invest these cash flows in ways th a t benefit them rather than the shareholders. Jensen pointed out that debt can provide a solution to this overinvestment problem because it forces managers to pay out cash. In Section 12.9, we outlined the pecking order theory, which is based on the effects o f financing decisions under inform a tion asymmetry. I t suggests th a t capital structures are determined largely by companies* past needs fo r external finance. In contrast to the static trade-off theory, the pecking order theory is dynamic in th a t it attempts to explain financing decisions over time. In this chapter we review empirical evidence on capital structure and we develop recommendations fo r financial managers. The reader who examines the available evidence in search o f support fo r ^he one correct* theory o f capital structure w ill inevitably be disappointed. There is no universal theory of capital structure. Rather, each o f the theories highlights different aspects o f the choice between debt and equity. The static trade-off theory emphasises taxes and financial distress; the pecking order theory emphasises differences in inform ation. I t is also im p o rta n t to realise that, while capital structure theories usually focus on the relatively simple generic issue o f debt-versus-equity, in practice, capital structure decisions may involve many different types o f debt, including long-term debt, short-term debt, fixed-rate debt, floating-rate debt, bank debt and marketable debt. In addition, financial managers may also need to consider h ybrid securities such as the various form s o f preference shares.

13.1.1 | Company financing: some initial facts US evidence provided by W righ t (2004) suggests that, fo r the non-financial corporate sector as a whole, the ratio o f debt to equity stayed w ith in a narrow range during the tw e ntie th century. W right reports th a t the ratio o f to ta l liabilities to to ta l m arket value o f assets typically fell w ith in the range 50% ± 10%. This is a remarkable fin ding given th a t the tw entieth century saw huge changes in the size, structure and activities o f the corporate sector. Evidence compiled by Frank and Goyal (2008) indicates that, across the non-financial corporate sector as a whole, capital expenditure is approximately equal to the volume o f internal funds generated— th a t is, the evidence suggests th a t m ost o f the investm ent by non-financial companies is generally financed from internal cash flows. However, there is wide variation between companies. Debt is used more heavily at both ends o f the size spectrum, w ith large listed companies and private firm s showing a bias towards debt. But fo r small listed companies debt issues are fa irly m in or and equity is the favoured method. As Frank and Goyal note, it is w o rth remembering th a t much o f the research published on capital structure is lim ite d to listed companies. A nother pervasive finding is th a t financial leverage differs across industries. For example, in the US, industries w ith consistently high leverage include paper, steel and airlines, while those w ith low leverage include pharmaceuticals and electronics (Harris & Raviv 1991). In fact, some companies effectively have negative debt-equity ratios because th e ir holdings o f cash and marketable securities are greater than th e ir debt so they are net lenders. Myers (2001, pp. 82-3) notes th a t large net lenders in the US at that tim e included the m ajor pharmaceutical companies, Ford M oto r Company and M icrosoft. In Australia, pharmaceutical and biotechnology company CSL is a net lender: at the end o f the 2012-13 financial year

C hapter thirteen C apital

PURSUING A NO-DEBT POLICY________________________________

structure decisions

F in a n c e

in

ACTION

S o m e c o m p a n ie s c h o o s e to k e e p d e b t a t e x tr e m e ly lo w le v e ls . O n e r e a s o n t h a t s o m e c o m p a n ie s c h o o s e th is p o lic y is to s ig n a l to o t h e r p a r t ie s — s u c h a s its s u p p lie r s — t h a t th e c o m p a n y is f in a n c ia lly s o u n d a n d h e n c e is s a fe to d o b u s in e s s w ith . T h e d e p a r tm e n t s to re H a r r is S c a r fe is a c a s e in p o in t, a s a s to r y in th e A u s tra l io n F in a n cia l Review explains. T h e p r iv a t e e q u ity o w n e r s o f b u d g e t d e p a r t m e n t s to r e c h a in H a r r is S c a r f e s a id a d e c is io n to ru n th e c o m p a n y w it h o u t a n y d e b t h a d b e e n a g o d s e n d a s th e g lo b a l c r e d it c r u n c h s p ilt o v e r in to w o r s e n in g e c o n o m ic c o n d it io n s . M o m e n t u m P r iv a te E q u ity b o u g h t H a r r is S c a r f e in A p r il la s t y e a r , w it h d e p a r t m e n t s to r e o p e r a t o r M y e r t a k in g a 2 0 p e r c e n t s ta k e a s p a r t o f th e $ 8 0 m illio n d e a l. L ik e o t h e r r e t a ile r s , H a r r is S c a r f e is n o w f a c in g t o u g h e r c o n d it io n s a s th e b r o a d e r r e ta il s e c to r s lo w s d o w n u n d e r th e w e ig h t o f r is in g in te r e s t ra te s a n d h ig h p e t r o l p r ic e s . T h e m a n a g in g d ir e c t o r o f M o m e n t u m ’s c o r p o r a t e d iv is io n , K e v in J a c o b s o n , s a id H a r r is S c a r fe w a s d e lib e r a t e ly s tru c tu re d to b e u n g e a r e d , w h ic h h a d t u r n e d o u t to b e fo r t u it o u s a s th e w o r ld b a ttle d th e c r e d it c r u n c h . M o m e n tu m w a s t a k in g a ' b u i ld a n d h o ld ' s tr a te g y w it h H a r r is S c a r fe , a n d th e d e c is io n to h a v e th e b u s in e s s u n g e a r e d in it ia l ly h a d b e e n a b ig p lu s in its r e la t io n s h ip s w it h s u p p lie r s to th e r e ta ile r . T h e r e t a ile r h a s n o w b e e n t r a d in g s u c c e s s fu lly f o r a lm o s t s e v e n y e a r s a f t e r a f in a n c ia l c o lla p s e in e a r ly 2 0 0 1 .

Source: 'Harris Scarfe counts blessings of no-debt policy', Simon Evans, Australian Financial Review, 1 1 March 2008.

it held US$762 m illio n in cash and cash equivalents and had only US$6 m illio n in interest-bearing debt. A t the same date, the online travel service company W otif.com Holdings held A$132 m illio n in cash and cash equivalents and had only A$112 000 in interest-bearing debt. Similarly, the budget departm ent store Harris Scarfe pursues a no-debt policy (see Finance in Action). Leverage is generally low fo r grow th1companies and fo r companies w ith significant intangible assets. In addition, high business risk tends to be associated w ith low financial leverage. International studies by Rajan and Zingales (1995) and Wald (1999) find th a t differences in leverage between m ajor industrial countries are moderate. They also fin d th a t the correlations between debt-asset ratios and factors such as the ta ng ibility o f assets and p ro fita b ility are sim ilar across countries. Financial leverage is also associated w ith the inten sity o f com petition in an industry. In a study o f US m anufacturing companies, MacKay and Phillips (2005) report th a t financial leverage is higher in industries where a few large companies dominate than in more com petitive industries. If, as M M s Proposition 1 suggests, capital structure is irrelevant, we would not expect to see any empirical patterns in capital structure. Hence, these empirical observations suggest th a t capital structure decisions are regarded as im p o rta n t. The next section outlines the results o f empirical research on factors that may influence capital structure decisions.

13.2 Evidence on capital structure As noted earlier, the m ain theories o f capital structure attem pt to explain different aspects o f the choice between debt and equity, and each theory emphasises different factors. Accordingly, our discussion of the evidence is divided in to subsections th a t outline evidence on taxes, costs o f financial distress, agency costs and inform ation costs.

13.2.1 | Evidence on taxes As discussed in Chapter 12, the effects o f taxes on capital structure decisions involve personal tax as well as company tax, and the effects o f these tend to be offsetting— th a t is, while the tax deductibility o f interest on debt reduces company tax, interest income is taxed more heavily than dividends and

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NON-DEBT TAX SHIELDS (N D TSs) ta x d e d u c tio n s fo r item s such a s d e p r e c ia tio n o n assets a n d ta x losses c a rrie d fo r w a r d

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capital gains. As discussed in Section 12.4.3, lenders w ill effectively require companies th a t borrow to pay the extra tax fo r them by paying a higher interest rate on debt relative to the returns to shareholders. In other words, the argum ent is th a t companies w ill bear the fu ll effects o f the taxes generated by their operations, regardless o f whether the tax is paid directly by the company or indirectly through higher interest rates required by lenders. W hile the effects o f company tax and personal tax tend to be offsetting, a company s tax position can s till have im p o rta n t effects. For example, suppose th a t a company is profitable b ut its taxable income is negative, either because it has large tax deductions fo r depreciation on assets th a t were purchased recently o r because it has tax losses carried forw ard from previous years. For this company, borrow ing is likely to have a tax disadvantage because lenders w ill have to pay personal tax on the interest, b ut there w ill be no immediate reduction in company tax— the interest deductions w ill add to the tax losses being carried forward. Therefore, in m aking financing decisions, managers can be expected to view non-debt ta x sh ields (NDTSs), such as depreciation deductions or tax losses carried forward, as substitutes for interest deductions. To reflect tax effects, many studies o f capital structure include measures o f NDTSs as an explanatory variable w ith the expectation th a t NDTSs w ill be negatively related to leverage. The evidence on this issue is mixed. Studies th a t test fo r a relationship between leverage and NDTSs typically fin d that the effect is insignificant or th a t the NDTS variable has a positive coefficient一 the opposite o f the theoretical prediction. The findings o f these studies are d iffic u lt to in te rp re t because a company w ith large depreciation deductions is likely to have m ainly tangible assets. Companies w ith m ainly tangible assets w ill fin d it less costly to borrow because tangible assets can be pledged as security fo r debt. Similarly, a company th a t has tax losses being carried forw ard may be in financial distress. For a company in distress, the m arket value o f equity w ill usually fall, causing leverage to increase. In summary, NDTS may n ot be an adequate proxy fo r a company s tax position. Rather than indicating th a t the tax benefits o f debt are low, high NDTSs may indicate high tangible assets or financial distress. In the pre-1990 literature, evidence o f any significant relationship between leverage and taxes is sparse. As MacKie-Mason (1990) notes, this is somewhat surprising because ‘nearly everyone believes’ th a t taxes m ust be im p o rta n t in financing decisions. He suggests th a t taxes are im p orta nt, b u t had failed to show up in most previous studies because they were designed to test fo r average rather than marginal effects. To see this point, consider the argument th a t the incentive to save tax by borrow ing is less when a company has non-debt tax shields. The underlying logic is th a t higher non-debt tax shields w ill lower a company s expected m arginal tax rate, thus reducing the expected tax savings on additional debt. While this logic is sound, non-debt tax shields w ill lower a company s actual m arginal tax rate only i f they are large enough to reduce its taxable income to zero— a condition know n as ‘tax exhaustion’. MacKie-Mason argues th a t in m ost cases, non-debt tax shields w ill cause only a small change in the probability o f tax exhaustion and a sim ilarly small change in a company s expected m arginal tax rate. Therefore, differences in expected m arginal tax rates among companies w ill be small and d iffic u lt to measure. A nother problem is th a t previous studies have typically measured the leverage o f companies using accounting ratios, which reflect the cumulative results o f many separate financing decisions made over several years. To overcome these problems i t is necessary to examine individual financing decisions on a m arginal basis fo r companies th a t are at, or near, the p o in t o f tax exhaustion. Using this approach, MacKie-Mason finds strong evidence th a t taxes do influence financing decisions. The results o f MacKie-Mason are supported by those o f Graham (1996), who examined the incremental use o f debt by more than 10 000 US companies fo r the years 1980 to 1992. When allowance is made fo r the effects o f operating losses and investm ent tax credits, he finds th a t the m arginal tax rate varies considerably across companies and th a t high tax-rate companies borrow more heavily than those w ith low tax rates. In a later study, Graham (2000) makes a detailed estimate o f the effects o f taxes on company value. By examining the interest rate spread between taxable corporate bonds and tax-free m unicipal bonds he estimates the personal tax rate o f m arginal investors in corporate debt. The estimated rate varies w ith changes in statutory tax rates and is approximately 30 per cent from 1993 to 1994, the last year covered by the study. Graham also estimates th a t the average tax rate on equity income is about 12 per cent. This effective rate is much lower than the m arginal income tax rate o f 30 per cent because o f the benefits associated w ith deferring the realisation o f capital gains. W hat do these tax rates im ply in terms o f the net tax effects o f borrow ing under the US classical tax system w ith a company tax rate o f 35 per cent? Assume th a t Company X borrows $1 m illio n at an interest rate o f 10 per cent and uses the funds to repurchase shares w o rth $1 m illion . Company X w ill pay an extra $100000 in interest each year and

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reduce its company tax b ill by $35 000 per year. The m arginal lender w ill pay an extra $30000 per year income tax. Equity income w ill fall by $65 000 per year— equal to the extra interest o f $100000 less the company tax saving o f $35 000. Therefore, taxes paid by investors on equity income w ill fa ll by $65 000 x 0.12 = $7800 per year. The net tax saving is $35 000 - ($30 000 - $7800) = $12 800 per year. In this case the extra tax paid by investors reduces the net tax saving to less than 40 per cent o f the company interest tax saving. Despite this large reduction, the net tax saving is s till significant and should be very valuable. Graham estimated th a t in 1994, the net tax benefits o f debt added 3.5 per cent to the value o f a typical US company. Over the whole o f the 1980 to 1994 period covered by his study, Graham estimated that on average the tax benefit o f debt added 9.7 per cent to company value (or 4.3 per cent, net o f personal taxes). The studies referred to above were all based on companies subject to the classical tax system. Many countries, including Australia, Canada and New Zealand, have switched to the im p utatio n tax system. As discussed in Section 12.5.2, the im putation tax system is designed to remove any tax-related bias towards the use o f debt finance by companies. A t least three studies provide evidence th a t supports this expectation. Schulman et al. (1996) examine the effects o f im p utatio n on corporate leverage in New Zealand and Canada. New Zealand introduced a fu ll im putation tax system in 1988. Canada introduced partial im putation in 1972 and simultaneously introduced a capital gains tax on the sale o f shares. These two changes have opposing effects: the intro du ction o f im putation should reduce leverage while a capital gains tax increases taxes on equity and favours the use o f debt finance. Accordingly, the sample o f Canadian companies was divided in to four portfolios: a b

c d

companies th a t experienced a net operating loss during the study period (NOL sample) a high-dividend low -grow th sample a low-dividend high-grow th sample a fo u rth p o rtfo lio th a t contained all other companies.

The authors expected that the intro du ction o f im putation would have little effect on the leverage o f companies in the NOL sample because those companies have a low m arginal tax rate. Similarly, the tax changes should provide little benefit fo r low-dividend companies th a t deliver returns to investors m ainly as capital gains. Conversely, companies in the
1 3 .2 .2 1 Evidence on the costs of financial distress The trade-off theory proposes th a t each company has an optim al capital structure based on a trade­ o ff between the benefits o f debt on the one hand and the adverse effects o f financial distress costs on

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the other. Costs o f financial distress refer to the costs o f liquidating or restructuring a company that has failed, and also to the agency costs th a t can arise when there is doubt about a company s a b ility to meet its obligations to lenders. The discussion in this section is confined to evidence on costs directly associated w ith financial distress. The agency costs associated w ith high levels o f debt together w ith other agency costs o f debt are discussed in the next section. W hile few would dispute the argument th a t the costs associated w ith financial distress can reduce company value, there is some dispute about whether these costs are large enough to have an economically significant effect. First, there is evidence that suggests th a t the direct costs are too small to have a significant effect on company value. For example, W arner (1977) estimated th a t the direct (out-of-pocket*) expenses incurred in the adm inistration o f the bankruptcy process fo r ‘failed’ US railroad companies averaged only 5.3 per cent o f the m arket value o f th e ir assets at the date o f bankruptcy. This figure falls to 1 per cent i f company value is measured 7 years before bankruptcy. Weiss (1990) investigated a sample o f bankrupt listed US companies and found th a t the direct costs o f bankruptcy averaged 3.1 per cent o f the sum o f the book value o f debt and the m arket value o f equity measured at the end o f the fiscal year p rio r to filing fo r bankruptcy. This percentage falls to 2.8 per cent i f direct costs are measured as a p roportion o f the book value o f to ta l assets. Similarly, Pham and Chow (1987) reported direct costs averaging 3.6 per cent o f company value at the date o f failure fo r a sample o f Australian companies. The figures quoted in this paragraph refer to the actual costs incurred by failed companies. For a company th a t is n o t in financial distress, the expected costs would be far smaller because the actual costs have to be m u ltip lie d by the probability o f failure. For m ost companies, it seems th a t expected direct costs o f financial distress would be minuscule. W hile expected direct costs o f financial distress appear to be very small, companies considered likely to fa il may incur significant indirect costs. For example, Titm an and Wessels (1988) argue th a t these indirect costs may be high fo r companies whose suppliers and customers may be harmed by th e ir financial distress. Suppliers m ig ht refuse to supply products to companies th a t may default. Similarly, financial distress may cause sales to be lost because customers change to more reliable suppliers who are less likely to default and are more likely to be able to continue to service the product. Banerjee, Dasgupta and Kim (2008) fin d support fo r this argument by showing th a t companies use less debt when they have a dedicated supplier— th a t is, a supplier th a t provides much o f its purchases. Similarly, suppliers use less debt when they have a dedicated customer— th a t is, a customer who purchases much o f th e ir product. They find that these relationships are strongest in markets fo r durable goods where on-going relationships between suppliers and customers are im p o rta n t (see earlier Finance in Action on ‘Pursuing a no-debt policy’). F urther support fo r the significance o f the indirect costs o f financial distress is provided by Opler and Titm an (1994), who examine the performance o f companies during in d u stry dow nturns. They found that highly levered companies lost substantial m arket share to th e ir more conservatively financed competitors during these periods o f economic distress. Opler and Titm an also found th a t the companies that suffered the m ost were highly levered companies th a t engaged in research and development. This finding suggests th a t companies w ith specialised or unique products are particularly vulnerable to financial distress. A nother example o f an indirect cost is the risk o f employees becoming unemployed in the event o f a company defaulting. Berk, Stanton and Zechner (2010) argue th a t this cost is u ltim ately borne by companies in the form o f higher wages. Agrawal and Matsa (2013) found support fo r this argument in th a t when states in the US increased benefits to the unemployed, which has the effect o f reducing the expected costs o f being unemployed, companies increased th e ir use o f debt. There is empirical evidence indicating th a t in aggregate these indirect costs can be a significant pro po rtio n o f a company s value. A ltm an (1984) estimated both direct and indirect costs o f financial distress fo r a sample o f 26 bankrupt US companies. He found th a t in many cases the aggregate costs exceeded 20 per cent o f the value o f the company just before bankruptcy. Using a revised version o f A ltm ans methodology, Pham and Chow (1987) found that, fo r a sample o f 14 failed Australian companies, aggregate costs o f financial distress averaged 22.4 per cent o f company value just before failure. These estimates are much greater than the reported levels o f direct costs. Further evidence on the costs o f financial distress is provided by Andrade and Kaplan (1998), who studied highly levered companies th a t encountered financial distress. They p o in t out th a t i t is d ifficu lt to measure the costs o f financial distress. The source o f this d iffic u lty is *an in a b ility to distinguish whether poor performance by a company in financial distress is caused by the financial distress its e lf or is caused by the same factors th a t pushed the company in to financial distress in the firs t place* (Andrade & Kaplan 1998, p. 1444). Suppose th a t a particular ind ustry suffers a significant unexpected fall in

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sales. A ll companies in the ind ustry w ill experience lower profits (economic distress), b u t those th a t are highly levered w ill be most likely to also experience d ifficu lty in meeting repayments to lenders (financial distress). Therefore, the large indirect costs o f financial distress found by authors such as Altm an are likely to reflect the effects o f economic distress as well as those o f financial distress. A ll the companies studied by Andrade and Kaplan have operating margins th a t are positive, and typically exceed the ind ustry median, in the years they are distressed. Therefore, the sample companies appear to be largely financially distressed, n ot economically distressed. For the whole sample they estimate that the net costs o f financial distress are between 10 and 20 per cent o f company value. As they are unable to completely elim inate economic distress or the effects o f economic shocks, Andrade and Kaplan regard th eir estimates as upper bounds on the costs o f financial distress fo r the sample companies. They also divide th e ir sample in to two subsamples based on whether companies suffered an adverse economic shock, such as a severe dow nturn in in d u stry sales. The costs o f financial distress are found to be negligible fo r the subsample th a t did n o t experience an economic shock. I t is possible that the results obtained by Andrade and Kaplan are influenced by a selection bias— i t may be th a t companies w ith low costs o f financial distress are more likely to become highly leveraged. I f th a t is the case, th eir estimates may understate the costs o f financial distress fo r a typical company. On the other hand, the probability o f financial distress is very small fo r m ost public companies. Therefore, even i f the actual costs o f financial distress are as high as 20 per cent o f company value, the expected costs o f financial distress should be modest fo r m ost public companies. In summary, the direct costs o f financial distress are small relative to company value. The indirect costs appear to be considerably larger than the direct costs b u t are very d ifficu lt to distinguish from the costs o f economic distress. Unless the probability o f financial distress is high, the expected costs of financial distress appear to be modest.

As we explained in Section 12.7.1, there may be conflicts o f interest between shareholders and lenders, which can lead to several problems, including the problem th a t the company may underinvest. I f a company s value consists largely o f investm ent opportunities and the company is highly levered (and hence at greater risk o f experiencing financial distress), the underinvestm ent problem is likely to be severe. We also explained in Section 12.7.2 th a t because managers’ interests may diverge from shareholders’ interests, managers may overinvest on the company s behalf; the p rim ary m otive fo r m aking such investments is to benefit the managers rather than the shareholders. In this section we consider empirical evidence relevant to underinvestm ent and overinvestment. We also consider empirical evidence relating to conflicts o f interest between companies and th e ir employees.

Debt and underinvestment To illustrate the underinvestm ent problem, suppose th a t Zenacom Pty Ltd, a high-grow th technology company w ith a new product ready to manufacture, persuades its bank to finance the necessary plant and equipment w ith a high percentage o f debt.1 Also suppose th a t sales o f the product grow more slowly than anticipated and management now faces a choice between tw o unattractive alternatives. I f i t is to keep up the loan repayments i t w ill have to cut the research and development (R&D) budget, b u t its R&D activities are expected to generate much o f the company s growth. I f it m aintains the R&D budget, there is a high probability o f defaulting on the bank loan. W hat Zenacom really needs in this case is an injection o f new equity. However, attracting new shareholders is likely to be difficult. Because o f Zenacoms financial situation, much o f the value created (or preserved) by injecting additional equity w ill serve largely to support the lenders position. To induce new shareholders to invest, e ither the bank w ill have to w rite down its loan substantially— which it would be reluctant to do— or the new equity w ill come at a very high price, in the form o f excessive d ilu tio n o f ownership. Management w ill probably decide th a t the best alternative is to cut the R&D budget— in which case its financing decision has caused Zenacom to pass up valuable investm ent opportunities. As the Zenacom example illustrates, a company whose value consists m ostly o f intangible investm ent opportunities is likely to find th a t debt is very costly fo r two reasons. First, the lack o f tangible assets to 1

For a more detailed discussion of this example and topic, see Barclay, Smith and Watts (1995, pp. 8-9).

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serve as security w ill mean th a t debt is both expensive and d iffic u lt to obtain. Second, i f such a company does borrow, there are likely to be fu rth e r costs in the form o f investments forgone i f it gets into financial difficulty. The clear im plication is th a t growth* companies should restrict th e ir financial leverage. W hile the underinvestm ent problem can be severe fo r grow th companies, i t should n o t be significant fo r mature companies w ith few profitable investm ent opportunities. The value o f such companies comes m ostly from assets in place th a t can be used as security fo r debt. In summary, mature companies w ith a high p ro po rtio n o f assets in place are expected to have higher leverage than growth companies. This difference should be reflected in a negative relationship between leverage and investm ent opportunities.

Debt and overinvestment In some cases, the use of high leverage can add value because o f the beneficial effects o f debt in controlling the inclina tion o f managers to overinvest. Suppose th a t M am m oth Ltd generates large, stable cash flows from its operations in a mature in d u stry where there are few profitable new investments. Nevertheless, its managers may continue to invest in the same industry, m aking expensive attem pts to gain m arket share, or they may attem pt to achieve grow th by acquiring companies in other industries. These diversifying acquisitions are likely to destroy value fo r M am m oths shareholders, who can diversify th e ir own portfolios by purchasing the shares o f companies in other industries w ith o u t paying any prem ium for control. As noted earlier, Jensens (1986) free cash flow theory is applicable to companies like M am m oth and i t suggests th a t fo r such companies a high p roportion o f debt may be beneficial. Increasing leverage is an effective way o f forcing managers to pay out cash because o f the contractual obligations to make payments to lenders. In summary, debt finance can be beneficial fo r mature companies w ith few investm ent opportunities by curbing managers* inclina tion to overinvest. The necessity o f servicing debt should mean that managers w ill be more critical in evaluating capital expenditure proposals. The role o f debt in reducing overinvestment is an additional factor th a t suggests th a t leverage w ill be negatively related to the extent o f a company’s investm ent opportunities. In empirical studies the extent o f a company s investm ent opportunities is typically measured using the ratio o f the m arket value o f assets to the book value o f assets, which is usually referred to as the m arket-to-book ratio. By definition, a growth* company is expected to have extensive investment o pportunities in the future. The value o f these opportunities should be reflected in its share price, but n ot in its statement o f financial position (or ‘balance sheet’). Assets appearing on a balance sheet are assets in place*, n ot dreams o f the future. Therefore, the larger are a company s investm ent opportunities relative to its assets in place, the higher its m arket-to-book ratio is expected to be. In contrast, mature companies w ith few investm ent opportunities and a relatively high value o f assets in place are predicted to have low m arket-to-book ratios. Barclay, Sm ith and Watts (BSW) (1995, pp. 4-19) assessed the importance o f investm ent opportunities when they studied a sample o f more than 6700 US industrial companies over the period 1963 to 1993. Leverage was calculated as the ratio o f the book value o f debt to the m arket value o f the company (debt plus equity). The authors expected leverage to be determined largely by the extent o f a company s investm ent opportunities, which was measured using the ratio o f m arket value to book value. The results provided strong support fo r the importance o f investm ent opportunities as a determ inant o f leverage. As expected, companies w ith high m arket-to-book ratios had significantly lower leverage than those w ith low m arket-to-book ratios. The relationship between leverage and the m arket-to-book ratio was highly significant in a statistical sense and was also ‘economically’ significant. Economic significance refers to the size o f the change in leverage ratio associated w ith changes in m arket-to-book ratios. BSW found that m oving from the b ottom te nth percentile o f corporate m arket-to-book ratios to the n in e tie th percentile corresponded to a fa ll in the predicted leverage ratio o f 14.3 percentage points— a large fraction o f the average ratio o f 25 per cent. BSW interpreted th e ir results as showing th a t the extent o f a company s investm ent opportunities appears to be the m ost im p o rta n t systematic determ inant o f its leverage ratio. Their explanation fo r this finding is th a t fo r companies whose value consists largely o f intangible investm ent opportunities, the underinvestm ent problem associated w ith a high pro po rtio n o f debt finance makes high leverage p ote ntia lly very costly. On the other hand, fo r mature companies w ith lim ite d investm ent opportunities, high leverage has benefits in controlling the problem associated w ith free cash flow. As discussed above,

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free cash flow tempts managers to overinvest in mature businesses or make diversifying acquisitions that may n ot be in the interests o f shareholders. BSW acknowledged th a t th e ir results are also consistent w ith an explanation th a t includes taxes. Low-growth companies, w ith low costs o f financial distress and p otentially large benefits from using debt because o f its role in controlling overinvestment, are also likely to have greater use fo r interest-tax deductions than high-grow th companies. However, the results o f th e ir tests do n o t support the argument that taxes have an im p o rta n t effect on corporate leverage decisions. Consequently, BSWs preferred explanation fo r th e ir results does n ot include the effect o f taxes. BSW also pointed out th a t th eir m ain findings are fundam entally inconsistent w ith the predictions made by the pecking order theory. It would Suggest th a t companies w ith few investm ent opportunities and substantial free cash flow w ill have low debt ratios— and th a t those high-grow th firm s w ith lower operating cash flows w ill have high debt ratio s\ BSW (1995, p. 12) predicted, and found, results th a t are the exact opposite o f those suggested by the pecking order theory. On the other hand, there is evidence from other studies th a t provides support fo r the pecking order theory. In particular, one finding to emerge clearly from all relevant studies is th a t leverage is negatively related to pro fitab ility. As noted earlier, this finding is the opposite o f the static trade-off theory s prediction, and instead supports the pecking order theory— th a t is, companies w ith high p ro fita b ility may use less debt than other companies, simply because they have less need to raise funds externally and because debt is firs t on the pecking order o f external fund sources. Evidence o f a relationship between leverage and investm ent opportunities has been found in several countries. Rajan and Zingales (1995) used 1987 to 1991 data to examine the capital structures o f public companies in seven countries: the US, Japan, Germany, France, Italy, the UK and Canada. For each country, they found th a t leverage was positively related to the ta n g ib ility o f assets (measured by the ratio o f fixed assets to to ta l assets) and negatively related to the m arket-to-book ratio. As we discussed in Section 12.7.2, Jensen (1986) pointed out th a t a high level o f debt forces companies to pay interest, and hence prevents managers from wasting free cash flow on poor investments or organisational inefficiencies. The most prom inent example o f this role o f debt can be found in leveraged buyouts. Indeed, as we discuss in Chapter 19, th e ir p rim ary role is to provide a solution to the free cash flow problem. W hile the role o f debt in restricting the use o f free cash flow may be very im p o rta n t fo r large cash cow* companies, i t is probably o f lim ite d relevance in most other circumstances. I t appears that listed companies do n o t generally overinvest because announcements o f capital investments are associated w ith small b ut significant share price increases. Further, i f increased leverage generally adds value by disciplining managers, then debt issues should be associated w ith share price increases. However, there is no evidence o f such price increases, even fo r issues o f high-risk debt, where the pressure on managers to pay out cash is high (Shyam-Sunder 1991).

Conflicts of interest between companies and their employees While the studies discussed in Section 13.2.2 suggest th a t high debt levels may increase wage costs, Brander and Lewis (1986) argue th a t management may use high debt levels as a negotiating device to lower wage costs. They argue th a t high debt levels may be used to encourage employees to take a pay cut to help avoid financial distress fo r the company. Consistent w ith this argument, Hennessy and Livdan (2009) argue that there is a trade-off between the bargaining benefits o f debt and the debt-related disincentives discussed in Section 13.2.2. They argue th a t companies whose employees have greater bargaining power (such as through a highly unionised workforce) w ill have high debt levels, while those whose employees are key in m aintaining relationships w ith suppliers and customers w ill have low debt levels. Matsa (2010) provides support fo r the argument relating to the unionisation o f the workforce, fin ding th a t a 10 per cent increase in the level o f unionisation is associated w ith a 1 per cent increase in debt levels.

1 3 .2 .4 1 Evidence on information costs and the pecking order theory The pecking order theory outlined in Section 12.9 is based on in fo rm a tio n asymmetry, w hich occurs when managers know more than outside investors about the value o f th e ir company. When there

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are such in fo rm a tio n differences— which in practice is often the case— the company may incur large ‘in fo rm a tio n costs’ i f it issues (that is, sells) new shares to outside investors. Potential buyers o f new shares w ill be aware th a t they are at an in fo rm a tio n disadvantage compared w ith the company s managers. They are therefore like ly to take the sensible precaution o f assuming th a t the managers m ust have some in fo rm a tio n th a t leads them to believe th a t the shares are overvalued: w hy else would they be w illin g to sell new shares to outsiders? Therefore, potential investors w ill demand a price discount on the shares they are offered. O f course, the managers are also aware th a t this w ill occur— even if in fact they d on^ believe th a t the shares are overvalued. Therefore, managers w ill generally sell new shares to outside investors only as a last resort. Myers (1984) suggests that, in tu itive ly, issuing risky debt w ould rank between using in te rn a lly generated funds and issuing new shares. This conclusion is the cornerstone o f the pecking order theory: managers* firs t choice is to use interna l funds, followed by borrow ing and lastly by issuing new shares. The pecking order th eo ry is consistent w ith the observation th a t in te rn a lly generated cash is the largest single source o f finance fo r companies and debt is the larger o f the external sources. O f course, the fact th a t these observations are consistent w ith the pecking order th eo ry does n o t prove th a t the theory is correct— there may be other explanations fo r the data. The evidence we discuss concerns share price responses to announcements o f security issues and the relationship between p ro fita b ility and leverage.

Share price response to new financing An im p o rta n t prediction o f the pecking order theory is th a t the announcement o f a new share issue w ill cause the company s share price to fall. W hen debt or hybrid security issues are announced, the fall in share price should be smaller. The em pirical studies reviewed by Sm ith (1986) report findings th a t are consistent w ith these predictions. Various proposed explanations were investigated, b ut the only consistent result was th a t the price response was related to the type o f security issued. However, it seems likely th a t the m arket response should also depend on the company s grow th prospects. For example, Jensen (1986) argued th a t free cash flow is likely to be invested unprofitably, or wasted by allowing inefficiencies to develop. W hen a company announces th a t it intends to raise new funds, the m arket w ill assess the company s a b ility to invest the funds profitably. I f the company is mature, w ith few investm ent opportunities, the m arket is likely to perceive th a t the new funds w ill create excess cash, so the company s share price w ill fall. On the other hand, i f the company is growing rapidly, it is more likely th a t the new funds w ill be invested in positive net present value (NPV) projects, so its share price is likely to rise. The effect o f investm ent o pportunities on the share price response to new security issues was studied by Pilotte (1992). He found th a t fo r share issues, the average share price response was negative, b ut the average price fa ll was much larger fo r mature companies than fo r grow th companies. For issues o f debt, the share prices o f mature companies fell significantly, b u t fo r grow th companies, there was no significant price change. Therefore, P ilottes results show th a t the share price response to new financing depends on the company s investm ent o pportunities and is n o t related only to the type o f security being issued.

Leverage and the pecking order theory The pecking order theory does n o t have any role fo r an optim al capital structure or a target debt-equity ratio. According to the theory there are tw o form s o f equity— interna l equity and external equity— and they are at opposite ends o f the pecking order. The theory implies th a t a company s leverage w ill depend on the difference between its operating cash flow and its investm ent needs over tim e. Therefore, the pecking order theory predicts that, other things being equal, a company s leverage w ill be negatively related to its pro fitab ility. Consider two companies th a t operate in the same ind ustry and are sim ilar except fo r th e ir efficiency and, hence, th e ir profitability. Suppose th a t the two companies invest at sim ilar rates to keep up w ith the average growth o f the industry. The less profitable company w ill have larger needs fo r external finance and w ill end up w ith higher leverage because debt is firs t on the pecking order o f external sources o f finance. Consistent w ith the pecking order theory, several studies o f capital structure fin d th a t leverage is negatively related to profitability. For example, studies by Bradley, Jarrell and Kim (1984), Titm an and Wessels (1988), Rajan and Zingales (1995), Wald (1999), Graham (2000) and Graham and Harvey (2001) all report this finding, which holds over different tim e periods and in different countries.

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Testing the pecking order and the static trade-off theories Suppose that each company has a target debt ratio as proposed by the static trade-off theory. In practice, of course, a company s actual debt ratio w ill vary over tim e due to factors such as unexpected changes in operating cash flows and changes in the m arket value o f its shares. To test the static trade-off theory empirically, it is often assumed th a t actual debt ratios w ill be described by a *target-adjustment, model where companies have a leverage target and make gradual adjustments towards it. In contrast, the pecking order theory assumes th a t there is no target debt ratio and states th a t a company s debt ratio w ill vary over tim e depending on the company’s cumulative needs fo r external finance. Shyam-Sunder and Myers (1999) examined a panel o f 157 companies from 1971 to 1989 and tested the time-series predictions o f both models. They found th a t i t is d iffic u lt to distinguish between the models. For example, in one test they assumed th a t each company followed the pecking order exactly. The researchers then calculated the corresponding annual debt ratios. They found th a t a target-adjustm ent model fitte d this simulated data just as well as it fitte d the actual data. In other words, the statistical tests indicated th a t the static trade-off theory was consistent w ith debt ratios generated by the pecking order theory. This finding suggests th a t tests o f the static trade-off theory have low statistical power. ShyamSunder and Myers concluded th a t the pecking order theory provided the best explanation o f the financing behaviour o f the companies in th e ir sample. Fama and French (2002) examined b oth the pecking order and the static trade-off theories by testing whether the predictions o f these tw o models were consistent w ith the dividend and financing behaviour o f a large sample o f US companies from 1965 to 1999. In th e ir tests, both models had considerable success b ut also recorded some notable failures. Specifically, as in previous studies, the static trade-off theory is unable to explain the strong negative relationship between p ro fita b ility and leverage. On the other hand, in the case o f small grow th companies, those w ith the lowest leverage rely m ost heavily on equity issues. Since these low-leverage companies appear to have the capacity to issue lo w -risk debt, this finding is n ot consistent w ith the pecking order theory. Frank and Goyal (2003) also found weaknesses in the pecking order theory when they tested i t on a large sample o f publicly traded US companies from 1971 to 1998. Small companies do n o t fo llo w the pecking order, which works best fo r large companies in the earlier years. However, even fo r larger companies, support fo r the pecking order theory declines over time. In summary, support fo r the pecking order theory is mixed and the strongest evidence in its favour is probably the negative relationship between leverage and p ro fita b ility th a t consistently emerges from studies on broad samples o f companies. However, several authors have noted th a t this relationship could also arise in other ways. Suppose th a t companies have target leverage ratios. When a company earns profits, debt is often repaid so leverage can fa ll automatically. There maybe an incentive to borrow more in order to capture the tax benefits o f leverage. However, i f companies face fixed costs in raising debt finance and buying back shares, adjustments towards the leverage target may take place only periodically rather than frequently. More generally, suppose th a t every company has a target debt-equity ratio. Between ^refinancing points*, such as when new securities are issued, many companies w ill n o t have achieved th eir target. How can a researcher decide when a company is off-target because i t has no target and when a company has a target but has n o t been able to achieve it?2 To overcome this problem some recent studies have used narrow samples o f companies selected so that tim e series effects such as the
Hovakimian, Hovakimian and Tehranian (HHT) (2004) studied ‘dual issues’一 th a t is, cases where companies raise both debt and equity in the same financial year. They reported th a t dual issues are typically large and therefore have the potential to make substantial changes in a company s capital structure. In the case o f dual issues, the post-issue structure should reflect each company s leverage target w ith o u t 2

A simulation study has suggested that in these circumstances cross-sectional statistical tests can be very misleading. If companies in fact trade off the costs and benefits of leverage but change their debt-equity ratio only infrequently, then a cross-section test could show a negative relation between expected profitability and leverage even though the ‘true’ relationship is known to be positive at refinancing points. See Strebulaev (2007).

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any distortions induced by accumulated profits or losses. Hence, dual issues provide a setting that should make it easier to determine whether corporate financing behaviour is better explained by the static trade­ o ff or pecking order theories. The static trade-off theory predicts th a t high-grow th companies w ill have low leverage targets while low -grow th companies w ill have high leverage targets. H H T found results consistent w ith this prediction: companies w ith a high m arket-to-book ratio (indicating high grow th prospects) have a low target debt ratio. However, there is an alternative explanation fo r this finding: perhaps companies tend to make equity issues when th e ir m arket-to-book ratio is high. Baker and W urgler (2002) proposed th a t managers w ill prefer to issue equity when they believe th a t the company s shares are overvalued, which w ill tend to be at tim es when the m arket-to-book ratio w ill also be higher than usual. Moreover, they contend that observed capital structures reflect the cumulative outcome o f these attem pts by managers to tim e the equity m arket. H H T did find some evidence o f m arket tim in g in th a t recent increases in share price increase the p robability o f an equity issue. H H T also examined the effects o f p ro fita b ility and found th a t there is no relationship between p ro fita b ility and leverage after a dual issue. Thus, th e ir results im p ly th a t the usual negative relationship between p ro fita b ility and observed leverage is due to the cumulative effects o f profits and losses. An im p o rta n t conclusion o f the study is th a t the evidence supports the hypothesis th a t firm s have target capital structures’ （p. 539). H istorical effects can also be avoided by examining the capital structure o f companies th a t emerge from corporate spin-offs— th a t is, transactions in which a subsidiary is separated from its parent company and each becomes a separate listed entity. In comparison to studies o f broad samples, this setting should make it easier to detect relationships between leverage and company characteristics because the leverage ratios o f the ‘new’ companies can be chosen deliberately. M ehrotra, M ikkelson and Partch (2003) studied a sample o f 98 spin-offs from 1979 to 1997.3 They tested whether the difference in leverage o f the two companies th a t emerge from a spin-off is explained by differences in: • • • •

p ro fita b ility va ria b ility o f in d u stry operating income the nature o f assets tax status.

They found th a t higher leverage is related to higher pro fitab ility, lower va riab ility o f in d u s try operating income and a greater proportion o f tangible assets. They also found no evidence o f a relationship between leverage and tax status. Thus, in this setting, the relationship between leverage and p ro fita b ility is the opposite o f the pervasive negative relationship th a t is regarded as providing strong evidence against the static trade-off theory. Except fo r the lack o f support fo r a corporate tax effect, M ehrotra, M ikkelson and Partchs results are consistent w ith the static trade-off theory.

13 .2 .6 1 Evidence on the choice of maturity and priority of debt So far we have discussed the effects o f capital structure largely in term s o f financial leverage, which im p lic itly assumes th a t all debt is the same. In practice, the debt used by companies can vary considerably in terms o f features such as m aturity, covenant restrictions, p rio rity , security and w hether the debt is in the fo rm o f marketable securities or non-marketable loans. Therefore, as well as deciding how much debt to use, the financial manager has to make decisions about what type(s) o f debt to use and whether debt should be secured or unsecured, short term or long term , and so on. Barclay and Sm ith (1996) suggest th a t one factor th a t may be im p o rta n t in m aking such decisions is fle xib ility: private bank loans are relatively easy to renegotiate i f circumstances change, whereas once marketable debt securities have been issued it is much more d ifficu lt to vary the rights o f the holders. F lexibility is likely to be more im p orta nt to grow th companies than it is to others, because they are more likely to get in to financial d ifficulty than mature companies. Therefore, growth companies th a t borrow are likely to prefer private debt.

3

Dittmar (2004) also studied capital structure in corporate spin-offs. Since her results are consistent with those of Mehrotra, Mikkelson and Partch, we discuss only one of the studies.

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Barclay and Smith investigated the significance o f tw o features o f debt— m a tu rity and p rio rity — by examining 6000 US companies over the period 1981 to 1993. They pointed out th a t it may be d ifficu lt to assess the individual effects o f some features o f debt because many o f them are related. For example, bank loans are typically shorter term , cheaper to arrange and contain tig h te r covenant restrictions than publicly issued corporate bonds. Consistent w ith the findings o f Barclay, Sm ith and Watts (1995), they argued that, because o f the higher risk th a t grow th companies pose fo r lenders, such companies w ill find it prohibitively expensive to obtain long-term debt. Consequently, these companies are likely to use shorter-term, private debt which, by its nature, provides greater financing fle x ib ility than long-term debt. Similarly, the managers o f grow th companies m ig ht prefer to issue debt th a t is unsecured or subordinated in order to retain financing flexibility. However, Barclay and Sm ith argued th a t prospective lenders w ill require very high interest rates on such risky debt, so grow th companies are likely to be forced to issue higher p rio rity secured debt instead. The results o f th e ir analysis were consistent w ith these arguments. Companies w ith high ratios o f m arket value to book value (‘grow th’ companies) tend to use debt o f shorter m a tu rity and higher p rio rity than mature companies. Barclay and Sm ith found little evidence th a t m a tu rity and p rio rity choices were determined by taxes or signalling effects. Benmelech (2009) argues th a t companies w ith assets th a t are more easily sold— th a t is, assets sold in liquid markets and assets that may be useful to p otential buyers— may be able to use longer-term debt. He found support fo r this argum ent by exam ining nineteenth-century US railroad companies. He found that those companies w ith trains designed to ru n on standard-gauge tracks used more long-term debt. Benmelech, Garmaise and M oskowitz (2005) also found th a t real estate companies holding more liquid properties used more long-term debt.

An alternative approach to em pirical testing is to ask chief financial officers (CFOs) w hat factors they consider when they make capital structure decisions. This approach has the virtu e o f being direct and simple but has two weaknesses. First, the survey respondents may be unrepresentative o f the population of CFOs. Second, what a CFO believes, says and does may be three different things. Nevertheless, wellconducted surveys provide a tim ely reality check. The results o f an im p o rta n t survey o f 392 US CFOs were published in Graham and Harvey (2001). The survey was repeated by Brounen, de Jong and Koedijk (2006) in a study o f 313 CFOs from France, Germany, The Netherlands and the UK and repeated again by Coleman, Maheswaran and Pinder (2010) in a survey o f 76 Australian CFOs. A ll three studies used the same questions on capital structure. Unfortunately, the response rates were only 9 per cent in the US and just 5 per cent in Europe and Australia. Survey respondents were provided w ith 14 factors th a t m ig ht explain th e ir capital structure decisions and were asked to rank the importance o f each factor on a five-point scale. Table 13.1 lists the top five factors in each country. The results o f the studies are remarkably similar. O f the 14 factors, the m ost im p o rta n t was clearly the desire to m aintain financial fle xib ility: this factor ranked second in Australia and firs t in the other five countries. A t firs t sight, th is response appears to support the pecking order theory, b u t on fu rth e r questioning i t did n ot appear that the m otivation fo r this desire was in fo rm a tio n asymm etry or grow th options, as im plied by the theory. O f the 13 other factors, only six appeared in the top five responses across the countries, suggesting th a t a sim ilar set o f factors is considered im p o rta n t in all countries. One o f these is the tax advantage o f debt. There was some support fo r the static trade-off theory, w ith CFOs reporting th a t company tax was o f moderate importance, while the importance accorded to earnings vo la tility and the company's credit rating is consistent w ith a desire to avoid financial distress. This sim ilarity in responses is perhaps surprising given th a t company tax rates in Europe are considerably higher than in the US. Curiously, German CFOs were the least concerned about company tax despite Germany having the highest tax rate. The importance o f company tax ranked lowest in Australia, which is consistent w ith Australia’s use o f a pure form o f im putation. None o f the surveys found much evidence that CFOs considered th a t asset substitution, asymmetric inform ation, free cash flows or personal tax were im p orta nt factors.

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TABLE 13.1 Top five responses of CFOs to the question: W hat factors affect how you choose the appropriate amount of debt for your firm? R ank

A u s tr a lia

F ra n c e

G e rm a n y

N e th e rla n d s

UK

USA

1

Volatility

Flexibility

Flexibility

Flexibility

Flexibility

Flexibility

2

Flexibility

Customers

Credit rating

Volatility

Volatility

Credit rating

3

Credit rating

Credit rating

Volatility

Tax advantage

Tax advantage

Volatility

4

Transaction costs

Tax advantage

Transaction costs

Credit rating

Transaction costs

Tax advantage

5

Tax advantage

Volatility

Tax advantage

Bankruptcy costs

Customers

Transaction costs

Sources: Australia: Coleman, Maheswaran and Pinder (2010); France, Germany, Netherlands and UK: Brounen, de Jong and Koedijk (2006); US: Graham and Harvey (2001). The full statement of each factor was: Volatility

The volatility of our earnings and cash flows

Flexibility

Financial flexibility (restrict debt so we have enough internal funds available to pursue new projects when they come along)

Credit rating

Our credit rating (as assigned by ratings agencies)

Transaction costs

The transaction costs and fees for issuing debt

Tax advantage

The tax advantage of interest deductibility

Customers

We limit debt so our customers/suppliers are not worried about our firm going out of business

Bankruptcy costs

The potential costs of bankruptcy, near-bankruptcy or financial distress

13.3 Assessing the theories o f capital LEARNING OBJECTIVE 2 Assess the implications of the evidence for the static trade-off and pecking order theories

structure In Section 13.2 we reviewed empirical evidence on the effects o f several factors th a t may influence capital structure decisions: taxes, costs o f financial distress, agency costs and inform a tion costs. In this section we discuss the im plications o f th a t evidence fo r the two main contenders to explain capital structure: the static trade-off theory and the pecking order theory.

13.3.1 | How useful is the static trade-off theory? The static trade-off theory emphasises the effects o f taxes and also recognises th a t costs o f financial distress act as a deterrent to high financial leverage. It proposes th a t companies should borrow u n til the marginal tax advantage o f additional debt is exactly offset by the increase in the present value o f the expected costs o f financial distress. The static trade-off theory is consistent w ith much o f the evidence presented earlier. For example, i t is consistent w ith the fact th a t companies w ith tangible assets borrow more than those w ith riskier, intangible assets in the fo rm o f valuable investm ent opportunities. Similarly, it is consistent w ith the fact th a t companies w ith less volatile cash flows (low business risk) borrow more than those w ith higher business risk. W hile the static trade-off theory is consistent w ith some observations, Myers argues th a t *the trade­ o ff theory is in immediate trouble on the tax fro n t1(2001, p. 89). Essentially Myers1argum ent is th a t the static trade-off theory does n o t do a good job o f explaining capital structure decisions because there are cases where corporate leverage is much lower than the theory suggests it should be. For example, many large profitable companies such as M icrosoft and the m ajor pharmaceutical companies have operated for years w ith low debt ratios. These companies have high credit ratings and could achieve significant interest tax savings by increasing th e ir debt ratios w ith o u t the p robability o f financial distress becoming more

命

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than remote. Graham (2000) found th a t conservative use o f debt finance was typical o f US companies. About h alf the companies in his sample paid company tax at the fu ll sta tu tory rate. Graham noted that the average company in this subsample could have doubled its interest payments and almost certainly doubled its interest tax savings. How would such an increase in leverage affect company value? Graham estimated that on average these companies could have added 7.5 per cent to company value by increasing leverage to take advantage o f the net tax benefits o f debt. Graham s study did n ot ignore the fact that increasing leverage w ill increase the likelihood o f financial distress. His estimates suggest that fo r most companies the expected costs o f financial distress are sim ply too small to offset the net tax benefits o f debt. Historically, the static trade-off theory has been criticised because it appears to be inconsistent w ith the evidence th a t p ro fita b ility is negatively related to financial leverage. For example, as Myers points out, *if managers can exploit valuable interest tax shields as the trade-off theory predicts, we should observe exactly the opposite relationship. High p ro fita b ility means th a t the firm has more taxable income to shield, and that the firm can service more debt w ith o u t risking financial distress* (2003, p. 231). This criticism was certainly valid based on the evidence available at the tim e, b ut the more recent evidence outlined in Section 13.2.5 indicates th a t p ro fita b ility is positively related to target leverage. While critical o f the static trade-off theory, Myers points out th a t there are many examples o f tactical financing decisions that are tax-driven. For example, finance leases are largely tax-driven. As discussed in Chapter 16, when the lessors effective tax rate is higher than the lessees tax rate, a lease can provide an overall tax advantage th a t arises from deferring the payment o f tax. There are form al studies that demonstrate th a t taxes have a m aterial effect on financing decisions. For example, MacKie-Mason (1990) found that companies w ith low m arginal tax rates are more likely to issue equity than companies that are paying tax at the fu ll sta tu tory rate. Similarly, Graham (1996) found th a t changes in long-term debt are positively related to the company s effective m arginal tax rate. Both o f these studies show th a t taxes affect financing decisions and th e ir results are consistent w ith the static trade-off theory. However, these studies do n ot show th a t taxes give rise to a net benefit th a t increases company value. Similar results would be expected under the im p utatio n system, which is designed to ensure th a t corporate debt does not have a net tax advantage. For example, i f a company operating under im putation is not in a tax-paying position, b u t needs to raise finance, i t should be better fo r it to issue equity rather than debt. In comparison to issuing equity, borrow ing w ould involve an immediate increase in taxes fo r investors w ith no immediate tax saving at the company level. Therefore, studies th a t show th a t taxes affect marginal financing decisions only show th a t taxes are im p o rta n t at the tactical level. They do not show that the present value o f interest tax savings is positive and influences the choice o f company debt ratios. In other words, while i t is clear th a t taxes affect financing tactics, i t is much more d iffic u lt to find evidence that taxes have a predictable effect on financing strategy. Indeed, Fama and French (1998), who conducted an extensive statistical investigation o f relationships between company value, dividends and debt, were unable to find any evidence th a t debt has net tax benefits. The static trade-off theory can explain many o f the differences in capital structure th a t exist between companies in different industries. In particular, it can explain why leverage is generally low when business risk is high and when most o f a company s assets are intangible. I t can also explain the fact th a t the companies th a t become private in leveraged buyouts (discussed in Chapter 19) are typically mature companies w ith stable cash flows and tangible assets b ut few opportunities fo r growth. While the static trade-off theory has commonsense appeal and can explain some aspects o f capital structure, there are some facts th a t it struggles to explain. First, the static trade-off theory cannot explain why companies are generally conservative in using debt finance. Second, i t is d iffic u lt to explain why financial leverage is similar, on average, across many countries despite differences in th e ir tax systems. If corporate borrow ing has a significant tax advantage, as proposed by the static trade-off theory, then leverage should be higher in the US w ith its classical tax system than in other countries w ith im putation tax systems. Third, there is the inconvenient historical fact th a t companies used debt long before companies were required to pay income tax. Something caused them to use debt and i t certainly wasn’t tax.

1 3 .3 .2 1 How useful is the pecking order theory? The pecking order theory, w hich we discussed in Section 12.9, can explain why interna l finance is so popular and why debt is generally the firs t choice when external finance is needed. But, as is the case w ith

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the static trade-off theory, there are some observations th a t are d iffic u lt fo r the pecking order theory to explain. Frank and Goyal (2003) found th a t some companies make extensive use o f external financing. Barclay, Sm ith and Watts (1995) found th a t leverage is typically low in high-technology industries where there are large grow th opportunities and large needs fo r external finance. They noted th a t th e ir finding was the exact opposite o f w hat the pecking order theory predicts. However, th e ir finding may n ot be d ifficu lt to explain. High-technology, high-grow th companies typically have m ostly intangible assets and would therefore fin d debt very expensive. Further, heavy borrow ing by such companies should expose them to the underinvestm ent problem. In other words, the empirical finding can be explained more easily by considering costs o f financial distress and agency costs rather than relying on the pecking order theory. Is this criticism o f the pecking order theory a fa ir one? Perhaps not. The pecking order theory does not say th a t debt is always the best source o f external finance. I t does say th a t companies should raise external equity only when they have exhausted th e ir debt capacity. For high-technology, high-grow th companies, debt capacity may well be very low.

13.4 Financing as a marketing problem LEARNING OBJECTIVE 3 Explain how financing can be viewed as a marketing problem

Companies raise external finance by borrow ing, issuing preference shares and issuing ordinary shares. The differences between these three methods are significant in terms o f risk, required rate o f return, tax treatm ent, voting rights attached ( if any) and p rio rity fo r repayment in the event o f liquidation. Less obvious perhaps are the differences th a t can exist w ith in these categories, particularly debt. For example, companies can borrow in different currencies, fo r different periods o f tim e, and the interest rate may be fixed or variable. In addition, the repayment term s can differ, in th a t the principal may be repayable in instalments or in a lum p sum. Also, the p rio rity o f the lenders claim can d iffer and some debt is convertible to ordinary shares. The reason fo r o u tlin in g all these differences is to show th a t in choosing a capital structure, a company is essentially choosing a particular package o f financial services th a t it supplies to investors— th a t is, in raising different form s o f finance, a company provides financial assets th a t offer investors different combinations o f risk, return, liq u id ity and vo ting power. Further, the return can consist o f different proportions o f capital gains, compared w ith ordinary income, which in tu rn w ill have taxation consequences fo r the investor. Shapiro (1998) points out th a t to a person skilled in m arketing, the reason fo r these different combinations is obvious.4 D ifferent securities coexist fo r the same reason th a t different makes and models o f cars coexist: individuals have different tastes, preferences and levels o f wealth. The sales o f a given model o f car w ill depend on the demand fo r the package o f features it offers, the cost o f m anufacturing th a t package, and the com petition from suppliers o f sim ilar vehicles. Similarly, the capital structure decisions o f companies w ill be influenced by the demand fo r different financial services, the costs o f providing each package o f financial services, and the level o f com petition from financial in s titu tio n s that provide sim ilar services. The m arketing approach suggests another way in which M odigliani and M ille rs Proposition 1 can be violated. Cars and other products w ill sell at a higher price i f they are well designed and have characteristics tailored to the preferences o f potential buyers. The same principle can be applied to security issues. I f a company^ financial manager can design a security th a t appeals to a particular clientele o f investors, such th a t these investors are prepared to pay a higher price fo r it, the company can raise funds at a lower cost than would otherwise be the case— th a t is, the required rate o f retu rn on the security is less than the m arkets required rate o f return on other securities o f the same risk. In other words, the m arketing approach focuses on the disequilibrium th a t can exist when there is some m ismatch between the demands o f investors and the available supply o f securities. In a com petitive market, a disequilibrium o f this type w ill generally be short lived b ut can certainly occur. For example, a heightened fear o f in fla tio n could increase the demand fo r indexed bonds. W hen the unsatisfied demand fo r a p articular type o f security becomes evident, innovative financial managers w ill move to exploit the opportunity, and the supply o f suitable securities is likely to increase substantially. Therefore, while there are rewards fo r financial innovation, the benefits are likely to go m ainly to the 4

Shapiro is not the only one to emphasise that the financing decision can be viewed as a marketing problem. See Brealey, Myers and Allen (2013, p. 440).

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structure decisions

companies whose financial managers are the genuine innovators. As the supply o f new securities increases, the price investors are prepared to pay fo r them w ill decrease, and therefore the required rate of return w ill increase. Once the clienteles needs have been met, there are no fu rth e r opportunities to sell more securities at a premium.

13.5 Determining a financing strategy The evidence discussed in this chapter shows th a t financing decisions are im p o rta n t and can be influenced by many factors. There is no single model or theory that can be used to specify the best financing strategy for any particular company. Such a strategy m ig ht include a long-term leverage target, b ut in m ost cases such a target is unlikely to be adhered to precisely. Even where a target is chosen, it may be only one part o f an overall strategy. For example, suppose a company has decided to raise new funds by borrowing. There are then many more decisions to be made. Should the company borrow from banks or should it issue marketable debt securities direct to lenders? W hat should be the term o f the loan? Should the interest rate be fixed or variable? Are there opportunities to add value by adding some new features to the security? Clearly, there are no simple solutions th a t w ill always be the best, b ut by drawing on both theory and evidence, it is possible to specify some general principles and guidelines th a t can be used by financial managers to determine a company’s financing strategy. An im p orta nt principle is th a t i t is usually harder to add value by m aking good financing decisions than by making good investm ent decisions. W hile a company may be able to fin d investm ent projects w ith positive net present values, the highly competitive nature o f financial markets means th a t it is much more d ifficu lt to make financing decisions th a t have positive net present values. For example, as discussed in Section 13.4, any m arketing advantage associated w ith issuing a security th a t is in high demand w ill generally be short lived. Investm ent decisions are im p o rta n t because the p rim ary source of a company s value is the cash flows generated by its assets. By comparison, the financing decision is less im portant. Even so, the financing decision determines more than how the company s cash flows are divided between different classes o f investors— there is evidence th a t financing decisions can also have im portant effects on investm ent decisions. However, given the prim acy o f investm ent decisions, i t seems sensible to suggest th a t a company s financing strategy should be designed to complement and support its investment strategy. In particular, factors such as business risk and asset type, which are discussed below, can have im p o rta n t effects. A second im p o rta n t principle is th a t while it is n ot easy to add value by m aking good financing decisions, it is certainly possible to reduce value by m aking poor financing decisions. For example, a high proportion o f debt can reduce shareholders* wealth because the expected bankruptcy costs become significant. We now tu rn to some o f the more im p o rta n t factors to be taken in to account when m aking capital structure decisions.

13.5.1 I Business risk In Section 12.6 we pointed o ut th a t a company s expected bankruptcy costs reduce its m arket value. The expected bankruptcy costs are positively related to the present value o f bankruptcy costs and the probability o f bankruptcy occurring. The probability o f bankruptcy depends p a rtly on the company s ability to meet its fixed financial comm itments. By issuing debt, the company increases these financial commitments, and hence also increases its probability o f bankruptcy. In order to gauge the bankruptcy cost implications o f issuing (more) debt, a financial manager has to consider the variab ility o f the company s future net cash flows. The greater the variability, the greater is the probability that, at some future tim e, the company w ill be unable to meet its financial comm itments. The variability o f the net cash flows from a company s assets is typically taken as a measure o f its business risk. Therefore, the greater a company s business risk, the less the company can borrow before its probability o f bankruptcy is increased. As a result, the optim al capital structure fo r a company w ill be affected by its business risk. Therefore, some sim ilarities may be expected between the capital structures o f companies in the same industry, and the leverage used by sim ilar companies may be a useful guide fo r the financial manager.

LEARNING OBJECTIVE 4 Outline the main factors that financial managers should consider when determining a company's financing strategy

B usiness finance

M ost companies have both tangible assets and intangible assets. Also, some assets, referred to as general purpose assets*, can easily be redeployed to alternative uses, w hile other assets, referred to as company-specific assets1, are w o rth much more in th e ir current use than in any alternative uses. For example, a m oto r vehicle is a general-purpose asset, while a specialised item o f equipm ent may be company-specific. M any company-specific assets are also intangible. These asset characteristics are im p o rta n t in determ ining how much a company can borrow. This is the case because a lenders risk is lower i f the company s value is largely attributable to assets th a t can be sold w ith low transaction costs and little or no loss o f value. Tangible assets are usually easier to sell than intangible assets; indeed, many intangible assets cannot be sold separately from the business as a whole. This suggests th a t companies w ith a high proportion o f tangible assets would be able to borrow more than companies th a t have a high p roportion o f intangible assets. For example, companies in many service industries, such as advertising agencies and consulting companies, have a high pro po rtio n o f intangible assets and are largely financed by equity capital. Similarly, general purpose assets can support more debt than company-specific assets. Lenders recognise th a t company-specific assets w ill lose much o f th e ir value i f the borrow er defaults and is liquidated. In other words, expected bankruptcy costs w ill be high and this w ill be reflected in the interest rate charged. A related argum ent is th a t the agency costs o f debt are high fo r companies w ith a high p roportion of intangible assets. For example, i f a company relies heavily on research and development (R&D) activities, problems such as asset substitution w ill be d ifficu lt fo r lenders to detect. Therefore, borrow ing would involve high m on itoring costs th a t would also be passed on to borrowers in the form o f higher interest rates. Rather than incur the higher interest cost, such companies w ill tend to rely on equity capital and hence w ill operate on relatively low d ebt-equity ratios.

The effects o f taxes on financing decisions w ill depend to a large extent on the nature o f the country s tax system. However, under any tax system it should n ot be assumed th a t debt has a tax advantage just because interest is tax deductible. Such an assumption is unwarranted because i t ignores personal taxes. As discussed in Section 12.4.3, M ille r has shown that, under the classical system, the effects o f corporate and personal taxes can offset each other exactly. I f there is, in practice, any net tax advantage o f corporate borrow ing under the classical system, this advantage is likely to go only to companies w ith high and stable earnings. For companies th a t are unable to make immediate use o f interest deductions (because, fo r example, they have tax losses being carried forward), borrow ing w ill increase personal taxes, b ut there w ill be no immediate reduction in company tax. Therefore, in this case, borrow ing is likely to have a net tax disadvantage. Under a fu ll im putation tax system, company income tax is, as discussed in Section 11.4.1, effectively a w ith h o ld in g tax and can be recovered by resident shareholders. I f all company tax paid is effectively recovered by shareholders through receipt o f franked dividends, any advantage from reducing company tax would be due only to differences in the tim in g o f tax payments. However, in practice, many Australian companies have both resident and non-resident shareholders. W hile Australian residents can use franking credits, non-residents cannot use them and are therefore effectively s till taxed under the classical system. In other words, i f a company pays franked dividends and some o f its shares are held by non-residents, some tax credits w ill be 'wasted*. One way to reduce this waste is to issue a fu rth e r class o f shares th a t allows a higher p ro po rtio n o f the tax credits to be transferred to resident investors. Some companies have achieved this by issuing converting preference shares, which typically carry an e ntitlem ent to fu lly franked dividends at a fixed rate. I f these shares are issued to ordinary shareholders via a renounceable rights issue, non-resident shareholders can sell th e ir rights to residents. The price residents are prepared to pay fo r the rights w ill reflect the value, to them, o f the tax credits. Therefore, reduction o f the wastage o f tax credits means th a t all shareholders are able to benefit, either directly or indirectly. As discussed in Section 12.5.2, the im putation tax system has the potential to be neutral between debt and equity, but, in its Australian version, it tends to be biased towards equity. Thus the conclusion is that, under the im p utatio n system, sim ply changing a company s d ebt-equity ratio is u nlikely to have any significant tax-based effect on company value. However, the above discussion shows th a t changing the type o f equity securities th a t a company issues can have im p o rta n t tax effects.

C hapter thirteen C apital

13.5.4 | M aintaining reserve borrowing capacity ('financial slack7) As discussed in Section 12.9, when there is inform a tion asymmetry between managers and investors, the announcement o f a new share issue is likely to cause the company s share price to fall. Therefore, if a company needs to issue new shares to finance a new project, the overall effect can be a reduction in shareholders* wealth, even though the project has a positive net present value. This problem does n ot occur i f the project can be financed inte rn a lly or financed by borrowing. In other words, inform a tion asymmetry can effectively force companies to follow a financing pecking order in which interna l funds are the firs t choice and external equity is the last choice. The problem o f being forced to choose between forgoing a positive NPV project and seeing the share price fall because o f a share issue can be overcome by m aintaining reserve borrow ing capacity or 'financial slack*. In this way additional finance can always be raised at short notice to take advantage o f profitable investments. Clearly, the value o f m aintaining reserve borrow ing capacity w ill be greatest fo r companies that operate in industries where there are significant investm ent opportunities. A survey o f financial managers by Allen (1991) found th a t the m ajority o f Australian companies have a policy o f m aintaining a substantial <cushion, o f reserve borrow ing capacity, typically in the form o f unused credit facilities established w ith banks and other financial intermediaries. Allen (2000) investigated the extent to which a sample o f listed Australian, B ritish and Japanese companies m aintained spare borrowing capacity. He reported th a t 60 per cent o f Australian, 90 per cent o f B ritish and 32 per cent o f the Japanese respondents to his survey m aintained spare borrow ing capacity. While financial slack is valuable fo r some companies, i t is n ot valuable fo r all companies. Suppose th a t a company is currently very profitable b u t operates in an ind ustry w ith few investm ent opportunities. I f this company has a low d ebt-equity ratio, it w ill have considerable financial slack. However, i t w ill also have a large free cash flow, so there is a danger th a t its managers may squander resources on takeovers or diversification projects th a t benefit them b ut harm the shareholders. In other words, as discussed in Section 12.7.2, the agency costs o f equity can be large when a company has large free cash flow. One solution to this problem is to increase debt.

13 .5 .5 | Other factors In discussing the effects o f business risk we referred to the va riab ility o f cash flows as a measure o f risk. A company s cash flows can vary fo r many reasons, and financial managers should n o t assume th a t business risk w ill be identical fo r all companies in a given industry. To illustrate some o f the many risk factors that can influence financing decisions, we consider p olitical risk and in fla tio n risk.

Political risk Many m ultinational companies have operations in countries th a t can be p olitically unstable. There is the risk th a t a sudden change o f government may be followed by expropriation o f foreign-owned assets. In addition, it is typically much more d ifficu lt to take dividends out o f such countries than i t is to move investment capital in to them. M ultin a tio n a l companies w ill therefore structure the financing o f foreign operations and projects to m inim ise the impact o f p olitical risk. For example, they may invest as little o f their own funds as possible and raise most o f the finance w ith in the foreign country.

Inflation risk Financial managers should consider the effects o f in fla tio n when deciding w hether to borrow at fixed or floating interest rates. I f the rate o f in fla tio n increases, nom inal interest rates w ill increase, w ith the result that floating-rate borrowers w ill incur higher loan repayments. This may n ot be a significant problem i f net operating cash flows also increase in line w ith inflation. For example, companies th a t provide services are generally able to increase th e ir prices in line w ith inflation, or they may have contracts w ith th eir customers that provide fo r regular price reviews in accordance w ith a general price level index, such as the consumer price index. On the other hand, capital-intensive industries are likely to suffer reductions in real cash flows under inflationary conditions. One reason for this is th a t the cost o f replacing productive assets as they wear out w ill increase, b ut fo r tax purposes companies can only claim depreciation based on the historical cost o f their assets. For a company in this situation, borrow ing at a fixed interest rate may be preferred because borrowing at a floating interest rate w ill tend to increase the variability o f its net cash flows.

structure decisions

SUMMARY •

E m p iric a l

e v id e n c e

in d ic a te s

th a t

c o r p o r a te

o f th e

s im ila r itie s w ith in in d u s trie s a n d d iffe re n c e s b e tw e e n

s tu d ie s p r o v id e e v id e n c e th a t f in a n c ia l le v e r a g e is

in d u s trie s

th a t te n d

to

p e rs is t o v e r tim e .

A c ro s s

th e US n o n - fin a n c ia l c o r p o r a te s e c to r a s a w h o le ,

p a r tic u la r ,

th e se

p o s itiv e ly re la te d to p r o fita b ility . •

E v id e n c e fro m s u rv e y s o f C F O s g iv e s s o m e s u p p o rt

ra n g e d u r in g th e tw e n tie th c e n tu ry . T he p r in c ip le s

a n d f in a n c ia l d is tre s s re c e iv in g a tte n tio n fro m C F O s .

in

C h a p te r

12

m ay be

suggest

th a t

c a p it a l

im p o r ta n t b e c a u s e o f

O th e r th e o rie s re c e iv e d less s u p p o rt. •

C o m p a n y f in a n c in g c a n b e v ie w e d as e s s e n tia lly a

th e e ffe c ts o f fa c to rs such as ta x e s , a s s e t ty p e , co sts

m a rk e tin g p r o b le m . T h is a p p r o a c h uses th e fa c t th a t

o f f in a n c ia l d is tre s s a n d th e e x te n t o f a c o m p a n y ’s

d iffe r e n t in v e s to rs h a v e d iffe r e n t ta ste s, p re fe re n c e s

in v e s tm e n t o p p o r tu n itie s .

a n d le v e ls o f w e a lth to e x p la in th e c o e x is te n c e o f

M any

s tu d ie s

c o m p a n ie s

fo c u s

and

tr y

on to

d iffe re n c e s

e x p la in

th e ir

s e c u ritie s th a t d iff e r in te rm s o f c h a r a c te ris tic s such

b e tw e e n

a s ris k , re tu rn , ta x tr e a tm e n t a n d v o tin g rig h ts .

o b s e rv e d

•

le v e ra g e in te rm s o f v a r ia b le s c h o s e n a s e m p ir ic a l

If th e s u p p ly o f e a c h m a tc h e s

th e se

e q u ilib r iu m w o u ld e x is t in w h ic h th e re w o u ld b e

s tu d ie s

suggest

th a t

c a p it a l

s tru c tu re s

a re

th e

dem and

ty p e o f s e c u rity e x a c tly

p ro x ie s f o r th e s e a n d o th e r fa c to rs . T h e re su lts o f

fo r

it,

th e n

a

m a rk e t

c h o s e n s y s te m a tic a lly a n d th a t f in a n c ia l le v e r a g e is

n o in c e n tiv e fo r a c o m p a n y to c h a n g e its c a p ita l

p o s itiv e ly r e la te d to th e p r o p o r tio n o f a sse ts th a t a r e

stru c tu re . •

ta n g ib le a n d n e g a tiv e ly re la te d to e a r n in g s v o la tility , n o n -d e b t t a x s h ie ld s a n d p r o fita b ility . •

O ne

fa c to r

th a t a p p e a r s

to

be

p a r tic u la r

s a tis fie d

w ith

h ig h

ra tio s

r a n g e o f s e c u ritie s a v a ila b le ,

b e v io la te d .

a s m e a s u re d b y th e r a t io o f m a rk e t v a lu e to b o o k C o m p a n ie s

b y th e

th e n th e M o d ig lia n i a n d M ille r p r o p o s itio n s c a n

is n e g a tiv e ly re la te d to in v e s tm e n t o p p o r tu n itie s v a lu e .

H o w e v e r, if th e re is d is e q u ilib r iu m su ch th a t th e re is a c lie n te le o f in v e s to rs w h o s e n e e d s a r e n o t

of

im p o r ta n c e is in v e s tm e n t o p p o r tu n itie s : le v e r a g e •

To e x p lo it such

a

d is e q u ilib r iu m ,

a

fin a n c ia l

o f m a rk e t

m a n a g e r n e e d s to d e s ig n a s e c u rity th a t m ee ts

v a lu e to b o o k v a lu e ( 'g r o w th c o m p a n ie s ’ ）a ls o

th e re q u ire m e n ts o f th e u n s a tis fie d c lie n te le o f

te n d to use d e b t o f s h o rte r m a tu rity a n d h ig h e r

in v e s to rs . In o th e r w o r d s , th e re c a n b e re w a r d s fo r

p r io r it y th a n m a tu re c o m p a n ie s . T he r e la tio n s h ip

f in a n c ia l in n o v a tio n , b u t b e c a u s e c a p it a l m a rk e ts

b e tw e e n le v e r a g e a n d a c o m p a n y ’s ta x p o s itio n

a r e h ig h ly c o m p e titiv e , a n y s u ch d is e q u ilib r iu m is

is r e la tiv e ly w e a k , b u t e x a m in a tio n o f fin a n c in g

lik e ly to b e s h o rt liv e d a n d th e r e w a r d s a r e lik e ly

d e c is io n s o n a m a r g in a l b a s is s h o w s th a t ta x e s

to g o

d o in flu e n c e th e se d e c is io n s .

m a n a g e rs a r e th e re a l in n o v a to rs , ra th e r th a n to

o n ly to th e c o m p a n ie s

w h o s e fin a n c ia l

th o s e w h o m e re ly im ita te th e le a d e rs .

Tests o f th e p e c k in g o r d e r t h e o r y fin d e v id e n c e th a t is c o n s is te n t w ith th e fin a n c in g p e c k in g o r d e r b e in g

•

In

to th e s ta tic tr a d e - o ff th e o ry , w ith b o th ta x b e n e fits

s tru c tu re d e c is io n s

•

s ta tic tr a d e - o ff th e o ry .

th e r a t io o f d e b t to e q u ity s ta y e d w ith in a n a r r o w d is c u s s e d

•

c o r p o r a te s p in -o ffs is c o n s is te n t w ith th e p r e d ic tio n s

f in a n c ia l le v e r a g e h a s n o tic e a b le p a tte rn s , in c lu d in g

•

B e c a u s e a c o m p a n y ’s v a lu e d e p e n d s p r im a r ily o n

c a u s e d b y in fo r m a tio n a s y m m e try b e tw e e n m a n a g e rs

th e c a s h flo w s g e n e ra te d b y its assets, a c o m p a n y 's

a n d in v e s to rs . T h e re is a ls o e v id e n c e th a t, c o n s is te n t

fin a n c in g s tra te g y s h o u ld b e d e s ig n e d to c o m p le m e n t

w ith th e p e c k in g o r d e r th e o ry , a n n o u n c e m e n t o f a n

a n d s u p p o rt its in v e s tm e n t stra te g y . In a p p ly in g this

e x te rn a l c a p it a l r a is in g , p a r tic u la r ly a s h a re issu e,

p r in c ip le th e fin a n c ia l m a n a g e r m a y n e e d to c o n s id e r

c a u s e s a c o m p a n y ’s s h a re p r ic e to fa ll.

m a n y fa c to rs , th e m a in o n e s b e in g th e c o m p a n y 's

E v id e n c e fro m

c o m p a n ie s th a t m a k e 'd u a l issu e s'

o f d e b t a n d e q u ity a n d fro m c a p it a l s tru c tu re s o f

KEY TERMS n o n -d e b t ta x s h ie ld s (N D TS s)

396

b u sin e ss risk, th e n a tu re o f its assets, its ta x p o s itio n a n d th e n e e d fo r re s e rv e b o r r o w in g c a p a c ity .

C hapter thirteen C apital

structure decisions

1

2

[LO 1

O u tlin e th e c h a r a c te r is tic s y o u w o u ld e x p e c t a c o m p a n y to h a v e if it h a d :

a)

a v e r y lo w d e b t - e q u it y ra tio

b)

a v e r y h ig h d e b t - e q u it y ra tio .

\ i 〇 1 \ E m pirical evidence suggests that m anagem ent takes account o f m arket conditions a n d recent security prices when determ ining w hether to m ake a d e b t o r an e q u ity issue. D iscu ss th e re le v a n c e o f th e se fa c to rs fo r m a n a g e m e n t's d e c is io n .

3

[ L O l ] W o u ld y o u n e c e s s a rily e x p e c t c o m p a n ie s in th e s a m e in d u s try to h a v e s im ila r d e b t - e q u it y ra tio s ? G iv e re a s o n s fo r y o u r a n s w e r.

4

[LO 1 J S u p p o s e th a t th e g o v e r n m e n t s u b s ta n tia lly r e d u c e d th e c o m p a n y ta x ra te in a c la s s ic a l ta x syste m . a)

W h a t w o u ld th e M o d ig lia n i a n d M ille r (w ith c o m p a n y ta x) a p p r o a c h s u g g e s t a b o u t th e e ffe c t o f this

b)

W h a t w o u ld M ille r 's m o d e l p r e d ic t a b o u t th e e ffe c t o n :

c h a n g e o n th e c a p ita l stru ctu re s o f c o m p a n ie s ?

i) th e q u a n tity o f d e b t fo r th e c o r p o r a te s e c to r a s a w h o le ii) th e c a p ita l stru ctu re s o f in d iv id u a l c o m p a n ie s ? 5

[ L O l ] T he c o sts o f f in a n c ia l d is tre s s a r e lik e ly to b e h ig h fo r s o m e ty p e s o f c o m p a n ie s , a n d lo w fo r o th e rs . O u tlin e th e ty p e s o f c o m p a n ie s f o r w h ic h th e s e co sts a r e lik e ly to b e :

6

a)

h ig h

b)

lo w .

CHAPTER THIRTEEN REVIEW

QUESTIONS

A sample o f com panies that m ake 'd u a l issues' o f d e b t a n d e quity provides a better setting than a b ro a d sample o f com panies fo r testing w hether com panies hove c a p ita l structure forgets. E x p la in w h y y o u

[LO 1

a g r e e o r d is a g r e e w ith th is s ta te m e n t. 7

[LO 1 1 The e m p irica l studies o f c a p ita l structure decisions are attempts to infer from the d ata the decision­

m aking processes o f c o m p a n y managers. Such attempts ore heroic because they face numerous problem s o f statistical design a n d interpretation. Surely there is a much sim pler a p p ro a ch : w h y not just ask c o m p a n y managers w h o t factors they consider w hen they m ake c a p ita l structure decisions? D iscuss. 8

[LO 1

S tu d y th e c a p it a l s tru c tu re s o f a b a n k , a f in a n c e c o m p a n y , a r e ta ile r a n d a m a n u fa c tu re r. A r e th e re

d is c e r n ib le d iffe re n c e s in th e c a p it a l s tru c tu re s o f th e c o m p a n ie s c h o s e n ? G iv e re a s o n s fo r a n y d iffe re n c e s y o u fin d . 9

[L O 1] C h o o s e a c o m p a n y a n d tr a c e th e m a jo r c h a n g e s in its c a p it a l s tru c tu re o v e r th e p a s t 1 0 y e a rs . O u tlin e th e e c o n o m ic fa c to rs y o u c o n s id e r h a v e c o n trib u te d to th e m a jo r c h a n g e s in its fin a n c in g p o lic y d u r in g th is p e r io d .

10

[LO 1] T h e p ro b le m is h o w to m o tiv a te m a n a g e rs to d is g o r g e th e c a s h ra th e r th a n in v e s tin g it b e lo w th e c o s t o f c a p it a l o r w a s tin g it o n o r g a n is a t io n a l in e ffic ie n c ie s 7 (Jensen 1 9 8 6 , p . 3 2 3 ) . E x p la in h o w d e b t f in a n c e c a n p r o v id e a s o lu tio n to th is p ro b le m .

11

[LO 1] T he M o d ig lia n i a n d M ille r (M M ) a n a ly s is o f c a p it a l s tru c tu re a ssu m e s th a t th e c o m p a n y 's n e t o p e r a tin g c a s h flo w s a r e g iv e n . C a p it a l s tru c tu re is ir r e le v a n t u n d e r th e M M a s s u m p tio n s b e c a u s e , in a p e rfe c t c a p it a l m a rk e t w ith n o ta x e s , th e v a lu e o f th is c a s h f lo w s tre a m is u n a ffe c te d b y c a p it a l s tru c tu re d e c is io n s . O n e re a s o n w h y c a p it a l s tru c tu re d e c is io n s m a y b e im p o r ta n t in p r a c tic e is th a t c a s h flo w s a r e not in d e p e n d e n t o f th e se d e c is io n s . E x p la in h o w th is c o u ld o c c u r fo r:

12

a)

a c o m p a n y th a t g e n e ra te s la r g e fre e c a s h f lo w

b)

a c o m p a n y th a t is h ig h ly le v e re d .

[L O 2 ] The e m p iric a l observation that there is a negative relationship betw een p ro fita b ility a n d leverage is

em barrassing fo r the static tra d e o ff th e o ry o f c a p ita l structure. D o y o u a g r e e ? H o w r e lia b le is th e e v id e n c e th a t th e re la tio n s h ip b e tw e e n p r o fita b ilit y a n d le v e r a g e is n e g a tiv e ra th e r th a n p o s itiv e ?

413

B usiness finance

13

[L 0 2] a)

T he s ta tic tra d e - o ff th e o r y o f c a p ita l s tru c tu re c a n e x p la in so m e o f th e d e b t - e q u it y r a tio d iffe re n c e s between in d u s trie s , b u t c a n n o t e x p la in such d iffe re n c e s b e tw e e n c o m p a n ie s w ithin a g iv e n in d u s try . E x p la in w h y this s ta te m e n t is c o rre c t o r in c o rre c t.

b)

B rie fly o u tlin e a n o th e r th e o ry th a t c a n e x p la in d iffe re n c e s in c a p ita l stru ctu re s b e tw e e n c o m p a n ie s in th e s a m e in d u s try .

14

[ L 0 4 ] A n e x e c u tiv e o f a m in in g c o m p a n y e x p la in s th a t it h a s a p o lic y o f m a in ta in in g a p o r tf o lio o f p ro je c ts a t v a r io u s s ta g e s o f d e v e lo p m e n t. In th is w a y th e n e e d fo r e x te rn a l fin a n c e is m in im is e d b e c a u s e th e c a s h f lo w g e n e r a te d b y o p e r a tin g m in e s c a n b e u se d to f in a n c e th e d e v e lo p m e n t o f n e w o n e s . A ls o th e c o m p a n y 's n e t c a s h flo w s c a n b e s m o o th e d b y a d ju s tin g p r o d u c tio n p la n s to s u it th e tim in g o f n e w p ro je c ts . F o r e x a m p le , if th e re a re d e la y s in b r in g in g a n e w m in e in to p r o d u c tio n , th e life o f a n o ld m in e m ig h t b e e x te n d e d b y m in in g lo w - g r a d e o re th a t w o u ld n o t n o r m a lly b e c o n s id e r e d e c o n o m ic . C r it ic a lly e v a lu a te th e c o m p a n y 's s tr a te g y fro m th e v ie w p o in t o f s h a re h o ld e rs .

15

[ L 0 4 ] T he c h ie f e x e c u tiv e o f P la n e ts Ltd, a y o u n g c o m p a n y th a t h a s ju st b e e n se t u p , sa ys: 'W e d e c id e d to b o r r o w m o s t o f th e fu n d s n e e d e d to e s ta b lis h o u r o p e r a tio n s b e c a u s e h ig h le v e r a g e w o u ld s ig n a l to th e m a rk e ts th a t w e w e r e c o n fid e n t a n d fu lly c o m m itte d to m a k in g th is b u s in e s s s u c c e e d / E v a lu a te th is s tra te g y , a s s u m in g th a t P la n e ts p ro d u c e s :

16

a)

v o ic e -a c tiv a te d s o ftw a re system s

b)

h o u s e h o ld d e te rg e n ts .

[L O 4 ] In A p r il 1 9 9 7 , T e lstra , th e n a te le c o m m u n ic a tio n s c o m p a n y w h o lly o w n e d b y th e A u s tr a lia n G o v e rn m e n t, a n n o u n c e d a c a p it a l re s tru c tu rin g a h e a d o f its p r o p o s e d p a r tia l p r iv a tis a tio n th ro u g h a s h a re m a rk e t f lo a t d u r in g th e s e c o n d h a lf o f 1 9 9 7 . T he c a p it a l re s tru c tu rin g in v o lv e d p a y m e n t o f a s p e c ia l d iv id e n d o f $ 3 b illio n to th e g o v e r n m e n t a n d th e b o r r o w in g o f $ 3 b illio n b y T e lstra . Its f in a n c e d ir e c to r r e p o r te d ly s a id th a t 'th e re s tru c tu rin g w o u ld lo w e r th e a v e r a g e c o s t o f c a p it a l a n d e n a b le g r e a t e r fin a n c ia l f le x ib ilit y 7. S im ila rly , o n e jo u r n a lis t n o te d th a t 'd e b t fin a n c in g is c h e a p e r th a n e q u ity r a is in g '. H is a r tic le a ls o s ta te d th a t 'd e b t in te re s t p a y m e n ts a r e a ls o ta x d e d u c tib le , w h ile d iv id e n d s a r e n o t7. C r it ic a lly e v a lu a te th e se c o m m e n ts o n th e e ffe c ts o f, a n d re a s o n s fo r, th e re s tru c tu rin g .

17

[L O 4 ] T h e c a p it a l re s tru c tu rin g o f T e lstra o u tlin e d in Q u e s tio n 1 6 p r o m p te d r a tin g a g e n c ie s to d o w n g r a d e T e lstra 's d e b t. F o r e x a m p le , S ta n d a r d & P o o r’s lo w e r e d T e ls tra ’s r a tin g fro m A A A to A A + . T h e re s tru c tu rin g w a s th e s u b je c t o f m a n y c o m m e n ts b y f in a n c ia l jo u rn a lis ts , e c o n o m is ts a n d f in a n c ia l a n a ly s ts , s o m e o f w h o m d iffe r e d w id e ly in th e ir p re d ic tio n s a b o u t its e ffe c ts . T he c o m m e n ts in c lu d e d : a)

A s p o k e s m a n fo r th e A u s tra lia n T e le c o m m u n ic a tio n s U sers G r o u p p r e d ic te d in c re a s e d c h a rg e s to p h o n e users. C o n v e rs e ly , a n o th e r c o m m e n ta to r s ta te d th a t 'm o s t im p o rta n tly , it d o e s n o t m e a n h ig h e r c h a rg e s to " g e t th e m o n e y b a c k " ’ . H e a d d e d th a t fu tu re te le p h o n y c h a rg e s w o u ld d e p e n d o n a m ix o f Telstra's m o n o p o ly p o w e r ve rsu s th e e ffe c tiv e n e s s o f c o m p e titio n a n d th a t, 'p r o v id e d th e re g u la to rs d o th e ir jo b h a lf­ w e ll, th e Telstra b a la n c e s h e e t is ir r e le v a n f .

b)

S o m e c ritic s n o te d th a t th e ra tin g d o w n g r a d e w o u ld in c re a s e T e lstra ’s b o r r o w in g costs, w h ile o th e rs s u g g e s te d th a t d e s p ite th e re d u c tio n o f $ 3 b illio n in n e t assets it w a s lik e ly th a t Telstra w o u ld fa ll in v a lu e b y s o m e th in g less th a n $ 3 b illio n a n d m ig h t n o t lo se a n y v a lu e a t a ll. T he la tte r a rg u m e n t is s u p p o rte d b y the c o m m e n t th a t th e p a y m e n t d id n o t p u t a n y fin a n c ia l p re s s u re o n Telstra a n d 'm ig h t c o n c e n tra te m in d s o n h o w it s p e n d s its h u g e ca sh f lo w ’ . S im ila rly , a b ro k in g a n a ly s t c o m m e n te d th a t 'b y th e ir n a tu re , m o re h ig h ly g e a r e d c o m p a n ie s e x e rc is e tig h te r c o s t d is c ip lin e s ’ .

C r itic a lly e v a lu a te th e a rg u m e n ts o u tlin e d in (a) a n d (b).

REFERENCES

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C hapter thirteen C apital

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Journal of Finance, M arch 1991, pp. 2 9 7 -3 5 5 . Hennessy, C. & Livdan, D.; 'Debt, bargaining, and credibility in firm-supplier relationships,/ Journal of Financial Economics, September 2 0 0 9 , pp. 3 8 2 -9 9 .

Banerjee, S., Dasgupta, S. & Kim, Y., 'Buyer-supplier relationships and the stakeholder theory of capital structure', Journal of Finance, September 2 0 0 8 , pp. 2 5 0 7 -5 2 .

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Barclay, M . & Smith, C., 'O n financial architecture: leverage, maturity and priority,/ Journal of Applied Corporate Finance, W inter 1996, pp. 4 -1 7 .

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-------■ -------, & Watts, Rw 'The determinants of corporate leverage and dividend policies7, Journal of Applied Corporate Finance, W inter 1995, pp. 4 -1 9 .

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-------/ Garmaise, M . & M oskowitz, T., 'Do liquidation values affect financial contracts? Evidence from commercial loan contracts and zoning regulations', Quarterly Journal of Economics, August 2 0 0 5 , pp. 1 1 2 1 -5 4 .

Matsa, D., 'C apital structure as a strategic variable: evidence from collective barga ining ^ Journal of Finance, June 2 0 1 0 , pp. 1 1 9 7 -2 3 2 .

Berk, J., Stanton, R. & Zechner, J., 'Human capital, bankruptcy and capital structure7, Journal of Finance, M ay 2 0 1 0 , pp. 8 9 1 -9 2 6 . Bradley, M ., Jarrell, G. & Kim, Ew 'O n the existence of an optimal capital structure: theory and evidence', Journal of Finance, M y 1984, pp. 8 5 7 -7 8 . Brander, J. & Lewis, T.; 'O lig o p o ly and financial structure: the limited liability effect7, American Economic Review, December 1986, pp. 9 5 6 -7 0 . Brealey, R., Myers, S. & Allen, F., Principles of Corporate Finance, 1 1th edn, M cG raw-H ill, N e w York, 20 1 3 . Brounen, D., d e jo n g , A. & Koedijk, K.; 'C apital structure policies in Europe: survey evidence', Journal of Banking and Finance, M a y 2 0 0 6 , pp. 1 4 0 9 -4 2 . Coleman, L., Maheswaran, K. & Pinder, S., 'Narratives in managers' corporate finance decisions', Accounting and Finance, September 2 0 1 0 , pp. 6 0 5 -3 4 . Dittmar, A., 'C apital structure in corporate spin-offs', Journal of Business, January 2 0 0 4 , pp. 9 -4 3 . Fama, E. & French, K., 'Taxes, financing decisions and firm value', J o u rn o /o f F/nance, June 1998, pp. 8 1 9 -4 3 . -------; -------, 'Testing trade-off and pecking order predictions about dividends and debt', Review of Financial Studies, Spring 2 0 0 2 , pp. 1 -3 3 . Frank, M. & G oyal, V., Testing the pecking order theory of capital structure', Journal of Financial Economics, February 20 03 , pp. 2 1 7 -4 8 . -------, -------, 'Trade-off and pecking order theories of debt', in B.E. Eckbo (ed.); Handbook of Corporate Finance: Empirical Corporate Finance, vol. 2, Elsevier North Holland, Amsterdam, 2 0 0 8 , pp. 1 3 5 -2 0 2 . Graham, J., 'Debt and the marginal tax rate', Journal of Financial Economics, M a y 1996, pp. 4 1 -7 3 . -------, 'H ow big are the tax benefits of debt?', Journal of Finance, O ctober 2 0 0 0 , pp. 1 9 0 1 -4 1 . -------, & Harvey, C., 'The theory and practice of corporate finance: evidence from the fields Journal of Financial Economics, M a y 2 0 0 1 ; pp. 1 8 7 -2 4 3 .

M ehrotra, V., Mikkelson, W . & Partch, M ., 'The design of financial policies in corporate spin-offs7, Review of Financial Studies, W inter 2 0 0 3 , pp. 1 3 5 9 -8 8 . Myers, S.t yThe capital structure puzzle', Journal of Finance, July 1984, pp. 5 7 5 -9 2 .

CHAPTER THIRTEEN REVIEW

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structure decisions

------- , 'C apital structure', Journal of Economic Perspectives, Spring 2 0 0 1 , pp. 8 1 -1 0 2 . ------- , 'Financing of corporations', in G. Constantinides, M. Harris & R. Stulz (eds), Handbook of the Economics of Finance, Elsevier North Holland, Amsterdam, 2 0 0 3 , pp. 2 1 5 -5 3 . O pler, T. & Titman, S., 'Financial distress and corporate perform ance', Journal of Finance, July 1994, pp. 1 0 1 5 -4 0 . Pattenden, K.; 'C apital structure decisions under classical and imputation tax systems: a natural test for tax effects in Australia', Ausfra//anJot;/7ia/ofM anagfem enf, June 2 0 0 6 , pp. 6 7 -9 2 . Pham, T. & Chow, D., 'Some estimates of direct and indirect bankruptcy costs in Australia: September 1 9 7 8 -M a y 1 9 8 3 ', Australian Journal of Management, June 1987, pp. 7 5 -9 5 . Pilotte, E., 'G row th opportunities and the stock price response to new financing', Jouma/ ofBi/s/ness, July 19 92 , pp. 3 7 1 -9 4 . Rajan, R. & Zingales, L.; 'W h a t do we know about capital structure? Some evidence from international da ta', Journal of Finance, December 1995, pp. 1 4 2 1 -6 0 . Richardson, G. & Lanis, Rw 'The influence o f income taxes on the use o f debt held by publicly listed Australian corporations', Australian Tax Forum, 2 0 0 1 , pp. 3 -3 2 . Schulman, C., Thomas, D., Sellers, K. & Kennedy, D., 'Effects of tax integration and capital gains tax on corporate leverage7, National Tax Journal, M arch 1996, pp. 3 1 -5 4 . Shapiro, A .C ., 'Guidelines for long-term corporate financing strategy7, in J. Stern & D. Chew (eds), The Revolution in Corporate Finance, 3rd edn, Basil Blackwell, O xford, 1998, pp. 1 7 4 -8 7 .

4 15

Shyam-Sunder, L., 'The stock price effect o f risky versus safe debt7, Journal of Financial and Quantitative Analysis, December 1991, pp. 5 4 9 -5 8 .

W ald, 'H ow firm characteristics affect capital structure: an international comparison,/ Journal of Financial Research, Summer 1999, pp. 1 6 1 -8 7 .

------- , & Myers, S., 'Testing static trade-off against pecking order models of capital structure,/ Journal of Financial Economics, February 1999, pp. 2 1 9 -4 4 .

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Smith, C.W . Jr, 'Raising capital: theory and evidence ’， M idland Corporate Finance Journal, Spring 1986, pp. 6 -2 2 . Strebulaev, I., 'D o tests o f capital structure theory mean what they say?', Journal o f Finance, August 2 0 0 7 , pp. 1 7 4 7 -8 6 . Titman, S. & Wessels, R., 'The determinants of capital structure choice,/ Journal of Finance, M arch 1988, pp. 1 -1 9 .

Weiss, L., 'Bankruptcy resolution: direct costs and violation of priority of claims7, Journal of Financial Economics, O ctober 1990, pp. 2 8 5 -3 1 4 . W righ t, S., 'Measures of stock market value and returns for the US nonfinancial corporate sector, 1 9 0 0 -2 0 0 2 ', Review of Income a n d Wealth, December 2 0 0 4 , pp. 5 6 1 -8 4 .

CHAPTER CONTENTS 14.1

In tr o d u c t io n

418

14.6

14.2

R isk, re tu rn a n d th e c o s t o f c a p it a l

418

IH H

14.3

■

T a x e s a n d th e c o s t o f c a p it a l

419

14.4

A lt e r n a t iv e a p p r o a c h e s to e s t im a tio n o f

■

14.8 th e c o s t o f c a p it a l

421

P r o je c t a n d c o m p a n y c o s t o f c a p it a l T h e w e ig h t e d a v e r a g e c o s t o f c a p it a l a n d a lt e r n a t iv e p r o je c t e v a lu a t io n te c h n iq u e s

436

U s in g c e r t a in t y e q u iv a le n t s to a l lo w f o r r is k

437

A p p e n d ix 1 4 .1

T h e c o s t o f c a p it a l u n d e r

a lt e r n a t iv e t a x s y s te m s

14.5

431

447

E s tim a tio n o f th e c o s t o f c a p it a l: a n e x t e n d e d e x a m p le

423

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

u n d e r s ta n d th e c o n c e p t o f th e c o s t o f c a p it a l

2

u n d e r s ta n d th e e ffe c t o f r is k o n th e c o s t o f c a p it a l

3

u n d e r s ta n d h o w th e c o s t o f c a p it a l c a n b e m e a s u r e d u n d e r th e im p u t a t io n t a x s y s te m

4

u n d e r s ta n d w h y th e c o s t o f c a p it a l f o r a c o m p a n y is e x p r e s s e d a s a w e ig h t e d a v e r a g e o f th e c o s ts o f a ll o f th e c o m p a n y 's s o u rc e s o f c a p it a l

5

e s tim a te th e c o s t o f e a c h s o u r c e o f c a p it a l a n d c o m b in e th e s e c o s ts in to a w e ig h t e d a v e r a g e c o s t o f c a p it a l f o r a c o m p a n y

6

e x p la in h o w to t r e a t is s u e c o s ts in p r o je c t e v a lu a t io n

7

u n d e r s ta n d th e d is t in c t io n b e t w e e n th e c o s t o f c a p it a l f o r a p r o je c t a n d a c o m p a n y 's w e ig h t e d a v e r a g e c o s t o f c a p it a l

8

e s tim a te th e c o s t o f c a p it a l f o r a d iv is io n o f a d iv e r s if ie d c o m p a n y

9

u n d e r s ta n d th e a d v a n ta g e s a n d d is a d v a n t a g e s o f u s in g th e w e ig h t e d a v e r a g e c o s t o f c a p it a l in p r o je c t e v a lu a tio n

10

u n d e r s ta n d th e a p p l ic a t io n o f th e c e r t a in t y - e q u iv a le n t m e th o d o f in c o r p o r a t in g ris k in to p r o je c t e v a lu a t io n .

B usiness finance

14.1

Introduction

A s w e n o te d in C h a p te r 5, w h e n a p ro je c t is e va lu a te d u s in g th e n e t p re s e n t va lu e (N P V ) m e th o d , i t is LEARNING OBJECTIVE 1 Understand the concept of the cost of capital

necessary to have in fo r m a t io n o n th e p ro je c ts fo re c a s t

net cash flows a n d it s required rate of return. U n d e r

th e N P V m e th o d , th e fo re c a s t n e t cash flo w s are d is c o u n te d a t th e p ro je c ts re q u ire d ra te o f r e tu r n a n d th e p ro je c t s h o u ld be u n d e rta k e n i f i t has a p o s itiv e NPV. In th is case, th e d e c is io n to u n d e rta k e th e n e w p ro je c t s h o u ld increase s h a re h o ld e rs ’ w e a lth , because i t is e xp e cte d to g e ne rate n e t cash flo w s t h a t are s u ffic ie n t to c o m p e n sa te th e s u p p lie rs o f c a p ita l f o r th e resources c o m m itte d to th e p ro je c t.

OPPORTUNITY COST

highest price or rate of return that would be provided by an alternative course of action. The opportunity cost of capital is the rate of return that could be Gamed on another investment with the same risk

The ra te o f r e tu r n re q u ire d b y th e s u p p lie rs o f c a p ita l is also k n o w n as th e co st o f capital*. I t is an o p p o r tu n ity cost because c a p ita l s u p p lie rs w ill re q u ire t h a t a p ro je c t s h o u ld p ro d u c e a ra te o f r e tu r n a t le a s t as g re a t as th e ra te o f r e tu r n th e y c o u ld o b ta in o n o th e r in v e s tm e n ts o f s im ila r ris k . In tu r n , th is ra te o f r e tu r n is u s u a lly th o u g h t o f as c o n s is tin g o f tw o c o m p o n e n ts : th e ris k -fre e ra te o f r e tu r n to c o m p e n sa te f o r th e tim e va lu e o f m o n e y, p lu s a p re m iu m to co m p e n sa te f o r ris k . The co st o f c a p ita l is a c ru c ia lly im p o r t a n t in p u t to th e in v e s tm e n t d e c is io n . O fte n th e d e c is io n to accept o r re je c t a p ro p o s e d p ro je c t can change i f th e e s tim a te d cost o f c a p ita l is ch a n g e d b y as li t t le as a fe w pe rce n ta g e p o in ts . There are, h o w e ve r, d iffe re n t d e fin itio n s o f th e co s t o f c a p ita l t h a t can be a d op te d. The co n sisten cy prin ciple re q u ire s t h a t th e d e fin itio n o f th e cash flo w s in th e n u m e ra to r o f an NPV c a lc u la tio n m u s t m a tc h th e d e fin itio n o f th e d is c o u n t ra te in th e d e n o m in a to r o f th e c a lc u la tio n . F o r e xa m p le , in fla t io n m u s t be tre a te d c o n s is te n tly in th e cash flo w s a n d th e cost o f c a p ita l. T h ere fore, i f th e

CONSISTENCY PRINCIPLE

in applying the NPV model, the net cash flows in the numerator should be defined and measured in a way that is consistent with the definition of the discount rate

cash flo w s are n o m in a l— t h a t is, are based o n p rice s e xp e cte d in fu tu r e ye a rs— th e n th e d is c o u n t ra te m u s t also be expressed in n o m in a l (ra th e r th a n real) te rm s . S im ila rly , taxes m u s t be tre a te d c o n s is te n tly in th e cash flo w s a n d th e co st o f c a p ita l. T here fore, a fte r-c o m p a n y -ta x cash flo w s are d is c o u n te d u s in g an a fte r-ta x co st o f c a p ita l. In th is c h a p te r w e c o n s id e r th e d e fin itio n , e s tim a tio n a n d use o f th e cost o f c a p ita l. In p ra c tic e , r is k y p ro je c ts are u s u a lly e va lu a te d b y u s in g a co st o f c a p ita l t h a t re fle c ts th e r is k o f th e p ro je c t. I n th is c h a p te r w e also c o n s id e r th e c e rta in ty -e q u iv a le n t ap p ro a ch . T his a p p ro a c h in c o rp o ra te s r is k in to th e a n alysis b y a d ju s tin g th e cash flo w s ra th e r th a n th e d is c o u n t rate.

14.2 Risk, return and the cost of capital In C h a p te r 7 w e discussed th e r e la tio n s h ip b e tw e e n r is k a n d r e t u r n f o r r is k y assets such as shares. In th a t LEARNING OBJECTIVE 2 Understand the effect of risk on the cost of capital COST OF CAPITAL

minimum rate of return needed to compensate suppliers of capital for committing resources to an investment

d is c u s s io n w e use d th e te rm s ‘e xp e cte d r e t u r n ’ a n d ‘re q u ire d r e t u r n ’ to re fe r to th e re tu rn s d e m a n d e d b y in v e s to rs . The re tu rn s rece ive d b y in v e s to rs in s e c u ritie s m u s t be p ro v id e d b y th e issu ers o f th o se s e c u ritie s and, fr o m th e is s u e rs v ie w p o in t, th e r e tu r n d e m a n d e d b y in v e s to rs is e ffe c tiv e ly a co st— ty p ic a lly re fe rre d to as th e cost o f c a p ita l. T h e re fo re , th e te rm s cost o f capital* a n d ^re qu ired re tu rn * c o u ld be used in te rc h a n g e a b ly , an d, in assessing th e co st o f capital f o r a n y p ro je c t, w e fo cu s o n th e r e tu r n re q u ire d b y in v e s to rs to co m p e n sa te th e m f o r p ro v id in g c a p ita l. S uppose t h a t a co m p a n y has tw o n e w p ro je c ts ava ila ble: one is r is k fre e a n d th e o th e r is ris k y . H o w s h o u ld th e co m p a n y s fin a n c ia l m a n a g e r assess th e cost o f c a p ita l f o r each o f the se p ro je c ts ? E sse n tia lly, th e fin a n c ia l m a n a g e r s h o u ld ask: W h a t ra te o f r e tu r n w o u ld o u r

shareholders re q u ire

f r o m th e se p ro je cts?

C learly, a d e cisio n to u n d e rta k e th e ris k -fre e p ro je c t w ill in crea se s h a re h o ld e rs ’ w e a lth o n ly i f th e p ro je c t’s e xp e cte d ra te o f r e tu r n is a t le a s t as g re a t as th e ra te t h a t in v e s to rs can e a rn o n o th e r ris k -fre e in v e s tm e n ts , such as g o v e rn m e n t d e b t se c u ritie s . In o th e r w o rd s , th e co st o f c a p ita l f o r th e ris k -fre e p ro je c t is th e r is k ­ fre e ra te in th e s e c u ritie s m a rk e t. The co st o f c a p ita l f o r th e r is k y p ro je c t w ill be h ig h e r th a n th e ris k -fre e ra te a n d w ill de p e n d o n th e ra te o f r e tu r n t h a t in v e s to rs re q u ire fr o m o th e r in v e s tm e n ts o f s im ila r ris k . In s u m m a ry , th e co st o f c a p ita l f o r a p ro je c t de pe nd s o n th e r is k o f th e p ro je c t. The re la tio n s h ip b e tw e e n r is k a n d r e tu r n is discusse d in C h a p te r 7 a n d o n e o f th e m a in c o n clu sio n s is t h a t th e r e le v a n t m easure o f r is k f o r a n y asset is its s y s te m a tic o r n o n -d iv e rs ifia b le ris k , because in v e s to rs w ill n o t be co m p e n sa te d f o r b e a rin g r is k t h a t can be e lim in a te d b y d iv e rs ific a tio n — t h a t is, th e y w ill n o t be c o m p e n s a te d f o r u n s y s te m a tic o r d iv e rs ifia b le ris k . C o n s is te n t w it h th is c o n c lu s io n , th e c a p ita l asset p r ic in g m o d e l (C A P M ) sta te s t h a t th e re q u ire d r e tu r n o n an in v e s tm e n t d e pe nd s o n th e in v e s tm e n ts s y s te m a tic ris k . Hence, a c c o rd in g to th e C A P M , th e re le v a n t m ea sure o f r is k f o r a p ro je c t is th e

risk of the project, m e a su re d b y

its be ta.

systematic

C hapter fourteen T he

c o s t o f capital

14.2.1 | Risk independence I f th e cost o f c a p ita l f o r a p ro je c t depe nd s o n th e r is k o f th e p ro je c t th e n i t does

not

d e p e n d o n th e

c h a ra cte ristics o f th e c o m p a n y c o n s id e rin g th e p ro je c t. The d e c is io n r u le is to accept a ll p ro je c ts w h o se n e t p re s e n t values are p o s itiv e w h e n th e e xp e cte d cash flo w s are d is c o u n te d a t th e p ro je c t-s p e c ific d is c o u n t rate. Thus, th e v a lu e o f a p ro je c t depends o n w h a t th e p ro je c t is, n o t w h o th e in v e s to r is. F u rth e r, p ro je c ts can be e va lu a te d as i f t h e ir r is k is in d e p e n d e n t o f th e r is k o f a ll o th e r p ro je c ts u n d e rta k e n b y th e c om p an y. T his p rin c ip le o f r is k in d e p e n d e n ce can be e x p la in e d b y c o n s id e rin g co m p a n y d iv e rs ific a tio n . I t is e x p la in e d in C h a p te r 7 t h a t a r a tio n a l risk-a ve rse in v e s to r w ill h o ld a w e ll-d iv e rs ifie d p o r tfo lio a n d t h a t th e r is k o f an asset in a la rg e p o r tf o lio depends o n th e co va ria n ce o f th e re tu rn s o n th e in d iv id u a l asset w it h th e re tu rn s o n th e p o r tfo lio . I t c o u ld be a rg u e d t h a t co m p a n ie s s h o u ld also d iv e rs ify . I f so, th e n com p an ies w o u ld ta k e in to a cco u n t th e c o rre la tio n b e tw e e n re tu rn s o n th e p ro p o se d p ro je c t and re tu rn s o n t h e ir e x is tin g p ro je c ts . F o rtu n a te ly th is a rg u m e n t is in c o rre c t, because in v e s to rs can d iv e rs ify f o r th e m se lve s s im p ly b y in v e s tin g in th e shares o f m a n y d iffe re n t co m p a n ie s. T h ere fore, d iv e rs ific a tio n b y a co m p a n y does n o t p ro v id e a n y in v e s tm e n t o p p o r tu n it y t h a t is n o t a lre a d y a va ila b le to in v e s to rs .1 C o n se q u e n tly, each p ro je c t s h o u ld be e va lu a te d u s in g th e co s t o f c a p ita l a p p ro p ria te f o r th a t p ro je c t. This depends o n th e r is k o f th e p a rtic u la r p ro je c t. R isk in d e p e n d e n c e com es a b o u t because o f th e e ffe ctive n e ss o f th e c a p ita l m a rk e t in p ro v id in g o p p o rtu n itie s f o r in v e s to rs to d iv e rs ify .

14.3 Taxes and the cost of capital As m e n tio n e d in S e ctio n 14 .1, taxes m u s t be tre a te d c o n s is te n tly in th e n e t cash flo w s a n d in th e cost o f cap ital. As d e m o n s tra te d in C h a p te r 6, p ro je c ts are n o rm a lly e va lu a te d o n an a fte r-c o m p a n y -ta x ba sis 一 th a t is, a fte r-c o m p a n y -ta x cash flo w s are d is c o u n te d u s in g a n a fte r-c o m p a n y -ta x re q u ire d ra te o f r e tu rn . W h ile th is p rin c ip le sou nd s s im p le , i t can be d iff ic u lt to a p p ly because th e re is m o re th a n one w a y to d e fin e ‘a fte r-c o m p a n y -ta x ’ cash flo w s . P a rtic u la r care is n e ed ed u n d e r th e im p u ta tio n ta x s yste m because, as discussed in C h a p te r 11, som e o r a ll o f th e ta x c o lle c te d fr o m a co m p a n y is, in e ffe c t, p e rs o n a l ta x , not

(tYue

co m p a n y ta x. O ffic e r (1 9 9 4 ) discussed several a lte rn a tiv e ways o f d e fin in g n e t cash flo w s a n d

th e cost o f c a p ita l u n d e r im p u ta tio n .2 O ne w a y to d e fin e a fte r-ta x cash flo w s is t h a t th e y are eq ua l to th e b e fo re -ta x cash flo w s m u ltip lie d b y (1 - t e), w h e re com p an y ta x ra te is

te= tc( l -

y), w h e re

tcis th e

teis

th e

effective c o m p a n y in c o m e

ta x rate. The e ffe c tiv e

s ta tu to r y c o m p a n y ta x ra te a n d y re p re se n ts th e p r o p o r tio n

o f th e ta x co lle cte d fr o m a c o m p a n y t h a t is p a id o u t to sh a re h o ld e rs a n d reco vere d th ro u g h ta x c re d its associated w ith fra n k e d d iv id e n d s . N o te t h a t i f y is eq u a l to 1, th e n th e e ffe c tiv e c o m p a n y ta x ra te is zero, w h ile i f y is eq ua l to zero, th e n th e e ffe c tiv e c o m p a n y in c o m e ta x ra te is th e sam e as th e s ta tu to r y rate. The c o rre s p o n d in g d e fin itio n o f th e co st o f c a p ita l is discusse d in S e c tio n 14 .4.2. O ffic e r also sho w e d th a t, u n d e r th e im p u ta tio n ta x system , a d ju s tm e n ts m a y be ne eded w h e re observe d m a rk e t rates o f r e tu r n are used to e s tim a te th e co st o f e q u ity . C o n v e n tio n a lly , th e co st o f e q u ity ,

keJis

d e fin e d a n d m e a su re d o n an a fte r-c o m p a n y -ta x , b u t b e fo re -p e rs o n a l-ta x , basis. U n d e r th e classical

ta x system th is a p p ro a ch is s tra ig h tfo rw a rd , because o b se rve d m a rk e t rates o f r e tu r n o n e q u ity are also a fte r c o m p a n y ta x , b u t b e fo re p e rs o n a l ta x. H o w e ve r, u n d e r th e im p u ta tio n system , p a r t o f th e r e t u r n to e q u ity con sists o f ta x c re d its . Because the se ta x c re d its are n o t in c lu d e d in c o n v e n tio n a l r a te -o f-re tu rn m easures, a d ju s tm e n ts are re q u ire d to o b ta in tru e a fte r-c o m p a n y -ta x rates o f re tu rn . The a d ju s tm e n t o f th e d iv id e n d y ie ld c o m p o n e n t o f th e r e tu r n to e q u ity to re fle c t th e in c lu s io n o f ta x c re d its is illu s tra te d in E x a m p le 14.1. E xam p le 14.1 show s t h a t w h e re d iv id e n d s are fra n k e d , o b se rve d rates o f r e t u r n o n shares need to be a d ju s te d to o b ta in a fte r-c o m p a n y -ta x rates o f re tu rn . The a d ju s tm e n t is s im p le : add b a ck th e value o f im p u ta tio n ta x f r a n k in g c re d its t h a t re p re s e n t p e rs o n a l ta x t h a t has a lre a d y been p a id . The va lu e o f these

1

2

Interestingly, in the context of companies acquiring other companies, Mukherjee, Kiymaz and Baker (2004) report that diversification is the second-most popular reason for acquisitions cited by a sample of chief financial officers of acquiring companies. This popularity exists despite shareholders being able to diversify their portfolios to match their risk appetite and, in many cases, being able do so more cheaply than the acquiring company, which is forced to pay a control premium. This point is discussed in greater depth in Section 19.2.1. For a more detailed discussion of alternative definitions of the cost of capital and the derivation of equations for a company s cost of capital on a before-tax and after-tax basis see Appendix 14.1.

LEARNING OBJECTIVE 3 Understand how the cost of capital can be measured under the imputation tax system

T he s h a re s o f PXT Ltd h a v e a m a rk e t p r ic e o f $ 4 a n d a n a n n u a l d iv id e n d o f 1 7 . 5 c e n ts p e r s h a re , fu lly fr a n k e d a t th e c o m p a n y ta x ra te o f 3 0 p e r c e n t. C a lc u la te : a)

th e d iv id e n d y ie ld o n th e s h a re s o f PXT th a t w o u ld b e r e p o r te d in th e f in a n c ia l p re ss

b)

th e d iv id e n d y ie ld a fte r c o m p a n y ta x , b u t b e fo r e p e rs o n a l ta x

c)

th e d iv id e n d y ie ld a fte r c o m p a n y t a x a n d a fte r p e rs o n a l ta x , f o r s h a re h o ld e rs w ith p e rs o n a l ta x ra te s o f: i) 3 0 p e r c e n t ii) 4 5 p e r c e n t.

SOLUTION a)

D iv id e n d

y ie ld s r e p o r te d

in th e f in a n c ia l p re ss a r e

b a s e d o n c a s h d iv id e n d s e x c lu d in g

any

im p u ta tio n ta x f r a n k in g c re d its . T he r e p o r te d d iv id e n d y ie ld o n th e s h a re s is:

〇.175 = 0.04375 or 4.375% $4.00

气

b)

T he d iv id e n d y ie ld a fte r c o m p a n y ta x , b u t b e fo r e p e rs o n a l ta x , is b a s e d o n th e c a s h d iv id e n d o f $ 0 . 1 7 5 p e r s h a re , p lu s th e im p u ta tio n ta x f r a n k in g c r e d it, w h ic h re p re s e n ts p e rs o n a l ta x a lr e a d y p a id . A s d is c u s s e d in S e c tio n 1 1 . 4 .1 , th e im p u ta tio n ta x f r a n k in g c r e d it is:

Dt x tc 1 - fc

= $ 0.17 5

X

0.03

0.07 =$0.075 T he d o lla r re tu rn to s h a re h o ld e rs a fte r c o m p a n y ta x is $ 0 . 1 7 5 d iv id e n d y ie ld a fte r c o m p a n y ta x is c)

+ $ 0 .0 7 5

= $ 0 . 2 5 0 , so th e

= 0 .0 6 2 5 o r 6 .2 5 % .

T h e s h a r e h o ld e r s ' p e r s o n a l t a x w ill b e c a lc u la te d a s fo llo w s : T a x a b le d iv id e n d in c o m e = d iv id e n d + im p u ta tio n f r a n k in g c r e d it = $ 0 . 1 7 5 + $ 0 .0 7 5 = $ 0 .2 5 0 G ro s s p e rs o n a l ta x = $ 0 . 2 5 0 x tp N e t p e rs o n a l ta x = $ 0 . 2 5 0 x fp - $ 0 . 0 7 5 i) W h e n tp = 0 . 3 0 N e t p e rs o n a l ta x = $ 0 . 2 5 0 x 0 . 3 0 - $ 0 . 0 7 5 = 0

$0 175

In th is c a s e , th e d iv id e n d y ie ld a fte r a ll ta x e s is — ^------- = 4 .3 7 5 % , w h ic h is e x a c tly e q u a l to

the reported dividend yield.

$4.00 i)

ii) W h e n tp = 0 . 4 5 N e t p e r s o n a l ta x = $ 0 . 2 5 0 x 0 . 4 5 - $ 0 . 0 7 5 = $ 0 .0 3 7 5 T h e d iv id e n d a fte r a ll ta x e s is $ ( 0 . 1 7 5 - 0 . 0 3 7 5 ) = $ 0 . 1 3 7 5 a n d th e c o r r e s p o n d in g d iv id e n d

yield is

丨0 1

$4.00

=0.034 375 or 3.4375%. 3.4375%

A s a c h e c k , th is y ie ld c a n b e c o n v e r te d to a b e fo re -p e rs o n a l ta x y ie ld , w h ic h is w h ic h is e x a c tly th e s a m e a s th e a n s w e r to p a r t (b ).

丨一

6.25%,

：

•

J

ta x c re d its can be expressed as a ra te o f r e tu rn , X, b y d iv id in g th e ta x c re d its b y th e share p ric e . I t fo llo w s t h a t a s im ila r a d ju s tm e n t is ne ed ed w h e n th e C A P M is used to e s tim a te th e co st o f c a p ita l. T h e re fo re , th e C A P M w o u ld becom e:

C hapter fourteen T he

A d d in g x, w h ic h can be c a lle d a f r a n k i n g p r e m iu m , a d ju s ts th e o b se rve d r e tu r n o n th e m a rk e t p o r tfo lio to an a fte r-c o m p a n y -ta x ra te o f r e tu r n . The v a lu e o f X w ill d e p e n d o n th e average d iv id e n d y ie ld o n th e shares in th e m a rk e t p o r tf o lio a n d th e e x te n t to w h ic h th e d iv id e n d s are fra n k e d . Suppose a share m a rk e t in d e x re p re s e n ts th e m a rk e t p o r tfo lio , th e average d iv id e n d y ie ld o n shares in th e in d e x is 3 p e r ce n t a n d d iv id e n d s are 8 0 p e r c e n t fra n k e d a t a co m p a n y ta x ra te o f 30 p e r c e n t. In th is case, th e ta x c re d its received o n an in v e s tm e n t o f $ 1 0 0 w o u ld be: $ 3 x 0 . 8 x Q.30=$1Q286 ( 1 - 0 .0 3 ) T here fore, th e fr a n k in g p re m iu m , I , is a p p ro x im a te ly 1 p e r cen t.

14.4 Alternative approaches to estimation of the cost of capital I t is im p o r ta n t to reco gn ise t h a t th e co st o f c a p ita l re fle c ts rates o f r e t u r n t h a t in v e s to rs e xp e ct to receive in th e fu tu re . Because in v e s to rs 1 e x p e c ta tio n s c a n n o t be o b se rve d , i t is u s u a lly n o t p o ssib le to m ea sure th e cost o f c a p ita l pre cise ly. I t m u s t be

estimated a n d

th e p re fe rre d a p p ro a ch w ill be in flu e n c e d b y th e

a v a ila b ility o f d a ta a n d th e im p o rta n c e o f th e in v e s tm e n ts t h a t w ill be e va lu a te d u s in g th e e s tim a te d cost o f c a p ita l. The fo llo w in g s e c tio n s discuss tw o approaches: th e d ire c t use o f th e C A P M a n d th e use o f th e w e ig h te d average co st o f c a p ita l (W AC C ).

14.4.1 | Direct use of the CAPM A c c o rd in g to th e C A P M , w h ic h is discusse d in S e ctio n 7.6 .2 , th e co st o f c a p ita l, /c;, f o r p r o je c t; is:

|Q I

kj = Rf + 0j[E(RM) - R f]

R^yth e e xp e cte d J3y E s tim a tio n o f a n d

T herefore, to use th e C A P M d ire c tly , i t is necessary to e s tim a te th e ris k -fre e in te re s t rate, ra te o f r e tu r n o n th e m a rk e t p o r tf o lio ,

E(Rm) is

E(RM) a n d

th e p ro je c ts s y s te m a tic ris k ,

discussed in S e ctio n 1 4 .5 .3 , b u t f o r n o w w e fo cu s o n th e p ro b le m o f e s tim a tin g th e s y s te m a tic

ris k o r b e ta o f a p ro je c t. T echn iq ues f o r e s tim a tin g th e b e ta s o f s e c u ritie s , such as shares, u s in g n u m b e rs d e riv e d fr o m share m a rk e t da ta, are e x p la in e d in S e c tio n 7.6. The necessary d a ta are re a d ily a va ila ble i f th e s e c u ritie s con cern ed are tra d e d a c tiv e ly o n a s to c k exchange. P ro p o se d in v e s tm e n t p ro je c ts are, o f course, n o t tra d e d o n a s to c k exchange, o r o n a n y o th e r m a rk e t, a n d th e re fo re th e d a ta re q u ire d to e s tim a te p ro je c t betas d ire c tly are n o t a va ila b le . T his p ro b le m c o u ld e a sily be o ve rco m e i f a ll o f a c o m p a n y s p ro je c ts h a d th e sam e b e ta , a n d i f th e c o m p a n y w e re fin a n c e d s o le ly b y e q u ity . S h a re h o ld e rs w o u ld b e ar a ll th e ris k associated w ith th e c o m p a n y s n e t cash flo w s . A s the se cash flo w s are g e n e ra te d b y th e c o m p a n y s p ro je c ts (o r assets) th e b e ta o f th e c o m p a n y s assets w o u ld be eq u a l to th e b e ta o f its shares. In p ra c tic e , th e v a s t m a jo r it y o f c o m p a n ie s use d e b t fin a n c e as w e ll as e q u ity . T his increases th e b e ta o f e q u ity because s h a re h o ld e rs o f le v e re d co m p a n ie s face fin a n c ia l r is k as w e ll as b u sin e ss ris k . I n th e absence o f taxes, th e b e ta o f a c o m p a n y s assets w o u ld be e q u a l to th e w e ig h te d average o f th e b e ta s o f its e q u ity a n d it s d e b t. W h ile e q u ity b e ta s are r o u tin e ly e s tim a te d u s in g d a ta o n share m a rk e t re tu rn s , th is is n o t th e case f o r d e b t. I n A u s tra lia , m o s t c o rp o ra te d e b t is e ith e r n o t lis te d o n a s to c k exchange or, a t b e st, tra d e d irre g u la rly , a n d i t is th e re fo re v e ry d iff ic u lt to e s tim a te th e b e ta o f d e b t. M o re o v e r, in p ra ctice , th e re la tio n s h ip b e tw e e n s e c u rity b e ta s a n d asset be ta s can be m o re c o m p lic a te d th a n i t is in th e n o -ta x case. In s u m m a ry , th e d ire c t use o f th e C A P M to e s tim a te th e co st o f c a p ita l in v o lv e s tw o m a in p ro b le m s . F irs t, th e re is th e p ro b le m o f th e lim it e d a v a ila b ility o f d a ta to e s tim a te be tas o f d e b t. Second, care is needed to e n sure t h a t ta x a n d leverage e ffe cts are h a n d le d c o rre c tly . These p ro b le m s m e a n t h a t th e d ire c t use o f th e C A P M is g e n e ra lly n o t fea sible. H o w e ve r, th is does n o t m e a n t h a t th e m o d e l s h o u ld be disreg arde d. The C A P M can be v e ry u s e fu l in e s tim a tin g som e c o m p o n e n ts o f th e w e ig h te d average cost o f ca p ita l.

c o s t o f capital

FR AN KIN G PREMIUM

that part of the return on shares or a share market index that is due to tax credits associated with franked dividends

A

B usiness finance

1 4 .4 .2 1 The weighted average cost of capital (WACC) In S e c tio n 14 .2, w e em phasise th e p rin c ip le t h a t th e co st o f c a p ita l is p ro je c t-s p e c ific . In o th e r w o rd s, e v a lu a tio n o f a p ro p o s e d p ro je c t s h o u ld be based o n th e p ro je c ts co st o f c a p ita l. H o w e ve r, i t can be v e ry LEARNING OBJECTIVE 4 Understand why the cost of capital for a company is expressed as a weighted average of the costs of all of the company's sources of capital

d iff ic u lt to m ea sure a p ro je c ts cost o f c a p ita l. T his is because w h e n a c o m p a n y raises c a p ita l, th e re is g e n e ra lly n o d ire c t lin k b e tw e e n th e re tu rn s to th e s u p p lie rs o f th e co m p a n y s c a p ita l a n d th e re tu rn s on in d iv id u a l p ro je c ts . F o r exa m ple, suppose t h a t a co m p a n y b o rro w s , u s in g an e x is tin g asset as s e c u rity , to p ro v id e th e cash f o r a n e w p ro je c t. The in te re s t ra te o n th e d e b t is

not a v a lid

m easure o f th e n e w p ro je c ts

co st o f c a p ita l. The rea son is sim p le : th e in te re s t ra te o n th e d e b t depe nd s o n th e r is k o f th e co m p a n y a n d its e x is tin g assets, a n d does n o t d e p e n d s o le ly o n th e r is k o f th e n e w p ro je c t. The s itu a tio n is s im ila r i f a c o m p a n y m akes a share issue to raise th e cash needed f o r a n e w p ro je c t. S h a re h o ld e rs are exposed to th e r is k o f th e w h o le com pany. T h e re fo re , th e co st o f e q u ity w ill d e p e n d o n th e average r is k o f a ll th e c o m p a n y s assets a n d o n its fin a n c ia l leverage, n o t ju s t o n th e c h a ra c te ris tic s o f th e n e w p ro je c t. In s u m m a ry , th e rates o f r e tu r n to th e s u p p lie rs o f a c o m p a n y s c a p ita l do n o t n e ce ssa rily re fle c t th e cost o f c a p ita l t h a t is a p p lica b le to a n y in d iv id u a l p ro je c t, even i f th e n e w c a p ita l is ra ise d a t th e tim e th e p ro je c t is im p le m e n te d . H o w e ve r, th e re is an im p o r t a n t s pe cia l case t h a t o fte n p ro v id e s a p ra c tic a l s o lu tio n to these p ro b le m s . Suppose t h a t a c o m p a n y s assets are a ll o f s im ila r r is k a n d t h a t th e r is k o f th e p ro p o s e d p ro je c t is th e same as th e r is k o f th e c o m p a n y s e x is tin g assets. T his s h o u ld be th e case i f th e p ro je c t is s im p ly an e x p a n s io n o f th e c o m p a n y s e x is tin g o p e ra tio n s . Since th e re is n o change in ris k , th e co st o f c a p ita l f o r th e c o m p a n y as a w h o le s h o u ld also be a v a lid m easure o f th e co st o f c a p ita l f o r th e n e w p ro je c t. The

company cost of capital is

d e fin e d as th e d is c o u n t ra te t h a t equates th e p re s e n t v a lu e o f a co m p a n y s

e xp ected f u tu r e cash flo w s to th e c o m p a n y s value. To m a ke th is d e fin itio n u s e fu l i t is necessary to d e fin e b o th cash flow s* a n d V a lu e 1. The

value o f

a co m p a n y is th e m a rk e t va lu e o f its e q u ity p lu s th e m a rk e t

va lu e o f it s d e b t. H o w e ve r, th is d e fin itio n o f va lu e can be c o m b in e d w it h several d e fin itio n s o f

cash flow,

le a d in g to d iffe re n t v e rs io n s o f th e co st o f c a p ita l. F o r exa m p le , cash flo w s can be m e a su re d b e fo re ta x o r a fte r ta x . W e use a fte r-ta x cash flo w s , d e fin e d as b e in g e q u a l to th e b e fo re -ta x cash flo w s m u ltip lie d b y

( l - t e), w h e re teis th e effective co m p a n y in c o m e ta x ra te . The e ffe c tiv e c o m p a n y in c o m e ta x ra te is t c( l - y ), tc is th e s ta tu to r y co m p a n y in c o m e ta x ra te a n d y is th e p r o p o r tio n o f th e ta x c o lle c te d fr o m th e

w h e re

co m p a n y t h a t is c la im e d as a c re d it b y s h a re h o ld e rs. F o r e xa m p le , i f th e b e fo re -ta x cash flo w is $1 m illio n , th e s ta tu to r y co m p a n y in c o m e ta x ra te is 3 0 cen ts in th e d o lla r, a n d 60 p e r c e n t o f th e ta x c o lle c te d fr o m th e c o m p a n y is c la im e d as a c re d it b y sh a re h o ld e rs, th e n th e e ffe c tiv e c o m p a n y ta x ra te is 0 .3 0 (1 - 0 . 6 ) = 0 .1 2 a n d th e a fte r-c o m p a n y -ta x cash flo w is $ 1 0 0 0 0 0 0 x (1 - 0 .1 2 ) = $ 8 8 0 00 0. WEIGHTED AVERAGE

W h e n n e t cash flo w s are d e fin e d in th is way, a c o m p a n y s w e ig h ted a verage c o st o f capital (W ACC)

COST OF CAPITAL

can be fo u n d as fo llo w s . C o n s id e r a c o m p a n y t h a t has fin a n c e d its assets u s in g b o th d e b t a n d e q u ity

(WACC)

the cost of capital determined by the weighted average cost of all sources of finance

fin a n ce . The c o m p a n y s cost o f c a p ita l is th e m in im u m ra te o f r e tu r n t h a t i t needs to e a rn o n its assets in o rd e r to m e e t th e c ost o f d e b t fin a n c e a n d p ro v id e th e ra te o f r e t u r n t h a t s h a re h o ld e rs re q u ire . To s im p lify m a tte rs , assum e t h a t th e c o m p a n y s n e t o p e ra tin g cash flo w s re m a in c o n s ta n t in p e rp e tu ity . In th is case, th e a n n u a l in te re s t cost o f th e c o m p a n y s d e b t is: In te re s t ra te (a fte r ta x ) x m a rk e t v a lu e o f d e b t = A:f/(1 - g w h e re

If and

x D

kd = lenders* re q u ire d ra te o f r e t u r n — t h a t is, th e cost o f d e b t te= th e e ffe c tiv e co m p a n y in c o m e ta x ra te D = th e m a rk e t v a lu e o f th e co m p a n y s d e b t tc = 30 cen ts in th e d o lla r a n d y = 0.6 0, th e n te = 0 .1 2 . T hen i f kd = D = $ 1 0 m illio n , th e a n n u a l in te re s t cost o f th e c o m p a n y s d e b t is:

0.1 x ( 1 - 0 . 1 2 ) x $100 00 000 = $880000 S im ila rly , th e m in im u m n e t cash flo w re q u ire d b y s h a re h o ld e rs is: R e q u ire d ra te o f r e tu r n o n e q u ity x m a rk e t v a lu e o f e q u ity

= kex E w h e re /ce = s h a re h o ld e rs ’ re q u ire d ra te o f r e t u r n — t h a t is, th e co st o f e q u ity

E = th e

m a rk e t v a lu e o f th e co m p a n y s e q u ity

10 p e r c e n t p e r a n n u m

C hapter fourteen T he

ke =

F or exam ple, i f

20 p e r c e n t p e r a n n u m a n d

E = $10

c o s t o f capital

m illio n , th e m in im u m cash flo w re q u ire d by

sha reh old ers is $2 m illio n p e r year. To m e e t these re q u ire d ra te s o f re tu rn , th e c o m p a n y s m in im u m a n n u a l n e t o p e ra tin g cash flo w s m u s t be:

k f i^ k d( \ - t e)D Since w e assum e t h a t cash flo w s are c o n s ta n t in p e rp e tu ity , th e co m p a n y s co st o f c a p ita l

kf is

s im p ly th e

a n n u a l n e t o p e ra tin g cash flo w d iv id e d b y th e to t a l m a rk e t va lu e o f th e c o m p a n y — t h a t is: _ a n n u a l n e t o p e ra tin g cash flo w to ta l m a rk e t v a lu e o f c o m p a n y

keE + ^ ( 1

—te)D

E+D E = ke + .e T d . ke

'E

+ ^ (1 -

V.

- te) te)

D

.E+D .

D

4.2

V.

V =E+D

w h ere

= t h e t o ta l m a rk e t v a lu e o f th e c o m p a n y F or exa m ple, i f

ke= 20

kd =

10 p e r c e n t p e r a n n u m ,

tc =

30 ce n ts in th e d o lla r, y = 0 .6 0 ,

p e r ce n t p e r a n n u m a n d E = $1 0 m illio n , th e c o m p a n y s cost o f c a p ita l

kf = {0.2)

^

+ ( 0 .1 0 ) ( 1 - 0 .1 2 )

D

= $ 1 0 m illio n ,

kr is:

10 20

= 0.10 + 0.044 = 0 . 1 4 4 o r 14.4% p e r a n n u m E q u a tio n 14 .2 show s t h a t a co m p a n y s co st o f c a p ita l can be expressed as a w e ig h te d average o f th e costs o f its e q u ity a n d d e b t. O u r d e riv a tio n o f E q u a tio n 1 4 .2 sho w s t h a t th e c o n ce p t u n d e rly in g th e W ACC fo rm u la is th a t, to be acceptable, a n e w p ro je c t s h o u ld g e ne rate n e t cash flo w s t h a t are s u ffic ie n t to m ee t th e a fte r-ta x co st o f d e b t used to fin a n c e th e p ro je c t, as w e ll as p ro v id e a t le a s t th e re q u ire d ra te o f re tu rn o n th e e q u ity used to fin a n c e th e p ro je c t. E q u a tio n 14.2, w h ic h w e use f o r th e v a lu a tio n o f co m p a n ie s a n d p ro je c ts u n d e r th e im p u ta tio n ta x system , is also d e riv e d in A p p e n d ix 1 4 .1 , w h e re i t appears as E q u a tio n A 1 4 .7 . The v a lu a tio n ap p ro a ch we a d o p t, w h ic h in v o lv e s u s in g an e ffe c tiv e c o m p a n y ta x ra te in th e c a lc u la tio n o f th e cash flo w s a n d th e w e ig h te d average cost o f c a p ita l, is c o n s is te n t w it h th e m e th o d d e riv e d b y M o n k h o u s e (1 9 9 6 ).3

Estimation of the cost of capital: an extended example E q u a tio n 14 .2 sho w s t h a t a c o m p a n y s a fte r-ta x cost o f c a p ita l is eq u a l to th e w e ig h te d average o f th e costs o f d e b t a n d e q u ity , w h e re th e cost o f each in d iv id u a l source o f c a p ita l is w e ig h te d a c c o rd in g to its p ro p o rtio n in th e c o m p a n y s c a p ita l s tru c tu re . W h ile th e W ACC has b e e n e x p la in e d a s s u m in g t h a t th e re are o n ly tw o classes o f c a p ita l, n a m e ly e q u ity a n d d e b t, in re a lity a c o m p a n y m a y issue d iffe re n t classes o f shares, as w e ll as d iffe re n t classes o f d e b t. These a d d itio n a l classes o f c a p ita l can be h a n d le d b y e x te n d in g E q u a tio n 14 .2 to in c lu d e a ll sources o f fin a n c e used b y th e com p an y. C o n se q u e n tly, e s tim a tio n o f th e W ACC re q u ire s th e e s tim a tio n o f each v a ria b le in E q u a tio n 1 4 .2 i f o n ly one class o f d e b t a n d e q u ity is em p lo yed, o r an e x te n d e d v e rs io n o f i t i f m o re th a n one class o f d e b t a n d e q u ity is e m p lo ye d . To e s tim a te th e cost o f c a p ita l i t is necessary to e s tim a te th e cost o f each source o f fin a n c e a n d th e p r o p o r tio n o f each source o f fin a n c e in th e co m p a n y s c a p ita l s tru c tu re . Since we are e s tim a tin g a cost o f c a p ita l based on in ve sto rs* e x p e c ta tio n s o f fu tu r e re tu rn s , i t is im p o r t a n t to use c u rre n t m a rk e t rates a n d c u rre n t m a rk e t values, ra th e r th a n h is to ric a l rates a n d b o o k values.

3

Monkhouse showed that the approach he derived is applicable to non-uniform cash flow streams of finite duration.

LEARNING OBJECTIVE 5 Estimate the cost of each source of capital and combine these costs into a weighted average cost of capital for a company

B usiness finance

Fixed-interest debt may be used as an example to explain why current m arket rates, rather than historical rates, m ust be used in estimating the cost o f capital. Suppose th a t a company has a loan w ith a fixed interest rate o f 10 per cent per annum, b u t the current m arket rate on sim ilar loans is 15 per cent per annum. When estimating the company s cost o f capital, the current m arket rate o f 15 per cent should be used. This may appear to ignore the fact th a t the company is paying only 10 per cent on its existing loan. Surely there m ust be some advantage in paying only 10 per cent instead o f 15 per cent? There is an advantage, but the company s shareholders have already received the benefit o f the old, lower interest rate, and the current share price w ill take this into account. Investments to be made now m ust be attractive in comparison w ith the current cost o f capital, and the old interest rate is irrelevant. In the next fo ur sections, we discuss estim ation o f the individual components o f the WACC. Each component is illustrated using the inform a tion on Tasman Industries Ltd (TIL). The discussion concludes in Section 14.5.4 w ith an estimate o f the company s WACC as at 30 June 2015, using the components calculated in the previous three sections. The sources o f finance used by T IL are shown in Table 14.1.

TABLE 14.1 Tasman Industries Ltd: selected balance sheet data as at 30 June 2015 S o u rce s o f fin a n c e

Commercial bills Bank overdraft Bonds

B o o k v a lu e ($ m )

20.000 7.368 10.000

Preference shares, 8%

2.000

Ordinary shares: issued and paid up, 12 500 000 at 50 cents

6.250

TILs financial manager also has the follow ing inform ation: a

b c

d

e f

The commercial bills have a current interest rate (yield) o f 6.08 per cent per annum. The existing bills mature on 31 August 2015 b u t w ill be replaced by a fu rth e r issue at th a t date, The interest rate on the bank overdraft is 9.5 per cent per annum, calculated daily and charged to TIL’s account twice per year. There are 100 bonds, each w ith a face value o f $100 000 and a coupon interest rate o f 10 per cent per annum, payable on 30 June and 31 December each year. The bonds w ill be redeemed at th e ir face value on 30 June 2018. On 30 June 2015 the m arket value o f each bond was $102474.18. The preference shares are irredeemable, have a face value o f $2 and pay a dividend rate o f 8 per cent per annum. Dividends are payable on 30 June and 31 December each year.4 On 30 June 2015, the m arket price o f each preference share was $1.50. TIL pays dividends on its ordinary shares once per year on 30 June. The latest dividend was 17.5 cents, fu lly franked. On 30 June 2015, the m arket price o f each ordinary share was $4.20. The sta tu tory company income tax rate is 30 per cent.

14.5.1 | The cost of debt Companies can raise debt from a variety o f sources. There are short-term and long-term sources o f debt, and debt may be marketable or non-marketable. The overall cost o f debt fo r a company is a weighted average o f the costs o f its individual sources o f debt. This weighted average cost w ill n ot be accurate i f the individual costs are expressed inconsistently. For example, it would be inconsistent to average nom inal interest rates th a t are based on different repayment frequencies. To ensure consistency, all costs o f debt fo r T IL w ill be expressed as effective annual rates. The after-tax cost o f debt is found by m u ltip lyin g the before-tax cost by (1 - te) t where te is the effective company income tax rate. For example, i f the before-tax cost o f debt is 10 per cent per annum, the statutory 4

It is assumed for simplicity in this example that coupon interest payments are made on 30 June and 31 December, and that preference dividends are also payable on 30 June and 31 December.

C hapter fourteen T he

company income tax is 30 cents in the dollar, and the pro po rtio n o f tax collected from the company th a t is claimed by shareholders is 0.60, then the effective company tax rate is 30(1 - 0.6) = 12 cents in the dollar and the after-tax cost o f debt is 10(1 - 0.12) = 8.80 per cent per annum. This calculation assumes th a t the company is operating p rofitably and th a t there is no tim e lag in the payment o f company income tax. The calculation is the same fo r each item o f debt and is reflected in Equation 14.2. Therefore, in this example the annual interest rates applicable to the individual sources o f debt finance w ill be stated as before-tax rates and the conversion to an after-tax cost o f debt w ill be made in the final WACC calculation. For convenience, debt may be classified as shown in Table 14.2.

TABLE 14.2 Types of debt S h o rt-te rm d e b t

Marketable

; L o n g -te rm d e b t

Commercial paper

Bonds

Commercial bills

Debentures Unsecured notes Floating-rate notes

Non-marketable

Accounts payable

Mortgage loans

Bank overdraft

Finance leases

Money market loans

Term loans

Cost of short-term debt Short-term debt securities, such as commercial bills and commercial paper, are marketable, and current interest rates are quoted in the financial press.5 From these quotations the current effective annual interest rate on marketable debt can be calculated. In the case o f TILs commercial bills, the quoted interest rate is 6.08 per cent per annum. The m arket conventions are to quote nom inal annual rates and to use simple interest fo r short-term securities. In calculating the effective annual interest rate on the bills, the firs t step is to convert the nom inal rate o f 6.08 per cent per annum to the effective rate z fo r the 62 days from 30 June to 31 August. Therefore: on i = 6.08 x — 365 = 1.032 767% The second step is to convert this rate to an annual rate as follows:

= (1.010327 67)5-8871 - ! =0.062 355 Therefore, the rate applicable to bills issued by T IL is approxim ately 6.24 per cent per annum before tax. To calculate the WACC it is also necessary to know the m arket value o f debt, which can be found using the nom inal interest rate. Therefore, fo r a commercial b ill or commercial paper:

14.3 where P = current m arket price o f the security F = face value o f the security ; = nom inal interest rate per annum t = the number o f days from the date o f price calculation to the m a tu rity date 5

Details of these securities are provided in Chapter 10.

c o s t o f capital

B usiness finance

For TILs commercial bills, the m arket value at 30 June 2015 is: $20 000 000 1 + 0.0608 x

62 365

$19 795 558 The cost o f non-marketable interest-bearing debt, such as a bank overdraft, w ill be its current interest rate, converted i f necessary to an effective annual rate. The interest rate on TILs overdraft is 9.5 per cent per annum or 4.75 per cent per half-year. Therefore, the effective annual rate is: (1.0475)2 - 1 =0.097256 That is, the rate applicable to the bank overdraft is approximately 9.73 per cent per annum before tax. O ther form s o f non-marketable short-term debt such as taxes payable, wages payable and accounts payable, which do n ot have an explicit interest cost, should be excluded. The reason is not th a t these forms o f debt are ‘free ’；rather, th e ir costs are accounted fo r in other ways. For example, the cost o f trade credit (the difference between the price o f goods purchased w ith cash on delivery and the price when purchased on credit) has already been deducted in calculating the cash flows. Therefore, accounts payable do n ot have to be serviced out o f those cash flows; to include accounts payable as a source o f finance would be inconsistent.

Cost of long-term debt Some form s o f long-term debt, such as debentures, unsecured notes and corporate bonds, are marketable. We use the term 'bonds1to refer to these long-term debt securities. Given a current m arket price, P, the effective interest rate on a company s bonds is equal to the discount rate th a t equates the m arket price of the bond w ith the discounted value o f the cash flows promised under the terms o f the bond. M ost bonds pay interest twice a year, and the price o f such a bond on a coupon payment date is given by: 'j

1

14.4

(1 + 0 " . where P = current m arket price o f the bonds z = the effective interest rate per half-year . Fj R = interest payments = —, where F = face value o f the bonds, and ; = nom inal interest rate per annum C = redem ption price o f the bonds n = num ber o f future interest payments Equation 14.4 can be used to calculate the effective interest rate per half-year and i t is then a simple m atter to calculate the annual rate. The logic o f Equation 14.4 can be explained using the bonds issued by T IL as an example. On 30 June 2015, a T IL bond was sold fo r $102474.18. The term s o f the bond were as follows: face value, F, is $100000; nom inal interest r a t e , i s 10 per cent per annum payable on 30 June and 31 December each year; redem ption price, C, is $100000; and m a tu rity date is 30 June 2018. Therefore, each interest payment, R, is equal to ($100 000)(0.10/2) = $5000. There are six interest payments to be made, the firs t on 31 December 2015, then tw o in each o f the years 2016 and 2017 and the last on 30 June 2018.6 The redem ption price is a lum p sum payable in exactly 6 half-years’ tim e. A t a yield (or required rate o f return) o f i per half-year, the value o f the bond calculated as at 30 June 2015 is given by: (Present value o f the interest payments) + (present value o f the lum p sum) $5000 r _____1 _ i

$100 000

[ 一（ 1 + /)6

(1 + i f

Therefore: $102 474.18

\ $5000 l

6

[i

1 (1 + /)6

$100 000 ] ^ (1 + 0 6 1

These six payments comprise an ordinary annuity. See Section 3.6.2 for an explanation of the valuation of an ordinary annuity.

C hapter fourteen T he

As noted in Section 4.2, equations o f this type cannot be solved directly fo r i b u t the required value for z can be found by other methods. In this case, i equals 0.0452. This is shown as follows: \ $5000

1

[0.0452

(1.0452)6

= < ($5000)(5.154 546) +

$100 000 ] 1 (1.0452)”

$100 000 1.303 756

= {$ 2 5 772.73 + $76 701.45} =$102 474.18 The required rate o f retu rn on this bond is therefore 4.52 per cent per half-year. Converting this rate to an effective annual rate gives a rate equal to: (1.0452)2 - 1 = 0.092 443 Therefore, the rate applicable to TILs bonds is approximately 9.24 per cent per annum before tax. Where a fixed-interest debt contract, such as a mortgage, is n ot marketable, the current cost o f the debt cannot be measured in the way described fo r bonds. The best measure o f the current cost in this case is an estimate o f the interest rate th a t the company would now have to pay to raise mortgage funds on conditions th a t match those o f the existing mortgage.

1 4 .5 .2 1 The cost of preference shares Preference shares have attributes o f b oth debt and equity. As explained in Section 10.8.3, i t is usual fo r irredeemable preference shares to be cumulative and non-participating. Such preference shares pay a fixed dividend per share, Dp, at regular tim e intervals. Although the payment o f a preference dividend is at the discretion o f the Board o f Directors, it is unusual to o m it payment. As a result, preference dividends form a perpetuity, and fo r a share th a t pays dividends twice a year, the share price on a preference dividend payment date is given by: p

= \ ^ • i

14.5

where P = current m arket price o f preference shares i = effective yield per half-year Dp = half-yearly preference dividend per share For TILs preference shares the m arket price was $1.50 on 30 June 2015 and the next dividend o f 8 cents per share is due on 31 December. Therefore: $ 1 .5 0 = ^ " . i . In this case, z = 0.053 33, so the effective annual cost o f the preference shares, k f is: kp = (1.053 33)2 - l =0.109511 Therefore, the rate applicable to TILs irredeemable preference shares is approximately 10.95 per cent per annum after company tax. I f the preference shares are redeemable on a predetermined date, the calculation o f the cost o f preference shares is the same as the calculation o f the effective interest rate on debt. However, preference dividends are generally a d istrib u tio n o f p ro fit rather than a tax-deductible expense. Thus, certain preference shares may carry franked dividends, and th e ir cost can be calculated using the procedures outlined fo r ordinary shares.

1 4 .5 .3 1 The cost of ordinary shares In contrast to debt, ordinary shares issued by a company do n ot involve a contractual obligation to provide any specific return. Therefore, i t is necessary to estimate the rate o f retu rn th a t investors expect the shares to provide in the future. One approach is to focus on the company s expected future dividend

c o s t o f capital

stream and estimate the discount rate im plied by the current share price. This approach was discussed in Section 4.3.2 and is summarised in Equation 14.6: r _ f -

14.6

E(Pt) (1 + ke)'

where P〇= current share price E(Dt) = expected dividend per share to be paid at tim e t ke = required rate o f re tu rn — th a t is, the cost o f ordinary shares The cu rre n t share price w ill be know n and, given an estimate o f expected fu tu re dividends, an estimate o f the cost o f o rd in a ry shares can be derived. In e stim ating a company s fu tu re dividend stream it is usual to make sim p lify in g assum ptions. For example, i f i t is assumed th a t the dividend per share w ill grow at a constant rate, g, ind efin itely, th en as shown in Section 4.3.2, Equation 14.6 becomes: P〇

DIVIDEND GROWTH MODEL

model expressing the value of a share as the sum of the present values of future dividends where the dividends are assumed to grow at a constant「 ate

A)(l +g) ke —g

where D 〇= the current period’s dividend per share The m odel expressed by Equation 14.7 is usually referred to as the d iv id e n d g ro w th m od el. To find ke} Equation 14.7 may be rew ritten as:

A )(i+ g ) P〇

+ g

TILs share price at 30 June 2015 was $4.20 and the latest annual dividend was 17.5 cents per share, fu lly franked. Since the dividend is fu lly franked, the 17.5 cent dividend carries a tax franking credit of tc _ $0,175 x ------- . W ith a sta tu tory company income tax rate o f 30 per cent, this tax fran king credit is $0,175 x

= $0,075. This tax franking credit represents personal tax th a t has been paid by T IL on

behalf o f its shareholders and m ust be added to the cash dividend to give the after-com pany-tax dividend D q. Therefore, D q is $0,175 + $0,075 = $0,250. I f the dividend grow th rate is estimated to be 8 per cent per annum, then TILs cost o f equity can be calculated as follows: ke :

柳

+g)

Pi) $0.250(1.08) $4.20

+ 0.08

0.1443 Therefore, the after-com pany-tax cost o f equity applicable to TILs ordinary shares is 14.43 per cent. I t was shown in Section 4.3.2 th a t estimates o f current share price based on the dividend growth model are extremely sensitive to estimates o f the future grow th rate in dividend per share. The same problem arises when the model is used to estimate the cost o f equity. Therefore, while the model is theoretically correct given its assumptions, the practical problems involved in its application mean that the CAPM may be preferred. The CAPM describes the equilibrium relationship between systematic risk (beta) and expected returns on risky assets, and can therefore be used to estimate the cost o f equity. The im plem entation o f the CAPM is discussed in Section 7.6.3 and requires estim ation o f the risk-free interest rate, Rf , the expected rate o f retu rn on the m arket p ortfo lio , E(RM ), and the systematic risk o f equ ity, 汊 . A fte r estimates o f the three variables have been prepared, the cost o f equity can be calculated using Equation 14.1. As noted in Section 14.3, i f the expected retu rn on the market, E(RM) y is based on rates o f return observed under the im p utatio n system, the observed rates should be adjusted by adding back a franking prem ium ,!. This adjustm ent is needed to express the return on the m arket on an after-companytax basis. Over the period since the intro du ction o f the im p utatio n tax system in Australia in 1987 u n til 2010, Brailsford, Handley and Maheswaran (2012) provide an estimate o f the franking prem ium in the order o f 1 per cent per annum. Therefore, Equation 14.1 becomes: ke = R f+ f3e \^E(Rm +

t

) -

C hapter fourteen T he

I f TILs financial manager has the follow ing estimates: Rf： = 5% or 0.05 E(Rm) = 10% or 0.10 X = 1% or 0.01

then:

< = 0 .05 + 1.2(0.10 + 0 .1-0.05 ) = 0.122 or 12.2%

1 4 .5 .4 1 The company's cost of capital A fter the explicit cost o f each source o f funds has been calculated, they should be checked fo r consistency. For example, the estimated cost o f ordinary shares should exceed the estimated cost o f preference shares, which in tu rn should exceed the estimated cost o f debt. The company s cost o f capital may then be calculated by applying the appropriate weights to the cost o f each source o f funds. The appropriate weights are the p roportion th a t each source represents o f the to ta l sources used to finance proposed projects. I f the company s capital structure is expected to change, the weights should be the proportions o f debt and equity in the target capital structure. However, unless there is reason to believe th a t im plem enting new projects w ill alter the companys optim al capital structure, its current capital structure can be used to calculate the weights. The weights should be calculated using m arket values.

Debt Recall that T IL has three classes o f debt comprising commercial bills, bonds and bank overdraft. a b

The m arket value at 30 June 2015 o f T IL s commercial b ills was calculated previously to be $19 795 558. Each TIL bond had a m arket value o f $102 474.18, so w ith 100 bonds on issue, th e ir to ta l m arket value w ill be $10 247 418. Bank overdrafts carry a variable interest rate, which is adjusted in accordance w ith fluctuations in m arket rates. Therefore, the m arket value o f a bank overdraft w ill always equal its book value, which, in this case, is $7 368 000. The data fo r TILs debt are summarised in Table 14.3. The average cost o f debt fo r T IL is approximately 7.75 per cent before tax.

TABLE 14.3 Calculation of the weighted average cost of debt for TIL Type o f d e b t

Commercial bills Bank overdraft Bonds

M a r k e t v a lu e ($ )

P ro p o rtio n

C o s t (%)

W e ig h te d co st

19 795 558

0.52914

6.24

3.30182

7368000

0.19695

9.73

1.91630

10247418

0.27391

9.24

2.53097

37410976

7.74909

Equity TIL also has two classes o f equity comprising preference shares and ordinary shares. a

b

The $2 preference shares issued by T IL have a book value o f $2 m illion , so i t is clear th a t there are 1 m illion shares outstanding. Since the share price at 30 June 2015 was $1.50, the to ta l market value is $1500 000. There were 12 500 000 ordinary shares issued by TIL and the share price was $4.20, giving a m arket value o f $52 500 000. The data fo r TILs equity are summarised in Table 14.4.

The average cost o f equity fo r T IL is approximately 12.17 per cent. These weighted average costs o f debt and equity can then be combined to form a weighted average cost o f capital fo r TIL using Equation 14.2. The to ta l value o f the company is equal to the m arket value o f debt plus the market value o f equity, which fo r TIL is $37 410 976 + $54 000 000 = $91410 976.

c o s t 〇 f capital

TABLE 14.4 Calculation of the weighted average cost of equity for TIL T ype o f e q u ity

M a r k e t v a lu e ($ )

P ro p o rtio n

C o s t (%)

1500000

0.0278

10.95

0.30441

52500000

0.9722

12.20

11.86084

Preference shares Ordinary shares

54000000

W e ig h te d cost

12.165 25

I f Equation 14.2 is used, then the effective company tax rate, te rel="nofollow">m ust also be estimated, and this means th a t the p ro po rtio n o f the tax collected from the company th a t is claimed as tax credits by shareholders, y, m ust be estimated. As explained in Section 11.4.4, the value o f y depends on the company s dividend policy and on the tax dass(es) o f its shareholders. Even i f a company adopts a policy o f paying the m axim um possible franked dividends, it w ill be d iffic u lt to determine the appropriate value o f y in cases where some o f the company s shares are held by resident taxpayers (fo r whom theoretically y equals 1) and other shares are held by tax-exempt or non-resident investors (for whom theoretically y equals 0). The value o f y should reflect the value o f tax credits to the m arginal (as d istin ct from average) shareholder. As Officer (1994, p. 4) points out, i f there is a m arket fo r tax credits, the m arket price could be used to estimate the value o f y fo r the m arginal investor. However, any m arket in tax credits is hidden, so the ‘m arket price’ o f tax credits is usually estimated through dividend drop-off ratios. As discussed in Section 11.4.4, these estimates are unfortunately subject to a large degree o f error. W hile Hathaway and Officer (2004) and Walker and Partington (1999) both provide positive estimates fo r y, Cannavan, Finn and Gray (2004) and Feuerherdt, Gray and Hall (2010) find th a t y may be zero. Beggs and Skeels (2006) report evidence consistent w ith a zero value fo r y p rio r to the year 2000, when changes in the tax system allowed fo r the refund o f unused franking credits— and a positive value fo r y subsequent to this legislative change. For TIL we w ill assume th a t y equals 0.60, which means th a t w ith a sta tu tory company income tax rate o f 30 cents in the dollar, the effective company tax rate, is 0.12. Using Equation 14.2, the weighted average cost o f capital fo r T IL is: kf = ke -

V]

= 0.1217

+ k(i{ \ - te) $54 000 000 .$91 410976

D V. + 0.0775(1 -0.1 2)

$37410976 .$91410976

= 0.099 805 or approximately 10 per cent after effective company tax.

14.5.51 Issue costs and the cost of capital LEARNING OBJECTIVE 6 Explain how to treat issue costs in project evaluation ISSUE COSTS

costs of raising new capital by issuing securities, including underwriting fees and legal, accounting and printing expenses incurred in preparing a prospectus or other offer documents. Also known as flotation costs

So far we have discussed the cost o f capital w ith o u t recognising th a t i f a company undertakes a new project, i t may incur issue costs involved in raising new capital. These costs include underwriters* fees as well as legal and adm inistration costs. When evaluating a project, such costs should not be included in the cost o f capital. As we emphasised in Section 14.2, the cost o f capital is an o p p o rtu n ity cost th a t depends on the risk o f the project in which the capital is invested. I t does n o t depend on the source o f the funds. However, issue costs w ill be incurred i f a project is undertaken and cannot be ignored. They m ust therefore be included in the cash flows associated w ith the project. The incorporation o f issue costs into project evaluation is illustrated in Example 14.2. Note th a t the weighted average issue cost is used in Example 14.2 rather than the issue cost fo r debt or the issue cost fo r equity. It is incorrect to assume th a t one project w ill be financed by debt and hence w ill incur the issue costs fo r debt, while another project w ill be financed by equity and hence w ill incur the issue costs fo r equity. I f a company is to m aintain its optim al or target capital structure, both debt and equity m ust be raised over tim e. It follows th a t all o f a company s projects are effectively financed by a po 〇r o f funds consisting o f both debt and equity, and all projects m ust be assumed to incur the weighted average issue costs.

C hapter fourteen T he

E xample

c o s t o f capital

14.2

TIL is evaluating a project that w ill require an initial investment of $ 10 million and w ill generate an annual after-tax cash flow o f $2 million in perpetuity. The net present value of this project, ignoring issue costs, is:

6

NPV = -$ 1 0 000 000 + $2 000 Q〇Q 0.10

=$10000000 W hat is the net present value of the project, after allowing for issue costs, if issue costs for equity, fe, are 8 per cent and issue costs for debt, fd, are 2 per cent?

SOLUTION Using the market value weights of TIL's outstanding securities, the weighted average issue cost, f。， will be: fa =

rd

\v .

= 0.08 ( $54 000 0 0 0 N 0.02

$37410976、

•

,$91 4 10 97 6,

,$91 4 10 9 7 6 ,

=0.055 44 Therefore,

in order to

raise a

net $ 10

million,

TIL w ill

need

to

issue securities worth

$ 10J)00^)00^ = $ i 0 5 8 6 9 4 0 . The net present value of the project, including issue costs, is:

NPV = -$ 1 0 5 8 6 9 4 0 +

$2 000000 0.10

= $ 94 13 060 In this case the project should still be undertaken even after issue costs have been included in the cash flows.

14.6 Project and company cost of capital A company s cost o f capital, as calculated in the previous section, should be used as an estimate o f the cost o f capital fo r a new project only when certain conditions are met. These conditions follow from the fact th a t all the variables in the WACC form ula apply to the company as a whole. Therefore, a company s WACC w ill reflect the risk o f its existing projects. It follows th a t a company s WACC should only be applied to projects that are identical, apart from th e ir size, to the company s existing projects. The consequences o f using single discount rate to evaluate all projects are illustrated in Figure 14.1. The broken line represents the cost o f capital kf fo r the company and the solid line represents the security market line, which is simply the graphical representation o f the trade-off between risk and expected return im plied by the CAPM. Assume th a t Eastfarmers Ltd is a diversified company th a t has m ultiple divisions operating in different industrial sectors. Each year the heads o f each o f the divisions meet w ith the senior management team o f the company to apply fo r funding fo r new projects. The head o f the retail division puts forw ard a proposal to open up a new retail outlet in a grow th suburb while the head o f the exploration division asks fo r funding to open up a new coal mine in Western Australia. The risk-re tu rn coordinates fo r the two projects are denoted by the titles o f the divisions th a t suggested the project. I f the company applies the single discount rate V to all projects, then the project suggested by the retail division w ill be rejected. Its expected rate o f retu rn is less than k \ even though it is greater than the required rate o f return consistent w ith its systematic risk_ th a t is ，爲 etail. Conversely, the project suggested by the exploration division w ill be accepted. Its expected rate o f retu rn exceeds k \ even though it is less than the required rate o f retu rn consistent w ith its systematic risk— th a t is , 爲 xploration.

LEARNING OBJECTIVE 7 Understand the distinction between the cost of capital for a project and a company’s weighted average cost of capital

B usiness finance

Applying a single discount rate,

k\

to all projects

Exploration 5jdD3j o so u

A e r

Systematic risk [fi]

^ E x p lo

Therefore, a likely consequence fo r a diversified company th a t uses a single discount rate is th a t it w ill make incorrect investm ent decisions. It w ill accept some projects th a t have a negative expected net present value, and reject some projects th a t have a positive expected net present value. Moreover, highsystematic-risk divisions w ill fin d it comparatively easy to have th e ir proposed projects accepted, while low-system atic-risk divisions w ill fin d it d iffic u lt to have th e ir proposed projects accepted. As a result, the systematic risk o f the company w ill d rift upward over time. The low-system atic-risk divisions are likely to stagnate snd m 冱y even be dosed down. The company s cost o f capital is also based on its existing capital structure. I f the debt capacity o f a new project differs from th a t o f the existing projects, then this difference could affect the projects cost o f capital. Therefore, another condition is th a t WACC should be used only i f the new project is n o t expected to change the company s optim al or target capital structure. In principle, each proposed project should be valued using a discount rate appropriate fo r the risk o f th a t particular project. Where a company s operations are in more than one in d u stry and these industries differ in risk, the company s cost o f capital is unlikely to be appropriate fo r evaluating a new project in any o f the individual industries, o r in another ind ustry that the company may plan to enter. However, the company s cost o f capital should be appropriate fo r evaluating an expansion by a company th a t operates in only one industry. Where a company has divisions in different industries b u t the assets w ith in each division are reasonably u nifo rm in terms o f risk, i t is reasonable fo r management to calculate a cost o f capital fo r each o f the company s divisions. There are tw o approaches th a t are used to calculate the cost o f equity fo r divisions o f a company. These approaches are the pure play* approach and the direct estim ation approach.

LEARNING OBJECTIVE 8 Estimate the cost of capital for a division of a diversified company PURE PLAY

company that operates almost entirely in only one industry or line of business

14.6.1 I Calculating the cost of capital for divisions using the 'pure play, approach The approach th a t is m ost commonly recommended fo r calculating the cost o f capital fo r a project or division relies on id e n tifyin g other companies th a t operate only in the same ind ustry as the proposed project or division (Fuller & Kerr 1981). Such companies are known as p u re plays. The steps fo r estim ating the cost o f capital fo r a project or division using data fo r a pure-play company are as follows: a

b

Id e n tify a pure-play company w ith operations sim ilar to the proposed project, Estimate the beta o f the pure-play company s equity.

C hapter fourteen T he

Adjust the equity beta fo r financial leverage to obtain an estimate o f the pure-play company s asset beta, which is the beta th a t the pure-play company would have i f i t were all-equity financed— th a t is, the beta o f equity has been ‘unlevered’. d ‘Relever’ the asset beta, based on the financial leverage o f the company th a t is considering the project, to obtain an estimate o f the beta o f equity fo r the project, e Use the CAPM to estimate the cost o f equity fo r the project. Calculate the WACC o f the project using the target debt-equity ratio o f the company th a t is considering the project. As discussed in Section 14.4.1, in the absence o f taxes, the beta o f a company s assets is simply a veighted average o f the betas o f its equity and its debt— th a t is: E Pa = Pe

D

ID + E]

+ Pci

VD + E.

where fia - the beta o f the company s assets Pe = the beta o f the company s equity Pd = the beta o f the company s debt D = the m arket value o f debt E = the m arket value o f equity I f the company’s debt is assumed to be risk-free— th a t is, J3d = 0— then Equation 14.8 can be sim plified and rearranged to give:7 D' Pe = Pa

E_

This equation can be rearranged to give: Pa

14.10

0e

i +l This use o f the pure-play procedure is illustrated in Example 14.3. The pure-play approach is used by some companies b ut i t involves conceptual and practical problems. The conceptual problems concern the issue o f how best to adjust betas fo r financial leverage. The adjustments used in Example 14.3 are only approximate because they are based on the sim plifying

E xample

14.3

P e rc o Parts Ltd h a s tw o d iv is io n s : o n e m a n u fa c tu re s c a r p a rts a n d th e o th e r d is trib u te s a g r ic u ltu r a l m a c h in e ry . T he a g r ic u ltu r a l m a c h in e r y d iv is io n is c o n s id e r in g a n e x p a n s io n p ro je c t. P e rc o h a s a ta r g e t d e b t - e q u it y r a t io o f 1 :3 th a t w ill n o t b e c h a n g e d b y th e n e w p ro je c t. P e rc o 's f in a n c ia l m a n a g e r ha s id e n tifie d S ty le F a rm E q u ip m e n t Ltd a s a c o m p a n y w ith th e s a m e b u s in e s s ris k a s th e n e w p ro je c t. S tyle F arm E q u ip m e n t h a s a d e b t - e q u it y r a tio o f 1 : 1 ; a n d its e q u ity h a s a b e ta o f 1 . 2 5 . T he ris k -fre e in te re s t ra te is 9 p e r c e n t p e r a n n u m a n d th e ris k p re m iu m fo r th e m a rk e t p o r tf o lio is e s tim a te d to b e 8 p e r c e n t p e r a n n u m . It is a ls o a s s u m e d th a t P e rc o c a n b o r r o w a t th e ris k -fre e in te re s t ra te o f 9 p e r c e n t, th a t th e s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 p e r c e n t a n d th a t th e p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 , g iv in g a n e ffe c tiv e c o m p a n y ta x ra te o f 1 2 p e r c e n t. T he p ro c e d u re o u tlin e d a b o v e

re q u ire s a r e la tio n s h ip b e tw e e n e q u ity b e ta s a n d

a s s e t b e ta s .

E q u a tio n s 1 4 . 9 a n d 1 4 .1 0 m a y b e u se d to e s tim a te a n a s s e t b e ta a n d th e c o s t o f c a p it a l f o r P e rc o ’s a g r ic u ltu r a l e q u ip m e n t p r o je c t. T h e firs t s te p is to use E q u a tio n 1 4 . 1 0 to c a lc u la te th e b e ta o f S tyle F arm E q u ip m e n t’s assets:

=0.625 continued 7

The conditions under which various relationships between the betas of a company's equity and its assets apply are discussed by Taggart (1991).

6

c o s t o f capital

continued N e x t, E q u a tio n 1 4 . 9 is u se d to c a lc u la te th e b e ta o f e q u ity fo r th e p ro je c t:

p e = 0.625 h + 1

L = 0.8333

3J

T h a t is, th e b e ta f o r th e e q u ity p r o p o r tio n o f P e rc o 's p r o p o s e d

in v e s tm e n t is e s tim a te d to b e

a p p r o x im a t e ly 0 . 8 3 3 . T he c o s t o f e q u ity fo r th e p r o je c t c a n n o w b e e s tim a te d u s in g th e C A P M . The c o s t o f e q u ity is c a lc u la te d a s fo llo w s :

ke = R f+ P e [E[Rm +

t)

-

/?^]

= 0.09 + 0.833(0.08) = 0.15667 T h e p r o je c t's W A C C c a n n o w b e c a lc u la te d a s:

k’ = ke

E

LVJ

M 1- ^ )

0.15667

-0.09(1 -0.12)

0.137303 T h e re fo re , b a s e d o n th e p u r e - p la y a p p r o a c h , th e a p p r o p r ia te d is c o u n t ra te fo r P e rc o P a rts' fin a n c ia l m a n a g e r to use w h e n e v a lu a tin g th e p r o p o s e d p r o je c t is 1 3 . 7 3 p e r c e n t.

assumption th a t corporate debt is risk-free. Other, more complex, models have been suggested, but such models are generally based on a specific theory o f capital structure. Also, the appropriate leverage adjustm ent depends on the company s capital structure policy.8 The m ain practical problem is th a t pureplay companies are rare. Even i f some pure-play companies are available, relying only on data from such companies means th a t a great deal o f inform a tion from diversified companies is ignored.

1 4 .6 .2 1 Calculating the cost of capital for divisions using the direct estimation approach An alternative approach th a t overcomes the problems associated w ith the pure-play approach is the direct estim ation approach outlined by Harris, O’Brien and Wakeman (1989). This approach involves estimating, directly, divisional weighted average costs o f capital. I t is assumed th a t a diversified company s WACC is itse lf a weighted average o f the WACCs o f its divisions, where the weights are the values o f the divisions as proportions o f the to ta l value o f the company— th a t is: k' =

w i k 'j

14.11

7=1

where V = the company cost o f capital k '. = the cost o f capital fo r th e jth division w- = the ratio o f the value o f the ;th division to the to ta l value o f the company Equation 14.11 can be used to estimate divisional costs o f capital. The procedure is illustrated in Example 14.4. Example 14.4 shows th a t it is possible to in fe r divisional costs o f capital from inform a tion on diversified companies, provided th a t the follow ing in fo rm a tio n is available: a

b 8

the WACC o f each company the ratio o f the value o f each division to to ta l company value fo r each company.*1 9

For example, the relationship between asset betas and equity betas depends on whether the debt associated with the project is assumed to be constant, or whether the debt is adjusted to maintain a constant debt-value ratio over time. See Taggart (1991) and Conine and Tamarkin (1985). The taxation of capital gains is discussed in Section 11.4.2.

C hapter fourteen T he

E xample

c o s t o f capital

14.4

T h re e c o m p a n ie s — A , B a n d C — o p e r a te in t w o in d u s trie s , 1 a n d 2 . C o m p a n y A h a s 4 0 p e r c e n t o f its assets in v e s te d in In d u s try 1 a n d 6 0 p e r c e n t in In d u s try 2 . F o r c o m p a n ie s B a n d C , th e p r o p o r tio n s a re 3 0 : 7 0 a n d 8 0 : 2 0 , re s p e c tiv e ly . T he co sts o f c a p it a l f o r c o m p a n ie s A , B a n d C h a v e b e e n e s tim a te d to b e 1 5 .3 p e r c e n t, 1 5 . 8 5 p e r c e n t a n d 1 3 .1 p e r c e n t, re s p e c tiv e ly . U se th is in fo r m a tio n to e s tim a te th e c o s t o f c a p it a l fo r d iv is io n s th a t o p e r a te in in d u s trie s 1 a n d 2 .

SOLUTION It is a s s u m e d th a t th e risks, a n d th e re fo re th e c o sts o f c a p it a l, in a g iv e n in d u s try a r e th e sa m e fo r e a c h c o m p a n y . E q u a tio n 1 4 .1 1 h o ld s fo r e a c h c o m p a n y , so it c a n b e w r itte n a s fo llo w s : C om pany A:

0 . 1 5 3 = 0 .4 k "] + 0 . 6 / ^ 2

C o m p a n y B:

0 . 1 5 8 5 = 0 . 3 ^ ! + 0 .7 k /2

C om pany C:

0 • 13 1 = 0 .8 /c ^ + 0 . 2 / ^

A n y tw o o f th e s e e q u a tio n s c a n b e s o lv e d s im u lta n e o u s ly to g iv e ^

= 12% a n d 6

= 1 7 .5 % .

In practice, these variables w ill have to be estimated, which means th a t the estimates w ill involve some degree o f error. Consequently, it w ill n ot be possible to fin d an exact analytical solution fo r the divisional costs o f capital. This problem can be overcome by using regression to estimate these costs. For this purpose Equation 14.11 is w ritte n as:

V = a 1w 1 + a2w2 +

... +

anwn + e

where e = an error term w ith a mean o f zero In this regression, each company s cost o f capital is one observation o f the dependent variable and each company s division weights are the corresponding measures o f the independent variables to wn. The regression coefficients al to an are estimates o f the costs o f capital fo r industries 1 to n. The estimate for a given industry can be used as a measure o f the divisional cost o f capital fo r all companies th a t operate in that industry, w ith o u t any adjustm ent fo r financial leverage. This does n ot mean th a t differences in leverage are ignored. Rather, i f different industries have different debt capacities and these differences affect the cost o f capital, then such effects should automatically be reflected in the cost o f capital estimates. This is one significant advantage compared w ith the pure-play approach. Another advantage is flexibility. For example, to estimate the company WACCs there is no need to employ any particular model such as the CAPM. O ther models such as the dividend grow th model can be used to estimate the cost o f equity as a component o f the WACC. On the other hand, the divisional weights w- m ust be estimated fo r each company. In theory, these weights should be based on m arket values, which are typically unknown. Therefore, in practice, the weights may be based on book values or, perhaps, divisional sales.

INSIGHTS INTO W ACC ESTIMATION FROM THE ENERGY INDUSTRY____________________________________________ In s ig h ts in to th e p r a c t ic a l is s u e s a s s o c ia te d w it h e s t im a tin g a c o m p a n y 's w e ig h t e d a v e r a g e c o s t o f c a p it a l ( W A C C ) a r e p r o v id e d b y c o n s id e r in g w h a t h a p p e n s in th e h ig h ly r e g u la t e d e n e r g y in d u s tr y . R e g u la rly , th e p e a k r e g u la t o r y b o d y f o r th is s e c to r, th e A u s t r a lia n E n e r g y R e g u la to r (A E R ), m a k e s a d e t e r m in a t io n o f th e r a te o f r e tu r n t h a t e le c t r ic it y d is tr ib u to r s c a n g e n e r a t e fr o m t h e ir a s s e ts , w h ic h in tu rn u ltim a t e ly d e te r m in e s th e p r ic e t h a t th e s e c o m p a n ie s c a n c h a r g e f o r t h e ir s e r v ic e s . In th e p a s t, th is w a s a m u lti- s ta g e p r o c e s s t h a t in v o lv e d n u m e ro u s s u b m is s io n s fr o m p o w e r d is tr ib u to r s — in e v it a b ly a r g u in g f o r h ig h e r re tu r n s b a s e d u p o n c u r r e n t m a r k e t c o n d it io n s — a n d o t h e r in te r e s te d p a r tie s s u c h a s c o n s u m e r a d v o c a c y b o d ie s a r g u in g th e o p p o s it e c a s e . A g r e a t d e a l o f tim e a n d re s o u rc e s w e r e s p e n t b y th e d if f e r e n t p a r tie s a r g u in g o v e r fa c t o r s s u c h a s th e a p p r o p r ia t e m a r k e t ris k p r e m iu m o r th e v a lu e o f im p u t a t io n c r e d its d e r iv e d b y th e s h a r e h o ld e r s o f th e p o w e r d is t r ib u t io n c o m p a n ie s (a s m e a s u r e d b y y a n d d is c u s s e d in S e c tio n 1 4 . 3 ) . T h e s e d e c is io n s a r e e x t r e m e ly im p o r t a n t , a s a d if f e r e n c e in re tu rn s

continued

F in a n c e in

A C T IO N

B usiness finance

continued o f a s little a s o n e b a s is p o in t r e p r e s e n ts s ig n if ic a n t a m o u n ts o f m o n e y w h e n a p p l ie d to b illio n s o f d o lla r s o f a s s e ts . In D e c e m b e r 2 0 1 3 , in a n e f f o r t t o s t r e a m lin e th e p r o c e s s w h ile p r o v id in g e n h a n c e d 'r e g u la t o r y s t a b ilit y ' a n d ’ in c r e a s e d c e r t a in t y t h r o u g h g r e a t e r t r a n s p a r e n c y ’ ，th e A E R is s u e d its R a te o f R e tu rn G u id e lin e t h a t sets o u t th e p r o c e s s t h a t it w i ll a p p l y in d e t e r m in in g th e r a te o f r e tu r n t h a t e le c t r ic it y a n d g a s p r o v id e r s m a y e a r n fr o m t h e ir a s s e ts . F ig u r e 1 4 . 2 sets o u t th e w a y in w h ic h th e W A C C f o r th e s e fir m s w i l l n o w b e c a lc u la t e d b y th e A E R .

Source: Australian Energy Regulator, Better Regulation: Rate of Return Guideline, 2013. Available at www.aer.gov.au.

14.7 The weighted average cost of capital LEARNING OBJECTIVE 9 Understand the advantages and disadvantages of using the weighted average cost of capital in project evaluation

and alternative project evaluation techniques I t has been emphasised th a t the weighted average cost o f capital (WACC) has im p o rta n t lim ita tion s. In particular, it can only be estimated directly fo r a whole company, and a company s cost o f capital should only be used to evaluate new projects th a t are identical to the company s existing operations. A nother problem is th a t the WACC lends its e lf to m isinterpretation because i t makes debt appear to be cheaper than equity. For example, in the T IL case discussed in Section 14.5, the cost o f equity was more than 11 per cent, b u t the cost o f debt was less than 8 per cent. An observer could easily jum p to the conclusion th a t a company s cost o f capital could be reduced by increasing the p ro po rtio n o f debt in its capital structure. That conclusion is likely to be incorrect because it ignores some im p o rta n t effects o f financial leverage. First, i f leverage is increased, the risk o f the borrower defaulting w ill increase, and lenders w ill demand higher interest rates. Second, as discussed in Section 12.3.2, the risk faced by shareholders w ill also increase and the cost o f equity w ill increase. As a result o f these changes, the WACC could increase rather than decrease. The WACC is designed as a tool to be used in evaluating investm ent decisions. I t can give misleading results i f attem pts are made to use it to analyse financing decisions. The adjusted present value (APV) m ethod is an alternative technique th a t calculates separately the value created by a project and the value created by the financing decision. This technique involves forecasting a projects after-tax cash flows assuming th a t the project is financed entirely by equity. The net present value o f these cash flows is found by using the rate o f retu rn th a t w ould be required by investors i f the project were financed entirely by equity. Any value created by taxation effects associated w ith debt

C hapter fourteen T he

c o s t o f capital

financing may then be added to obtain the to ta l value created by undertaking the project. Similarly, the value o f any government subsidies th a t may be offered to the company to undertake the project may be added to the total value.9 Another lim ita tio n o f the WACC approach to project evaluation is th a t it only includes cash flows directly associated w ith the project. I t does n ot include strategic options th a t may be associated w ith the project. These options include the possibility o f reducing or expanding the scale o f the project, or abandoning the project entirely. A nother option m ight be to w ait before investing. Section 18.8.6 discusses how option pricing models may be used to incorporate these options into project evaluation. Despite its lim itations, the WACC also has considerable strengths, including fle x ib ility and relative simplicity. It is flexible in th a t there are different versions o f the WACC, each o f which is correct provided that it is used in conjunction w ith the appropriate defin itio n o f net cash flows. It is also conceptually easier to understand than alternative project evaluation techniques and is the m ost widely used.

14.8 Using certainty equivalents to allow for risk In most cases, risky projects are evaluated by using a cost o f capital th a t reflects the risk o f the project— that is, the projects expected cash flows are discounted using a risk-adjusted discount rate. Using this approach, the net present value, NPV, is calculated as follows: NPV--

A - C 〇

E(Ct)

14.12

+ Z ^ 77—Tv t= \

I1+

where E(Ct) = the expected net cash flow in year t k = the cost o f capital, appropriate to the risky expected cash flows £(Ct) C〇= the in itia l cash outlay 77 = the life o f the project, in years The c e rta in ty -e q u iv a le n t approach is an alternative m ethod o f incorporating risk into project evaluation. This approach incorporates risk into the analysis by adjusting the cash flows rather than the discount rate— th a t is, each years expected net cash flow is converted to a certainty equivalent. The certainty-equivalent net cash flow in year t, C*t i is the smallest certain cash flow th a t the decision maker would be prepared to accept in exchange fo r the expected risky cash flow, E(Ct ). For example, assume that a projects risky net cash flow is $10 000 at the end o f the firs t year. I f the decision maker is prepared to exchange the claim to th is risky cash flow fo r a claim to receive, w ith certainty, $8000 at the end o f the firs t year, then $8000 is the certainty equivalent o f the risky $10000. In this example, = $10 000 and CTt = $8000 = $8000. Therefore, the expected net cash flow fo r any year can be converted to its certainty equivalent as follows:

14.13

Ct = a tE(Ct)

where a t = the certainty-equivalent factor in year t The certainty-equivalent factor in this example can be calculated as follows: C^t

C； _ E(Ct)

$8000 $10 000

0.8

Using the certainty-equivalent approach, the net present value is calculated by discounting the certainty-equivalent net cash flow fo r each period at the appropriate risk-free interest rate: NPv=c〇 + y

9

t

14.14

The adjusted present value method was developed by Myers (1974). A detailed treatment is provided in Berk and DeMarzo (2007, pp. 581-5). Details of how to adapt the technique for the dividend imputation system are provided in Monkhouse (1997).

LEARNING OBJECTIVE 10 Understand the application of the certaintyequivalent method of incorporating risk into project evaluation

CERTAINTY-EQUIVALENT

approach that incorporates risk by adjusting the cash flows rather than the discount rate

I f all variables are properly specified, the present value o f any future cash flow m ust be identical in both the risk-adjusted discount-rate m ethod and the certainty-equivalent method. Therefore:

E(Q) (1

= atE(Ct)

+ k)r _

(l+R f)'

/. Qt = -------- — Jr

(1

+

14.15

冰

In Examples 14.5 and 14.6 we illustrate both methods. We then discuss th e ir relative m erits.

Example

14.5

C a s s ilis Ltd is c o n s id e r in g a n in v e s tm e n t in a n e w m a c h in e . T he m a c h in e w ill re q u ire a n in it ia l o u tla y o f $ 1 0 0 0 0 0 a n d is e x p e c te d to g e n e r a te c a s h flo w s o f $ 5 0 0 0 0 , $ 4 0 0 0 0 a n d $ 5 0 0 0 0 a t th e e n d o f Y e a rs 1, 2 a n d 3 , re s p e c tiv e ly . T he ris k -a d ju s te d d is c o u n t ra te is 1 2 p e r c e n t p e r a n n u m a n d th e ris k -fre e in te re s t ra te is 8 p e r c e n t p e r a n n u m . The

net

p re s e n t

v a lu e

u s in g

th e

ris k - a d ju s te d

d is c o u n t

r a te

m e th o d

is

c a lc u la t e d

u s in g

E q u a tio n 1 4 .1 2 :

N P V = $100000+ $50 000 + $4000° + $5000°

1.12

(

1. 12)2

(

1. 12)3

= -$100 000+ $44 643+ $31 888 + $35 589 =$12 120 F rom E q u a tio n 1 4 . 1 5 , th e c e r ta in ty - e q u iv a le n t f a c to r fo r e a c h y e a r is c a lc u la te d a s fo llo w s :

1.08 al a2

U2 (1 0 8 )

= 0.964 28 2

可 =0.929 85

( 1.121

(1.08)3 a3 (

= 0 .8 96 64

1. 12)3

U s in g th e se c e r ta in ty - e q u iv a le n t fa c to rs , th e n e t p re s e n t v a lu e c a n b e c a lc u la te d u s in g E q u a tio n 1 4 .1 4 :

N p y _ $1〇〇〇〇〇 ( 0.964 28($50 000) + 0.929 85($40000) + 0.896 64($50000) 1.08

(1.08)2

(1.08)3

= -$100 000 + $44 643 + $31888 + $35 589 =

$12 120

T he n e t p re s e n t v a lu e s a re th e s a m e a n d , o n th e fa c e o f it, th e re see m s to b e n o re a s o n fo r p r e fe r r in g o n e m e th o d to th e o th e r.

However, remember th a t in discounting a future cash flow to a present value there are tw o factors to be taken in to account: tim e and risk. These factors are logically separate but the risk-adjusted discount rate approach requires the effect o f both to be incorporated in to the discount rate. In particular, use o f a constant risk-adjusted discount rate implies th a t the risk associated w ith the project increases over tim e at a constant rate. This was illustrated in Example 14.5, which showed th a t a constant risk-adjusted discount rate results in the certainty-equivalent factors decreasing at a constant rate in each successive year. In Example 14.5, the rate o f decrease is approximately 3.6 per cent per year. The fact that the certainty-equivalent factors decrease at a constant rate over tim e is shown by Equation 14.15, which can be rew ritten as: Off =

l+ R f . l + k

= (^\Y

C hapter fourteen T he

The decrease o f certainty-equivalent factors at a constant rate indicates th a t the cumulative risk associated w ith each successive cash flow increases steadily as we look fu rth e r in to the future. In cases where this risk pattern does n o t apply, a constant risk-adjusted discount rate should n o t be used, and the certainty-equivalent approach offers practical advantages. This is illustrated in Example 14.6.

E xample

14.6

J a m e s o n Ltd h a s re c e n tly in v e n te d a n e w m e th o d o f s e p a r a tin g p re c io u s m e ta ls . F u rth e r d e v e lo p m e n t w o r k is r e q u ire d o v e r th e n e x t 2 y e a rs a n d m a n a g e m e n t b e lie v e s th e re is a 6 0 p e r c e n t p r o b a b ilit y o f th e n p r o c e e d in g to c o m m e r c ia l p r o d u c tio n u s in g p la n t c o s tin g $ 2 m illio n . E x p e c te d c a s h in flo w s a re $ 5 0 0 0 0 0 p e r y e a r fo r 2 0 y e a rs . T h e re is a 4 0 p e r c e n t p r o b a b ilit y th a t th e d e v e lo p m e n t w o r k w ill fa il, in w h ic h c a s e th e re w ill b e n o c a s h flo w s a fte r th e firs t 2 y e a rs . T he d e v e lo p m e n t w o r k w ill b e u n d e rta k e n b y a lo c a l u n iv e rs ity re s e a rc h c o m p a n y in re tu rn f o r a n im m e d ia te p a y m e n t o f $ 2 5 0 0 0 0 . S u p p o s e th a t, b e c a u s e o f th e h ig h ris k , m a n a g e m e n t e v a lu a te s th e p r o je c t u s in g a d is c o u n t ra te o f 3 0 p e r c e n t p e r a n n u m , c o m p a r e d w ith its n o rm a l ra te o f 1 5 p e r c e n t p e r a n n u m . T he e x p e c te d c a s h flo w s a re : Year 0 :

PV o f o u tla y s o n d e v e lo p m e n t w o r k = - $ 2 5 0 0 0 0

Year 2 :

C o n s tru c tio n o f p la n t: ( 0 .6 ) x ( - $ 2 0 0 0 0 0 0 ) + 0 . 4 x $ 0 = - $ 1 2 0 0 0 0 0

Y ea rs 3 - 2 2 :

C a s h in flo w s : 0 . 6 x $ 5 0 0 0 0 0 + 0 . 4 x $ 0 = $ 3 0 0 0 0 0

NPV= - $250 0 0 0 - ~ 0

+ $300000

(1.3)20 0.3

(1.3)2

= -$371 457 B a s e d o n th is re s u lt th e p r o je c t w o u ld b e r e je c te d n o w w ith o u t u n d e r ta k in g th e d e v e lo p m e n t w o r k . H o w e v e r, m u c h o f th e ris k a s s o c ia te d w ith th e p r o je c t w ill b e re s o lv e d a fte r th e firs t 2 y e a rs . If th e d e v e lo p m e n t w o r k is su c c e s s fu l, th e p r o je c t m a y b e o f n o rm a l ris k , in w h ic h c a s e th e fu tu re c a s h flo w s w o u ld b e d is c o u n te d a t J a m e s o n 's n o r m a l ra te o f 1 5 p e r c e n t p e r a n n u m . A s s u m in g t h a t th e ris k -fre e in te re s t ra te is 8 p e r c e n t p e r a n n u m , th e p r o je c t's N P V c a n b e r e c a lc u la te d u s in g a c o m b in a tio n o f th e tw o a p p r o a c h e s . If th e p r o je c t g o e s a h e a d a fte r th e 2 y e a r s 7 d e v e lo p m e n t w o r k , th e N P V a t th e e n d o f Y e a r 2 w ill b e :

NPV[2) = -$2 000 000 + $500 000

(1.15)20 0.15

=$1 129666 But th e re is o n ly a 6 0 p e r c e n t p r o b a b ilit y o f th is o u tc o m e . A s s u m in g a c e r ta in ty - e q u iv a le n t fa c to r o f 0 . 6 , th e p r o je c t N P V is:

NPV= $250000+ 0 6 x $1 129666 (1.08)2 =$331104 T h e re fo re , th e p r o je c t s h o u ld p r o c e e d , w h ic h is th e o p p o s ite o f th e d e c is io n o r ig in a lly in d ic a te d b y th e c o n s ta n t ris k -a d ju s te d d is c o u n t ra te .

To summarise, discounting risky future cash flows to present values requires adjustments fo r the effects o f two factors: tim e and risk. In the risk-adjusted discount-rate approach the effects o f both factors are included in the discount rate. The tw o factors are logically separate and are treated separately in the certainty-equivalent approach, which is easier to use in cases where the risk per u n it o f tim e is not constant.

6

c o s t o f capital

B usiness finance

SUMMARY •

T his c h a p te r fo c u s e d o n th e e s tim a tio n a n d use o f th e c o s t o f c a p it a l, w h ic h e v a lu a tio n .

In v e s tin g

in

•

is im p o r ta n t in p r o je c t a

p r o je c t

w ill

c o m p a n y a s a w h o le , so it fo llo w s th a t a c o m p a n y ’s

in c re a s e

W A C C s h o u ld b e u se d as a n e s tim a te o f th e c o s t o f

c o m p a n y v a lu e o n ly if th e p r o je c t p ro m is e s a t le a s t

c a p it a l o n ly f o r p ro je c ts th a t a r e id e n tic a l, e x c e p t

th e ra te o f re tu rn th a t in v e s to rs c a n e a rn o n o th e r

fo r s c a le , to th e e x is tin g c o m p a n y . In p a r tic u la r , th is

in v e s tm e n ts o f th e s a m e ris k a s th e p ro je c t. T h e re fo re ,

m e a n s th a t:

th e r e q u ire d r a te o f re tu rn , o r c o s t o f c a p it a l, fo r a

•

th e p r o p o s e d p r o je c t ’s ris k s h o u ld b e th e s a m e

p r o je c t is a n o p p o r tu n it y c o s t th a t d e p e n d s o n th e

a s th e a v e r a g e

ris k o f th e p r o je c t in w h ic h th e c a p it a l is in v e s te d .

p ro je c ts •

T h e C A P M c a n b e u s e d a s a fr a m e w o r k f o r m a k in g ris k

a d ju s tm e n ts ,

and,

a c c o r d in g

to

th is

m o d e l,

th e re le v a n t m e a s u re o f ris k fo r a n y p r o je c t is its •

A ll th e v a r ia b le s in th e W A C C fo r m u la a p p ly to a

ris k o f th e c o m p a n y ’s e x is tin g

a c c e p ta n c e o f th e p r o je c t w ill n o t c h a n g e th e c o m p a n y 's o p tim a l c a p it a l s tru c tu re .

•

F o r a d iv e r s ifie d c o m p a n y , use o f a s in g le d is c o u n t

s y s te m a tic ris k (b e ta ).

ra te f o r a ll p ro je c ts

T he c o s t o f c a p it a l c o u ld , in p r in c ip le , b e e s tim a te d

in v e s tm e n t

b y d ir e c t use o f th e C A P M , b u t th is in v o lv e s p r a c tic a l

d iv is io n o r a n in d iv id u a l p r o je c t c a n b e e s tim a te d

d e c is io n s .

is lik e ly to re s u lt in in c o r r e c t The

cost

of

c a p it a l ( 'p u r e

fo r

a

d iffic u ltie s r e la te d m a in ly to e s tim a tio n o f th e b e ta s

if th e re a r e o th e r lis te d c o m p a n ie s

o f p ro je c ts . A lte r n a tiv e ly , th e c o s t o f c a p it a l f o r a

w h o s e s o le o p e r a tio n s a r e o f th e s a m e s y s te m a tic

p la y s ’ }

c o m p a n y c a n b e e x p re s s e d a s a w e ig h te d a v e r a g e

ris k a s th e d iv is io n o r p ro je c t. If su ch a s u b s titu te

o f th e costs o f th e v a r io u s s o u rc e s o f c a p it a l u se d b y

c o m p a n y c a n b e fo u n d , its W A C C c a n b e e s tim a te d

th e c o m p a n y . T h e w e ig h te d a v e r a g e c o s t o f c a p it a l

a n d u s e d , p o s s ib ly w ith a n a d ju s tm e n t fo r fin a n c ia l

(W A C C ) a p p ro a c h

le v e ra g e , a s th e c o s t o f c a p it a l f o r th e d iv is io n o r

is g e n e r a lly u se d

in p ra c tic e .

E s tim a tio n o f th e a fte r-ta x W A C C in v o lv e s e s tim a tio n o f e a c h te rm in th e e q u a tio n :

p ro je c t. •

A lte r n a tiv e ly ,

d iv is io n a l

c o sts

of

c a p it a l

can

be

e s tim a te d u s in g in fo r m a tio n o n d iv e r s ifie d c o m p a n ie s

= ke

-h

k^(l - te)

^

b y v ie w in g th e W A C C o f e a c h d iv e r s ifie d c o m p a n y a s a w e ig h t e d a v e r a g e o f th e W A C C s o f its d iv is io n s .

T h e se e s tim a te s s h o u ld b e b a s e d o n c u rre n t m a rk e t ra te s a n d

T h is a p p r o a c h h a s s ig n ific a n t a d v a n ta g e s o v e r th e

m a r k e t v a lu e s , n o t h is to ric a l ra te s a n d

b o o k v a lu e s .

use o f p u r e - p la y c o m p a n ie s . •

W e c o n c lu d e th a t w h ile th e W A C C

h a s im p o r ta n t

The im p u ta tio n ta x system h a s im p lic a tio n s fo r th e

a d v a n ta g e s ,

w a y th a t c a sh flo w s a n d th e c o s t o f c a p ita l sh o u ld

im p o r ta n t lim ita tio n s th a t s h o u ld b e u n d e rs to o d b y

be

d e fin e d

and

m e a s u re d ,

because

o n ly

p a rt

o f th e ta x c o lle c te d fro m c o m p a n ie s is /tru e / c o m p a n y ta x .

T his

fe a tu re

o f th e

system

can

be

re fle c te d

in p r o je c t e v a lu a tio n b y u s in g a n e ffe c tiv e c o m p a n y ta x

ra te

and

th e c o s t o f c a p ita l.

in

c a lc u la tin g

b o th

a fte r-ta x

c a sh

flo w s

Rates o f re tu rn o b s e rv e d

su ch a s f le x ib ility ,

it a ls o

has som e

its users. •

We

a ls o

c o n c lu d e

a p p ro a c h ,

w h ic h

th a t

th e

in c o r p o r a te s

c e r ta in ty - e q u iv a le n t ris k

by

b e e a s ie r to use w h e r e ris k p e r u n it o f tim e is n o t c o n s ta n t.

u n d e r th e im p u ta tio n ta x system a ls o re q u ire a d ju s tm e n t if th e y a r e u se d to e s tim a te th e c o s t o f e q u ity .

KEY TERMS c e rta in ty -e q u iv a le n t

437

c o n s is te n c y p r in c ip le co s t o f c a p ita l

418

418

fr a n k in g p re m iu m

issue costs

421

428

430

o p p o r tu n ity co st p u re p la y

d iv id e n d g ro w th m o d e l

a d ju s tin g

th e c a s h flo w s ra th e r th a n th e d is c o u n t ra te , m a y

418

432

w e ig h te d a v e r a g e co st o f c a p ita l (W A C C )

422

C hapter fourteen T he

SELF-TEST PROBLEMS 1

T he C a n b e r r a C o r p o r a t io n is c o n s id e r in g a n in v e s tm e n t in a n e w p r o je c t; it w ill in v o lv e a n in itia l in v e s tm e n t o f $ 2 0 0 0 0 0 a n d is e x p e c te d to g e n e r a te a n e t c a s h in flo w o f $ 2 3 5 0 0 0 in 1 y e a r ’s tim e . T he ris k -fre e in te re s t ra te is 1 2 p e r c e n t a n d th e e x p e c te d re tu rn o n th e m a rk e t p o r tf o lio ( in c lu d in g th e f r a n k in g p re m iu m ) is 1 8 p e r c e n t.

2

a)

S h o u ld th e p r o je c t b e a c c e p te d if its s y s te m a tic ris k is e x p e c te d to b e 0 . 7 5 ?

b)

W o u ld y o u r a n s w e r to (a) c h a n g e if th e p ro je c t's s y s te m a tic risk is e x p e c te d to b e 1 .0 ?

The E x p a n d o C o m p a n y h a s th re e n e w p ro je c ts th a t a r e b e in g e v a lu a te d . T he c o m p a n y 's W A C C is e s tim a te d a t 1 4 . 6 p e r c e n t a fte r e ffe c tiv e c o m p a n y ta x . T he e x p e c te d a fte r-ta x re tu rn s a n d b e ta s o f th e th re e p ro je c ts a r e a s fo llo w s : I

P ro je c t

E x p e c te d re tu rn (%)

B eta

M a rs

14.5

0.70

Pluto

15.0

0.85

Neptune

20.0

1.20

1

T he ris k -fre e in te re s t ra te is 9 p e r c e n t a n d th e e x p e c te d re tu rn o n th e m a rk e t p o r tf o lio ( in c lu d in g th e fr a n k in g p re m iu m ) is 1 6 .5 p e r c e n t. a)

W h ic h o f th e p ro je c ts s h o u ld b e a c c e p te d ?

b)

W o u ld a n y o f th e a c c e p t / r e je c t d e c is io n s c h a n g e if th e p ro je c ts w e re e v a lu a te d u s in g th e c o m p a n y c o s t o f c a p ita l?

3

A c o m p a n y is c o n s id e r in g th e p u rc h a s e o f e q u ip m e n t c o s tin g $ 8 4 0 0 0 , w h ic h w ill p e r m it it to re d u c e its e x is tin g la b o u r co sts b y $ 2 0 0 0 0 a y e a r fo r 1 2 y e a rs . T h e c o m p a n y e s tim a te s th a t it w ill h a v e to s p e n d $ 2 0 0 0 e v e r y 2 y e a rs o v e r h a u lin g th e e q u ip m e n t. T he e q u ip m e n t m a y b e d e p r e c ia te d fo r ta x p u rp o s e s b y th e s tra ig h t-lin e m e th o d , o v e r a 1 2 - y e a r p e r io d . T h e c o m p a n y ta x ra te is 3 0 c e n ts in th e d o lla r , th e p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 7 5 , a n d th e a fte r ­ ta x c o s t o f c a p it a l is 1 0 p e r c e n t p e r a n n u m . A s s u m in g a ll c a s h flo w s , in c lu d in g ta x p a y m e n ts , a r e m a d e a t th e e n d o f e a c h y e a r, s h o u ld th e c o m p a n y p u rc h a s e th e e q u ip m e n t?

Solutions to self-test problem s ore a v a ila b le in A p p e n d ix B.

QUESTIONS 1

[LO 1 ] E x p la in w h a t is m e a n t b y th e consistency p rin c ip le in th e c o n te x t o f e s tim a tin g a c o m p a n y 's c o s t o f c a p ita l.

2

[LO 2 ] E x p la in th e im p o r ta n c e o f th e ris k -in d e p e n d e n c e a s s u m p tio n fo r p r o je c t a p p r a is a l.

3

[LO 2 ] T he c o s t o f c a p it a l f o r a p r o je c t c a n b e d e te r m in e d u s in g th e f o llo w in g e q u a tio n :

kj = i?y + (3y [E(Rm + l ) - Rf] a) Ju s tify th is sta te m e n t, a n d in d ic a te th e c o n d itio n s n e c e s s a ry fo r it to b e c o rre c t. b)

D iscuss th e p ro b le m s a s s o c ia te d w ith e s tim a tin g

i?/ ? P7and£(/?M + T). 4

[L O 2 ] The errors associated w ith estim ating a com pany's beta are so g re a t that you m a y as w e ll assume

that o il betas equ a l one. D o y o u a g re e ? G iv e y o u r re a s o n s . 5

[LO 2 ] A n a lu m in iu m p r o d u c e r is p la n n in g to e x p a n d b y c o n s tru c tin g a n e w r o llin g m ill to p r o d u c e a lu m in iu m she ets u se d in b e v e r a g e c a n s a n d th e b u ild in g in d u s try . T he p r o je c t's c o s t o f c a p it a l h a s b e e n e s tim a te d a t 1 2 p e r c e n t p e r a n n u m , b a s e d o n a b e ta o f 0 . 5 . E x p la in th e e ffe c ts , if a n y , th a t th e f o llo w in g w o u ld h a v e o n th e p r o je c t's c o s t o f c a p it a l: a)

th e c o rre la tio n b e tw e e n th e re tu rn s fro m a lu m in iu m p ro d u c e rs , a n d th e m a rk e t p o r tfo lio , d e c re a s e s

b)

th e c o m p a n y re d u c e s its fin a n c ia l le v e ra g e

CHAPTER FOURTEEN REVIEW

o

c o s t o f capital

B usiness finance

c) d)

th e risk-fre e in te re s t ra te in c re a s e s o w in g to a te c h n o lo g ic a l b re a k th ro u g h , th e c o s t o f p r o d u c in g sh e e t steel is re d u c e d . A n a ly s ts fo re c a s t lo w e r g r o w th in sa le s o f sh e e t a lu m in iu m .

6

[LO 3 ] W h e n e s tim a tin g a c o m p a n y 's c o s t o f c a p it a l, w h y is it im p o r ta n t to d is tin g u is h b e tw e e n th e effective c o m p a n y ta x ra te a n d th e statutory com pany in c o m e t a x ra te ? U n d e r w h a t c irc u m s ta n c e s m ig h t y o u e x p e c t th e s e tw o ra te s to b e v e r y d iffe re n t?

7

[LO 41 The weights used to estimate a com pany's W A C C reflect pa st decisions a b o u t the m ix o f financing choices a n d hence w e should utilise the historical cost o f funds in the W A C C formula. C o m m e n t o n this s ta te m e n t.

8

[L O 5 ] Trade c re d it is a free source o f finance. Therefore, w hen estim ating a com pany's cost o f ca p ital, trade

cre d it con be ignored. C o m m e n t o n th is s ta te m e n t. 9

[LO 6

E x p la in w h y th e costs a s s o c ia te d w ith r a is in g n e w c a p it a l, su ch as u n d e r w r it in g , le g a l a n d

a c c o u n tin g fe e s , a r e n o t s im p ly in c lu d e d in th e p r o je c t ’s c o s t o f c a p it a l, b u t in s te a d a r e a llo w e d fo r in th e n e t c a s h flo w s a s s o c ia te d w ith th e p r o je c t itse lf. 10

11

[L 〇7 ] D iscu ss e a c h o f th e f o llo w in g s ta te m e n ts: a)

A project's cost o f c a p ita l reflects the return investors require to finance the project.

b)

The cost o f c a p ita l is project-specific.

[ L 0 7 ] W hen evaluating a n ew project, m anagem ent requires an estimate o f the project's ow n cost o f

capital. The W A C C form ula o n ly gives a cost o f c a p ita l a p p lic a b le to the c o m p a n y as a w hole a n d is therefore in a p p ro p ria te fo r this purpose. C o m m e n t o n th is s ta te m e n t. 12

[ L 0 7 ] In a c o m p a n y that has separate divisions, m anagem ent should a p p ly d iffe re n t discount rates to

projects p ro p o se d b y its various divisions. D iscu ss th is s ta te m e n t. 13

[ L 0 7 ] D iscuss th e re la tiv e m e rits o f th e a lte r n a tiv e m e th o d s o f c a lc u la tin g th e c o s t o f c a p it a l f o r a d iv is io n o f a com pany.

14

[ L 0 8 ] T h e A c e C lo th in g C o m p a n y h a s d e c id e d to d iv e r s ify its o p e r a tio n s b y m a n u fa c tu r in g a n d m a rk e tin g fo o tw e a r . M a n a g e m e n t n o te s th a t th e s y s te m a tic ris k o f th e sh a re s o f a lis te d f o o tw e a r c o m p a n y is 0 . 8 . W h e n w o u ld it b e a p p r o p r ia t e to use 0 . 8 a s th e e s tim a te o f th e s y s te m a tic ris k o f th e e q u ity f o r th e c o m p a n y 's n e w in v e s tm e n t?

15

[LO 9 , A n im p o rta n t im p lica tio n o f using the W A C C to evaluate projects is that it suggests that com panies

should m axim ise the use o f d e b t—as kd is a lw ays less than ke. C o m m e n t o n th is s ta te m e n t. 16

[L O 1 0 ] W h e n d is c o u n tin g a fu tu re c a s h f lo w to its p re s e n t v a lu e , w h a t a r e th e t w o fa c to rs t h a t n e e d to b e a c c o u n te d fo r? U n d e r w h a t c irc u m s ta n c e s d o e s th e certainty-equivalent m e th o d p r o v id e a b e tte r a p p r o a c h to

CA

d is c o u n tin g c a s h flo w s re la tiv e to th e s ta n d a r d use o f a ris k -a d ju s te d d is c o u n t ra te ?

PROBLEMS

1

Calculating cost of capital [LO 1] B a y -o f-ls la n d s D a irie s Ltd h a s a n in te re s t ra te o n its d e b t o f 6 p e r c e n t p e r a n n u m . T h e s y s te m a tic risk o f its e q u ity is 1 .2 a n d th e e ffe c tiv e c o m p a n y ta x ra te is 0 . 1 2 . F o rty p e r c e n t o f its fu n d in g is p r o v id e d b y d e b t,

w h ile 6 0 p e r c e n t is p r o v id e d b y e q u ity . T h e risk-fre e in te re s t ra te is 5 p e r c e n t p e r a n n u m . In c a lc u la tin g its c o s t o f c a p ita l, B a y-o f-lsla n d s h a s o b ta in e d tw o e x p e rt o p in io n s a s to th e m a rk e t risk p re m iu m (in c lu d in g th e fr a n k in g p re m iu m ). O n e e x p e rt su g g e sts th a t th e m a rk e t risk p re m iu m is 1 p e r c e n t p e r a n n u m , w h ile th e o th e r s u g g e sts th a t th e m a rk e t risk p re m iu m is 5 p e r c e n t p e r a n n u m . W h a t is B a y -o f-ls la n d s 7 c o s t o f c a p ita l b a s e d o n the se e x p e rts 7 o p in io n s o f th e m a rk e t ris k p re m iu m ?

2

N P V analysis [LO 2] S p a re s Ltd m a n u fa c tu re s c a r p a rts a n d m a n a g e m e n t is c o n s id e rin g a n e x p a n s io n o f its e x is tin g o p e ra tio n s a t a c o s t o f $ 6 0 0 0 0 0 . It e x p e c ts th is e x p a n s io n to g e n e ra te a d d itio n a l n e t c a s h in flo w s fo r th e n e x t 1 0 y e a rs as fo llo w s : $ 1 0 0 0 0 0 p e r a n n u m in Y ea rs 1 - 5 a n d $1 3 0 0 0 0 p e r a n n u m in Y ea rs 6 - 1 0 . T he c o m p a n y 's a n a ly s t h a s m a d e th e fo llo w in g e s tim a te s: a)

th e s y s te m a tic risk o f th e c o m p a n y 's e x is tin g assets is 0 . 7 5

b)

th e risk-fre e in te re s t ra te is 1 1 p e r c e n t p e r a n n u m

c)

th e e x p e c te d ra te o f re tu rn o n th e m a rk e t p o r tf o lio is 1 5 p e r c e n t p e r a n n u m .

A s s u m in g th a t th e re is n o c o m p a n y in c o m e ta x , s h o u ld th e c o m p a n y u n d e rta k e th e e x p a n s io n ?

442

C hapter fourteen T he

Calculating cost of capital [LO 3] A b c o D is trib u to rs Ltd w is h e s to e v a lu a te a n in v e s tm e n t in a n e w a r e a o f a c t iv ity — m a n u fa c tu rin g p a in t. B ath Paints (BP) ha s b e e n id e n tifie d a s a c o m p a n y w h o s e s o le a c tiv ity is to p ro d u c e p a in t. T he s y s te m a tic risk o f BP’s e q u ity is 1 .2 . H o w e v e r, BP is fin a n c e d b y o n e p a r t d e b t to o n e p a r t e q u ity , w h e re a s A b c o D is trib u to rs is fin a n c e d b y tw o p a rts d e b t to th re e p a rts e q u ity . F urthe r, A b c o 's m a n a g e m e n t ha s e s tim a te d th e risk-fre e in te re s t ra te to b e 1 2 p e r c e n t a n d th e e x p e c te d ra te o f re tu rn o n th e m a rk e t p o r tfo lio (in c lu d in g th e fr a n k in g p re m iu m ) to b e 1 7 p e r c e n t. T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r . T he p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 , a n d th e b e fo re -ta x c o s t o f A b c o 's d e b t is 1 4 p e r c e n t p e r a n n u m . C a lc u la te th e c o s t o f c a p ita l o f th e p ro p o s e d n e w p ro je c t, s p e c ify in g th e a s s u m p tio n s o n w h ic h y o u r c a lc u la tio n s a r e b a s e d .

4

Calculating cost of capital [LO 5] R ylstone Ltd h a s c o m m e n c e d o p e r a tio n s w ith th e f o llo w in g c a p ita l stru ctu re :

Rylstone Ltd: statement of financial position as at date of incorporation ($) Assets Sundry assets

1000000

Liabilities and shareholders’ funds Debentures, 8% (10 years)

300000

Preference shares, 9%

200000

Ordinary shares, issued and paid-up, 500 000 at $1

500000

CHAPTER FOURTEEN REVIEW

3

c o s t o f capital

1000000

The c o m p a n y 's p ro s p e c tu s c o n ta in s e s tim a te s th a t it w ill e a rn $ 1 0 0 0 0 0 in th e firs t y e a r a n d p a y d iv id e n d s o f 1 0 cen ts p e r s h a re . B ro k e rs a n tic ip a te th a t d iv id e n d s w ill g r o w a t 5 p e r c e n t p e r a n n u m . T he sh a re s a re c u rre n tly s e llin g a t $ 1 . T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 cen ts in th e d o lla r a n d th e p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 . C a lc u la te th e c o s t o f c a p ita l fo r R ylstone Ltd.

5

Calculating cost of capital [LO 5] The f o llo w in g fin a n c ia l in fo rm a tio n re la te s to th e o p e r a tio n s o f W o o d T im b e r Ltd: A d d itio n a l in fo rm a tio n : a)

The n o m in a l in te re s t ra te o n th e b a n k o v e r d r a ft is 1 0 p e r c e n t p e r a n n u m a n d in te re s t is c a lc u la te d h a lf-y e a rly .

b) The d e b e n tu re s a r e c u rre n tly s e llin g a t $ 9 7 e a c h a n d m a tu re in 6 y e a r s ' tim e .

Wood Timber Ltd: abstract from the statement of profit and retained earnings for the year ended 31 December 2014 ($) Net profit after taxes

200000

Retained earnings 1.1.2014

150000

Total available for appropriation

350000

less Dividends on ordinary shares

120000

less Dividends on preference shares Retained earnings 31.12.2014

28000 202000 4 43

B usiness finance

Summary statement of financial position as at 31 December 2014 Assets Inventory

120000

Accounts receivable

82 000

Land and buildings

1200000

Plant and equipment

900000 2 302000

Liabilities Accounts payable

100000

Bank overdraft

200000

12% debentures, $100 face value

600000

900000

Shareholders’ funds 14% preference shares, $10 face value Ordinary shares, $1 face value Retained earnings

200000

1000000 202000

1402000 2302 000

c)

The p re fe re n c e sh a re s a re c u rre n tly s e llin g a t $ 9 . 5 0 e a c h .

d)

The o r d in a r y sh a re s a re c u rre n tly s e llin g a t $ 1 . 1 0 e a c h .

e)

T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r.

f)

The p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 .

C a lc u la te th e c o s t o f c a p ita l fo r W o o d T im b e r Ltd, u s in g th e d iv id e n d g r o w th m e th o d to c a lc u la te th e c o s t o f e q u ity . N o te a n y a s s u m p tio n s y o u m a k e .

6

Cost of debt capital [LO 5] If the appropriate cost o f debt capital is greater than the coupon rate o f a debt security, its price w ill usually be less than its face value. C o m m e n t o n th e v a lid it y o r o th e r w is e o f th is s ta te m e n t w ith th e a id o f th e f o llo w in g e x a m p le : a 5 - y e a r d e b t s e c u rity h a s a fa c e v a lu e o f $ 1 0 0 a n d a c o u p o n ra te o f 1 0 p e r c e n t p e r a n n u m , w ith in te re s t p a id s e m i-a n n u a lly . T h e a p p r o p r ia te c o s t o f d e b t c a p it a l is 1 3 p e r c e n t p e r a n n u m (e ffe c tiv e ).

7

Calculating cost of capital [LO 5] The m a n a g e m e n t o f H e a v y C la y Ltd w a n ts to k n o w th e c o s t o f c a p ita l a s s o c ia te d w ith e x p a n d in g its bu sin ess. You h a v e b e e n to ld th a t fu n d s w ill b e ra is e d fo r th is p u rp o s e a c c o r d in g to a ta r g e t c a p it a l s tru c tu re re fle c te d in th e m a rk e t v a lu e o f its s e c u ritie s . Y o u r ta s k is to c a lc u la te th e c o s t o f c a p ita l f o r th e c o m p a n y . The fo llo w in g in fo rm a tio n m a y a ssist y o u in y o u r task: a)

T he 1 3 p e r c e n t d e b e n tu re s h a v e just b e e n issu e d a n d in te re s t ra te s h a v e re m a in e d s ta b le s in c e th e issue. T his ra te w a s 1 p e r c e n t p e r a n n u m a b o v e th e in te re s t ra te o n g o v e rn m e n t s e c u ritie s .

b)

T h e la s t o b s e r v e d m a r k e t p r ic e o f th e p r e fe r e n c e s h a re s w a s $ 1 , w h e r e a s it w a s $ 3 f o r th e o r d in a r y s h a re s .

c)

T h e b e ta o f e q u ity o f H e a v y C la y w a s r e c e n tly e s tim a te d a t 0 . 5 , w h ile th e c o n s e n s u s v ie w is t h a t th e e x p e c te d r a te o f re tu rn f o r th e m a r k e t is 1 8 p e r c e n t p e r a n n u m , w h ic h in c lu d e s a f r a n k in g p re m iu m o f 2 p e r c e n t.

444

C hapter fourteen The

A n e x tra c t o f th e m o st re c e n t s ta te m e n t o f fin a n c ia l p o s itio n s h o w s :

Debentures

2500

7% preference shares ($2 face value)

1000

Paid-up capital ($1 face value)

3000

Reserves

500 7000

e)

T h e s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r.

f)

T he d iv id e n d s o n H e a v y C la y ’s o r d in a r y sh a re s w ill b e fu lly fra n k e d a n d a ll th e sh a re s a r e h e ld b y A u s tra lia n re s id e n ts.

8

Company versus project cost of capital [LO 7 】 D o rs e t Ltd is a ll-e q u ity fin a n c e d a n d h a s a c o s t o f c a p ita l o f 1 6 p e r c e n t p e r a n n u m . O b s e rv e rs s u g g e s t th a t D o rs e t c o u ld e a s ily b o r r o w u p to 4 0 p e r c e n t o f th e v a lu e o f its assets a t a n in te re s t ra te o f 1 0 p e r c e n t p e r a n n u m a n d a c h ie v e a r a tin g fo r its d e b t o f A + o r b e tte r. T h e y a rg u e th a t ra is in g n e w c a p ita l b y b o r r o w in g w o u ld lo w e r th e c o m p a n y 's c o s t o f c a p ita l, a n d in c re a s e th e n e t p re s e n t v a lu e o f so m e p ro je c ts th a t w e re re c e n tly re je c te d . U se a n u m e ric a l e x a m p le to illu s tra te th e o b s e rv e r's a rg u m e n t. Is th e ir a rg u m e n t c o rre c t? G iv e re a s o n s fo r y o u r a n s v /e r.

9

Calculating cost of capital [LO 7] a)

Use th e f o llo w in g in fo r m a tio n to c a lc u la te th e c o s t o f c a p ita l fo r S A M Ltd, a s s u m in g th a t in v e s to rs c a n re m o v e a ll u n s y s te m a tic risk b y d iv e rs ific a tio n . i) The s y s te m a tic risk o f S A M Ltd's e q u ity is 0 . 8 . ii) T he ris k -fre e in te re s t ra te is 1 0 p e r c e n t p e r a n n u m . iii) T he e x p e c te d ra te o f re tu rn o n th e m a rk e t p o r tfo lio ( in c lu d in g th e fr a n k in g p re m iu m ) is 1 5 p e r c e n t p6「 annum . iv) The v a rio u s s o u rc e s o f fu n d s u se d b y S A M Ltd a n d th e ir re s p e c tiv e m a rk e t v a lu e s a re a s fo llo w s :

S o u rc e o f fu n d s

M a r k e t v a lu e ($ m )

Debt (face value $100)

1

Equity

3

v) T he in te re s t ra te o n th e d e b t is 1 1 p e r c e n t p a id a n n u a lly . T h e d e b t, w h ic h is d u e to m a tu re in 8 y e a r s ' tim e , h a s a c u rre n t m a rk e t p ric e o f $1 1 1. vi) T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r. v ii) The p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 . b)

U n d e r w h a t a s s u m p tio n s is th e c o s t o f c a p ita l y o u h a v e c a lc u la te d fo r S A M Ltd in (a) a p p r o p r ia te fo r a p ro p o s e d p ro je c t?

10

Estimating divisional cost of capital [LO 8] T h re e c o m p a n ie s — X, Y a n d Z — o p e r a te in in d u s trie s 1 a n d 2 . T he c o m p a n ie s , costs o f c a p ita l a n d in v e s tm e n t in e a c h in d u s try a re as fo llo w s :

X

14.0

0.5

0.5

Y

12.8

0.7

0.3

Z

14.6

0.4

0.6

CHAPTER FOURTEEN REVIEW

d)

c o s t o f capital

a)

E stim a te th e d iv is io n a l c o s t o f c a p ita l fo r e a c h c o m p a n y .

b)

O u tlin e th e m a in a s s u m p tio n s th a t u n d e rlie y o u r m o d e l.

c)

D iscuss th e a d v a n ta g e s a n d d is a d v a n ta g e s o f th e m e th o d y o u use d in (a) c o m p a r e d w ith th e /p u re -p la y , a p p ro a c h .

11

Understanding the advantages and disadvantages of using W A C C for project evaluation [LO 9 】 V e rity C o tto n Ltd (VCL) o p e ra te s a la r g e c o tto n fa rm n e a r B u lla m a k a n k a . Its w a te r s u p p ly c o m e s fro m tw o so u rce s: r a in fa ll a n d a n a n n u a l a llo c a tio n fro m th e B u lla m a k a n k a W a t e r S u p p ly A u th o rity . In re c e n t y e a rs it ha s b e e n d iffic u lt to o b ta in s u ffic ie n t w a te r to p ro d u c e a g o o d c r o p . G e o ff S in g h , th e m a n a g in g d ir e c to r o f V C L, h a s re c e n tly re c e iv e d a r e p o r t fro m th e B u lla m a k a n k a Tourism B o a rd s u g g e s tin g th a t V C L s h o u ld c o n s id e r o p e n in g a c a m p in g g ro u n d to s e rv e v is ito rs to th e re c e n tly -o p e n e d B u lla m a k a n k a N a tio n a l P a rk a n d H e rita g e S ite , w h ic h is lo c a te d n e a r th e fa rm . S uch a d e v e lo p m e n t w o u ld ta k e a b o u t 1 0 p e r c e n t o f V C L 's la n d o u t o f c o tto n p r o d u c tio n . G e o ff p r e p a r e d a n N P V a n a ly s is o f th e p r o p o s a l, w h ic h he p re s e n te d to a re c e n t m e e tin g o f th e V C L b o a r d o f d ire c to rs . A t th e m e e tin g , th e re w a s s o m e d is a g re e m e n t o v e r tw o a s p e c ts o f G e o ff's a n a ly s is . T hese a s p e c ts w e r e : a)

G e o ff ig n o r e d th e fa c t th a t 1 0 p e r c e n t o f th e la n d w o u ld n o lo n g e r b e u se d fo r c o tto n p r o d u c tio n . S o m e d ire c to rs fe lt th a t b e c a u s e 1 0 p e r c e n t o f th e la n d w o u ld n o lo n g e r b e use d to p r o d u c e c o tto n , th e a n a ly s is s h o u ld in c lu d e a 1 0 p e r c e n t re d u c tio n in th e n e t c a s h f lo w e x p e c te d fro m c o tto n p r o d u c tio n .

b)

In his a n a ly s is , G e o ff h a d use d a n e s tim a te o f V C L 's c o s t o f c a p ita l to d is c o u n t th e fo re c a s t n e t ca s h flo w s o f th e c a m p in g g r o u n d p ro je c t. H o w e v e r, G e o ff n o te d in his a n a ly s is th a t a ll o f th e costs o f th e p r o je c t w o u ld b e fin a n c e d b y a b a n k lo a n . S o m e d ire c to rs a r g u e d th a t, in v ie w o f th is fa c t, th e a p p r o p r ia te d is c o u n t ra te to use is th e in te re s t ra te th a t th e b a n k w o u ld c h a rg e . A s H a n k , o n e o f th e d ire c to rs , e x p la in e d , 'S in c e n o n e o f th e s h a re h o ld e rs ' m o n e y w ill b e use d in th e p ro je c t, w e d o n 't n e e d to re w a r d th e s h a re h o ld e rs ; w e o n ly n e e d to e n s u re th a t th e c a s h flo w s a r e s u ffic ie n t to m e e t th e b a n k 's re q u ire m e n ts '.

P ro v id e th e b o a r d w ith y o u r a d v ic e o n e a c h o f th e tw o m a tte rs ra is e d in (a) a n d (b).

REFERENCES Beggs, DJ. & Skeels, C., 'M arket arbitrage of cash dividends and franking credits', The Economic Record, September 2 0 0 6 , pp. 2 3 9 -5 2 .

2 0 0 4 . Available at w w w .capitalresearch.com .au/ dow nloads/lm putationU pdate2004.pdf.

Berk, J. & DeMarzo, P., Corporate Finance, Pearson Education, Boston, 20 07 .

Monkhouse, P.H.L., The valuation o f projects under the dividend imputation tax system7, Accounting and Finance, November 1996, pp. 1 8 5 -2 1 2 .

Brailsford, T., Handley, J. & Maheswaran, K., The historical equity risk premium in Australia: post-GFC and 128 years of data7, Accounting and Finance, March 2 0 1 2 , pp. 2 3 7 -4 7 .

------ , 'A dapting the APV valuation methodology and the beta gearing formula to the dividend imputation tax system', Accounting and Finance, M ay 1997, pp. 6 9 -8 8 .

Brown, P. & Clarke, A ., The ex-dividend day behaviour o f Australian share prices before and after dividend imputation', Australian Journal of Management, June 1993, pp. 1-4 0.

Mukherjee, T.K., Kiymaz, H. & Baker, H., 'M erger motives and target valuation: a survey of evidence from CFOs', Journal of Applied Finance, W inter 2 0 0 4 , pp. 7 -2 4 .

Cannavan, D.; Finn, F. & Gray, S., 'The value o f imputation credits in Australia', Journal of Financial Economics, April 2 0 0 4 , pp. 167-97. Conine, T. & Tamarkin, M ., 'Divisional cost of capital estimation: adjusting for leverage', Financial Management, Spring 1985, pp. 5 4 -8 . Feuerherdt, C., G ray, S. & Hall, J., 'The value of imputation tax credits on Australian hybrid securities', International Review of Finance, September 2 0 1 0 ; pp. 3 6 5 -4 0 1 .

Myers, S.C., 'Interactions of corporate financing and investment decisions: implications for capital budgeting ’， Journal of Finance, M arch 1974, pp. 1 -2 5 . ------, & Turnbull, S., 'C apital budgeting and the capital asset pricing model: good news and bad news', Journal of Finance, M ay 1977, pp. 3 2 1 -3 3 . Officer, R.R., 'The measurement o f a firm ’s cost of c a p ita l: Accounting and Finance, Novem ber 1981, pp. 3 1 -6 3 . ------, 'The cost of capital of a company under an imputation tax system,/ Accounting and Finance, M a y 1994, pp. 1 -1 7 .

Fuller, RJ. & Kerr, H.S., 'Estimating the divisional cost of capital: an analysis o f the pure-play technique,, Journal of Finance, December 19 81 , pp. 9 9 7 -1 0 0 9 .

Taggart, R., 'Consistent valuation and cost-of-capital expressions with corporate and personal taxes7, Finonciol Management, Autumn 1991, pp. 8 -2 0 .

Harris, R.S., CXBrien, TJ. & Wakeman, D., 'Divisional cost-of-capital estimation for multi-industry firms', Financial Management, Spring 1989, pp. 7 4 -8 4 .

W alker, S. & Partington, G ., The value o f dividends: evidence from cum-dividend trading in the ex-dividend period,/ Accounting and Finance, Novem ber 1999, pp. 2 7 5 -9 6 .

Hathaway, N. & Officer, R.R.; The Value of Imputation Tax Credits: Update 2004, Capital Research Pty Ltd, November

A pp en d ix 1 4 .1

A p p e n d ix

♦

T he

c o s t o f capital under alternative tax systems

The cost of capital under alternative tax systems10

Introduction In this appendix we discuss alternative definitions o f the cost o f capital and derive equations fo r a company s cost o f capital on both a before-tax and an after-tax basis. We show th a t under the im p utatio n tax system there is more than one way to define an after-tax cost o f capital. Under an im putation system the d istin ction between company tax and personal tax becomes blurred because resident shareholders can use im p utatio n credits to offset th e ir personal tax liabilities. There are at least three ways in which this issue can be handled. The firs t is to adjust the after-tax cash flows generated by a company or project. A second approach involves adjusting the d efin itio n o f the cost o f capital, while a th ird approach involves adjusting both the cash flows and the cost o f capital. One principle that must be stressed is that, whichever approach is adopted, it m ust be used consistently: that is, the definition o f the cost o f capital m ust be consistent w ith the definition o f the cash flows that are discounted using that cost o f capital. I f consistency is maintained, the three approaches are equivalent. But if consistency is not maintained, a biased valuation w ill result and incorrect investment decisions may be made.

Deriving cost of capital form ulae11 To define the cost o f capital, we assume th a t all o f a company s cash flows are expected to remain constant in perpetuity. This assumption is necessary fo r algebraic convenience. The value o f a company depends on the net operating cash flows generated by the company s assets and the cost o f capital applicable to those cash flows. For cash flows th a t remain constant in perpetuity: y= ^ ^0

A14.1

where V = value o f the company (value o f equity plus debt) X 〇= annual net operating cash flow before tax k 〇 = before-tax cost o f capital From Equation A14.1, the general d efinition o f the before-tax cost o f capital is:

A14.2 V Equation A14.2 form s the basis fo r all the cost-of-capital form ulae th a t we derive. To derive formulae fo r the cost o f capital it is necessary to consider only company tax, because we work on a before-company-tax or after-company-tax, b ut always before-personal-tax, basis. A company s net operating cash flow before tax, X〇 , is the net cash flow th a t remains after m eeting the costs o f all factors o f production other than payment o f company income tax to the government and providing returns to suppliers o f capital. Therefore X 〇 can be divided in to three components:

A14.3 where X = net cash flow to the government = net cash flow to debtholders X a = net cash flow to shareholders The am ount o f tax collected from a company w ill be equal to tc(X〇 - X ^ ) , where t c is the statutory company tax rate. This is because interest paid is a tax-deductible expense o f the company. But a proportion y o f the tax collected from the company w ill be claimed by shareholders as a consequence o f receiving franking credits. Therefore, the tax collected from the company can be divided into tw o components: im p licit personal tax and ^true* or effective company tax.

10 The discussion in this appendix is largely a simplified version of that provided by Officer (1994). 11 The general approach used in this section follows that adopted by Officer (1981, pp. 31-61).

This c o n ce p t m a y re q u ire e x p la n a tio n . Suppose t h a t a b u sin ess is u n in c o rp o ra te d . F o r exa m ple, i t m a y be s tru c tu re d as a p a rtn e rs h ip ra th e r th a n as a com pany. A p a rtn e rs h ip is n o t ta x e d as a separate e n tity ; ra th e r its p r o fits are ta xe d in th e h a n d s o f th e p a rtn e rs . T h e re fo re , a ll th e ta x o n its p ro fits is p e rs o n a l ta x. O n th e o th e r h a n d , i f a c o m p a n y s tru c tu re is used, p r o fits p a id o u t as fra n k e d d iv id e n d s are also s u b je c t to p e rs o n a l ta x , b u t som e o r a ll o f th e ta x has a lre a d y b e en co lle cte d fr o m th e com pany. I t is e x tre m e ly im p o r t a n t to u n d e rs ta n d th is p o in t: u n d e r th e im p u ta tio n syste m , m o s t o f th e in c o m e ta x p a id o n c o m p a n y p r o fits is im p lic itly p e rs o n a l ta x . C o n se q u e n tly, e ffe c tiv e co m p a n y ta x is a n y e x tra in c o m e ta x in c u rre d due to a bu sin ess b e in g s tru c tu re d as a com p an y, ra th e r th a n b e in g u n in c o rp o ra te d . F ro m th is d is c u s s io n w e can see t h a t th e n e t cash flo w to th e g o v e rn m e n t is:

A14.4

Xg= t c(X0-X cl) ( l - 7)

E q u a tio n A 1 4 .4 illu s tra te s th e s ig n ific a n c e o f th e v a ria b le y. I f n o ta x c re d its can be used, th e n

= tc(X - Xd)— t h a t

y = 0 and

〇

is, a ll o f th e ta x c o lle c te d f r o m a co m p a n y is tru e c o m p a n y ta x a n d th e ta x

s yste m is e ffe c tiv e ly a classical system . I f a ll o f th e ta x c re d its can be used, th e n y = 1 a n d

Xg =

0 — t h a t is,

a ll th e ta x c o lle c te d fr o m a co m p a n y is re a lly n o th in g m o re th a n a w ith h o ld in g o f p e rs o n a l ta x. S u b s titu tin g E q u a tio n A 1 4 .4 in to E q u a tio n A 1 4 .3 , m u ltip ly in g o u t th e b ra cke ts a n d c o lle c tin g te rm s , gives:

X〇 [l - fc(l - 7)] = ^ + Xf/[1 - ft.(l - 7)]

Xe

+ Xc/

-^ (1 -7 ) F ro m E q u a tio n A 1 4 .2 : =

Kv

S im ila rly ,

Xe= keE a n d Xd = kdD ke= co st o f e q u ity (a fte r e ffe c tiv e c o m p a n y E = m a rk e t v a lu e o f e q u ity kd = cost o f d e b t (b e fo re co m p a n y ta x ) D = m a rk e t v a lu e o f d e b t

w h e re

ta x )

S u b s titu tin g f o r th e cash flo w te rm s in E q u a tio n A 1 4 .3 gives:

^ = ^ / [ l - r c( l - 7)] + ^ D a n d d iv id in g b y k

〇=

V, th is

becom es:

f e / [ l - fc (l - 7 )]

E V.

D

A14.5

V.

E q u a tio n A 1 4 .5 show s t h a t a c o m p a n y s co st o f c a p ita l is e q u a l to a w e ig h te d average o f th e costs o f e q u ity a n d d e b t, w h e re th e w e ig h ts are th e p ro p o rtio n s o f e q u ity a n d d e b t in th e c o m p a n y s c a p ita l s tru c tu re . H o w e ve r, th is cost o f c a p ita l is o f lim ite d use because i t is a b e fo re -ta x co st o f c a p ita l, w hereas re tu rn s to in v e s to rs in a co m p a n y d e p e n d o n its a fte r-ta x cash flo w s. The s im p le s t d e f in itio n o f a fte r-ta x cash flo w s is a fte r-e ffe c tiv e -c o m p a n y -ta x cash flo w s: - 7)] a n d i t fo llo w s t h a t th e c o rre s p o n d in g a fte r-ta x cost o f c a p ita l is o b ta in e d b y m u ltip ly in g E q u a tio n A 1 4 .5 by

[(1

- t f( l -

kf = ke w h e re

7 )],

w h ic h gives:

A14.6 V.

kr = an

a fte r-e ffe c tiv e -c o m p a n y -ta x cost o f c a p ita l

A second d e fin itio n o f a fte r-ta x cash flo w s is: X 〇 ( l - fc) a n d th e c o rre s p o n d in g a fte r-ta x co st o f c a p ita l is o b ta in e d b y m u ltip ly in g E q u a tio n A 1 4 .5 b y (1 w h ic h gives:

tc)}

A pp en d ix 1 4 .1

k， f = k e ( l- t c ) / [ l- t c ( l- j) ]

E [V i

H-

T he

c o s t o f capital under alternative tax systems

A] 4.7

kd{ \ - tc)

This ap p ro a ch uses th e t r a d itio n a l d e fin itio n o f n e t cash flo w s a n d a ll th e a d ju s tm e n ts needed f o r th e im p u ta tio n system are m ade to th e W ACC. A t h ir d d e fin itio n o f a fte r-ta x cash flo w s is:

X〇 -

-

fc( X0-X ")(l - *y)

This d e fin itio n o f a fte r-ta x cash flo w s is n e t o p e ra tin g cash flo w b e fo re ta x less th e n e t cash flo w to th e g o v e rn m e n t. F ro m E q u a tio n A 1 4 .3 ,

X〇- Xg = Xe +

A14.8

kf,/ = ke \-} + k d \ -

[v\

a n d th e c o rre s p o n d in g a fte r-ta x co s t o f c a p ita l is:

[v\

A fo u r th d e fin itio n o f a fte r-ta x cash flo w s is: ^ 〇 ( 1 -

0

+

fc ( ^ 〇 _

y

This d e fin itio n o f a fte r-ta x cash flo w adds th e va lu e o f im p u ta tio n ta x fr a n k in g c re d its to th e t r a d itio n a l d e fin itio n o f n e t cash flo w s . S u b s titu tin g th is d e fin itio n o f a fte r-ta x cash flo w in E q u a tio n A 1 4 .3 p ro v id e s th e fo llo w in g c o rre s p o n d in g a fte r-ta x cost o f c a p ita l:

k， m = ke

E V.

+

k^(l - tc)

A14.9

Summary I t is im p o r ta n t th a t p ro je c ts are e va lu a te d u s in g a cost o f c a p ita l t h a t is c o n s is te n t w it h th e pro je cts* cash flow s. T ra d itio n a lly , in p ro je c t e v a lu a tio n , b o th cash flo w s a n d th e co st o f c a p ita l have b e en expressed o n an a fte r-c o m p a n y -ta x basis. T h a t a p p ro a ch is easy to use u n d e r th e classical ta x s yste m w h e re th e re is a d e a r d is tin c tio n b e tw e e n c o m p a n y ta x a n d p e rs o n a l ta x . H o w e ve r, u n d e r th e im p u ta tio n syste m , som e o r a ll o f th e ta x co lle cte d fr o m co m p a n ie s is re a lly p e rs o n a l ta x . T h e re fo re , to express cash flo w s o n an a fte rc o m p a n y -ta x basis, a d ju s tm e n ts are needed.

A CHAPTER FIFTEEN Leasing and other equipment finance

CHAPTER CONTENTS IB H 15.3

15.4

I n t r o d u c t io n

451

E v a lu a tio n o f f in a n c e le a s e s

T y p e s o f le a s e c o n tr a c ts

451

E v a lu a tio n o f o p e r a t in g le a s e s

15.7

A c c o u n t in g a n d t a x a t io n t r e a tm e n t o f le a s e s

455

S e ttin g le a s e r e n ta ls

456

A d v a n t a g e s a n d d is a d v a n t a g e s o f le a s in g

15.8

C h a t t e l m o r t g a g e s a n d h ir e - p u r c h a s

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

e x p la in th e m a in fe a tu r e s o f f in a n c e le a s e s a n d o p e r a t in g le a s e s

2

u n d e r s ta n d th e r e a s o n s f o r le v e r a g e d le a s e s a n d c r o s s - b o r d e r le a s e s

3

o u t lin e th e a c c o u n t in g a n d t a x t r e a t m e n t o f le a s e s in A u s t r a lia

4

c a lc u la t e r e n ta ls f o r a f in a n c e le a s e

5

e v a lu a t e a f in a n c e le a s e fr o m th e le s s e e 's v ie w p o in t

6

e v a lu a t e a n o p e r a t in g le a s e fr o m th e le s s e e ’s v ie w p o in t

7

c r it ic a lly e v a lu a t e th e s u g g e s te d a d v a n t a g e s o f le a s in g

8

e x p la in th e fa c t o r s t h a t c a n in flu e n c e le a s in g p o lic y

9

o u t lin e th e m a in f e a tu r e s o f c h a tte l m o r t g a g e s a n d h ir e - p u r c h a s e a g r e e m e n ts .

C hapter fifteen Le a s in g

a n d other e q u ip m e n t fin a n c e

Introduction W h en m o s t p e o p le th in k o f le a s in g , th e y p r o b a b ly th in k o f s o m e t h in g lik e h ir in g a c a r f o r th e w e e k e n d o r le a s in g a n a p a r t m e n t f o r 6 m o n t h s . W h ile su c h c o n t r a c t s a r e in d e e d l e a s e s , th e r e is a n o t h e r f o r m o f le a s e , k n o w n a s a fin a n c e le a s e , w h ic h u s e s th e le g a l f o r m o f le a s in g in su c h a w a y t h a t it b e c o m e s a n a lte r n a tiv e to b o r r o w in g f u n d s t o p u r c h a s e n e w a s s e t s . In t h is c h a p te r , w e c o n s id e r th e v a r io u s f o r m s o f le a s e s a n d e x p la in h o w a p r o p o s e d le a s e m a y b e e v a lu a te d . W e a ls o c o n s id e r c h a tte l m o r t g a g e s a n d h ir e - p u r c h a s e , w h ich , t o g e th e r w ith le a s in g , a r e k n o w n a s e q u ip m e n t fin a n c e *.

le sso r) is le sse e ) o b t a i n s th e r ig h t to u s e th e a s s e t in r e tu r n

L e a s in g is d is t i n g u i s h e d fr o m m o s t o t h e r f o r m s o f fin a n c e b y th e f a c t t h a t th e fin a n c ie r (th e th e le g a l o w n e r o f th e le a s e d a s s e t . The a s s e t u s e r (th e

fo r p e r io d ic p a y m e n ts (le a s e r e n t a ls ) to th e le s s o r . In o t h e r w o r d s , l e a s in g a llo w s a c o m p a n y to o b t a in th e use o f a n a s s e t , w ith o u t a ls o o b t a in in g ow n ersh ip o f th e a s s e t . Th e r a n g e o f a s s e t s t h a t c a n b e le a s e d is v ir tu a lly u n lim ite d . M a n y m o t o r v e h ic le s , a ir c r a ft , c o m p u t e r s , p h o t o c o p ie r s , m a c h in e r y a n d o t h e r i t e m s o f p r o d u c tio n e q u ip m e n t a r e le a s e d . U n u s u a l a s s e t s to b e le a s e d in c lu d e o il r ig s , s e w a g e t r e a t m e n t p la n t s

LESSOR

in a lease contract, the party that owns the asset LESSEE

in a lease contract, the party using the asset

a n d c o m m u n ic a tio n s s a t e llit e s (V a r d ig a n s 1 9 9 0 ). The A u s tr a lia n E q u ip m e n t L e s s o r s A s s o c ia t io n (w w w .a e l a .a s n .a u ) e s t im a t e s t h a t l e a s in g a n d o t h e r e q u ip m e n t fin a n c e a c c o u n t s f o r a r o u n d 4 0 p e r c e n t o f a ll c a p it a l e x p e n d it u r e o n e q u ip m e n t in A u s tr a lia .

^w w ^J

The le a s e c o m p o n e n t, w h ic h m a d e u p 6 0 p e r c e n t o f t o t a l e q u ip m e n t fin a n c e in 2 0 0 0 , d e c lin e d to a r o u n d 2 6 p e r c e n t o f th e t o t a l in 2 0 1 2 , w h ile o v e r th e s a m e p e r io d h ir e - p u r c h a s e d e c lin e d fr o m 4 0 t o 1 8 p e r c e n t a n d c h a tte l m o r t g a g e s g re w c o n s id e r a b ly to m a k e u p 5 6 p e r c e n t o f th e t o t a l .1 The sig n ific a n c e o f le a s in g in A u s tr a lia is c o m p a r a b le w ith i t s p r e v a le n c e in o t h e r m a r k e ts . F o r e x a m p le , L e a se u r o p e r e p o r t s t h a t , in 2 0 0 9 , e q u ip m e n t l e a s in g in E u r o p e a c c o u n te d fo r a r o u n d 2 0 p e r c e n t o f th e t o ta l in v e s t m e n t in e q u ip m e n t (w w w .l e a s e u r o p e .o r g ). The J a p a n L e a s in g A s s o c ia t io n r e p o r t s s u r v e y r e s u lts sh o w in g t h a t in 2 0 1 2 l e a s in g a c c o u n t e d fo r a b o u t 7 p e r c e n t o f p r iv a te c a p it a l in v e s t m e n t (w w w .

卜， |

l e a s in g .o r .jp ) . L e a s e fin a n c e is p r o v id e d o n a la r g e s c a le b y b a n k s a n d fin a n c e c o m p a n ie s a s a n a lte r n a tiv e to lo a n s . O th e r s o u r c e s o f le a s e fin a n c e in c lu d e in v e s t m e n t b a n k s , s p e c ia lis t l e a s in g c o m p a n ie s , a n d v e n d o r le a s in g c o m p a n ie s a s s o c i a t e d w ith e q u ip m e n t s u p p lie r s . L e a s e fin a n c e c o m m it m e n t s f o r fin a n c e l e a s e s m a d e b y s ig n ific a n t le n d e r s a r e s h o w n in T a b le 1 5 .1 .

TABLE 15.1 The value of new lease finance commitments for finance leases by type of lessor, $ million___________________________________________________ Year to June

Banks

General financiers

Other㈣

Total

2009

2144

1658

1885

5687

2010

1417

1614

1611

4642

2011

1251

1764

1900

4915

2012

1301

2351

2111

5763

2013

1363

2545

2264

6172

Includes finance companies and money market corporations. Source: Australian Bureau of Statistics, Lending Finance, Australia, cat. no. 5671.0, Table 3. ABS data used with permission from the Australian Bureau of Statistics, www.abs.gov.au.

15.2 Types of lease contracts L e a s e s ca n b e b r o a d ly c la s s if ie d a s e it h e r fin an ce le a s e s o r o p e ra tin g le a se s. W ith in t h e s e b r o a d c la s s e s , se v e r a l t y p e s o f le a s e c o n t r a c t s c a n a ls o b e id e n tifie d . F o r o u r p u r p o s e s , th e r e a s o n fo r d is tin g u is h in g b e tw e e n fin a n c e le a s e s a n d o p e r a t in g l e a s e s is t h a t th e y h a v e d iffe r e n t fin a n c ia l im p lic a t io n s f o r b o t h th e

1

The features of hire-purchase and chattel mortgages are outlined in Section 15.8.

m LEARNING OBJECTIVE 1 Explain the main features of finance leases and operating leases

B usiness finance

le sso r a n d th e lessee. T h ere fore, d iffe re n t fa c to rs can be im p o r t a n t in th e e v a lu a tio n o f each ty p e o f lease. The m a jo r lease typ e s are discussed in th e fo llo w in g se ctio n s a n d d e ta ils o f th e typ e s o f assets t h a t are leased are s h o w n in Table 15.2.

TABLE 15.2 The value of new lease finance commitments, by type of lease and type of goods leased, $ million Y e a r to Ju n e 2010

2011

2517

C o n s tru c tio n and e a rth m o v in g e q u ip m e n t

|

2012

2013

3 0 34

3230

3603

61

196

401

704

M a n u fa c tu rin g e q u ip m e n t

63

35

29

59

A g ric u ltu ra l m a ch in e ry and e q u ip m e n t

57

61

57

81

1433

12 0 1

1311

1203

512

387

735

520

4642

4915

5763

6172

1172

1289

1391

1547

652

662

760

578

77

48

69

134

195

380

368

257

T o ta l o p e ra tin g lease finance

2096

2379

2 5 88

2516

T o ta l l e a s e fin a n c e

6738

7294

8351

8688

1

F in a n c e l e a s e s / t y p e o f g o o d s M o to r vehicles and o th e r tra n s p o rt e q u ip m e n t

O ffice e q u ip m e n t O th e r goods T o ta l n o n -o p e ra tin g lease finance O p e r a t in g l e a s e s / t y p e o f g o o d s M o to r vehicles O ffice e q u ip m e n t A g ric u ltu ra l, c o n s tru c tio n and m a n u fa c tu rin g e q u ip m e n t O th e r

Source: Australian Bureau of Statistics, Lending Finance, Australia, cat. no. 5671.0, Tables 28 and 39. ABS data used with permission from the Australian Bureau of Statistics, www.abs.gov.au.

15.2.1 | Finance leases FINANCE LEASE

long-term lease that effectively transfers the risks and benefits of ownership of an asset from the lessor to the lessee

A

fin an ce le a se is a lo n g -te rm a g re e m e n t t h a t g e n e ra lly covers m o s t o f th e e c o n o m ic life o f an asset.

The a g re e m e n t w i ll e ith e r be n o n -c a n c e lla b le o r can cellab le o n ly i f th e lessee pays a s u b s ta n tia l p e n a lty to th e lessor. T h e re fo re , a fin a n c e lease is e ffe c tiv e ly n o n -c a n c e lla b le a n d th e lessee has an o b lig a tio n to m a ke a ll th e agreed lease p a y m e n ts . T his o b lig a tio n is e s s e n tia lly th e sam e as a b o rro w e rs o b lig a tio n to re p a y a lo a n . F in a n ce lease a g re e m e n ts n o rm a lly c o n ta in re s tric tiv e co ve n a n ts a n a lo g o u s to th o s e in lo a n a g re e m e n ts a n d th e le sso r w ill be co n ce rn e d to e n sure t h a t a p ro s p e c tiv e lessee is c re d it-w o rth y . In th is case th e ro le o f th e le s s o r is to p ro v id e fin a n ce , a n d fr o m th e le s s o rs v ie w p o in t a fin a n c e lease is, in e ffe ct, a secured lo a n . W h ile th e le s s o r is th e le g a l o w n e r o f th e asset, i t has n o g re a t in te re s t in m a tte rs such as th e d a y -to -d a y use o f th e asset, a n d th e lessee is re s p o n s ib le f o r re p a irs, m a in te n a n c e a n d in su ra n ce . Because o f the se c h a ra c te ris tic s , th e re is an e ffe c tiv e tra n s fe r fr o m th e le sso r to th e lessee o f m o s t o f th e ris k s a n d b e n e fits o f o w n e rs h ip o f th e leased asset. In o th e r w o rd s , w h e n a c o m p a n y s ig n s a fin a n c e lease i t is, in e ffe c t, e n te rin g in to an a g re e m e n t to p u rcha se th e asset u s in g fu n d s b o rro w e d f r o m th e lessor. The ro le o f th e b a n ks a n d o th e r in s titu t io n s t h a t a ct as lessors in fin a n c e leases is to p ro v id e fin a n ce ra th e r th a n to r e n t assets a n d th e y p re fe r th a t th e lessee s h o u ld p u rch a se th e asset a t th e e n d o f th e lease te rm . To be tre a te d as a g e n u in e lease* f o r ta x p u rp o se s, a lease a g re e m e n t c a n n o t e x p lic itly p ro v id e th e lessee w it h an o p tio n to p u rcha se th e asset. H o w e ve r, u n d e r a fin a n c e lease th e lessee w i ll g u a ra n te e th a t

C hapter fifteen Le a s in g

a n d other e q u ip m e nt f in a n c e

th e le ssor receives a sp e cifie d re s id u a l v a lu e fr o m th e sale o f th e asset a t th e e n d o f th e lease te rm . The a im o f th is p ro v is io n is to e n su re t h a t th e lessee p ro p e rly m a in ta in s th e asset. In p ra ctice , th e lessee o fte n purchases th e asset f o r th e re s id u a l v a lu e a t th e e n d o f th e lease te rm .

1 5 .2 .2 1 O perating leases An

o p e ra tin g le a se is e s s e n tia lly a re n ta l a g re e m e n t a n d has a te r m t h a t is s h o rt re la tiv e to th e e co n o m ic

life o f th e leased asset. F o r exa m ple, a tr u c k w it h an e xp ected life o f 15 years m ig h t be leased u n d e r an o p e ra tin g lease f o r 3 years. Because an o p e ra tin g lease covers o n ly p a r t o f th e life o f th e leased asset, i t fo llo w s t h a t th e le s s o r re ta in s a ll o r m o s t o f th e ris k s a n d b e n e fits o f o w n e rs h ip o f th e asset. T his is th e e sse ntia l d iffe re n c e b e tw e e n an o p e ra tin g lease a n d a fin a n c e lease w h e re , as discussed above, th e ris k s

OPERATING LEASE

lease under which the risks and benefits of ownership of the leased asset remain with the lessor

and b e n e fits o f o w n e rs h ip are s u b s ta n tia lly tra n s fe rre d to th e lessee. Lessors are w illin g to re ta in th e ris k s o f o w n e rs h ip o n ly i f th e y are c o n fid e n t t h a t th e asset, w h e n re tu rn e d b y th e lessee, w ill achieve a resale p rice th a t is p re d ic ta b le . A c c o rd in g ly , o p e ra tin g leases are m o re a ttra c tiv e to lessors i f th e re is an a ctive seco nd -han d m a rk e t f o r th e leased asset. D e ta ils o f th e type s o f go od s leased u n d e r th e m a in typ e s o f leases are s h o w n in Table 1 5 .2 . The d e ta ile d fig u re s f o r le a sin g s h o w n in th is ta b le are c o n s is te n t w it h b ro a d e r fig u re s o n th e e q u ip m e n t fin a n ce m a rk e t. The A u s tra lia n E q u ip m e n t Lessors A s s o c ia tio n (w w w .a b s .g o v .a u ) re p o rts t h a t as a t D ecem ber 2 0 1 2 m o to r v e h icle s a cco u n te d f o r 38 p e r c e n t o f to t a l e q u ip m e n t fin a n c e a n d o th e r tr a n s p o r t

|ww^|

e q u ip m e n t f o r 16 p e r ce n t. The re m a in in g 4 6 p e r c e n t is cla s s ifie d as ge n e ra l e q u ip m e n t. A b re a k d o w n o f these b ro a d asset classes is p ro v id e d b y th e A u s tra lia n B ure au o f S ta tis tic s o n ly f o r le a s in g an d, as s h o w n in Table 15 .2, n o n -m o to r le a s in g was d o m in a te d b y o ffic e e q u ip m e n t. In A u s tra lia , o p e ra tin g leases have be en lim it e d m a in ly to m o to r veh icle s, c o m p u te rs a n d m u ltip u rp o s e in d u s tria l e q u ip m e n t such as fo r k lift s . O p e ra tin g leases are n o r m a lly o ffe re d b y th e s u p p lie rs o f th o se assets, such as c o m p u te r co m p a n ie s, a n d b y s p e c ia lis t re n ta l co m p a n ie s, such as m o to r v e h ic le re n ta l com panies. The fig u re s in Table 1 5 .2 sh o w t h a t in 2 0 1 2 -1 3 , m o to r v e h icle s a c c o u n te d f o r 62 p e r c e n t o f th e value o f o p e ra tin g leases e n te re d in to , fo llo w e d b y o ffic e e q u ip m e n t (m a in ly c o m p u te rs ) a t 2 3 p e r cen t. In th e 2 0 1 2 -1 3 year, o p e ra tin g lease c o m m itm e n ts a cco u n te d f o r 29 p e r c e n t o f th e v a lu e o f n e w leases e n te re d in to . A n o p e ra tin g lease a g re e m e n t is n o r m a lly f o r a s h o rt p e rio d a n d th e asset m a y be leased to a series o f users. T h ere fore, an o p e ra tin g lease enables a b u sin ess to o b ta in th e use o f an asset t h a t is re q u ire d f o r o n ly a s h o rt p e rio d . F o r e xa m p le , suppose t h a t a M e lb o u rn e -b a s e d c o m p a n y needs a car f o r use b y an exe cutive v is itin g its A d e la id e b ra n c h f o r a m o n th . The co m p a n y c o u ld b u y a car a n d th e n se ll i t a m o n th la te r b u t t h a t is lik e ly to be b o th in c o n v e n ie n t a n d expensive. As w e ll as n e g o tia tin g th e p u rch a se an d resale prices, th e c o m p a n y w o u ld have to re g is te r a n d in s u re th e car a n d th e n tra n s fe r th e re g is tra tio n and cancel th e in s u ra n c e a m o n th la te r. C learly, in th is case i t m akes sense to r e n t o r lease th e car ra th e r th a n b u y it .

m ain te n an ce le a se s, w h ic h m ea ns t h a t th e le s s o r is re s p o n s ib le f o r

M AINTENANCE LEASE

in s u rin g th e asset, m a in ta in in g i t a n d f o r p a y m e n t o f a n y g o v e rn m e n t charges. A n o p e ra tin g lease enables

operating lease where the lessor is responsible for all mai门te门anc6 a 门d service of the leased asset

O p e ra tin g leases m a y also be

a lessee to use th e asset w ith o u t d ire c tly in c u r r in g th e ris k s o f o w n e rs h ip such as th e r is k o f obsolescence. The lease re n ta ls w ill re fle c t th e costs in c u rre d b y th e le s s o r in c lu d in g th e fa c t t h a t th e le sso r re ta in s th e ris k s o f o w n e rs h ip . F o r th e le ssor, o p e ra tin g leases are ch a ra c te ris e d b y re n tin g o u t assets a n d e xp osu re to th e ris k s o f o w n e rs h ip , ra th e r th a n b y th e p ro v is io n o f fin a n ce . O p e ra tin g leases are discussed f u r t h e r in S ection 15.6.

15.2.3|S ale and lease-back agreements U n d e r a sale

an d lea se -b ac k a g re e m e n t th e o w n e r o f an asset sells th e asset to a fin a n c ia l in s t it u t io n f o r

an a m o u n t u s u a lly eq ua l to it s c u rre n t m a rk e t v a lu e a n d im m e d ia te ly leases i t b a ck fr o m th e in s titu t io n . The o w n e r re lin q u is h e s th e t it le to th e asset in r e tu r n f o r cash a n d agrees to m ake p e rio d ic lease p a y m e n ts to th e lessor. A sale a n d lease-back tra n s a c tio n is an a lte rn a tiv e to ra is in g cash b y b o rro w in g , u s in g th e asset as s e cu rity. The le sso r m a y be an in s u ra n c e com p an y, a lth o u g h som e s u p e ra n n u a tio n fu n d s , b a n ks and s p e c ia lis t le a sin g co m p a n ie s also o ffe r th is fo r m o f fin a n ce . C o m m e rc ia l re a l esta te is o fte n th e su b je ct o f such tra n s a c tio n s . O ffic e b u ild in g s , re ta il stores, h o te ls , m o te ls , re g io n a l s h o p p in g cen tre s,

SALE A N D LEASE-BACK AGREEMENT

agreement in which a company sells an asset and then leases it back

B usiness finance

ra ilw a y r o llin g sto c k , ve h icle fle e ts , w a reh ouse s a n d fa c to rie s have a ll b e en th e su b je c t o f sale a n d lease­ back ag re e m e n ts. The te r m o f a sale a n d lease-back a g re e m e n t w ill d e p e n d o n th e ty p e o f asset c o n ce rn e d b u t in th e case o f c o m m e rc ia l p ro p e rty is u s u a lly less th a n 15 years. The lessee agrees to m ake th e lease p a y m e n ts f o r th is p e rio d and, in a d d itio n , is n o rm a lly re s p o n s ib le f o r p a y m e n t o f m a in te n a n c e costs, in su ra n ce , g o v e rn m e n t charges a n d a n y o th e r costs o f o cc u p a tio n .

¥ LEARNING OBJECTIVE 2 Understand the reasons for leveraged leases and crossborder leases

15.2.41 Leveraged leasing Le vera ged le a sin g , w h ic h is a fo r m o f fin a n c e lease, was in tro d u c e d in to th e A u s tra lia n c a p ita l m a rk e t in th e m id -1 9 7 0 s , a n d since th e n m a n y la rge a n d e xp en sive assets have b e en leased in th is w ay .2 The s tru c tu re o f a le vera ged lease is s h o w n d ia g ra m m a tic a lly in F ig u re 15.1. A le v e r a g e d le a s e d iffe rs fr o m an o rd in a ry fin a n c e lease in t h a t i t in v o lv e s a t le a s t th re e p a rtie s in s te a d o f tw o . The a d d itio n a l p a r ty is a le n d e r a n d is n o rm a lly re fe rre d to as a *debt p a rtic ip a n t*. In p ra ctice th e re m a y be m o re th a n th re e p a rtie s in v o lv e d because th e le s s o r is u s u a lly a p a rtn e rs h ip o f tw o o r m o re e q u ity p a rtic ip a n ts , an d th e re m a y be tw o o r m o re d e b t p a rtic ip a n ts .

LEVERAGED LEASE

The d e b t p a rtic ip a n ts le n d to th e le sso r a h ig h p r o p o r tio n o f th e co st o f th e asset. U n d e r th e p ro v is io n s

finance lease where the lessor borrows most of the funds to acquire the asset

o f T a x a tio n R u lin g IT 2 0 5 1 , th e d e b t p a rtic ip a n ts are e xp ected to c o n trib u te n o m o re th a n 8 0 p e r ce n t

NON-RECOURSE LOAN

S e c u rity f o r th e d e b t p a rtic ip a n t(s ) is p ro v id e d b y an a s s ig n m e n t o f th e lease p a y m e n ts , a n d in som e cases

type of loan used in leveraged leases where the lender has no recourse to the lessor in the event of default by the lessee

o f th e cost o f th e asset. A d e b t p a r tic ip a n t is u s u a lly a life in s u ra n c e co m p a n y, s u p e ra n n u a tio n fu n d , in v e s tm e n t b a n k o r b a n k . T y p ic a lly th e lo a n is a n o n - r e c o u r s e lo a n , w h ic h m ea ns t h a t th e le sso r is n o t re s p o n s ib le f o r its re p a y m e n t. T h e re fo re , i t is im p o r t a n t t h a t th e r is k o f d e fa u lt b y th e lessee is v e ry low . a m o rtg a g e o v e r th e leased asset. The e q u ity p a rtic ip a n ts are g e n e ra lly b a n ks, in v e s tm e n t b a n ks o r fin a n c e co m p a n ie s t h a t have s u ffic ie n t p r o fits to ta ke ad va n ta g e o f th e ta x d e d u c tio n s associated w ith o w n e rs h ip o f th e asset a n d th e

2

For more details of leveraged leasing, its legal documentation and taxation requirements, see Bennett, Hardaker and Worrall (1997, pp. 283-89, 292-303).

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

in te re s t p a y m e n ts o n th e lo a n . The e q u ity p a rtic ip a n ts p ro v id e th e fu n d s n o t a lre a d y p ro v id e d b y th e le n d e r a n d f o r m a p a rtn e rs h ip t h a t pu rcha ses th e asset. A s th e m a jo r ity o r, in som e cases, a ll o f each lease p a y m e n t is p a id o u t as in te re s t a n d p rin c ip a l to th e d e b t p a rtic ip a n t(s ), th e e q u ity p a rtic ip a n ts receive litt le , i f any, cash in flo w fr o m th e lease p a y m e n ts . T h e ir in v e s tm e n t is le ve re d in t h a t th e y p ro v id e o n ly

part

o f th e asse ts purcha se p ric e , b u t th e y receive

all

th e ta x b e n e fits fr o m o w n in g a n d fin a n c in g th e

asset. The e q u ity p a rtic ip a n ts ’ re tu rn s are ach ie ved m a in ly b y d e fe rra l o f ta x p a y m e n ts because th e le sso r p a rtn e rs h ip in c u rs ta x losses d u r in g th e e a rly years o f th e lease. W h ile a le vera ged lease is co m p le x f o r th e lessor, fro m th e lessees v ie w p o in t i t is e s s e n tia lly th e sam e as a n y o th e r fin a n c e lease. The lessee e n te rs in to a n o rm a l lease c o n tra c t, a g re e in g to lease th e asset f o r a sp e cifie d p e rio d a n d to m a ke sp e cifie d lease p a ym en ts.

1 5 .2 .5 1 Cross-border leasing In g e ne ral te rm s , a c r o s s - b o r d e r le a s e (C B L ) is a lease w h e re th e lessee a n d le sso r are lo c a te d in

CROSS-BORDER

d iffe re n t c o u n trie s . Such tra n s a c tio n s are u s u a lly le vera ged a n d are m o tiv a te d b y diffe re n ce s b e tw e e n

LEASE (CBL)

th e ta x re g u la tio n s o f d iffe re n t c o u n trie s . A s c o u n trie s assess tra n s a c tio n s d iffe re n tly , a llo w d e p re c ia tio n to be cla im e d a t d iffe re n t rates, a n d a p p ly d iffe re n t co m p a n y in c o m e ta x rates, i t is po ssib le to s tru c tu re tra n s a c tio n s to ta ke ad va n ta g e o f the se d iffe re n ce s. G en erally, th e lease w ill be s tru c tu re d so t h a t th e lessor a n d lessee can b o th c la im d e p re c ia tio n d e d u c tio n s o n th e sam e asset. Because o f th e costs in v o lv e d

finance lease, usually leveraged, where the lessor and lessee are located in different countries

in e s ta b lis h in g a CBL, o n ly v e ry exp en sive assets are fin a n c e d in th is way. Several c o u n trie s a llo w CBLs because th e y g e n e ra te b e n e fits such as in cre a se d e x p o rts , b u t som e g o v e rn m e n ts , in c lu d in g th e A u s tra lia n G o v e rn m e n t, have m o v e d to discou rage t h e ir use. In p a rtic u la r, re s tric tio n s c o n ta in e d in s e c tio n 5 1 A D a n d D iv is io n 1 6 D o f th e

Income Tax Assessment Act m e a n

th a t it

is v ir tu a lly im p o s s ib le f o r a n A u s tra lia n le sso r to p a rtic ip a te in a c ro s s -b o rd e r lease in v o lv in g a n o ffs h o re asset. H o w eve r, a CBL can be s tru c tu re d so t h a t a fo re ig n le sso r a n d an A u s tra lia n lessee can b o th c la im d e p re c ia tio n d e d u c tio n s , p ro v id e d t h a t th e lease c o n ta in s a pu rcha se o p tio n so t h a t i t is tre a te d as a h ire purchase a g re e m e n t in A u s tra lia . The CBL m a rk e t has b e en d o m in a te d b y tra n s a c tio n s in v o lv in g c o m m e rc ia l a irc ra ft, b u t o th e r assets fin a n ce d in th is w a y in c lu d e p r in t in g presses, tru c k s , r o llin g sto c k , cargo sh ip s a n d s h ip p in g c o n ta in e rs . A CBL can in v o lv e p a rtie s in several d iffe re n t c o u n trie s a n d th e a rra n g e m e n ts are ty p ic a lly v e ry co m p le x. A lso, th e c o n tra c tu a l a rra n g e m e n ts used in th e CBL m a rk e t can change fre q u e n tly in resp on se to fa c to rs such as changes in re g u la tio n s . T here fore, a n y b u sin ess t h a t c o n te m p la te s th e use o f a CBL w ill re q u ire specialised le ga l a n d ta x a tio n advice.

Accounting and taxation treatment of leases 15.3.1 | Accounting for leases3 T ra d itio n a lly , lease re n ta ls w e re re co g n ise d as an expense f o r th e lessee a n d th e re was n o re c o g n itio n b y th e lessee o f a n y lease assets o r lia b ilitie s . This a p p ro a ch was c ritic is e d f o r tw o reasons. F irs t, som e leases p ro v id e v a lu a b le rig h ts a n d o b lig a tio n s t h a t c a n n o t be a v o id e d a n d s h o u ld be in c lu d e d in th e lessees s ta te m e n t o f fin a n c ia l p o s itio n (balance she et). Second, i t was a rg u e d t h a t th e a c c o u n tin g tre a tm e n t o f tra n s a c tio n s s h o u ld be based o n t h e ir e c o n o m ic sub stance ra th e r th a n t h e ir le g a l fo rm . Since a fin a n ce lease is e c o n o m ic a lly e q u iv a le n t to b o rro w in g a n d b u y in g an asset, i t fo llo w s t h a t th e rig h ts a n d o b lig a tio n s in v o lv e d in a fin a n c e lease s h o u ld be s h o w n o n th e lessees s ta te m e n t o f fin a n c ia l p o s itio n . In A u s tra lia , A c c o u n tin g S ta n d a rd A ASB 11 7, Xeases*, p ro v id e s t h a t th e a c c o u n tin g tr e a tm e n t o f a lease depends o n w h e th e r i t is cla ssifie d as an o p e ra tin g lease o r a fin a n c e lease. O p e ra tin g leases are tre a te d in th e tra d itio n a l w a y b u t fin a n c e leases m u s t be re co g n ise d as assets a n d lia b ilitie s . AASB 1 1 7 p ro v id e s 3

For a full discussion of this topic, see Henderson, Peirson and Herbohn (2013).

LEARNING OBJECTIVE 3 Outline the accounting and tax treatment of leases in Australia

th a t a lease w o u ld n o rm a lly be cla s s ifie d as a fin a n c e lease i f s u b s ta n tia lly a ll o f th e ris k s a n d rew ards a sso cia te d w it h o w n e rs h ip o f th e leased asset are e ffe c tiv e ly tra n s fe rre d to th e lessee (para.

8 ). W h e re

th e

lease is a fin a n c e lease, a lease asset a n d lia b ilit y e q u a l to th e f a ir v a lu e o f th e leased p ro p e rty or, i f lo w e r, th e p re s e n t va lu e o f th e m in im u m lease p a y m e n ts m u s t be reco gn ised . H o w e ve r, som e lessees be lie ve t h a t i t is ad van ta g e o u s to a v o id re c o g n is in g fin a n c e leases as assets a n d lia b ilitie s . C o n se q u e n tly, lessors have re s p o n d e d b y d e s ig n in g leases t h a t are, in s ubstance, fin a n c e leases b u t can be cla ssifie d as o p e ra tin g leases u n d e r A ASB 117. T his a c tiv ity c o n tin u e d , d e sp ite e ffo rts b y th e s ta n d a rd se tte rs to em phasise th a t th e c la s s ific a tio n o f a lease s h o u ld d e p e n d o n it s e co n o m ic sub stance ra th e r th a n its legal fo rm . In response to s u s ta in e d c ritic is m b y users o f fin a n c ia l s ta te m e n ts t h a t th e a c c o u n tin g tr e a tm e n t o f leases was le a d in g to w id e s p re a d u n d e rs ta te m e n t o f d e b t le vels, in M a y 2 0 1 3 th e I n te r n a tio n a l A c c o u n tin g S ta n d a rd s B oa rd (IA S B ) a n d th e F in a n c ia l A c c o u n tin g S ta n d a rd s B o a rd (FASB) jo in t ly released f o r c o m m e n t a p ro p o se d a c c o u n tin g s ta n d a rd f o r leases th a t, i f a d o p te d , w o u ld replace th e e x is tin g A u s tra lia n s ta n d a rd A ASB 117. The k e y change suggested in th e p ro p o s e d s ta n d a rd was t h a t a ll n o n -re a l esta te leases o f g re a te r th a n

12

m o n th s ’ d u ra tio n w o u ld n e ed to be c a p ita lis e d in th e lessee’s s ta te m e n t o f fin a n c ia l p o s itio n —

re s u ltin g in th e re c o g n itio n o f b o th a lease asset a n d c o rre s p o n d in g lia b ility . As a t F e b ru a ry 20 14 , fo llo w in g a le n g th y p e rio d o f c o n s u lta tio n a n d n u m e ro u s s u b m is s io n s b y in te re s te d p a rtie s , th e Boards are 're d e lib e ra tin g * th e p ro p o sa ls, w h ic h u ltim a te ly w ill r e s u lt in a f u r t h e r d r a ft o f th e p ro p o s e d sta n d a rd .

1 5 .3 .2 1 Taxation treatment of leases The ta x a tio n tr e a tm e n t o f leases in A u s tra lia can be co m p le x a n d has been su b je c t to m a n y changes th ro u g h b o th le g is la tio n a n d ta x a tio n r u lin g s .4 O n ly a b ro a d o u tlin e o f th e m a in p rin c ip le s is p ro v id e d here. I f a leased asset is used to g e n e ra te ta x a b le in co m e , th e lease re n ta ls p a id b y th e lessee are an a llo w a b le ta x d e d u c tio n , p ro v id e d t h a t th e lease is cla s s ifie d as a g e n u in e lease 1 ra th e r th a n an In s t a lm e n t purchase arra n g e m e n t*. The p u rp o s e o f th is d is tin c tio n is to p re v e n t ta xp a ye rs u s in g le a sin g as a w a y o f o b ta in in g accelerated ta x d e d u c tio n s b y c la im in g , as d e d u c tio n s , o u tla y s t h a t are o f a c a p ita l n a tu re . C o nse que ntly, a d e d u c tio n m a y n o t be a llo w e d f o r lease re n ta ls i f th e lease a g re e m e n t gives th e lessee an o p tio n to p u rcha se th e leased asset a t th e e n d o f th e lease t e r m

.5

S im ila rly , th e C o m m is s io n e r o f T a x a tio n has

sp e cifie d ru le s c o n c e rn in g acceptable re s id u a l values a n d m a y d is a llo w a d e d u c tio n f o r lease re n ta ls th a t have b e en in crea sed b y th e use o f an u n re a lis tic a lly lo w re s id u a l value. W h ile lease re n ta ls are d e d u c tib le , th e lessee c a n n o t d e d u c t, f o r ta x p u rp o se s, d e p re c ia tio n o n th e leased asset. D e p re c ia tio n is d e d u c tib le b y th e le sso r as th e le g a l o w n e r o f th e asset, a n d lease re n ta ls rece ive d b y th e le sso r are, o f course, ta xa b le . Lessors m a y a tte m p t to d e fe r ta x p a y m e n ts b y v a ry in g th e size o r fre q u e n c y o f th e re n ta ls d u rin g th e te r m o f a lease. The A u s tra lia n T a x a tio n O ffic e m a y s c ru tin is e such a rra n g e m e n ts a n d is p a r tic u la r ly sce p tica l o f lease s tru c tu re s t h a t in v o lv e in cre a se d re n ta ls o ve r tim e (S zekely 1 9 9 1 , p. 49 ). The ta x a tio n ru le s o fte n have an im p o r t a n t e ffe c t o n th e choice b e tw e e n le a sin g a n d o th e r s im ila r fo rm s o f fin a n ce . F o r exa m ple, i f i t is a d va n ta g e o u s f o r d e p re c ia tio n d e d u c tio n s to be c la im e d b y th e asset user, a c h a tte l m o rtg a g e o r a h ire -p u rc h a s e a g re e m e n t m a y be used, ra th e r th a n a lease. C h a tte l m o rtg a g e s a n d h ire -p u rc h a s e are discussed in S e c tio n 15.8.

Setting lease rentals W h ile th e m a in em p ha sis in th is b o o k is o n th e v ie w p o in t o f th e lessee, i t is u s e fu l to c o n s id e r th e LEARNING OBJECTIVE 4 Calculate rentals for a finance lease

a p p ro a ch use d b y lessors in s e ttin g lease re n ta ls . P ro sp e ctive lessees w h o u n d e rs ta n d th e fa c to rs th a t in flu e n c e lease re n ta ls s h o u ld be in a s tro n g e r n e g o tia tin g p o s itio n th a n th o s e w h o do n o t. The s e ttin g o f lease re n ta ls is illu s tra te d in E xa m p le 15.1.

5

For a more detailed coverage of the taxation effects of leasing in Australia, see Australian Equipment Lessors Association (www.ae /.aela.asn.au). Although the requirements of the Commissioner of Taxation, set out in Taxation Ruling IT28, prevent the lessor from providing the lessee with an option to buy the asset, it is usual for such an option to be implicit in finance lease agreements. In the vast majority of cases, the lessee buys the asset by payment of the specified residual value at the end of the initial lease period. In most other cases the lessee renews the lease for an additional period.

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

E xample 15.1 M o n le a s e h a s b e e n a s k e d b y a g r o u p o f d o c to rs to q u o te o n a 4 - y e a r le a s e o f a n ite m o f m e d ic a l e q u ip m e n t th a t c o sts $ 6 0 0 0 0 0 . T h e e q u ip m e n t c a n b e d e p r e c ia t e d f o r t a x p u rp o s e s o n a s tra ig h t-lin e b a s is o v e r 3 y e a rs . M o n le a s e h a s a ta x ra te o f 3 0 p e r c e n t a n d re q u ire s a ra te o f re tu rn o f 8 p e r c e n t p e r a n n u m a fte r ta x fro m le a s e s . T h e re a r e to b e fo u r e q u a l le a s e p a y m e n ts , p a y a b le a n n u a lly in a d v a n c e . T he a g r e e d r e s id u a l v a lu e is $ 1 2 0 0 0 0 . W h a t is th e m in im u m a n n u a l le a s e p a y m e n t th a t M o n le a s e s h o u ld q u o te ?

SOLUTION The m a n a g e r o f M o n le a s e c a lc u la te s th e le a s e p a y m e n ts u s in g th e f o llo w in g step s, a)

Calculate the present value o f cosh flows from asset ownership.

T h e se c a s h flo w s a r e th e ta x

s a v in g s o n d e p r e c ia tio n a n d th e a fte r-ta x c a s h in flo w fro m th e s a le o f th e a s s e t (a t th e re s id u a l v a lu e ) a t th e e n d o f th e le a s e te rm . T h e p re s e n t v a lu e o f th e d e p r e c ia t io n ta x s a v in g s is c a lc u la te d a s s h o w n in T a b le 1 5 . 3 .

TABLE 15.3 Year

D e p re c ia tio n (D)

T ax s a v in g s (D x ta x ra te )

PV fa c to r @ 8 % p .a .

P rese nt v a lu e

1

$200000

$60000

0.9259

$55556

2

$200000

$60000

0.8573

$51440

3

$200000

$60000

0.7938

$47630 $154626

Total

M o n le a s e w ill a ls o re c e iv e th e re s id u a l v a lu e o f $ 1 2 0 0 0 0 b u t w ill h a v e to p a y ta x o n th e re s u ltin g p r o fit o n th e s a le o f th e e q u ip m e n t, w h ic h

is a ls o $ 1 2 0 0 0 0

b e c a u s e th e e q u ip m e n t

ha s a w r itte n - d o w n v a lu e fo r ta x p u rp o s e s o f z e r o . T h e re fo re , th e a fte r-ta x c a s h in flo w w ill b e $ 1 2 0 0 0 0 (1

-

0 . 3 ) = $ 8 4 0 0 0 , w h ic h h a s a p re s e n t v a lu e o f $ 8 4 0 0 0 / 1 . 0 8 4 = $ 8 4 0 0 0

x

0 . 7 3 5 0 o r $ 6 1 7 4 3 . T h e to ta l c a s h flo w s a s s o c ia te d w ith o w n e r s h ip o f th e e q u ip m e n t h a v e a p re s e n t v a lu e o f $ 1 5 4 6 2 6 + $ 6 1 7 4 3 = $ 2 1 6 3 6 9 . b)

Calculate the required present value o f the lease payments.

T h e a s s e t c o sts $ 6 0 0 0 0 0 , o f w h ic h

M o n le a s e w ill re c o v e r $ 2 1 6 3 6 9 fro m its o w n e r s h ip . T h e re fo re , th e r e q u ire d p re s e n t v a lu e o f th e le a s e p a y m e n ts is $ 6 0 0 0 0 0 - $ 2 1 6 3 6 9 = $ 3 8 3 6 3 1 . c)

Calculate the minimum ofter-tox lease payment.

W it h

a n n u a l le a s e p a y m e n ts ,

L,

p a y a b le

in

advance:

$383 631 = 二

\

1+ — 0.08

(1.08)3

【 (1 +2.5771)

$383 631 ~ 3.5771 = $107246

L_

d)

Calculate the minimum before-tox lease payment, L\ given the tax rote tc. = 1- t c

$107246 =$1532〇9 1 -0 .3

To a c h ie v e its r e q u ire d ra te o f re tu rn o f 8 p e r c e n t a fte r ta x , M o n le a s e s h o u ld q u o te a n n u a l le a s e p a y m e n ts o f $ 1 5 3 2 0 9 . F ro m th e s e c a lc u la tio n s it s h o u ld b e c le a r th a t M o n le a s e w o u ld b e a b le to q u o te lo w e r le a s e re n ta l p a y m e n ts if:

higher higher lower.

i) th e d e p r e c ia tio n r a te f o r ta x p u rp o s e s is ii) th e re s id u a l v a lu e o f th e e q u ip m e n t is iii) th e le s s o r's r e q u ire d ra te o f re tu rn is

6

B usiness finance

In p ra c tic e , o th e r fa c to rs w i ll also a ffe c t lease re n ta l p a y m e n ts . F o r exa m ple, le ssors w i ll a d ju s t lease re n ta ls to re fle c t a n y tra n s a c tio n costs in v o lv e d in e s ta b lis h in g th e lease a n d a n y g o v e rn m e n t charges, such as s ta m p d u ty a n d th e go od s a n d services ta x (G ST). T hey are also lik e ly to a d ju s t th e re q u ire d rate o f r e t u r n to re fle c t d iffe re n ce s in c re d it r is k b e tw e e n d iffe re n t lessees, a n d th e y m a y ta k e in to acco un t th e e xa ct tim in g o f ta x effects. T h e re fo re , f o r som e leases, p a r tic u la r ly la rg e ones, th e c a lc u la tio n o f lease re n ta ls is m o re co m p le x th a n th e p ro c e d u re illu s tra te d in E xa m p le 15.1. O n th e o th e r h a n d , th e p ro ce d u re m a y be less co m p le x. F o r s m a ll leases, a le sso r m a y ca lcu la te th e re q u ire d lease p a y m e n ts u s in g b e fo re -ta x cash flo w s a n d a b e fo re -ta x ra te o f re tu rn .

m LEARNING OBJECTIVE 5 Evaluate a finance lease from the lessee’s viewpoint

15.5 Evaluation of finance leases M a n y m e th o d s have been suggested f o r e v a lu a tin g fin a n c e leases. O ne rea son f o r th is is th a t th e re has been c o n tro v e rs y o v e r th e q u e s tio n o f h o w to s tru c tu re th e e v a lu a tio n o f leases; som e a u th o rs suggest t h a t th e a p p ro p ria te c o m p a ris o n is ‘le a sin g versu s b o r r o w in g ’，w h ile o th e rs suggest t h a t ‘le a sin g versus b u yin g * is th e c o rre c t ap pro ach. The a p p ro a ch w e discuss was p re s e n te d b y M y e rs , D ill an d B a u tis ta (M D B ) (1 9 7 6 ). E sse n tia lly, th e m ech an ics o f th e M D B m e th o d o f a n a ly s in g a fin a n c e lease are id e n tic a l to th o s e p ro p o s e d e a rlie r b y o th e r a u th o rs .6 H o w eve r, th e m a in c o n tr ib u tio n m ade b y M D B lie s in a n a ly s in g a fin a n c e lease in th e c o n te x t o f its e ffe c t o n th e lessees c a p ita l s tru c tu re . In p a rtic u la r, M D B e m p h a sise d t h a t e n te rin g in to a fin a n ce lease uses som e o f th e lessees d e b t capacity. T here fore, i t fo llo w s t h a t a fin a n c e lease s h o u ld be analysed b y c o m p a rin g i t w it h d e b t. M D B sho w e d t h a t th is c o n c lu s io n fo llo w s even i f th e c o m p a ris o n is in it ia lly v ie w e d as lease versus buy. T hey p o in te d o u t t h a t th e p h rase le a s e versus b u y 1 is v ir t u a lly m e a n in g le ss u n le ss th e m ea ns o f fin a n c in g th e p u rch a se are sp e cifie d . S uppose t h a t th e c o m p a ris o n is s p e c ifie d as le a s in g ve rsu s b u y in g , u s in g n o r m a l fin a n c in g — t h a t is, th e m ix tu r e o f d e b t a n d e q u ity in th e co m p a n y s n o rm a l c a p ita l s tru c tu re . I t is th e n necessary to a llo w f o r th e fa c t t h a t lease fin a n c e w ill use som e o f th e co m p a n y s d e b t capacity. W h e n th is is d o n e i t can be seen th a t, in e ffe c t, lease fin a n c e m u s t be co m p a re d w it h d e b t. The e ffe c t o f lease fin a n c e in u s in g d e b t c a p a city is illu s tra te d in E xa m p le 15.2. E xa m p le 15 .2 show s t h a t le a sin g uses a c o m p a n y s d e b t cap acity, w h ic h suggests t h a t a fin a n c e lease s h o u ld be e va lu a te d b y c o m p a rin g i t w it h o th e r d e b t fin a n ce . H o w e ve r, th is does n o t m e a n t h a t th e a lte rn a tiv e to le a s in g an asset is to b o rro w an a m o u n t e q u a l to th e p u rcha se p ric e o f th e asset. R a th e r i t m eans t h a t fin a n c e lease e v a lu a tio n m u s t a llo w f o r th e fa c t t h a t a c o m p a n y e n te rin g in to a fin a n c e lease reduces it s a b ility to b o rro w in o th e r w a ys— t h a t is, th e o b lig a tio n to m a ke re n ta l p a y m e n ts u n d e r a lease uses u p som e o f th e d e b t ca p a city p ro v id e d b y th e co m p a n y s assets. F o r le a s in g to be e c o n o m ic a lly

E xample 15.2 H e a v y H a u la g e Ltd h a s asse ts w ith a m a rk e t v a lu e o f $ 5 0 0 0 0 0 , fin a n c e d b y a c a p it a l s tru c tu re of $ 2 5 0 0 0 0

e q u ity a n d $ 2 5 0 0 0 0 d e b t. T h e c o m p a n y n e e d s a n e w tru c k , w h ic h c a n e ith e r b e

p u rc h a s e d fo r $ 1 0 0 0 0 0 o r le a s e d . W h a t e ffe c t w ill le a s in g th e tru c k h a v e o n th e c o m p a n y 's d e b t c a p a c ity ?

SOLUTION If th e tru c k is p u rc h a s e d u s in g th e c o m p a n y ’s n o r m a l c o m b in a t io n o f d e b t a n d e q u ity , th e s ta te m e n t o f f in a n c ia l p o s itio n w ill b e a s fo llo w s : S ta te m e n t o f fin a n c ia l p o s itio n

Assets

$500000

Debt

$300000

Truck

$100000

Equity

$300000

$600000

6

$600000

For an analysis of the origins of the MDB method, see Burrows (1988).

C hapter fifteen Le a s in g

a n d other e q u ip m e nt f in a n c e

A lte rn a tiv e ly , if th e tru c k is le a s e d , th e s ta te m e n t o f f in a n c ia l p o s itio n w ill b e : S ta te m e n t o f fin a n c ia l p o s itio n 2

Assets

$500000

Debt

$250000

Truck

$10 0 0 0 0

Lease liability

$10 0 0 0 0

Equity

$250000 $600000

$600000

L e a s in g h a s in c r e a s e d th e c o m p a n y 's d e b t - e q u it y r a t io b e c a u s e th e le a s e lia b ilit y is a n a d d itio n a l ty p e o f d e b t in th e c o m p a n y 's c a p it a l s tru c tu re . To re s to re th e o r ig in a l d e b t - e q u it y r a tio , th e c o m p a n y s h o u ld ra is e a n o th e r $ 5 0 0 0 0 o f e q u ity a n d r e p a y th e d e b t o f $ 5 0 0 0 0 . A fte r th e se c h a n g e s , th e s ta te m e n t o f fin a n c ia l p o s itio n w ill c o n ta in e q u ity o f $ 3 0 0 0 0 0 , d e b t o f $ 2 0 0 0 0 0 a n d th e le a s e lia b ilit y o f $ 1 0 0 0 0 0 . A c o m p a r is o n w ith S ta te m e n t o f f in a n c ia l p o s itio n 1 s h o w s th a t th e le a s e use d $ 1 0 0 0 0 0 o f th e c o m p a n y 's d e b t c a p a c ity .

advantageous to a lessee, th e fin a n c e p ro v id e d b y le a sin g m u s t be g re a te r th a n th e lia b ilit y in c u rre d b y leasing. The M D B m e th o d focuses o n m a k in g t h a t c o m p a ris o n b y c a lc u la tin g th e lia b ilit y in c u rre d b y leasing. E xa m p le 15 .3 illu s tra te s th e M D B m e th o d .

Example 15.3 S h a re m a rk e t R e s e a rch Ltd (SRL) n e e d s a n e w c o m p u te r, w h ic h c a n b e p u rc h a s e d fo r $ 6 0 0 0 0 0 . T he c o m p a n y 's f in a n c ia l m a n a g e r, E llio tt W a v e , is c o n s id e r in g th e a lte r n a tiv e o f le a s in g th e c o m p u te r fro m

E ffic ie n t F in a n c e , w h ic h

re q u ire s s ix le a s e re n ta ls o f $ 1 2 6 0 0 0

e a c h , p a y a b le a n n u a lly in

a d v a n c e . T he c o m p u te r c a n b e d e p r e c ia te d fo r ta x p u rp o s e s o v e r 3 y e a rs o n a s tra ig h t-lin e b a s is a n d its d is p o s a l v a lu e is e x p e c te d to b e z e r o a t th e e n d o f th e le a s e . T h e c o m p a n y in c o m e ta x ra te is 3 0 p e r c e n t. Is th e p r o p o s e d le a s e a ttr a c tiv e to SRL?

SOLUTION The in c re m e n ta l c a s h flo w s f o r le a s in g th e c o m p u te r, ra th e r th a n b u y in g it, a r e s h o w n in T a b le 1 5 .4 .

TABLE 15.4 Cash flows: lease versus purchase C a s h flo w s ($) Item

Year 0

1. Cost o f com p uter

600000

2. Lease rentals 3. Tax savings on lease

Year 1

Year 2

Year 3

Year 4

Year 5

—

—

—

—

—

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

37800

37800

37800

37800

37800

37800

-6 0 0 0 0

-6 0 0 0 0

-6 0 0 0 0

-1 4 8 2 0 0

-1 4 8 2 0 0

-1 4 8 2 0 0

rentals 4. D epreciation tax

一

_

一

savings lo s t Total

511800

-8 8 2 0 0

-8 8 2 0 0

R e m e m b e rin g th a t th e ta b le s h o w s th e increm ental c a s h flo w s fo r le a s in g ve rsu s b u y in g , th e e x p la n a tio n f o r e a c h ite m is s tr a ig h tfo r w a r d . F irst, b y le a s in g th e c o m p u te r, SRL d o e s n o t n e e d to p a y th e p u rc h a s e p r ic e o f $ 6 0 0 0 0 0 . T h e re fo re , th e re is a n e ffe c tiv e c a s h in flo w o f th is a m o u n t. S e c o n d , th e le a s e re n ta ls a r e a c a s h p a y m e n t e a c h y e a r, b u t th e se p a y m e n ts a r e ta x d e d u c tib le , g e n e r a tin g a n n u a l ta x s a v in g s o f $ 3 7 8 0 0 , w h ic h a r e a c a s h in flo w . F in a lly , b y le a s in g ra th e r th a n b u y in g , SRL

continued

6

B usiness finance

continued is u n a b le to c la im d e p r e c ia tio n d e d u c tio n s o f $ 2 0 0 0 0 0 p e r a n n u m in Y e a rs 1 , 2 a n d 3 . T h e re fo re , it fo r g o e s t a x s a v in g s o f $ 6 0 0 0 0 in e a c h o f th e se y e a rs . T h e b o tto m r o w o f T a b le 1 5 . 4 s h o w s th a t th e le a s e p r o v id e s f in a n c e o f $ 5 1 1 8 0 0 to SRL a n d re q u ire s n e t c a s h o u tflo w s b y SRL in Y e a rs 1 to 5 . To d e te r m in e w h e th e r th e le a s e is a ttr a c tiv e to SRL, th e c a s h o u tflo w s in Y e a rs

1 to 5 c a n b e

r e g a r d e d as a fte r-ta x re p a y m e n ts o f a lo a n th a t is e q u iv a le n t to th e le a s e — th a t is, w e a s k : if SRL h a d o ffe r e d th is set o f re p a y m e n ts to a n a lte r n a tiv e le n d e r, h o w m u c h c o u ld SRL h a v e b o r r o w e d ? If th e a m o u n t is less th a n $ 5 1 1 8 0 0 , SRL s h o u ld a c c e p t th e le a s e . T h e a m o u n t th a t c o u ld b e b o r r o w e d fro m a n a lte r n a tiv e le n d e r w ill d e p e n d o n th e in te re s t r a te o n th e h y p o th e tic a l e q u iv a le n t lo a n . T he in te re s t r a te w ill, in tu rn , d e p e n d o n th e s e c u rity o ffe r e d to th e le n d e r. F o r th e lo a n to b e e q u iv a le n t to th e le a s e , th e s e c u rity s h o u ld b e th e s a m e a s th a t h e ld b y th e le sso r. If th e le s s o r's o n ly s e c u rity is o w n e r s h ip o f th e c o m p u te r, th e in te re s t ra te o n a lo a n s e c u re d b y a m o r t g a g e o r o th e r c h a r g e o v e r th e c o m p u te r c o u ld b e a p p r o p r ia t e . 7 A s s u m e th a t E llio tt W a v e h a s b e e n q u o te d a ra te o f 1 0 . 8 p e r c e n t p e r a n n u m o n such a lo a n . B e c a u s e th e c a s h flo w s to b e d is c o u n te d a r e a fte r ta x , th e d is c o u n t ra te m u st a ls o b e a fte r t a x — th a t is, 1 0 . 8 x (1 - 0 . 3 ) = 7 . 5 6 p e r c e n t p e r a n n u m . T h e p re s e n t v a lu e o f th e n e t c a s h o u tflo w s is:

$148200 0 .0 7 5 6

(1 .0 7 5 6 )3 .

$88200

$88200

(1.07 56 )4

(1.07 56 )5

$512141 T he le a s e p r o v id e s fin a n c e o f $ 5 1 1 8 0 0 a n d th e p re s e n t v a lu e o f th e lia b ilit y in c u r r e d b y le a s in g is $ 5 1 2 1 4 1 , so th e n e t p re s e n t v a lu e (N P V ) o f th e le a s e re la tiv e to th e e q u iv a le n t lo a n is: N P V = $ 5 1 1 8 0 0 - $ 5 1 2 141 = - $ 3 4 1 B a s e d o n th is a n a ly s is th e le a s e is m a r g in a lly u n a ttra c tiv e a n d s h o u ld n o t b e a c c e p te d b y SRL.

15.5.1 | Leasing decisions and investment decisions To in te r p r e t c o rre c tly th e re s u lt o f a lease e v a lu a tio n such as t h a t in E xa m p le 15 .3, i t is necessary to

given that the services provided by the asset are to be acquired. I n o th e r w o rd s , th e lease e v a lu a tio n gives an N P V fo r le a s in g th e asset relative to b u y in g it . Suppose t h a t in E xa m p le 1 5 .3 th e N P V o f th e lease w as $ 1 0 0 0 . This u n d e rs ta n d t h a t th is e v a lu a tio n relates o n ly to th e q u e s tio n o f w h e th e r i t is b e tte r to lease o r buy,

p o s itiv e N P V does n o t ne ce ssa rily m e a n t h a t SRL s h o u ld lease th e c o m p u te r. I f b u y in g th e c o m p u te r has a n e g a tiv e NPV, say - $ 5 0 0 0 , th e n le a sin g i t w o u ld n o t be a ttra c tiv e because th e to t a l N P V f o r a c q u irin g th e c o m p u te r b y le a sin g is: N P V i f p u rch a se d N P V o f lease re la tiv e to purcha se N P V o f le a s in g c o m p u te r

-$ 5 0 0 0 $1000 -$ 4 0 0 0

Since th e to t a l N P V is n e g a tive , th e c o m p u te r s h o u ld n o t be leased: le a s in g is b e tte r t h a n p u rch a sin g , b u t b o th a lte rn a tiv e s are u n p ro fita b le . In p ra c tic e , th e in v e s tm e n t d e c is io n w o u ld n o r m a lly be c o n sid e re d f ir s t and, i f th e p ro je c t were p ro fita b le , th e a lte rn a tiv e o f le a sin g th e re q u ire d assets w o u ld th e n be e va lu a te d . H o w e ve r, th e fin a n c ia l m a n a g e r s h o u ld n o t ne ce ssa rily d isca rd a p ro je c t i f e v a lu a tio n o f th e in v e s tm e n t d e c is io n reveals a n e g a tive NPV. In som e cases, th e N P V o f a lease can be la rg e e n o u g h to Vescue 1 an o th e rw is e m a rg in a lly u n p ro fita b le p ro je c t.

7

The lessors formal security is generally, but not always, restricted to ownership of the leased asset. A case in which additional security was required is cited by Burrows (1998, p. 117). For evidence on factors that affect the cost of lease finance, see Schallheim et al. (1987).

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

15.5.2|The value of leasing in competitive capital markets L a te r sectio ns, in c lu d in g S e c tio n 1 5 .5 .3 , discuss som e o f th e c o n d itio n s t h a t can re s u lt in a lease h a v in g a p o s itiv e N P V f o r th e lessee. Lease fin a n c e is p ro v id e d in m a rk e ts t h a t are h ig h ly c o m p e titiv e , w h ic h has im p o r ta n t im p lic a tio n s f o r th e value o f leasing. To e x a m in e the se im p lic a tio n s , suppose t h a t a ll fin a n c ie rs an d asset users o p e ra te in a p e rfe c t c a p ita l m a rk e t w h e re th e fo llo w in g c o n d itio n s a p p ly: a

le asin g in v o lv e s n o tra n s a c tio n costs

b

in fo r m a tio n is costless a n d fre e ly a va ila ble

C

a ll p a rtie s are su b je c t to th e sam e ta x la w s a n d ta x rates. U n d e r these c o n d itio n s , th e cost o f le a s in g an asset s h o u ld be e x a c tly th e sam e as th e cost o f b u y in g

i t — t h a t is, th e le a se -o r-b u y d e c is io n s h o u ld be a m a tte r o f in d iffe re n c e . The a rg u m e n t t h a t leads to th is co n clu sio n w ill be e x p la in e d u s in g , f o r illu s tr a tiv e p u rp o se s, th e d a ta a n d re s u lts o f E xa m p le 15 .3. In th a t exam ple, th e N P V f o r th e lessee o f le a sin g th e n e w c o m p u te r ra th e r th a n p u rc h a s in g i t w as -$ 3 4 1 . N o w c o n s id e r th e p o s itio n o f th e lessor, E ffic ie n t Finance. F ro m th e le s s o rs v ie w p o in t th e d e cisio n is w h e th e r to lease th e c o m p u te r to SRL o r to le n d SRL fu n d s to b u y i t . I f E ffic ie n t F in a n ce is to lease th e c o m p u te r to SRL, i t m u s t f ir s t b u y th e c o m p u te r f o r $ 6 0 0 00 0. E ffic ie n t F in a n ce w ill receive th e lease re n ta ls, be ta xe d on th e m a n d can c la im ta x d e d u c tio n s f o r d e p re c ia tio n o f th e c o m p u te r. T here fore, p ro v id e d th a t b o th p a rtie s are ta xe d a t th e sam e rate, th e lessee s a fte r-ta x cash o u tflo w s are th e le s s o rs a fte r-ta x cash in flo w s . In o th e r w o rd s, E ffic ie n t F in a n c e s n e t cash flo w s w ill be th o s e s h o w n in th e b o tto m ro w o f Table 15.4, w it h th e sig n s reversed. Because th e a p p ro p ria te d is c o u n t ra te w ill re m a in u n c h a n g e d a t 7.5 6 p e r ce n t p e r a n n u m , th e N P V o f th is lease f o r th e le s s o r m u s t be + $ 3 4 1 . U n d e r the se circu m sta n ce s, th e lease a lte rn a tiv e is a ttra c tiv e to th e le sso r b u t n o t to th e lessee. R educing th e lease re n ta ls w o u ld increase th e v a lu e o f th e lease to SRL b u t m u s t also cause a n eq ua l re d u c tio n in th e v a lu e o f th e lease to E ffic ie n t F ina nce . Because o f th e s y m m e try b e tw e e n th e p o s itio n s o f th e tw o p a rtie s , i t is im p o s s ib le to d e sig n a lease t h a t w ill be m o re a ttra c tiv e to th e lessee th a n b o rro w in g , w ith o u t s im u lta n e o u s ly m a k in g th e lease less a ttra c tiv e to th e lessor. F u rth e r, in a p e rfe c t c a p ita l m a rk e t, lessors s h o u ld e a rn o n ly a n o rm a l ra te o f r e tu r n o n t h e ir a c tiv itie s . Therefore, in e q u ilib riu m , th e N P V o f p r o v id in g lease fin a n c e s h o u ld be zero. A g a in , because o f th e s y m m e tric a l p o s itio n s o f th e tw o p a rtie s , th e N P V o f le a s in g f o r th e lessee m u s t also be zero. T here fore, in a p e rfe c t c a p ita l m a rk e t a ll asset users s h o u ld be in d iffe r e n t b e tw e e n th e a lte rn a tiv e s o f le a sin g a n d b u yin g . This c o n c lu s io n s h o u ld n o t be s u rp ris in g . The le a s e -o r-b u y d e c is io n is a fin a n c in g d e cisio n , and, as discussed in C h a p te r 12, M o d ig lia n i a n d M ille r sh o w e d th a t, in a p e rfe c t c a p ita l m a rk e t, fin a n c in g de cisions have no e ffe c t o n s h a re h o ld e rs ’ w e a lth . In o th e r w o rd s, ju s t as th e re is n o m a g ic in fin a n c ia l leverage in a p e rfe c t c a p ita l m a rk e t, so th e re is n o m a g ic in leasing. C a lc u la tio n o f th e e q u ilib r iu m lease re n ta ls t h a t s h o u ld m a ke an asset u se r in d iffe r e n t b e tw e e n le a sin g and b u y in g is s h o w n in E x a m p le 15.4.

Example

15.4

W e s te rn C o m p u te r S e rv ic e s Ltd (W C S ) is c o n s id e r in g th e a c q u is itio n o f a c o m p u te r th a t c a n b e p u rc h a s e d fo r $ 5 0 0 0 0 0

o r le a s e d . T h e le a s e is to in v o lv e fiv e e q u a l re n ta l p a y m e n ts , p a y a b le

a n n u a lly in a d v a n c e , w ith a re s id u a l v a lu e o f $ 5 0 0 0 0 a fte r 5 y e a rs . W C S e x p e c ts to b e p a y in g ta x a t th e ra te o f 3 0 p e r c e n t d u r in g th e te rm o f th e le a s e . W h a t a r e th e m a x im u m le a s e re n ta ls th a t s h o u ld b e p a id , g iv e n th a t th e in te re s t ra te o n a n e q u iv a le n t lo a n is 1 0 p e r c e n t p e r a n n u m ?

SOLUTION A s in E x a m p le 1 5 . 3 , th e firs t ste p is to d e te r m in e th e in c re m e n ta l c a s h flo w s fo r le a s in g ve rs u s b u y in g . T he a d d itio n a l fa c to r to b e c o n s id e r e d is th e tre a tm e n t o f th e re s id u a l v a lu e , w h ic h in th is c a s e is $ 5 0 0 0 0 . To p u t th e le a s e a n d p u rc h a s e a lte rn a tiv e s o n th e s a m e b a s is it m ust b e a s s u m e d th a t W C S p a y s th e r e s id u a l v a lu e a n d t h e re b y p u rc h a s e s th e c o m p u te r fro m th e le sso r. T h is ra is e s o n e fu rth e r c o m p lic a tio n : if W C S le a se s th e c o m p u te r a n d th e n p u rc h a s e s it, th e c o m p a n y c a n c la im ta x d e d u c tio n s , b e g in n in g in Y e a r 6 , fo r d e p r e c ia tio n b a s e d o n th e p u rc h a s e p r ic e o f $ 5 0 0 0 0 . If W C S h a d p u rc h a s e d th e c o m p u te r w h e n it w a s n e w , a ll d e p r e c ia t io n d e d u c tio n s w o u ld h a v e b e e n c la im e d

continued

continued d u r in g th e firs t 3 y e a rs . T h e re fo re , th e t w o a lte rn a tiv e s in v o lv e a d iffe re n c e in a llo w a b le ta x d e d u c tio n s a fte r th e le a s e te rm . To m a k e a n u n b ia s e d c o m p a r is o n , it w ill b e a s s u m e d th a t in e a c h a lte r n a tiv e th e c o m p u te r is s o ld a t th e e n d o f Y e a r 5 — th a t is, a t th e e n d o f th e le a s e te rm , W C S b u y s th e c o m p u te r b y p a y in g th e re s id u a l v a lu e o f $ 5 0 0 0 0 a n d im m e d ia te ly sells it fo r its m a rk e t v a lu e , a ls o a s s u m e d to b e $ 5 0 0 0 0 . T h e re fo re , th e s a le p r o c e e d s w ill b e th e s a m e in e a c h c a s e a n d d o n o t h a v e to b e in c lu d e d , s in c e in c re m e n ta l c a s h flo w s a r e b e in g c o n s id e r e d . H o w e v e r, th e le a s e ’s re s id u a l v a lu e m ust b e in c lu d e d , as m ust a n y ta x e ffe c ts r e la te d to th e s a le o f th e c o m p u te r. In th is c a s e , th e le a s e a lte r n a tiv e d o e s n o t in v o lv e a n y ta x e ffe c t, s in c e W C S is a s s u m e d to sell th e c o m p u te r f o r $ 5 0 0 0 0 , w h ic h is th e s a m e a s th e p r ic e it p a id . T he a lte r n a tiv e o f b u y in g th e a s s e t in v o lv e s a p r o fit o f $ 5 0 0 0 0 (s in c e in th a t c a s e , th e w r itte n - d o w n v a lu e is z e ro ) o n w h ic h th e in c o m e ta x w ill b e $ 5 0 0 0 0 x 0 . 3 = $ 1 5 0 0 0 . T h e in c re m e n ta l c a s h flo w s f o r le a s in g ve rs u s b u y in g a re s h o w n in T a b le 1 5 . 5 , w h e r e L re p re s e n ts th e a n n u a l le a s e re n ta l.

TABLE 15.5 Cash flows: lease versus purchase C a sh flo w s ($) Item

Year 0

Year 1

Year 2

Year 3

1. Cost o f co m p u te r

500000

—

—

-L

-L

0.3L

4. D e pre ciatio n ta x savings lo s t

Year 4

Y ear 5

—

—

—

-L

-L

-L

—

0.3L

0.3L

0.3L

0.3L

—

—

-5 0 0 0 0

-5 0 0 0 0

-5 0 0 0 0

—

—

5. Lease residual value

—

—

—

—

—

-5 0 0 0 0

6 . Tax saved o n

—

—

—

2. Lease ren ta ls 3. Tax savings on lease ren ta ls

p ro fit on sale

丨

15 000

T h e a fte r-ta x in te re s t ra te o n a n e q u iv a le n t lo a n is 10 (1 - 0 . 3 ) = 7 p e r c e n t p e r a n n u m , a n d th e e q u ilib r iu m le a s e re n ta ls c a n b e fo u n d b y s o lv in g a s f o llo w s : 8

N PV =0 = $ 5 0 0 0 0 0 -0 .7 [ 1

[i 0.07 .

| 1 (1-07)4 . J

$50000 0.0 7

[i L

1 (i- 〇 7)3 J

$35 000 (10.7)5

3.071 〇 [ = $500 000 - $ 131216 - $24 955 and U $111958 T h e re fo re , th e

m a x im u m

le a s e re n ta ls th a t W C S

s h o u ld

be

p re p a re d

to

p a y a re

$111 95 8

p e r a n n u m . T h e se re n ta ls w ill a ls o p r o v id e a n o r m a l r a te o f re tu rn to th e le ssor.

Does th e p e rfe c t c a p ita l m a rk e t re s u lt o f in d iffe re n c e b e tw e e n le asin g an d b u y in g a p p ly in re a l-w o rld c a p ita l m arke ts? The p o p u la rity o f leasing has va rie d o ve r tim e a n d i t is p a rtic u la rly p o p u la r fo r som e types o f assets. These o b se rva tio n s suggest th a t th e re are cases w h e re asset users have a syste m a tic preference fo r leasing o r b u yin g . Clearly, f o r th is to be th e case, th e re m u s t be ta x differences o r im p e rfe c tio n s th a t can m ake leasing advantageous. Some c o n d itio n s th a t m a y give rise to a n o ve ra ll advantage f o r leasing are discussed in th e n e x t section. The advantages an d disadvantages o f le asin g are also discussed in S ection 15.7.

1 5 .5 .3 1 Establishing an advantage for leasing To m ake le a s in g a ttra c tiv e to th e u s e r o f an asset, w ith o u t s im u lta n e o u s ly m a k in g le a s in g u n a ttra c tiv e to th e lessor, re q u ire s som e d e p a rtu re fr o m th e p e rfe c t-m a rk e t c o n d itio n s o u tlin e d in th e p re v io u s sectio n. In p a rtic u la r, i t is necessary to b re a k th e s y m m e try b e tw e e n th e p o s itio n s o f th e tw o p a rtie s . There are 8

Since the residual value of $50 000 is specified in the lease agreement, it is of similar risk to the lease rentals and can be discounted at the after-tax cost of debt. However, the tax savings ($15 000) depend in part on the disposal (market) value of the computer and are therefore riskier. Discounting this cash flow at the after-tax cost of debt is an approximation.

C hapter fifteen Le a s in g

a n d other e q u ip m e nt f in a n c e

ways in w h ic h th is can be do ne . F o r exa m ple, th e le sso r m a y be e n title d to receive q u a n tity d is c o u n ts th a t are n o t ava ila ble to th e b u y e r o f a s in g le ite m . Such d is c o u n ts m a y be a va ila b le to s p e c ia lis t lessors o f m ass-p rod uced assets, such as cars, b u t are u n lik e ly to a p p ly w h e re th e asset is u n iq u e o r w h e re th e le sso r is a general fin a n c ie r. Le a sin g m a y also be ad va n ta g e o u s w h e re th e re is som e d iffe re n c e b e tw e e n th e ta x p o s itio n s o f th e le sso r a n d th e asset user. T his is illu s tra te d in E xa m p le 15 .5, w h ic h uses th e sam e basic in fo r m a tio n as E xa m p le 15.3.

E xample 15.5 S h a re m a rk e t R e s e a rch Ltd (SRL) is a g a in c o n s id e r in g th e a c q u is itio n o f a $ 6 0 0 0 0 0 c o m p u te r, b u t E llio tt W a v e h a s n o w e s ta b lis h e d th a t b e c a u s e o f p a s t lo sses th a t a r e b e in g c a r r ie d f o r w a r d , SRL is u n lik e ly to p a y c o m p a n y in c o m e ta x d u r in g th e n e x t 5 y e a rs . Is th e le a s e a ttra c tiv e ?

SOLUTION The re v is e d c a s h flo w s fo r le a s in g th e c o m p u te r, ra th e r th a n p u rc h a s in g it, a r e s h o w n in T a b le 1 5 . 6 . The o n ly re le v a n t c a s h flo w s a r e th e c o s t o f th e c o m p u te r a n d th e le a s e re n ta ls .

TABLE 15.6 Cash flows: lease versus purchase C a s h flo w s ($)

Year1

Year 2

Year 3

Year 4

Year 5

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

474000

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

-1 2 6 0 0 0

Item

Year 0

1. Cost o f com p uter

600000

2. Lease rentals T otal

B e c a u s e SRL is u n lik e ly to p a y c o m p a n y in c o m e ta x d u r in g th e te rm o f th e le a s e , th e se n e t c a s h flo w s s h o u ld b e d is c o u n te d a t th e b e fo re -ta x b o r r o w in g ra te o f 1 0 . 8 p e r c e n t. T he N P V o f th e le a s e to SRL is:

N P V = +$474 0 0 0 - $ 126000 0 .1 0 8

(1.10 8)5

=$5965 T h e re fo re , b e c a u s e SRL w ill n o t b e p a y in g c o m p a n y in c o m e ta x d u r in g th e te rm o f th e le a s e , th e N P V o f th e le a s e h a s in c r e a s e d fro m - $ 3 4 1

to $ 5 9 6 5 . A s s u m in g th a t E ffic ie n t F in a n c e w ill b e in a

t a x p a y in g p o s itio n e a c h y e a r , th e N P V to it w ill still b e $ 3 4 1 . T h e re fo re , th e le a s e a lte r n a tiv e n o w h a s a p o s itiv e N P V fo r b o th p a r tie s a n d th e re is a n o v e r a ll g a in fro m le a s in g : G a in fro m le a s in g = $ 5 9 6 5 + $ 3 4 1

= $6306

T h is g a in is r e a lis e d a t th e e x p e n s e o f th e g o v e r n m e n t a n d is a c h ie v e d b e c a u s e th e le s s o r is u tilis in g ta x d e d u c tio n s a s s o c ia te d w ith o w n e r s h ip a n d fin a n c in g o f th e le a s e d a s s e t (in th is c a s e , d e d u c tio n s fo r d e p r e c ia tio n a n d in te re s t o n b o r r o w in g s ) a s s o o n a s th e y a r e a v a ila b le . If SRL p u rc h a s e d th e c o m p u te r u s in g b o r r o w e d m o n e y , th e s e d e d u c tio n s w o u ld b e o f n o im m e d ia te v a lu e to th e c o m p a n y b e c a u s e th e y w o u ld o n ly a d d to th e ta x loss b e in g c a r r ie d f o r w a r d . T he m a n n e r in w h ic h th e g a in o f $ 6 3 0 6 is s h a re d b e tw e e n th e le s s o r a n d le sse e w ill d e p e n d , in p a rt, o n th e le v e l o f c o m p e titio n in th e le a s in g in d u s try . If th e re is p e r fe c t c o m p e titio n in th e in d u s try , th e a n n u a l le a s e re n ta ls w ill b e re d u c e d to a le v e l such th a t th e N P V to E ffic ie n t F in a n c e is z e r o a n d th e w h o le g a in w ill th e n a c c ru e to SRL.

1 5 .5 .4 1 Taxes and the size of leasing gains E xam ples 15 .3 a n d 15 .5 s h o w t h a t le a sin g can be less c o s tly th a n p u rc h a s in g w h e re th e le s s o r has advantages n o t a va ila ble to th e p o te n tia l lessee a n d w h e re som e o f th e se advan ta ge s are passed o n to th e lessee b y w ay o f lo w e r lease p a y m e n ts . H o w e ve r, the se exa m ples assum e an e x tre m e case in w h ic h th e lessees ta x ra te is zero a n d th e le s s o rs ta x ra te is th e f u ll s ta tu to r y ra te , assu m ed to be 30 p e r cen t.

k

B usiness finance

In m a n y cases, th e d iffe re n c e b e tw e e n th e e ffe c tiv e ta x rates o f th e tw o p a rtie s m a y be m u c h s m a lle r a n d i t m a y v a ry o ve r tim e . F o r exa m ple, th e lessee m a y in it ia lly have a ta x ra te o f zero b u t b e g in to p a y ta x d u rin g th e lease te rm . T h e re fo re , fa c to rs such as th e t im in g o f th e lease r e n ta l p a y m e n ts c an a ffe c t th e size o f th e g a in a sso cia te d w it h leasing. To id e n tify th e fa c to rs t h a t can be im p o r t a n t a n d to illu s tra te th e ir effects, c o n s id e r th e e ffe cts t h a t a lease can have o n th e p re s e n t v a lu e o f th e g o v e rn m e n ts ta x rece ip ts. In E xam p le s 1 5 .3 a n d 15 .5, th e N P V o f th e lease in v o lv e s c a lc u la tin g th e p re s e n t value s o f th re e type s o f cash flo w s : th e cost o f th e asset, th e a fte r-ta x lease re n ta ls a n d th e ta x savings o n d e p re c ia tio n . The N P V o f a lease to th e lessee (N P V LES) can be expressed as:

NPVles = C-PV(L) w h e re

P \/(D e p )

C = cost o f th e leased asset

PV(L) = p re s e n t va lu e

o f lease re n ta ls

P V (D e p ) = p re s e n t value o f d e p re c ia tio n ta x savings S im ila rly , th e

NPVlor =

NPV to

-C +

th e le sso r (N P V L〇R) w ill be:

15.2

PV(L)* + PV{Dep)*

The a s te ris k s (*) have be en adde d because th e p re s e n t values o f th e lease re n ta ls a n d th e d e p re c ia tio n ta x saving s can d iffe r, g iv e n t h a t th e le sso r a n d lessee have d iffe re n t ta x rates. The o v e ra ll g a in fr o m th e lease can be fo u n d b y a d d in g E q u a tio n s 15 .1 a n d 15.2. The co st o f th e asset, C, w ill cancel o u t, le a v in g o n ly te rm s in v o lv in g th e lease re n ta ls a n d th e d e p re c ia tio n ta x savings. T h ere fore, th e lease a ffe cts th e p re s e n t v a lu e o f th e g o v e rn m e n ts ta x re c e ip ts in tw o ways. F irs t, th e g o v e rn m e n t ga in s, in t h a t i t can ta x th e lease re n ta ls rece ive d b y th e lessor. Second, th e g o v e rn m e n t loses, in t h a t th e le s s o r is able to c la im d e d u c tio n s f o r d e p re c ia tio n o n th e leased asset. The n e t re s u lt is t h a t th e g o v e rn m e n t can lose th ro u g h d e fe rra l o f ta x re ce ip ts a n d i t fo llo w s th a t, o th e r th in g s b e in g equal, th e g o v e rn m e n ts n e t loss w ill be la rg e r in p re s e n t va lu e te rm s if:

a b

th e d iffe re n c e b e tw e e n th e e ffe c tiv e ta x rates o f th e le sso r a n d lessee is large th e d e p re c ia tio n ra te a p p lica b le f o r ta x p u rp o s e s is h ig h , so t h a t d e p re c ia tio n ta x savings are rece ive d e a rly

C

th e te r m o f th e lease is lo n g a n d th e lease re n ta ls are c o n c e n tra te d d u r in g th e la te r p a r t o f th e lease te rm , so t h a t ta x p a y m e n ts b y th e le s s o r are d e fe rre d

d

in te re s t rates a n d hence th e d is c o u n t ra te a p p lic a b le to th e cash flo w s are h ig h ( i f th e d is c o u n t ra te is zero , c h a n g in g th e t im in g o f ta x p a y m e n ts does n o t change t h e ir p re s e n t value). Thus, le a sin g is m o re lik e ly to be used i f th e re are h ig h c o m p a n y ta x rates, h ig h d e p re c ia tio n rates an d

h ig h in te re s t rates. I t is n o t s u rp ris in g t h a t le a s in g has g ro w n ra p id ly a t tim e s w h e n th e se fa c to rs have been p re s e n t. E xa m p le 15 .5 sh o w e d t h a t th e re can be a ta x-b a se d g a in fr o m le a sin g w h e n th e le s s o r has a h ig h e r ta x ra te th a n th e lessee b u t i t s h o u ld be n o te d t h a t

any d iffe re n c e

b e tw e e n th e ta x rates o f th e tw o

p a rtie s is lik e ly to re s u lt in a n e t g a in o r loss fr o m le asin g. Le w e lle n , L o n g a n d M c C o n n e ll (1 9 7 6 ) sho w e d t h a t a n e t g a in can arise w h e n th e le s s o rs ta x ra te is

lower th a n

th e lessees ra te a n d th e m a g n itu d e o f

th e g a in de pe nd s o n th e sp e cific fe a tu re s o f each case, in c lu d in g th e te rm o f th e lease, th e d e p re c ia tio n m e th o d a n d ra te a n d th e d is c o u n t rates a p p lie d to fu tu r e cash flo w s.

1 5 .5 .5 1 Leasing and the imputation tax system The d is c u s s io n in S ectio n 1 5 .5 .4 e x p la in e d t h a t a n y ta x advantages associated w it h a lease arise fro m d e fe rra l o f taxes, u s u a lly in th e f o r m o f c o m p a n y in c o m e ta x . I t was also e x p la in e d t h a t th e p o te n tia l ta x b e n e fits are la rge r, o th e r th in g s b e in g equal, w h e n th e re is a la rge d iffe re n c e b e tw e e n th e e ffe c tiv e ta x rates o f th e le sso r a n d th e lessee. The p o te n tia l f o r th e re to be la rge d iffe re n ce s b e tw e e n e ffe c tiv e ta x rates w ill be g re a te r w h e n ta x rates are h ig h . H o w e ve r, as discussed in S e ctio n 1 1 .4 .1 , u n d e r th e A u s tra lia n system o f f u ll im p u ta tio n , co m p a n y in c o m e ta x is, fr o m th e v ie w p o in t o f re s id e n t sh a re h o ld e rs, o n ly a w ith h o ld in g ta x . In o th e r w o rd s, f o r m a n y com p an ies th e e ffe c tiv e ra te o f

collected a t

company in c o m e

ta x (as d is tin c t fr o m ta x

th e co m p a n y le ve l) is v e ry lo w . I t fo llo w s t h a t f o r such co m p a n ie s a n y ad van ta ge associated

w ith d e fe rrin g a c o m p a n y s ta x p a y m e n ts w ill also be v e ry s m a ll a n d a n y ta x a d va n ta g e fr o m le a sin g m u s t also be sm a ll. O f course, in d iv id u a ls w h o op e ra te businesses as sole tra d e rs a n d p a rtn e rs h ip s are o fte n ta xe d a t m u c h h ig h e r rates th a n com p an ies, so le a sin g m a y have s ig n ific a n t ta x advantages in the se cases.

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

Evaluation of operating leases In S ectio n 1 5 .2 .2 w e e x p la in e d t h a t an o p e ra tin g lease a llo w s a lessee to o b ta in th e services p ro v id e d b y an asset w ith o u t d ire c tly b e a rin g th e ris k s o f asset o w n e rs h ip . The ris k s o f o w n e rs h ip re m a in w it h th e le ssor because an o p e ra tin g lease has a te rm t h a t is s h o rt re la tiv e to th e life o f th e asset. These leases are m o re co m p le x th a n fin a n c e leases f o r several reasons. F irs t, th e lessee m a y have th e r ig h t b u t n o t th e o b lig a tio n to re n e w th e lease a t th e e n d o f an in it ia l te rm . Second, th e lessee m a y have th e r ig h t to cancel th e lease, e ith e r a t a n y tim e a fte r i t has co m m e n ce d o r a t a n y tim e a fte r a n agreed date. T here fore, cancellable o p e ra tin g leases e n ab le a lessee to o b ta in in s u ra n c e a g a in s t an u n e x p e c te d ly la rg e d e clin e in th e value o f an asse t .9 The r is k o f an u n e x p e c te d d e clin e in va lu e can be p a r tic u la r ly h ig h f o r assets such as c o m p u te rs , w h ic h can becom e o b so le te v e ry q u ic k ly , because o f changes in te c h n o lo g y . T h ird , th e lease re n ta l m a y be c o n tin g e n t o n a n o th e r v a ria b le such as th e lessees v o lu m e o f sales. F o r exa m ple, re ta il te n a n ts in s h o p p in g cen tre s u s u a lly lease t h e ir p re m ise s u n d e r an a g re e m e n t w h e re th e re n t co n sists o f a fix e d base re n t p lu s a p e rcen ta ge o f a n y m o n th ly sales in excess o f a sp e cifie d th re s h o ld le vel. A u th o rs w h o have e x a m in e d th e v a lu a tio n o f th e se c o m p o n e n ts o f o p e ra tin g leases in c lu d e C o p e la n d a n d W e s to n (1 9 8 2 ) a n d G re n a d ie r (1 9 9 5 ). The d e cisio n o n w h e th e r to b u y an asset o r lease i t th ro u g h an o p e ra tin g lease o fte n ce n tre s o n th e tra n s a c tio n costs o f b u y in g a n d s e llin g th e asset. As n o te d in S e ctio n 1 5 .2 .2 , w h e re an asset such as a car is needed f o r a s h o rt p e rio d o f, say, a m o n th o r less, i t is u s u a lly cle ar t h a t an o p e ra tin g lease w i ll be cheaper th a n b u y in g th e car a n d th e n s e llin g it . O n th e o th e r h a n d , i f th e car is ne ed ed f o r a ye a r o r m o re , m o s t users w ill fin d i t che ap er to b u y ra th e r th a n lease. F o r in te rm e d ia te tim e p e rio d s th e p re fe rre d choice m a y n o t be o b v io u s a n d fin a n c ia l a n a lysis m a y be ne eded to d e te rm in e w h e th e r an o p e ra tin g lease is a ttra c tiv e . W h ile o p tio n -p ric in g m o d e ls such as th o se discussed in S e ctio n 1 8 .8 .6 can, in p rin c ip le , be used to v alue th e o p tio n s in h e re n t in an o p e ra tin g lease, such m o d e ls are c o m p le x. F o rtu n a te ly , th e re is a s im p le r m o d e l t h a t can be used in ste a d . In S e ctio n 6.4 th e e q u iv a le n t a n n u a l v a lu e m o d e l was used to co m p a re p ro je c ts w it h d iffe re n t eco no m ic lives. A v a r ia n t o f t h is m o d e l, e q u iv a le n t a n n u a l cost, can be used to eva lu ate o p e ra tin g leases.

an operating lease is attractive to the lessee if the annual rental is less than the equivalent annual cost of buying and operating the asset. In a p p ly in g th is p rin c ip le , care is n e ed ed to

The p rin c ip le in v o lv e d is sim p le :

ensure t h a t th e lease a n d b u y a lte rn a tiv e s are tre a te d c o n s is te n tly . F o r exa m p le , i f th e o p e ra tin g lease is a m a in te n a n c e lease, th e n th e costs o f in s u rin g a n d m a in ta in in g th e asset s h o u ld be in c lu d e d in th e e q u iv a le n t a n n u a l co st c a lc u la tio n , as w e ll as th e costs o f o w n in g th e asset. As n o te d in S e ctio n 1 5 .2 .2 , th e re n ta ls f o r an o p e ra tin g lease w ill re fle c t th e costs in c u rre d b y th e le ssor in a c q u irin g a n d m a in ta in in g th e asset. M o re precisely, in a c o m p e titiv e le a s in g m a rk e t th e a n n u a l re n ta l f o r an o p e ra tin g lease s h o u ld be eq ua l to th e e q u iv a le n t a n n u a l cost o f th e asset to th e lessor. W h e n th e u se r re q u ire s th e asset f o r a lo n g p e rio d such as 5 years, i t w ill g e n e ra lly be che ap er to b u y th e asset ra th e r th a n to lease it . In o th e r w o rd s , th e cost o f a ‘d o -it-y o u rs e lf lease’ o b ta in e d b y b u y in g th e asset is lik e ly to be lo w e r th a n th e re n ta ls cha rge d b y an e x te rn a l lessor. T his is so because, w h e n s e ttin g th e lease re n ta ls , an e x te rn a l le sso r w i ll n e ed to c o n s id e r th e costs o f n e g o tia tin g m u ltip le leases o v e r th e life o f th e asset a n d ta ke in to a cco u n t th e e x p e c ta tio n t h a t th e asset w i ll be id le f o r p a r t o f th e tim e . These costs can be avo id ed i f th e u se r b u ys th e asset. W h ile an o p e ra tin g lease w ill g e n e ra lly be m o re c o s tly th a n b u y in g a n asset t h a t is n e ed ed f o r an e xte n d e d p e rio d , th e re are c irc u m sta n ce s w h e re an o p e ra tin g lease can be less c o s tly th a n b u y in g . F irs t, an o p e ra tin g lease can be che ap er th a n b u y in g i f th e le sso r can ta k e ad va n ta g e o f co s t savings t h a t are n o t ava ila ble to th e lessee. F o r exa m ple, car re n ta l co m p a n ie s b u y th o u s a n d s o f cars each ye a r a n d can n e g o tia te v o lu m e d is c o u n ts t h a t are n o t a va ila ble to s m a lle r cu sto m e rs. S im ila rly , car re n ta l com p an ies p ro b a b ly face lo w e r costs in m a in ta in in g , s e rv ic in g a n d in s u r in g cars th a n m o s t o th e r o w n e rs. A b u sin ess th a t uses o n ly a fe w v e h icle s c a n n o t ta ke ad van ta ge o f th e se eco no m ies o f scale a n d w ill p ro b a b ly f in d i t cheaper to lease cars ra th e r th a n b u y th e m . Second, o p e ra tin g leases p ro v id e o p tio n s t h a t are va lu a b le to th e lessee a n d in som e cases th e o p tio n to cancel a lease can be th e m o s t cost e ffe c tiv e w a y o f o b ta in in g a b e n e fit such as in s u ra n c e a g a in s t th e r is k o f p re m a tu re obsolescence o r th e r is k t h a t an asset is n o lo n g e r needed o w in g to a d e clin e in d e m a n d . 9

The right to renew a lease provides a call option over the leased asset, while the right to cancel the lease provides a put option. A detailed coverage of options is provided in Chapter 18.

LEARNING OBJECTIVE 6 Evaluate an operating lease from the lessee's viewpoint

The a irlin e in d u s tr y is a g o o d e xa m p le o f an in d u s tr y t h a t faces flu c tu a tin g d e m a n d a n d changes in th e m ix o f a irc ra ft t h a t are n e ed ed a n d th is has im p o r t a n t im p lic a tio n s f o r th e d e c is io n to o w n o r lease a irc ra ft. Suppose t h a t a t e r r o r is t a tta c k a t a m a jo r a ir p o r t causes a d e clin e in d e m a n d f o r a ir tra v e l and a s u rp lu s o f a irc ra ft. In th is case, an a irlin e t h a t o w n s a ll o f its a irc ra ft can e xp e rie n ce m a jo r fin a n c ia l d iffic u ltie s , p a r tic u la r ly i f th e d e clin e in d e m a n d is w id e s p re a d a n d p e rs is ts f o r an e x te n d e d p e rio d so t h a t th e c o m p a n y has several a irc ra ft ly in g id le ra th e r th a n e a rn in g reve nu e. U n d e r the se circu m sta nce s, e ffo rts to se ll th e s u rp lu s a irc ra ft are lik e ly to be u n su cce ssfu l un le ss th e s e lle r is p re p a re d to d is c o u n t th e p ric e s ig n ific a n tly . A c c o rd in g ly , m o s t a irlin e s lease a p r o p o r tio n o f t h e ir fle e t u n d e r can cellab le o p e ra tin g leases a n d are p re p a re d to p a y a p re m iu m f o r th e le sso r to accept th e r is k o f c a n c e lla tio n . O n e s tu d y fo u n d t h a t leased a irc ra ft are tra d e d m o re fre q u e n tly a n d p ro d u ce h ig h e r o u tp u t th a n a irc ra ft t h a t are o w n e d b y th e user. The m a in rea son f o r th e h ig h e r o u tp u t is t h a t leased a irc ra ft spe nd m o re tim e in th e a ir a n d less tim e p a rk e d o n th e g ro u n d th a n o w n e d a ir c r a ft .10

15.7 Advantages and disadvantages LEARNING OBJECTIVE 7 Critically evaluate the suggested advantages of leasing

of leasing The p o p u la r ity o f le a s in g in d ic a te s t h a t th e re are m a n y cases w h e re users p re fe r to lease assets ra th e r th a n to p u rch a se th e m . I t is s h o w n in S e ctio n 15 .5 .3 t h a t le a sin g m a y be p re fe rre d w h e re : (a) th e le sso r has an a d va n ta g e (o r advantages) n o t a va ila ble to th e p o te n tia l lessee; a n d (b) th e le s s o r passes o n a t le a s t som e o f th e a d va n ta g e (s) to th e lessee b y w a y o f red uce d lease p a y m e n ts . A lte rn a tiv e ly , le a sin g m a y have advantages such as lo w e r tra n s a c tio n costs a n d i t m a y have in c e n tiv e effects t h a t m a ke i t m o re e ffe c tiv e th a n o th e r fo rm s o f fin a n c e in c o n tro llin g agency costs. Several o f th e alleged advan ta ge s o f le a s in g are discussed in th e fo llo w in g se ctio n s. F irs t, w e discuss p o ssib le advantages o f le a sin g in ge ne ral. Second, w e discuss fa c to rs t h a t m a y be im p o r t a n t in d e te rm in in g w h ic h p a rtic u la r assets s h o u ld be leased, ra th e r th a n p u rcha sed, b y a com pany.

15.7.1 I Possible advantages of leasing P ro p o n e n ts o f le a s in g o fte n stress ta x a tio n ad van ta ge s, c o n s e rv a tio n o f c a p ita l, in cre a se d c re d it a v a ila b ility a n d th e p o s s ib ility t h a t le a sin g m a y p ro v id e c a p ita l a t a lo w e r cost th a n o th e r fo rm s o f fina nce . The p re va le n ce o f such cla im s was n o te d b y S carm a n (1 9 8 2 ), w h o e x a m in e d p r o m o tio n a l lite ra tu re used b y fin a n c e c o m p a n ie s in t h e ir m a rk e tin g o f leases. H e fo u n d a h ig h in c id e n c e o f e rro rs a n d o v e rs ta te m e n ts w h ic h , n o t s u rp ris in g ly , w ere b iase d in fa v o u r o f le asin g. Several p o ssib le a d van ta ge s o f le a sin g are discussed in tu r n .

C om pany taxation The ta x d e d u c tio n s asso cia te d w it h o w n e rs h ip o f a n asset are g e n e ra lly th e sam e, regardless o f w h e th e r th e asset is o w n e d o r leased b y th e user. I f, as assum ed in E xam p le s 15 .2 a n d 1 5 .3 , th e p o te n tia l lessee an d le s s o r are ta x e d a t th e sam e rate, th e re s h o u ld be n o ta x a tio n a d va n ta g e a sso cia te d w ith leasing. I f th is a s s u m p tio n does n o t h o ld th e n , as discusse d in S e c tio n 1 5 .5 .3 , le a s in g m a y p ro v id e a ta x a tio n ad van ta ge . A n y such ad va n ta g e arises fr o m th e d e fe rra l o f taxes a n d can be la rg e in p re s e n t value te rm s w h e re a c o m p a n y re q u ire s an exp en sive asset b u t is n o t able to u tilis e f u lly th e d e p re c ia tio n d e d u c tio n s i f th e asset is p u rch a se d . This p ro b le m m a y be ove rco m e i f th e asset is a c q u ire d b y a le s s o r w h o can use a ll th e a llo w a b le d e d u c tio n s as soo n as th e y are ava ila ble. In th is case, th e le s s o r has a n ad van ta ge o ve r th e p o te n tia l lessee a n d i t w o u ld be p re fe ra b le to lease th e asset i f th e le s s o r shares som e (o r a ll) o f th is ad van ta ge w it h th e lessee. E s s e n tia lly th is ad van ta ge arises because th e le s s o rs e ffe c tiv e ta x ra te is h ig h e r th a n th e lessees e ffe c tiv e ta x rate. E xa m p le 15 .5 illu s tra te s th is a d va n ta g e in an e x tre m e case w h e re th e lessees e ffe c tiv e ta x ra te is zero. The in a b ilit y o f som e asset users to use im m e d ia te ly a ll th e a llo w a b le d e d u c tio n s asso cia te d w it h th e a c q u is itio n o f v e ry e xp en sive assets was a m a jo r fa c to r in th e g ro w th o f le vera ged le a s in g d u rin g th e

10 Gavazza (2011) found that for the US airline industry, the output of leased aircraft, as measured by flying hours, was 6.5 per cent higher than the output of owned aircraft.

C hapter fifteen Le a s in g

a n d other e q u ip m e nt f in a n c e

1970s a n d th e e a rly p a r t o f th e 1980s. Such leases are in v a ria b ly s tru c tu re d so as to e x p lo it s itu a tio n s w h ere th e le ssor has a h ig h e r e ffe c tiv e ta x ra te th a n th e lessee. T here is evide nce t h a t th is rea son f o r th e g ro w th in leveraged le a s in g is g e n e ra lisa b le to o th e r fo rm s o f le asin g. Thus, in th e US i t has been fo u n d th a t c om p an ies w ith lo w m a rg in a l ta x rates use le a sin g m o re th a n co m p a n ie s w it h h ig h m a rg in a l ta x rates (G raham , L e m m o n & S c h a llh e im 1 9 9 8 ). T his fin d in g is c o n s is te n t w it h th e v ie w t h a t h ig h ta x ra te lessors can b e n e fit m o re fr o m th e ta x d e d u c tib ility o f d e p re c ia tio n th a n lo w ta x ra te lessees. T a x a tio n advantages are also th e m o tiv e f o r cro s s -b o rd e r leases w h ic h , as discussed in S e ctio n 1 5 .2 .5 , are s tru c tu re d so as to ta ke ad van ta ge o f d iffe re n ce s b e tw e e n th e ta x e n v iro n m e n ts o f d iffe re n t c o u n trie s . I f th e re w ere n o d iffe re n ce s in ta x re g u la tio n s a n d ta x rates b e tw e e n c o u n trie s , cro s s -b o rd e r leases w o u ld p ro b a b ly n o t exist.

Transaction costs There is a d iffe re n ce b e tw e e n le a s in g a n d b o rro w in g t h a t can be im p o r t a n t in th e e v e n t o f d e fa u lt. I f a lessee d e fa u lts, th e lessor, as th e o w n e r o f th e asset, can repossess th e asset m o re e a sily th a n a secured le n d e r, w h o is lik e ly to face co n sid e ra b le delay, a n d g re a te r costs, because i t m a y be necessary f o r a d e fa u ltin g b o rro w e r to be liq u id a te d . In th is case, a liq u id a to r has to be a p p o in te d to se ll th e assets a n d d is tr ib u te th e proceeds to le n d e rs an d o th e r c re d ito rs . T h ere fore, th e re m a y w e ll be a d iffe re n c e in tra n s a c tio n costs th a t fa vo u rs leasing. S im ila rly , because lessors have th e s e c u rity o f o w n e rs h ip o f th e leased asset, th e y m ay be p re p a re d to p ro v id e fin a n c e w ith o u t c a rry in g o u t a f u ll check o n th e c re d it s ta n d in g o f th e lessee. A lso, th e le sso r m a y be able to use a re la tiv e ly s im p le , s ta n d a rd c o n tra c t f o r each lease, p a r tic u la r ly i f th e leased assets are s im ila r ite m s such as cars o r o th e r m o to r veh icle s. A s a re s u lt, le a s in g can be a ttra c tiv e to sm a ll c om p an ies t h a t do n o t have g o o d access to o th e r sources o f fin a n ce . F o r la rg e r co m p a n ie s, le a sin g m ay also be m o re a ttra c tiv e th a n o th e r sources o f fin a n c e because th e tra n s a c tio n costs are lo w e r th a n th e cost o f is s u in g s e c u ritie s o r n e g o tia tin g a lo a n .

Conservation of capital I t is o fte n suggested th a t, b y le a sin g , a c o m p a n y can con serve its c a p ita l f o r in v e s tm e n t elsew here. A lte rn a tiv e ly , th e sam e a rg u m e n t m a y be based o n th e su g g e s tio n t h a t le a s in g p ro v id e s 41 0 0 p e r ce n t fin a n c in g ’. In o th e r w o rd s, i t is a rg u e d t h a t th e re is som e fu n d a m e n ta l d iffe re n c e b e tw e e n le a sin g and o th e r fo rm s o f fin a n ce , w h ic h a llo w s a lessee to ‘b o r r o w ’

10 0

p e r c e n t o f th e p u rch a se p ric e o f an asset,

com pared w ith pe rh a p s 8 0 p e r c e n t in th e case o f a secured lo a n . T his a rg u m e n t is c o n tro v e rs ia l. M a n y academ ics have a rg u e d t h a t th e ‘10 0 p e r c e n t fin a n c in g ’ c la im is a fallacy. F o r e xa m p le , th e y p o in t o u t t h a t w h ere lease re n ta ls are payable in advance, w h ic h is usu al, th e fin a n c e e ffe c tiv e ly p ro v id e d b y le a s in g can be m u ch less th a n th e pu rcha se p ric e o f th e a sse t .11 A lso , th e fo r m a l s e c u rity p ro v id e d to th e le s s o r is n o t ne cessarily re s tric te d to o w n e rs h ip o f th e leased asse t .12 In o th e r w o rd s , to o b ta in a fin a n c e lease, i t is necessary to have som e e q u ity c a p ita l, a n d th e lease w ill use u p som e o f th e d e b t ca p a c ity p ro v id e d b y th e co m p a n y s e q u ity in th e sam e w a y as o th e r d e b t. T h ere fore, w h e n o n ly th e im m e d ia te cash consequences are considered, le a sin g m a y g ive th e appearance o f

10 0

p e r c e n t fin a n c in g , b u t th is appearance is m is le a d in g .

There is n o such th in g as *100 p e r c e n t lease fin a n c e 1, ju s t as th e re is n o such t h in g as *100 p e r c e n t d e b t finance*. O n th e o th e r h a n d , p ra c titio n e rs , p a rtic u la rly th o s e in v o lv e d in p r o m o tin g le a sin g , arg ue th a t le asin g is

not th e

sam e as o th e r d e b t a n d t h a t a d o lla r o f lease fin a n c e w i ll use less o f a c o m p a n y s d e b t

ca p a city th a n a d o lla r o f ‘o r d in a r y ’ d e b t. This v ie w is s u p p o rte d b y E is fe ld t a n d R a m p in i (ER) (2 0 0 9 ), w h o arg ue t h a t th e a b ility o f a le ssor to repossess an asset m o re e a s ily th a n a secured le n d e r p ro v id e s b e n e fits f o r le a s in g t h a t go b e yo n d th e tra n s a c tio n cost savings discusse d above. In t h e ir w o rd s: 'This a b ility to repossess a llo w s a le sso r to im p lic itly e x te n d m o re c re d it th a n a le n d e r w h ose c la im is secured b y th e sam e asset. The d e b t cap acity o f le asin g th u s exceeds th e d e b t c a p a c ity o f secured le n d in g 1 (p. 1 6 2 1 ). A f te r c o n s id e rin g th e tre a tm e n t u n d e r US b a n k ru p tc y law s o f secured le n d e rs a n d lessors in d iffe re n t typ e s o f leases, ER con clu de th a t th e ad van ta ge th e y id e n tify a p p lie s p r im a r ily to o p e ra tin g leases b u t m a y be a p p lica b le to som e fin a n ce leases. This d iffe re n c e arises because, u n d e r US law, an o p e ra tin g lease w i ll g e n e ra lly be c la ssifie d as a *true lease*, w h ic h a llo w s th e easiest rep osse ssion b y th e lessor. In th e case o f a fin a n c e lease, th e le sso r is lik e ly 11 This factor is illustrated by Example 15.3 where the lease provides finance of $511800, which is much less than the asset cost of $600000. 12 See Footnote 7.

to be re g a rd e d as h a v in g o n ly a ‘s e c u rity in te re s t’ in th e leased asset, w h ic h m eans t h a t th e p o s itio n o f th e le sso r is e s s e n tia lly th e sam e as t h a t o f a secured le n d e r. I f i t is tr u e t h a t le a s in g conserves c a p ita l, w h a t are th e m a in im p lic a tio n s f o r le a s in g de cisio ns? A c c o rd in g to ER, le a s in g , p a r tic u la r ly th r o u g h o p e ra tin g leases, w i ll be v a lu a b le to co m p a n ie s t h a t are fin a n c ia lly c o n s tra in e d — t h a t is, c o m p a n ie s t h a t have a s h o rta g e o f in te r n a l fu n d s a n d need to raise fu n d s e x te rn a lly . H o w e ve r, agency costs a ris in g f r o m th e s e p a ra tio n o f o w n e rs h ip a n d c o n tro l t h a t is in h e r e n t in le a s in g m e a n t h a t co m p a n ie s w it h s u ffic ie n t in te r n a l fu n d s w ill p re fe r to b u y assets. Tests u s in g d a ta o n US co m p a n ie s p ro v id e s tro n g s u p p o rt f o r th e p r e d ic tio n t h a t le a s in g is va lu a b le f o r c o m p a n ie s t h a t are s m a ll o r fin a n c ia lly c o n s tra in e d . L e a s in g is n e g a tiv e ly re la te d to c o m p a n y size— s m a ll c o m p a n ie s r e n t o r lease a h ig h e r p r o p o r tio n o f th e assets th e y use th a n la rg e c o m p a n ie s. ER also fo u n d a ro b u s t n e g a tiv e re la tio n s h ip b e tw e e n le a s in g a n d th e ra tio o f d iv id e n d s to assets. S im ila rly , th e ra tio o f cash flo w to assets— t h e ir m o s t d ire c t m ea sure o f a va ila b le in te r n a l fu n d s — is n e g a tiv e ly re la te d to le a sin g . The p r o p o r tio n o f c a p ita l leased is c o n s id e ra b ly h ig h e r f o r b u ild in g s th a n f o r e q u ip m e n t, an d th e re la tio n s h ip s b e tw e e n le a s in g a n d th e ra tio s use d as m ea sure s o f fin a n c ia l c o n s tra in ts w e re s tro n g e r f o r b u ild in g s . In s u m m a ry , ER fo u n d s tro n g e m p iric a l s u p p o rt f o r th e a rg u m e n t t h a t le a s in g conserves c a p ita l’ 一 a t le a s t in th e case o f o p e ra tin g leases— b u t th e y a c k n o w le d g e t h a t even o p e ra tin g leases do n o t p ro v id e *100 p e r c e n t fin a n c in g ,. T hey co n clu d e t h a t th e h ig h e r d e b t c a p a c ity o f le a s in g m a y m a ke i t p a r tic u la r ly a ttra c tiv e f o r s m a ll c o m p a n ie s a n d f o r n e w v e n tu re s , b o th o f w h ic h are lik e ly to have lim ite d in te r n a l fu n d s .

Leasing can provide 'off-balance-sheet’ finance A n a rg u m e n t re la te d to th e p re v io u s one is t h a t because lessees in th e p a s t have n o t been re q u ire d to re p o r t t h e ir lease o b lig a tio n s in th e s ta te m e n t o f fin a n c ia l p o s itio n , th e y can use le a s in g to increase th e ir access to d e b t. E ven i f th is w ere tru e , i t is o n ly a n ad van ta ge i f b o rro w in g re s tric tio n s im p o s e d b y le n d e rs have p re v e n te d th e p o te n tia l lessee fr o m a tta in in g th e o p tim a l d e b t- e q u ity ra tio . F u rth e r, e m p iric a l evide nce suggests t h a t lease fin a n c e is a s u b s titu te f o r d e b t, w it h th e re s u lt t h a t co m p a n ie s m a y n o t have been able to use le a sin g to in crea se t h e ir access to o th e r typ e s o f d e b t (B o w m a n 1 9 8 0 ). In a n y e ve n t, A c c o u n tin g S ta n d a rd AASB 1 1 7 re q u ire s th e c a p ita lis a tio n o f fin a n c e lease o b lig a tio n s , w h ic h m ea ns th a t a n y p o te n tia l *ofF-balance-sheet fin a n c in g * ad van ta ge f o r le a s in g s h o u ld n o lo n g e r be a v a ila b le .13 This sug ge ste d ad van ta ge is f u r t h e r d im in is h e d w h e n one c o n sid e rs th e c u rre n t p ro p o s a ls b y th e a c c o u n tin g s ta n d a rd s e tte rs to m o d ify A ASB 1 1 7 to e n sure t h a t a ll n o n -re a l esta te leases, w it h a te r m lo n g e r th a n

12

m o n th s , are re co g n ise d in co m p a n ie s’ fin a n c ia l s ta te m e n ts .

Cost of capital The a n a lysis o u tlin e d e a rlie r is c o n s is te n t w ith th e p rin c ip le th a t, in lease e v a lu a tio n , th e d is c o u n t ra te a p p lic a b le to a g iv e n c o m p o n e n t o f th e cash flo w s m u s t be th e sam e f o r b o th th e lessee a n d th e lessor. In o th e r w o rd s , f o r a g iv e n cash flo w , th e re q u ire d ra te o f r e t u r n s h o u ld d e p e n d o n th e r is k o f th e cash flo w , n o t th e id e n t it y o f th e re c ip ie n t. H o w e ve r, i f th e le s s o rs co st o f c a p ita l is lo w e r (h ig h e r) th a n t h a t o f th e p o te n tia l lessee, th e existe nce o f c o m p e titiv e c a p ita l m a rk e ts w i ll re s u lt in le a s in g (b u y in g ) b e in g p re fe rre d to b u y in g (le asin g). W h a t c irc u m sta n ce s w ill cause th e cost o f c a p ita l o f th e le s s o r a n d th e lessee to d iffe r? The an sw e r to th is q u e s tio n w ill d e p e n d o n th e ris k s a sso cia te d w it h u s in g th e asset. M ille r a n d U p to n (1 9 7 6 ) id e n tifie d tw o ty p e s o f re le v a n t ris k . O ne is a sso cia te d w it h u n c e r ta in ty a b o u t th e a sse ts e c o n o m ic d e p re c ia tio n , w h ile th e o th e r is associated w ith u n c e rta in ty a b o u t th e n e t cash flo w s fr o m u s in g th e asset. In th e case o f a fin a n c e lease w it h a sp e cifie d re s id u a l value , b o th th e se ris k s are b o rn e b y th e lessee. In th e case o f an o p e ra tin g lease, b o th the se ris k s are b o rn e b y th e lessor. There m a y be o th e r cases w h e re th e ris k s are sh a re d b e tw e e n th e tw o p a rtie s . A lth o u g h th e ris k s b o rn e b y th e tw o p a rtie s can d iffe r, c o m p e titiv e c a p ita l m a rk e ts w i ll e n sure th a t th e d is c o u n t ra te im p lic it in th e lease a g re e m e n t w ill re fle c t th e a llo c a tio n o f r is k b e tw e e n th e tw o p a rtie s . Suppose, h o w e ve r, t h a t th e lessee can raise c a p ita l a t a lo w e r co st f o r a g iv e n le v e l o f r is k th a n th e lessor. I f th is is so, th e p ro s p e c tiv e lessee s h o u ld fin d t h a t i t is m o re p ro fita b le to b u y th a n to lease. 13 There is conflicting evidence on whether the ofF-balance-sheet aspect of leasing ever provided borrowing opportunities that had a favourable effect on a company's share price. A number of these studies are summarised in Lev and Ohlson (1982, pp. 280-1).

C hapter fifteen Le a s in g

a n d other e q u ip m e nt f in a n c e

H o w eve r, as M ille r a n d U p to n (1 9 7 6 ) p o in te d o u t, th e lessee ‘w o u ld fin d i t even m o re p ro fita b le u n d e r th o se circu m sta n ce s to e n te r th e le a sin g business*. A n y d is e q u ilib riu m b e tw e e n th e costs o f c a p ita l f o r le asin g a n d b u y in g w o u ld th e n be e lim in a te d . In o th e r w o rd s, th e costs o f c a p ita l f o r le a sin g a n d b u y in g m u s t be th e same, because i f th e y w ere n o t, th e n one o f tw o re s u lts w o u ld occu r: le a s in g w o u ld e ith e r be d o m in a n t— t h a t is, a ll assets w o u ld be leased— o r le a sin g w o u ld disap pea r.

Leasing and agency costs As n o te d above, a leased asset is u n d e r th e c o n tro l o f a u se r w h o is n o t th e o w n e r, a n d th e s e p a ra tio n o f o w n e rs h ip a n d c o n tro l can g ive ris e to c o s tly agency p ro b le m s . F o r exa m ple, as discussed in S e ctio n 15 .7.2, i t w ill be d iff ic u lt a n d e xp en sive to lease assets t h a t are e a sily d a m ag ed b y carelessness o r n e glect. Leasing can also have in c e n tiv e e ffe cts t h a t c o n trib u te to agency costs. S m ith a n d W a ke m a n (1 9 8 5 ) p o in te d o u t t h a t m a n a g e m e n t c o m p e n s a tio n p la n s can create in c e n tiv e s to lease assets ra th e r th a n purchase th e m . F o r exa m ple, a m a n a g e r w h o se b o n u s depends o n th e ra te o f r e tu r n o n in v e s te d c a p ita l w ill fa v o u r th e le a sin g o f assets un le ss th e p re s e n t value o f fu tu r e lease p a y m e n ts is in c lu d e d as p a r t o f in ve ste d c a p ita l. Thus, a c o m p e n s a tio n p la n t h a t is n o t w e ll d e sig n e d can m o tiv a te m an ag ers to lease assets w h e n p u rc h a s in g w o u ld be b e tte r f o r sh a re h o ld e rs. The o w n e rs h ip s tru c tu re o f a b u sin ess m a y also in flu e n c e le a s in g de cisio n s. F o r e xa m p le , a m a n a g e r w h o has a la rge o w n e rs h ip sta ke in th e b u sin e ss m a y p re fe r to lease b u sin ess assets in o rd e r to reduce p e rso n a l e xp osu re to asse t-sp e cific ris k s such as th e r is k o f obsolescence. C o n s is te n t w it h th is a rg u m e n t, a s tu d y b y M e h ra n , T a g g a rt a n d Y e rm a ck (1 9 9 9 ) o f US m a n u fa c tu rin g fir m s fo u n d t h a t CEO share o w n e rs h ip has a s ig n ific a n t p o s itiv e e ffe c t o n b o th d e b t fin a n c in g a n d leasing. In s u m m a ry , th e m a jo r reasons f o r le a s in g ap p e a r to in v o lv e savings in taxes a n d tra n s a c tio n costs an d m in im is in g th e e ffe cts o f fin a n c ia l c o n s tra in ts . There can be s ig n ific a n t ta x advan ta ge s f o r le a sin g w h e n th e re is a la rge d iffe re n c e b e tw e e n th e e ffe c tiv e in c o m e ta x rates o f th e le s s o r a n d lessee. H o w e ve r, u n d e r th e im p u ta tio n ta x syste m , a n y ta x ad van ta ge s o f le a s in g a p p e a r to be s m a ll w h e n b o th th e le ssor an d lessee are A u s tra lia n -o w n e d co m p a n ie s. There is evide nce t h a t le a sin g does co n se rve capital*, a t le a st f o r o p e ra tin g leases, w h ic h can m a ke le a s in g a ttra c tiv e f o r s m a ll co m p a n ie s a n d n e w v e n tu re s t h a t lack in te rn a l fu n d s . W h ile som e o f th e c la im e d advan ta ge s o f le a s in g a p p e a r to be o f d u b io u s v a lid ity , i t seems th a t, in pra ctice , m a n y p e op le do p e rceive t h a t th e re are a d van ta ge s in k e e p in g leases o f f balance sheet*. Leasing in v o lv e s a s e p a ra tio n o f o w n e rs h ip a n d c o n tro l, so th e agency costs a ris in g fr o m th is s e p a ra tio n te n d to o ffs e t th e a d van ta ge s o f leasing. A lth o u g h o p p o r tu n itie s to reduce taxes a n d tra n s a c tio n costs, a n d to m in im is e th e e ffe cts o f fin a n c ia l c o n s tra in ts , p ro v id e th e m a in m o tiv e s f o r le a sin g , th e re are som e a d d itio n a l fa c to rs t h a t can g ive ris e to advantages f o r leasing. These are discussed in th e n e x t se ctio n .

S m ith a n d W a ke m a n (1 9 8 5 ) p o in te d o u t t h a t ta x -re la te d fa c to rs a n d in c e n tiv e s a ris in g fr o m fa c to rs such as c o m p e n s a tio n c o n tra c ts a n d o w n e rs h ip s tru c tu re p ro v id e an im p o r ta n t, b u t in c o m p le te , e x p la n a tio n o f som e aspects o f leasing. D iffe re n c e s in e ffe c tiv e ta x rates a n d o w n e rs h ip s tru c tu re are u s e fu l in id e n tify in g p o te n tia l lessors a n d lessees, b u t p ro v id e l i t t le e x p la n a tio n o f w h y som e assets are leased, w h ile o th e r s im ila r assets are ow n e d . F o r exa m ple, w h y is i t t h a t le a s in g o f o ffic e b u ild in g s is m o re c o m m o n th a n le asin g o f research la b o ra to rie s ? Som e o f th e in c e n tiv e s f o r le a s in g t h a t v a ry across d iffe re n t assets are n o w discussed.

Sensitivity to use and maintenance decisions As discussed in S e ctio n 1 5 .7 .1 , le a sin g m ea ns t h a t an asset is u n d e r th e c o n tro l o f a u se r w h o is n o t th e ow ner. A lessee does n o t have a r ig h t to th e d isp o sa l va lu e o f an asset a t th e e n d o f th e lease, so th e re is less in c e n tiv e to care f o r a n d m a in ta in assets t h a t are leased ra th e r th a n ow n e d . Lessors w ill recognise th is a n d w ill set lease re n ta ls o n th e basis o f e xp e cte d le vels o f abuse. T h e re fo re , th e m o re s e n s itiv e th e value o f th e asset to th e le vels o f use a n d m a in te n a n c e i t receives, th e m o re c o s tly i t w ill be t o lease ra th e r th a n purchase th e asset. T h e re fo re , i t is a rg u e d t h a t assets t h a t are v e ry s e n s itiv e to use a n d m a in te n a n c e de cisio ns w ill te n d to be p u rch a se d b y th e u s e r ra th e r th a n leased. T his a rg u m e n t appears to be m o re re le v a n t to o p e ra tin g leases th a n to fin a n c e leases.

m LEARNING OBJECTIVE 8 Explain the factors that can influence leasing policy

i

B usiness finance

Specialised assets S m ith a n d W a k e m a n (1 9 8 5 ) suggested t h a t th e re is an in c e n tiv e to buy, ra th e r th a n lease, specialised (o r co m p a n y -s p e c ific ) assets. Such assets are m o re h ig h ly v a lu e d w it h in th e co m p a n y th a n in t h e ir best a lte rn a tiv e use. They a rg u e d t h a t le a sin g c o m p a n y -s p e c ific assets in v o lv e s n e g o tia tio n costs a n d o th e r agency costs t h a t can be s ig n ific a n t because o f c o n flic ts b e tw e e n th e le sso r a n d lessee a b o u t th e d iv is io n b e tw e e n th e m o f t h a t p a r t o f th e va lu e o f th e asset t h a t exceeds its va lu e in a lte rn a tiv e uses. F o r exam ple, th e le sso r w ill w a n t to calcula te th e lease p a y m e n ts u s in g a c o n s e rv a tiv e re s id u a l va lu e based on th e lik e ly d isp o sa l v a lu e o f th e asset. T his va lu e is lik e ly to be u n c e rta in , a n d th e le sso r s e s tim a te w ill p ro b a b ly be m u c h less th a n th e va lu e placed o n th e asset b y th e user. T h e re fo re , th e lease p a y m e n ts re q u ire d b y th e le sso r are u n lik e ly to be acceptable to th e user. In c o n tra s t, f o r g e n e ra l use* assets, such as tru c k s a n d f o r k lift s , s u b s titu te s are re a d ily ava ila ble, and th e d iffe re n c e b e tw e e n th e v a lu e -in -u s e a n d th e v a lu e -in -e x c h a n g e is lik e ly to be sm a ll. M o re o v e r, th e re is an a c tiv e se co n d -h a n d m a rk e t in th e se assets, so i t is re la tiv e ly easy to fo re c a s t lik e ly d isp o sa l values a n d to agree o n th e te rm s o f a lease. T his a rg u m e n t, a n d th e asso cia te d e m p iric a l evide nce, is c o n s is te n t w ith th e o b s e rv a tio n t h a t le a sin g o f cars a n d o th e r m o to r veh icle s is re la tiv e ly c o m m o n . Gavazza (2 0 1 0 ) in v e s tig a te s th is issue in th e c o n te x t o f a irc ra ft le a sin g b y e x p lo rin g th e re la tio n s h ip b e tw e e n h o w liq u id th e m a rk e t is f o r a p a rtic u la r ty p e o f a irc ra ft a n d th e lik e lih o o d t h a t th e a irc ra ft w ill be leased, ra th e r th a n pu rch a se d , as w e ll as th e co st o f le asin g. H e re p o rts th a t a irc ra ft w it h m o re a c tiv e se c o n d a ry m a rk e ts are m o re lik e ly to be leased a n d a t a b e tte r ra te re la tiv e to less a c tiv e ly tra d e d a irc ra ft.

Flexibility and transaction costs As d iscusse d in S ectio ns 1 5 .2 .2 a n d 15 .6, an o p e ra tin g lease can have w o r th w h ile a d van ta ge s w h e n an asset is re q u ire d f o r o n ly a s h o rt p e rio d . A n o p e ra tin g lease is lik e ly to in v o lv e lo w e r costs th a n p u rc h a s in g an asset a n d th e n s e llin g it , p a r tic u la r ly i f th e costs o f o w n e rs h ip tra n s fe r are s ig n ific a n t. Le asing ra th e r th a n b u y in g can also in v o lv e d iffe re n ce s in search costs a n d costs o f assessing q u a lity .14 F o r e xa m p le , a co m p a n y th a t leases a tr u c k w ill be less co n ce rn e d a b o u t th e c o n d itio n o f its e n g in e , tra n s m is s io n a n d o th e r m e c h a n ic a l p a rts th a n a p o te n tia l b u y e r o f th e sam e ve h icle . T h e re fo re , a less c o s tly in s p e c tio n w ill s u ffice i f th e tr u c k is to be leased. T his a d va n ta g e f o r le a sin g w ill be o ffs e t b y th e fa c t t h a t, as discussed above, lessees w i ll te n d to be less c a re fu l in t h e ir use o f assets th a n o w n e rs are lik e ly to be. Lessors w i ll reco gn ise th is p ro b le m a n d base th e re n ta ls o n th e e xp ected re s id u a l v a lu e o f th e asset, g iv e n th e n o rm a l tre a tm e n t to w h ic h leased assets are sub je cte d. H o w e ve r, th e re can be an o v e ra ll a d va n ta g e f o r le a sin g , p ro v id e d t h a t th e c o s t sa vin g th ro u g h a v o id in g fre q u e n t o w n e rs h ip tra n s fe rs is g re a te r th a n th e a d d itio n a l costs a sso cia te d w it h d e te rio ra tio n o f leased assets.

I f th e le s s o r has a c o m p a ra tiv e ad va n ta g e in d is p o s in g o f an asset, th is m a y cause le a s in g to be p re fe rre d . F o r e xa m p le , a le sso r m a y be able to se ll an asset a t th e e n d o f th e lease te rm a t a h ig h e r p ric e th a n c o u ld a c o m p a n y t h a t ha d p u rch a se d th e asset. S m ith a n d W a ke m a n (1 9 8 5 , p. 9 0 2 ) id e n tifie d th re e p o te n tia l sources o f such a c o m p a ra tiv e advantage.

a

There is th e p o te n tia l f o r lo w e r search, in fo r m a tio n a n d tra n s a c tio n costs asso cia te d w it h th e le ssor p ro v id in g a sp e cia lise d m a rk e t f o r used assets. Such m a rk e ts m a ke i t ea sie r a n d che ap er f o r bu yers se e kin g a p a r tic u la r asset to lo ca te p o te n tia l sellers.

b

There m a y be red uce d re p a ir a n d m a in te n a n c e costs f o r e x is tin g assets fr o m re u s in g c o m p o n e n ts o f p re v io u s ly leased assets.

c

R educed p ro d u c tio n costs re s u lt fr o m re u s in g c o m p o n e n ts o f p re v io u s ly leased assets in th e p ro d u c tio n o f n e w assets. These advantages are lik e ly to e x is t o n ly w h e re th e le sso r is also th e m a n u fa c tu re r a n d /o r d is tr ib u to r

o f th e asset. H o w e ve r, S m ith a n d W a k e m a n a rg u e d t h a t m a n u fa c tu re rs w h o accept used assets as tra d e in s o ffe r th e sam e c o m p a ra tiv e advantages to asset b u ye rs. T h e re fo re , w h ile th e cost re d u c tio n s can be real, th e y are n o t p e c u lia r to leasing. 14 For a discussion of these and other factors relevant to short-term leasing, see Flath (1980).

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

Chattel mortgages and hire-purchase C h a tte l m o rtg a g e s a n d h ire -p u rc h a s e a g re e m e n ts are s im ila r to fin a n c e leases a n d are p ro v id e d b y th e

a m o rtg a g e o v e r m o va b le p ro p e rty ra th e r th a n re a l estate. I n c o n tra s t, w it h h ire -p u rc h a s e th e fin a n c ie r

LEARNING OBJECTIVE 9 Outline the main features of chattel mortgages and hirepurchase agreements

purchases th e asset a n d h ire s i t to th e u s e r f o r an agreed p e rio d .

CHATTEL MORTGAGE

same fin a n c ia l in te rm e d ia rie s , m a in ly b a n ks a n d fin a n c e com p an ies. The d iffe re n ce s b e tw e e n these v a rio u s fo rm s o f e q u ip m e n t fin a n c e are ‘te c h n ic a l’ b u t th e d iffe re n ce s can have im p o r t a n t legal a n d ta x im p lic a tio n s . In th e case o f a

c h a tte l m o rtg a g e , th e u se r b u ys th e goods d ire c tly fr o m th e s u p p lie r a n d

th e fin a n c ie r re g is te rs a charge o v e r th e goods as se c u rity . Thus, a c h a tte l m o rtg a g e is a lo a n secured b y

W h e re an asset is su b je c t to a c h a tte l m o rtg a g e o r a

h ire-p u rch ase a g re e m e n t, th e u se r w ill be

re q u ire d to m ake a series o f p a y m e n ts o r in s ta lm e n ts to th e fin a n c ie r f o r an agreed p e rio d . As f o r a fin a n ce lease, th e te rm u s u a lly ranges fr o m 2 to 5 years a n d th e in te re s t ra te is u s u a lly fix e d f o r th e w h o le o f th e te rm . The p a y m e n ts m a y be e q u a l o r th e y can be ta ilo re d to s u it th e u s e rs cash flo w p a tte rn . F o r exam ple, th e p a y m e n ts m a y in c lu d e an in it ia l d e p o s it a n d /o r a fin a l 'b a llo o n p a y m e n t. O ne e sse n tia l fe a tu re o f a h ire -p u rc h a s e a g re e m e n t is t h a t i t w ill e ith e r c o m m it th e u se r to b u y in g th e asset o r g ive th e u s e r a n o p tio n to b u y it . A lease c a n n o t c o m m it th e lessee to b u y in g th e asset o r e x p lic itly g ive th e lessee an o p tio n to do so. This d iffe re n c e is im p o r ta n t f o r ta x p u rp o se s because i t m eans th a t in th e case o f h ire -p u rc h a s e a g re e m e n ts th e user, ra th e r th a n th e fin a n c ie r, w ill be e n title d to c la im d e d u c tio n s f o r d e p re c ia tio n . The u se r w ill also be able to c la im d e d u c tio n s f o r th e in te re s t c o m p o n e n t o f th e h ire -p u rch a se p a y m e n ts . In A u s tra lia , th e p o p u la r ity o f c h a tte l m o rtg a g e s has in cre a se d m a rk e d ly since th e goods a n d services ta x was in tro d u c e d in 2 0 0 0 an d, as n o te d in S e ctio n 15.1, d u rin g 2 0 1 2 c h a tte l m o rtg a g e s m ade u p a p p ro x im a te ly 4 0 p e r c e n t o f th e v a lu e o f n e w e q u ip m e n t fin a n c e ag re e m e n ts e n te re d in to .

15.8.1 I Equipment finance and the goods and services tax C h a tte l m o rtg a g e s, h ire -p u rc h a s e a n d le a sin g are n o t tre a te d in e x a c tly th e sam e w a y u n d e r th e goods and services ta x (G ST). C h a tte l m o rtg a g e s are tre a te d in th e sam e w a y as o th e r lo a n s in t h a t th e y are classed as a fin a n c ia l su p p ly. A c c o rd in g ly , n o GST is payable o n th e p ro v is io n o f th e lo a n o r o n th e lo a n re p a ym e n ts. The p u rcha se p ric e o f th e e q u ip m e n t it s e lf w ill u s u a lly in c lu d e a GST c o m p o n e n t b u t th e p u rch a se r m a y be able to re co ve r th is o u tla y b y c la im in g an in p u t ta x c re d it. In c o n tra s t, le a s in g is n o t classed as a fin a n c ia l s u p p ly so lease re n ta ls are w h o lly su b je c t to GST. In o th e r w o rd s , f o r a lease, GST applies to b o th th e co st o f th e asset a n d th e c re d it charge in c lu d e d in th e lease re n ta ls . In th e case o f a c h a tte l m o rtg a g e , GST a p p lie s o n ly to th e co st o f th e asset. W h e re th e u s e r o f th e asset is a business th a t can c la im an in p u t c re d it f o r th e GST, th e h ig h e r GST o n a lease s h o u ld n o t m a tte r. H o w e ve r, i f th e asset use r is u n a b le to c la im in p u t ta x c re d its , le a s in g m a y be less a ttra c tiv e th a n a c h a tte l m o rtg a g e . H ire -p u rch a se ag re e m e n ts e n te re d in to a fte r 1 J u ly 2 0 1 2 are e ffe c tiv e ly tre a te d in th e sam e w a y as lease agree m ents f o r ta x p u rp o s e s .15 16 In s u m m a ry , w h ile c h a tte l m o rtg a g e s, h ire -p u rc h a s e a n d fin a n c e leases have m a n y s im ila ritie s , th e re are im p o r ta n t d iffe re n ce s b e tw e e n th e m in te rm s o f le ga l o w n e rs h ip a n d ta x a tio n tre a tm e n t. In th e case o f GST, c h a tte l m o rtg a g e s are e ffe c tiv e ly a t th e o p p o s ite e n d o f th e ta x S p e c tru m * to leases a n d h ire purchase ag ree m ents.

15 Prior to July 2012, the tax treatment of hire-purchase agreements depended upon whether a separate credit charge was disclosed to the asset purchaser. If such disclosure was made then the asset purchaser was only liable for GST on the cost of the asset, with no tax liability arising from the financial supply component of the agreement.

a loan secured by a mortgage over movable property HIRE-PURCHASE AGREEMENT

agreement under which an asset owned by a financier is hired by a user who has the right or an obligation to purchase the asset when the agreement expires

B usiness finance

SUMMARY •

T he re a s o n s fo r le a s in g d iff e r b e tw e e n th e v a rio u s

c a p a c ity in th e c a s e o f o p e r a tin g le a s e s . L e a s in g a n d

ty p e s o f le a se s. T h e t w o b a s ic ty p e s a r e o p e r a tin g

o th e r ty p e s o f e q u ip m e n t f in a n c e c a n b e a ttra c tiv e

le a s e s a n d f in a n c e le a se s.

f o r b u s in e s s e s th a t a r e s m a ll o r n e w a n d , th e re fo re ,

•

fa c e r e la tiv e ly h ig h tra n s a c tio n c o sts in o b ta in in g

O p e r a t in g le a s e s s e p a ra te th e risks o f o w n e r s h ip fro m th e use o f th e le a s e d a sse t a n d c a n p r o v id e a d v a n ta g e s

su ch

as

lo w e r

tra n s a c tio n

costs,

f in a n c e in o th e r w a y s . •

c o n v e n ie n c e a n d fle x ib ility , a s w e ll a s in s u ra n c e a g a in s t th e ris k o f o b s o le s c e n c e . •

In

th e

case

of

o w n e r s h ip a r e

fin a n c e

le a s e s ,

risks

of

•

o f o w n e r s h ip a n d

g e n e r a lly p r e fe r to p u r c h a s e r a t h e r th a n le a s e . •

d e b t fin a n c e . L e a s in g o f v e r y e x p e n s iv e assets fa c to rs .

a s e p a r a tio n

a s s e t u se rs w ith g o o d a c c e s s to in te r n a l fu n d s w ill

b o r n e b y th e u s e r o f th e a sse t

b y ta x -re la te d

in v o lv e s

h a s s ig n if ic a n t b e n e fits s u ch a s la r g e ta x s a v in g s , th e

a n d le a s in g is a n a lte r n a tiv e to o th e r fo rm s o f is d r iv e n

L e a s in g

c o n tr o l th a t re s u lts in a g e n c y c o s ts . U n le s s a le a s e

T h e le a s in g m a rk e t is h ig h ly c o m p e titiv e a n d v e r y f le x ib le . T h e re fo re , fa c to rs su ch a s c h a n g e s in ta x

E xcep t w h e re

ru le s

and

th e

le v e l

of

g o v e r n m e n t c h a rg e s

and

th e re a re s ig n if ic a n t ta x a d v a n ta g e s , le a s in g o f

d iffe re n c e s

s p e c ia lis e d

e ffe c ts o n th e p o p u la r ity o f le a s in g c o m p a r e d w ith

a sse ts

is m u c h

less c o m m o n

th a n

in G S T tr e a tm e n t c a n

have

im p o r ta n t

le a s in g o f g e n e r a l use o r m a r k e ta b le a sse ts, such

s im ila r fo rm s o f fin a n c e , n a m e ly c h a tte l m o rtg a g e s

a s m o to r v e h ic le s a n d c o m p u te rs .

a n d h ire -p u rc h a s e .

T he a b ilit y o f a le s s o r to re p o sse ss a n a s s e t m o re e a s ily th a n a s e c u re d le n d e r p r o v id e s g r e a te r d e b t

KEY TERMS c h a tte l m o rtg a g e c ro s s -b o rd e r le a se fin a n c e le a se

471

452

h ire -p u rc h a s e a g re e m e n t lessee

451

le ssor

45 1

le v e ra g e d le a se

455 471

454

m a in te n a n c e le a se

453

n o n -re c o u rs e lo a n

454

o p e r a tin g le a se

453

sa le a n d le a s e -b a c k a g re e m e n t

453

SELF-TEST PROBLEMS 1

D o n a s h Pty Ltd n e e d s a n e w c o m p u te r, w h ic h it c a n b u y f o r $ 4 4 0 0 0 0 o r it c a n le a s e fro m C o m le a s e . T he le a s e r e q u ire s s ix a n n u a l p a y m e n ts o f $ 1 0 0 0 0 0 e a c h , in a d v a n c e . D o n a s h h a s la r g e ta x losses a n d d o e s n o t e x p e c t to p a y ta x f o r a t le a s t 5 y e a rs . C o m le a s e p a y s ta x a t 3 0 p e r c e n t a n d c a n d e p r e c ia te th e c o m p u te r o n a s tra ig h t-lin e b a s is o v e r 3 y e a rs . T he c o m p u te r w i ll h a v e n o r e s id u a l v a lu e a t th e e n d o f 5 y e a rs , a n d th e b e fo re -ta x in te re s t r a te o n a n e q u iv a le n t lo a n w o u ld b e 1 5 p e r c e n t p e r a n n u m . a)

W h a t is th e N P V o f th e le a s e fo r D o n a s h ?

b)

W h a t is th e N P V fo r C o m le a s e ?

c)

W h a t is th e o v e ra ll g a in to le a s in g in th is tra n s a c tio n ?

Solutions to self-test problem s are a va ila b le in A p p e n d ix B.

47 2

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

1

[L O 1]

D is tin g u is h b e tw e e n a 'fin a n c e le a s e 7 a n d a n 'o p e r a t in g le a s e 7. W h y is it im p o r ta n t to m a k e th is

d is tin c tio n ? 2

[L O U

W h a t a r e th e im p o r ta n t c h a ra c te ris tic s o f a f in a n c e le a se ?

3

[L O 1]

W h a t a r e th e e s s e n tia l c h a ra c te ris tic s o f a s a le a n d le a s e -b a c k a g re e m e n t? O u tlin e th e a d v a n ta g e s

a n d d is a d v a n ta g e s o f su ch a n a g re e m e n t. 4

[LO 2 ]

W h a t d is tin g u is h e s a le v e r a g e d le a s e fro m o th e r ty p e s o f fin a n c e le a se s? W h a t a r e th e ro le s o f th e

v a rio u s p a rtie s to a le v e r a g e d le a se ? 5

[L O 2 ] C o m p a re a n d c o n tra s t a le v e r a g e d le a s e 7 a n d a 'c ro s s -b o rd e r le a s e '.

6

[L O 3 ]

Leasing is a form o f tax a vo id an ce that should be o u tla w e d b y legislation. D iscu ss th is s ta te m e n t,

in d ic a tin g w h y y o u a g r e e o r d is a g r e e w ith it. 7

[L O 7 ] Leasing increases a com pany's access to debt. D iscu ss c r itic a lly .

8

[LO 7 ] D iscuss c r it ic a lly th e a lle g e d a d v a n ta g e s o f le a s in g .

9

[LO 7 ] a) b)

W h ic h , if a n y , o f th e f o llo w in g a r e g e n u in e a d v a n ta g e s o f le a s in g ?

L e asing c o n s e rv e s th e lessee's c a p ita l. L e asing e n a b le s n e e d e d assets to b e a c q u ir e d e ve n w h e n th e B o a rd o f D ire c to rs w ill n o t a p p r o v e a n y c a p ita l e x p e n d itu re re q u e sts.

10

c)

By le a s in g a c o m p u te r, th e risk o f o b s o le s c e n c e c a n b e tra n s fe rre d to th e lessor.

d)

Le a sin g p ro v id e s 1 0 0 p e r c e n t fin a n c in g .

[L 0 7 ]

C H A P T E R FIFTEEN R E V I W W

QUESTIONS

It is c o m m o n f o r a ir lin e s to o w n s o m e a ir c r a f t w h ile le a s in g o th e rs u n d e r o p e r a tin g le a se s. W h a t a re

th e a d v a n ta g e s a n d d is a d v a n ta g e s o f th is a p p r o a c h ? 11

[L O 7 ]

If le a s in g d o e s c o n s e rv e c a p it a l in th e se n se th a t th e d e b t c a p a c it y o f le a s in g e x c e e d s th e d e b t

c a p a c ity o f le n d in g , w h a t a r e th e m a in im p lic a tio n s fo r le a s e ve rsu s p u rc h a s e d e c is io n s ? 12

[LO 7 ] Leasing means that an asset is under the control o f o user w h o is not the o w n e r a n d this separation gives rise to agen cy costs. W h a t a r e th e m a in im p lic a tio n s o f th e s e co sts f o r le a s e ve rs u s p u rc h a s e d e c is io n s ? C r itic a lly e v a lu a te th e f o llo w in g s ta te m e n t: M a n y ro o d transport com panies ore risky businesses w hich are unable to b o rro w enough to buy o il the trucks they need. For them, leasing makes a lo t o f sense. Trucks are attractive to lessors because they are d u ra b le a n d there is an active second-hand market.

13

[L O 8 ]

14

[L 0 8 ]

15

[L 0 8 ]

It is common to lease assets such os cars a n d trucks, w hereas specialised assets ore usually o w n e d b y the user. E x p la in .

In Australia, o p e ra tin g leases have been lim ite d m a in ly to m otor vehicles, computers a n d m ultipurpose industrial equipm ent such as forklifts. W h a t c h a ra c te ris tic s o f th e se assets m a k e th e m s u ita b le

fo r o p e r a tin g le a se s? 16

[L O 9 ]

O u tlin e th e m a in fa c to rs th a t a r e lik e ly to in flu e n c e th e c h o ic e b e tw e e n a c q u ir in g a n a s s e t th r o u g h a

fin a n c e le a s e o r b y h ire -p u rc h a s e . 17

18

[L O 9 ]

D is tin g u is h b e tw e e n :

a)

a fin a n c e le a s e a n d a h ire -p u rc h a s e a g re e m e n t

b)

c h a tte l m o r tg a g e a n d h ire -p u rc h a s e .

[LO 9 ]

Leases a n d c h a tte l m o rtg a g e s a r e tre a te d d iffe r e n tly u n d e r th e g o o d s a n d s e rv ic e s ta x (G S T). O u t lin e

th e G S T tre a tm e n t o f le a s e s a n d c h a tte l m o rtg a g e s . F o r a b u s in e s s , is th e o v e r a ll c o s t o f a le a s e lik e ly to b e g re a te r th a n th e c o s t o f a c h a tte l m o rtg a g e ?

473

B usiness finance

CA 1

PROBLEMS

Calculating lease rentals [LO 4] T he V is io n C o m p a n y is e v a lu a tin g th e a c q u is itio n o f a n a sse t th a t it re q u ire s fo r a p e r io d o f 6 y e a rs . The fo llo w in g in fo r m a tio n re la te s to th e p u rc h a s e o f th e asse t: a)

The p u rc h a s e p ric e is $1 m illio n .

b)

It c a n b e d e p r e c ia te d a t a ra te o f 1 0 p e r c e n t p e r a n n u m , s tra ig h t-lin e .

c)

The e s tim a te d d is p o s a l v a lu e in 6 y e a r s 7 tim e is $ 3 0 0 0 0 0 .

d) T h e c o m p a n y in c o m e t a x ra te is 3 0 ce n ts in th e d o lla r. e)

T h e re q u ire d ra te o f re tu rn o n th e in v e s tm e n t is 1 5 p e r c e n t p e r a n n u m a fte r ta x .

A s s u m e th a t th e c o m p a n y h a s th e a lte rn a tiv e o f le a s in g th e a sse t fro m th e A ja x Le a sin g C o m p a n y . A ss u m e a ls o th a t th e a fte r-ta x c o s t o f a n e q u iv a le n t lo a n is 9 p e r c e n t p e r a n n u m . A s s u m in g th a t th e a n n u a l le a s e p a y m e n ts a re m a d e a t th e b e g in n in g o f e a c h y e a r a n d th a t th e le a se s p e c ifie s a re s id u a l v a lu e o f $ 3 0 0 0 0 0 , w h a t le a s e p a y m e n ts w o u ld m a k e V is io n in d iffe r e n t b e tw e e n b u y in g o r le a s in g th e asset?

2

Calculating lease rentals [LO 4] A s s u m e th a t A ja x Le a sin g C o m p a n y c o u ld a c q u ir e th e a sse t re q u ire d b y V is io n (see P ro b le m 2 ) fo r $ 9 0 0 0 0 0 a n d d e p r e c ia te it a t a ra te o f 1 5 p e r c e n t p e r a n n u m , s tra ig h t-lin e . T he o th e r in fo r m a tio n is th e s a m e a s th a t p re s e n te d in P ro b le m 2 .

3

a)

C a lc u la te th e m in im u m a n n u a l le a s e p a y m e n t th a t A ja x Le a sin g C o m p a n y w o u ld c h a rg e .

b)

D o e s y o u r a n s w e r to (a) n e c e s s a rily im p ly th a t V is io n s h o u ld le a s e th e asset? W h y o r w h y not?

Calculating lease rentals [LO 4] C o n n e ll F in a n c e is d e te rm in in g p a y m e n ts fo r a 4 -y e a r fin a n c e le a se w ith a 2 0 p e r c e n t re s id u a l o n a n a sse t th a t costs $ 8 0 0 0 0 0 a n d c a n b e d e p r e c ia te d o n a s tra ig h t-lin e b a s is o v e r 3 y e a rs . T he ta x ra te fo r C o n n e ll is 3 0 p e r c e n t, a n d it re q u ire s a b e fo re -ta x ra te o f re tu rn fro m le ase s o f 1 2 p e r c e n t. D e te rm in e th e le a s e p a y m e n ts w h e n th e le a se p a y m e n ts a r e m a d e : a)

a n n u a lly in a d v a n c e

b)

q u a r te r ly in a d v a n c e .

S u p p o s e th a t th e le a se re n ta ls a re p a y a b le a n n u a lly in a d v a n c e a n d th e te rm s o f th e le a s e a re c h a n g e d so th a t it is a n o p e r a tin g le a se . W ill th e re n ta ls b e h ig h e r o r lo w e r th a n y o u r a n s w e r to (a)? G iv e re a s o n s fo r y o u r a n s w e r.

4

Evaluating investments: lease versus purchase [LO 5] The H y b e e C o m p a n y is e v a lu a tin g a n in v e s tm e n t to p ro d u c e a n e w p r o d u c t w ith a n e x p e c te d m a rk e ta b le life o f 5 y e a rs . T he e x p e c te d a n n u a l n e t c a s h f lo w b e fo re ta x is $1 2 0 0 0 0 . To p ro d u c e th is p r o d u c t th e c o m p a n y w ill h a v e to a c q u ir e n e w p la n t. The c o m p a n y c a n e ith e r p u rc h a s e this p la n t o r le a se it. D e ta ils o f these a lte rn a tiv e s a re as fo llo w s :

Purchase T he p u rc h a s e p ric e o f th e p la n t is $ 2 5 0 0 0 0 a n d it is e x p e c te d th a t it w ill h a v e a z e r o re s id u a l v a lu e a fte r 5 y e a rs . T h e a llo w a b le a n n u a l d e p r e c ia tio n c h a r g e o n th e p la n t is 2 0 p e r c e n t p e r a n n u m , s tra ig h t-lin e .

Lease T he le a se re q u ire s fiv e a n n u a l p a y m e n ts , e a c h o f $ 6 0 0 0 0 , p a y a b le a t th e b e g in n in g o f e a c h y e a r. T he c o m p a n y ta x ra te is 3 0 ce n ts in th e d o lla r . T he r e q u ire d ra te o f re tu rn o n th e in v e s tm e n t is 1 5 p e r c e n t p e r a n n u m a fte r ta x a n d th e a fte r-ta x c o s t o f a n e q u iv a le n t lo a n is 8 p e r c e n t p e r a n n u m . S h o u ld th e c o m p a n y u n d e rta k e th e in ve stm e n t? If so, s h o u ld it p u rc h a s e o r le a s e th e p la n t?

5

Lease versus purchase [LO 5] C a r r y Ltd is e v a lu a tin g th e p o s s ib ility o f te n d e rin g fo r th e lic e n c e to o p e r a te in te r n a tio n a l flig h ts fro m C a n b e r r a to Q u e e n s to w n (N Z ) fo r a 5 -y e a r p e r io d . If its b id is su cce ssfu l, th e lic e n c e fe e h a s to b e p a id im m e d ia te ly a n d is n o t ta x d e d u c tib le .

474

C hapter fifteen Le a s in g

a n d other e q u ip m e n t f in a n c e

$ 2 0 m illio n , a n d th a t it w o u ld re q u ire a n a fte r-ta x ra te o f re tu rn o f 1 5 p e r c e n t p e r a n n u m o n its in ve stm e n t. The c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r . C a r r y Ltd h a s th e o p tio n o f e ith e r b u y in g o r le a s in g a n a ir c r a ft. T he f o llo w in g in fo r m a tio n is re le v a n t to th e se o p tio n s :

Purchase T he p u rc h a s e p r ic e o f th e a ir c r a f t is $ 6 0 m illio n . \\ c o u ld b e d e p r e c ia te d a t a ra te o f 1 5 p e r c e n t p e r a n n u m , s tra ig h t-lin e . T h e e s tim a te d d is p o s a l v a lu e in 5 y e a r s ' tim e is $ 2 0 m illio n .

Lease T he a n n u a l le a s e p a y m e n ts w o u ld b e $ 1 5 m illio n , p a y a b le a t th e b e g in n in g o f e a c h y e a r, w ith a le a s e re s id u a l o f $ 2 0 m illio n . T he a fte r-ta x in te re s t ra te o n a n e q u iv a le n t lo a n is 1 1 p e r c e n t p e r a n n u m . W h a t is th e m a x im u m lic e n c e fe e th a t C a r r y Ltd s h o u ld te n d e r? 6

E v a lu a tio n o f a n o p e r a tin g le a se [LO 6 ] Ibus Ltd is c o n s id e rin g th e in s ta lla tio n o f a n e w c o m p u te r. B e c a u s e o f u n c e rta in ty a s to its fu tu re c o m p u tin g re q u ire m e n ts a n d th e p ro s p e c t o f a d v a n c e m e n ts in c o m p u tin g te c h n o lo g y , it is e v a lu a tin g th e a c q u is itio n o f the c o m p u te r b y e ith e r p u rc h a s in g it, o r le a s in g it u n d e r a c o n tra c t th a t in c lu d e s a c a n c e lla tio n o p tio n . In fo rm a tio n re le v a n t to th e c o m p a n y ’s e v a lu a tio n is as fo llo w s :

Purchase T he p u rc h a s e p ric e o f th e c o m p u te r is $ 3 0 0 0 0 0 a n d it c a n b e d e p r e c ia te d a t a ra te o f 1 5 p e r c e n t p e r a n n u m , s tra ig h t-lin e . Ib u s Ltd p la n s to o p e r a te th e c o m p u te r fo r a m a x im u m o f 5 y e a rs . T he c o m p u te r's d is p o s a l v a lu e a t th e e n d o f 5 y e a rs is e s tim a te d to b e $ 5 0 0 0 0 .

C H A P T E R FIFTEEN R E V I m w

T he c o m p a n y h a s e s tim a te d th a t th e b e fo re -ta x a n n u a l n e t c a s h in flo w fro m o p e r a tin g th e s e rv ic e w o u ld b e

Lease T he a n n u a l le a se p a y m e n ts o n th e o p e r a tin g le a s e w o u ld b e $ 9 0 0 0 0 , p a y a b le a t th e b e g in n in g o f e a c h y e a r. T he le a se c a n b e c a n c e lle d b y Ibu s Ltd a t a n y tim e w ith o u t in c u rrin g a n y p e n a lty p a y m e n t. The c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r, th e r e q u ire d re tu rn o n th e in v e s tm e n t is 2 0 p e r c e n t p e r a n n u m a n d th e a fte r-ta x c o s t o f a n e q u iv a le n t lo a n is 1 0 p e r c e n t p e r a n n u m . S h o u ld th e c o m p a n y p u rc h a s e o r le a se th e asset?

REFERENCES Australian Bureau of Statistics, Lending Finance, Australia, cat. no. 5 6 7 1 .0 , February 20 1 4 . Bennett, J., Hardaker, R. & W orrall, M ., 'Equipment: leasing and financing7, in R. Bruce, B. McKern, I. Pollard & M. Skully (eds), Handbook of Australian Corporate Finance, 5th edn, Butterworths, Sydney, 1997, pp. 2 7 4 -3 0 3 .

Graham, J.R., Lemmon, M.L. & Schallheim, J.S., 'Debt, leases, taxes and the endogeneity of corporate tax status’， Journal of Finance, February 1998, pp. 1 3 1 -6 2 . Grenadier, S.R., 'Valuing lease contracts: a real options approach', Journal of Financial Economics, July 1995, pp. 2 9 7 -3 3 1 .

Bowman, R., 'The debt equivalence of leases: an empirical investigation7, The Accounting Review, April 1980, pp. 2 3 7 -5 3 .

Henderson, S.f Peirson, G. & Herbohn, K.; Issues in Financial Accounting, 15th edn, Pearson Education, Sydney, 2 0 1 3 , Chapter 12.

Burrows, G .H .; 'Evolution of a lease solution', Abacus, September 1988, pp. 1 0 7 -1 9 .

Lev, B. & Ohlson, J., 'Market-based em pirical research in accounting: a review, interpretation and extension', in 'Studies on current research methodologies in accounting: a critical evaluation,/ Journal of Accounting Research, Supplement, 1982.

Copeland, T. & Weston, J., 'A note on the evaluation of cancellable operating leases7, Financial Management, Summer 1982, pp. 6 0 -7 .

pp. 1 6 2 1 -5 7 .

Lewellen, W ., Long, M . & McConnell, J.,'A sset leasing in competitive capital markets7, Journal of Finance, June 1976, pp. 7 8 7 -9 8 .

Flath, D., 'The economics of short-term leasing7, Economic Inquiry, April 1980, pp. 2 4 7 -5 9 .

M ehran, H., Taggart, R.A. & Yermack, D., 'CEO ownership, leasing and debt financing,/ Financial Management, Summer

Eisfeldt, A. & Rampini, A ./Leasing, ab ility to repossess, and debt capacity', /?ewevv o f/^n a n c/a / A pril 20 09 ,

Gavazza, A., 'Asset liquidity and financial contracts: evidence from aircraft leases', Journal of Financial Economics, January 2 0 1 0 , pp. 6 2 -8 4 . ------ , 'Leasing and secondary markets: theory and evidence from commercial aircraft', Journal of Political Economy, April 2 0 1 1 , pp. 3 2 5 - 7 7 .

19 99, pp. 5 -1 4 .

Miller, M . & Upton C., le a s in g , buying and the cost of capital services', Journal of Finance, June 1976, pp. 7 6 1 -8 6 . Myers, S., Dill, D. & Bautista, A., 'Valuation of financial lease contracts7, Journal of Finance, June 19 7 6 , pp. 7 9 9 -8 1 9 .

475

B usiness finance

476

Scarman, l.; 'Lease evaluation: a survey of Australian finance company approaches', Accounting and Finance, November 1 9 8 2 , pp. 3 3 - 5 1 .

Sharpe, S.A. & Nguyen, H.H., 'C apital market imperfections and the incentive to lease', Journal of Financial Economics, O cto be r/N ovem b er 1995, pp. 2 7 1 -9 4 .

Schallheim, J.S., Lease or Buy?, Harvard Business School Press, Boston, 1994.

Smith, C.W . Jr. & W akeman, L.M, 'Determinants of corporate leasing policy7, Journal of Finance, July 1985, pp. 8 9 5 -9 0 8 .

Schallheim, J., Johnson, R., Lease, R. & McConnell, J., 'The determinants o f yields on financial leasing contracts,/ Journal of Financial Economics, September 1987, pp. 4 5 -6 7 .

Vardigans, P., 'The benefits of leasing7, Banking World, August 1990, pp. 2 6 -7 .

CHAPTER CONTENTS 16.1

I n t r o d u c t io n

478

16.2

T h e e f f ic ie n t m a r k e t h y p o th e s is

478

16.3

Tests o f re tu r n p r e d i c t a b il it y

481

16.4

E v e n t s tu d ie s

487

16.5

Tests f o r p r iv a t e in f o r m a t io n

493

^ ^ 3

M a r k e t e f f ic ie n c y a t th e m a c r o le v e l

495

B e h a v io u r a l f in a n c e a n d m a r k e t e f f ic ie n c y

495

I m p lic a t io n s o f th e e v id e n c e w it h r e s p e c t to m a r k e t e f f ic ie n c y

LEARNING OBJECTIVES A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

u n d e r s ta n d th e c o n c e p t o f m a r k e t e f f ic ie n c y

2

u n d e r s ta n d th e m e th o d s u s e d to te s t f o r m a r k e t e f f ic ie n c y

3

u n d e r s ta n d th e e v id e n c e p r o v id e d b y te sts o f m a r k e t e f f ic ie n c y a n d th e e x t e n t to w h ic h t h a t e v id e n c e s u p p o r ts o r d o e s n o t s u p p o r t m a r k e t e f f ic ie n c y

4

u n d e r s ta n d th e d if f e r e n c e b e t w e e n m ic r o a n d m a c r o m a r k e t e f f ic ie n c y

5

u n d e r s ta n d th e r e le v a n c e o f b e h a v io u r a l f in a n c e t o m a r k e t e f f ic ie n c y

6

u n d e r s ta n d th e im p lic a t io n s o f th e e v id e n c e o n m a r k e t e f f ic ie n c y f o r in v e s to r s a n d f in a n c ia l m a n a g e r s .

497

Z

B usiness finance

16.1

Introduction

In C h a p te r 1, w e assu m ed t h a t th e o b je c tiv e o f a co m p a n y was to m a x im is e th e m a rk e t v a lu e o f its shares. In th e c h a p te rs t h a t fo llo w e d , w e discussed th e in v e s tm e n t, fin a n c in g a n d p a y o u t d e cisio n s c o n s is te n t w ith t h a t o b je c tiv e . T h ro u g h o u t th o se ch a p te rs i t was im p lic it ly assu m ed t h a t in v e s to rs w o u ld rea ct q u ic k ly to such de cisio n s, a n d a c c o rd in g ly t h a t th e m a rk e t p ric e o f th e co m p a n y s shares w o u ld a d ju s t q u ic k ly to re fle c t th e im p a c t o f each d e c is io n o n th e c o m p a n y s value. I n o th e r w o rd s , i t w as assum ed th a t th e shares w e re tra d e d in a m a rk e t t h a t was e fficie n t*, in th e sense t h a t share p rice s a ccu ra te ly re fle c t a va ila b le in fo r m a tio n . The e x te n t to w h ic h asset p rice s a ccu ra te ly re fle c t a va ila ble in fo r m a tio n has be en w id e ly tested . These EFFICIENT MARKET HYPOTHESIS (EM H )

that the price of a security (such as a share) accurately reflects available information

te sts e x a m in e th e

efficien t m a rk e t h y p o th esis (EM H) — th e h y p o th e s is t h a t th e p ric e o f a s e c u rity

(such as a share) a ccu ra te ly re fle c ts a va ila b le in fo r m a tio n . M o s t o f these te s ts have use d share prices, b u t o th e r m a rk e ts such as d e b t m a rk e ts a n d d e riv a tiv e s e c u ritie s m a rk e ts have also b e en e x te n s iv e ly tested. In re v ie w in g th e evide nce o n m a rk e t e ffic ie n c y i t is necessary to m a ke a d is tin c tio n b e tw e e n m ic ro ­ e ffic ie n c y an d m a c ro -e fficie n cy. A t th e m ic ro le vel, m a rk e t e ffic ie n c y con cern s th e e x te n t to w h ic h th e p ric e o f a s e c u rity re fle c ts in fo r m a tio n re la tiv e to o th e r s e c u ritie s in th e sam e asset class: f o r exam ple, w h e th e r B H P B illit o n shares are c o rre c tly p ric e d w h e n c o m p a re d w ith R io T in to shares. A t th e m a cro level, th e issue is w h e th e r c a p ita l m a rk e ts as a w h o le re fle c t a ll a va ila b le in fo r m a tio n — w h e th e r, f o r exa m ple, th e share m a rk e t is c o rre c tly p ric e d co m p a re d w it h a less r is k y asset class such as g o v e rn m e n t de bt. M ic ro -e ffic ie n c y does n o t n e ce ssa rily im p ly m a c ro -e ffic ie n c y . F o r exa m ple, shares in C o m p a n y X m a y be c o rre c tly p ric e d re la tiv e to shares in C o m p a n y Y, b u t th e share m a rk e t as a w h o le m a y be o v e rv a lu e d due to ‘ir r a tio n a l exu b e ra n ce ’. M o re o v e r, i t is p o ssib le t h a t som e in v e s to rs w ill k n o w t h a t th e share m a rk e t is o ve rv a lu e d , b u t i f th o se in v e s to rs c a n n o t p re d ic t w h e n th e 'bubble* w ill b u rs t, th e y m a y s t ill b u y shares t h a t th e y t h in k are re la tiv e ly cheap a n d sell shares t h a t th e y t h in k are re la tiv e ly expensive. W h ile th is tra d in g a c tiv ity m a y m a in ta in h ig h m ic ro -e ffic ie n c y , i t m a y n o t e lim in a te m a c ro -in e ffic ie n c y . This c h a p te r p ro v id e s a re v ie w o f th e evide nce o n m ic ro a n d m a cro m a rk e t e ffic ie n c y an d th e im p lic a tio n s o f t h a t evidence f o r fin a n c ia l d e c is io n m a k in g . O n th e basis o f th is e vide nce m o s t academ ics a n d p ra c titio n e rs b e lie ve t h a t m a rk e ts are n e ith e r c o m p le te ly e ffic ie n t n o r c o m p le te ly in e ffic ie n t. T h e re fo re , in re v ie w in g th is evidence, ra th e r th a n a s k in g w h e th e r m a rk e ts are e ffic ie n t o r in e ffic ie n t— one e x tre m e o r th e o th e r— th e m o re h e lp fu l q u e s tio n is to ask: To w h a t e x te n t are m a rk e ts e ffic ie n t? (D o u ka s e t al. 2 0 0 2 ). T his is n o t m e re s e m a n tics. I f y o u w is h to k n o w s o m e th in g a b o u t th e te m p e ra tu re , th e q u e s tio n : W h a t is th e te m p e ra tu re ? is lik e ly to le a d to m o re in s ig h ts th a n d e b a tin g w h e th e r i t is

either 'h o t* or

cold* w ith o u t

a llo w in g f o r a ran ge o f answ ers. The sam e a p p lie s to th e q u e s tio n o f m a rk e t e ffic ie n c y . To u n d e rsco re th e im p o rta n c e o f th is p o in t, i t m a y be n o te d t h a t Eugene Fam a a n d R o b e rt S h ille r w e re each aw arded th e 2 0 1 3 N o b e l M e m o ria l P rize in E co n o m ic Sciences f o r t h e ir w o rk e x a m in in g m a rk e t e fficie n cy. B o th have m ad e a fu n d a m e n ta l c o n tr ib u tio n to o u r u n d e rs ta n d in g o f m a rk e t e ffic ie n c y y e t th e y have d iffe re n t vie w s as to th e e x te n t t h a t m a rk e ts are e ffic ie n t.1 Fam a is one o f th e s tro n g e s t a d h e re n ts to th e v ie w th a t m a rk e ts are v e ry e ffic ie n t, w h ile S h ille r argues t h a t m a rk e ts are m ic ro -e ffic ie n t b u t m a c ro -in e ffic ie n t. See J u n g a n d S h ille r (2 0 0 5 ).

16.2

The efficient market hypothesis

Fam a (1 9 7 0 ) d e fin e d an e ffic ie n t c a p ita l m a rk e t as one in w h ic h s e c u rity p rice s ^ u lly refle ct* a ll ava ila ble LEARNING OBJECTIVE 1 Understand the concept of market efficiency

in fo r m a tio n . S e c u rity p rice s change w h e n n e w in fo r m a tio n becom es ava ila ble. I f th e m a rk e t processes n e w in fo r m a t io n e ffic ie n tly , th e re a c tio n o f m a rk e t p rice s to n e w in fo r m a tio n w ill be

unbiased (Fam a 1

2

instantaneous a n d

1 9 7 0 ).2 To g a in an in tu it iv e u n d e rs ta n d in g o f the se re q u ire m e n ts i t is u s e fu l to exa m in e

The prize was jointly awarded to Eugene Fama, Lars Hansen and Robert Shiller. A thorough analysis of their work that led to the Nobel Prize is provided in U n d e rsta n d in g A s s e t P rice s compiled by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences (2013). This definition focuses on 'the market', rather than on individuals responding to information, and is readily testable. For a discussion of alternative definitions, see Ball (1994), pp. 10-13.

C hapter sixteen C apital

m arket efficiency

a h y p o th e tic a l e xa m ple o f a n o n -in s ta n ta n e o u s p ric e re a c tio n a n d a h y p o th e tic a l e xa m p le o f a biased p rice re a ctio n .

E ffic ie n c y re q u ire s t h a t th e p ric e reacts in s ta n ta n e o u s ly . In p ra c tic e , th is m eans t h a t a fte r n e w in fo r m a tio n becom es ava ila ble i t s h o u ld be f u lly re fle c te d in th e n e x t p ric e e s ta b lis h e d in th e m a rk e t. Suppose t h a t th e m a rk e t in C o pp eram a L td shares opens f o r tra d in g a t 1 0 :1 0 am . O n a p a rtic u la r day, th e f ir s t tra d e in C opperam a shares occurs a t 1 0 :4 5 a m a n d th e p ric e e s ta b lis h e d in th e m a rk e t is $1 p e r share. A t 1 1 :0 0 am , C opperam a m akes a c o m p le te ly u n e x p e c te d a n n o u n c e m e n t: a la rg e d e p o s it o f g o ld has be en d isco ve re d in one o f its co p p e r m in e s. N a tu ra lly th is is g o o d new s. Suppose t h a t th is new s w a rra n ts an increase in C o pp eram a s share p ric e fr o m $1 to $ 1 .5 0 . A t 1 1 :1 5 am , a s h a re h o ld e r in C o pp eram a w ishes to sell his shares. H o w eve r, he has n o t h e a rd th e ne w s o f th e g o ld d is c o v e ry a n d asks o n ly $1 p e r share f o r h is shares. The sale is m ade a t $1. A t 1 1 :3 0 am , a C o p p e ra m a s h a re h o ld e r w h o

has h e a rd

th e new s w ishes to

sell h e r shares. H e r a s k in g p ric e is $ 1 .5 0 p e r share a n d th e sale is m ad e a t $1 .50. This m a rk e t is in e ffic ie n t. The p ric e e s ta b lis h e d a t 1 1 :1 5 a m d id n o t re fle c t th e in fo r m a tio n ava ila ble a t 11 :00 am . E ve n tu a lly, a t 1 1 :3 0 am th e m a rk e t p ric e rea cte d to th e new s. H o w e ve r, th is re a c tio n was n o t in s ta n ta n e o u s because i t s h o u ld have o c c u rre d a t th e 11 :1 5 am tra d e . C o m p e titio n b e tw e e n in fo rm e d p o te n tia l b u yers s h o u ld have s e t th e 1 1 :1 5 am p ric e a t $ 1 .5 0 , n o tw ith s ta n d in g th e fa c t t h a t th e s e lle r was u n in fo rm e d . This s im p le e xa m ple also illu s tra te s th e im p o rta n c e o f excess* o r a b n o rm a l* p r o fits in e ffic ie n c y tests. The

buyer a t

1 1 :1 5 am has m ad e an excess p r o f it o f 50 cents p e r share because he has o b ta in e d h is shares

a t a p rice 50 cen ts b e lo w th e p ric e t h a t s h o u ld have been e sta b lish e d , g iv e n th e in fo r m a tio n a va ila ble to th e m a rk e t a t 1 1 :1 5 am . N o te , h o w e ve r, t h a t a lth o u g h th e b u y e r a t 1 0 :4 5 a m has also m ad e a p r o fit o f 50 cents o n th e day, h is p r o f it

cannot be

d e scrib e d as excess. G ive n th e in fo r m a t io n a va ila b le to th e

m a rk e t a t 1 0 :4 5 am , th e p ric e he p a id was corre ct* a t t h a t tim e . This exa m ple also illu s tra te s th e ro le o f tra d in g stra te g ie s. I f th e m a rk e t o fte n fa ils to react in s ta n ta n e o u s ly , share tra d e rs can de ve lo p s im p le ru le s to g e n e ra te excess p ro fits . In th is case, th e ru le w o u ld be: purchase shares im m e d ia te ly a c o m p a n y m akes an u n a n tic ip a te d a n n o u n c e m e n t o f g o o d news. The m a rk e t w ill n o t re a ct in s ta n ta n e o u s ly a n d th e shares w ill increase in p ric e w h e n th e re a c tio n does e v e n tu a lly occur.

Suppose th e m a rk e t in th e shares o f M o rtla k e L td op en s f o r tra d in g a t 1 0 :1 0 am . O n a p a r tic u la r day, th e fir s t tra d e in M o r tla k e s shares occurs a t 1 0 :4 5 am a n d th e p ric e e s ta b lis h e d is $1. A t 1 1 :0 0 am , th e co m p a n y m akes a c o m p le te ly u n e x p e c te d a n n o u n c e m e n t: an u n c o n tro lla b le fire has d e s tro y e d its m a jo r fa c to ry , an d M o rtla k e s m a n a g e m e n t has d isco ve re d th a t, o w in g to an e rro r b y a ju n io r e m p lo yee, th e co m p a n y is n o t in s u re d a g a in s t fire . In v e s to rs p a n ic a n d th e n e x t sale o f M o rtla k e s shares a t 1 1 :1 5 a m is a t 5 cents p e r share. S h o rtly a fte r, h o w e ve r, c o o le r heads p re v a il a n d i t is re m e m b e re d t h a t M o rtla k e also has a n u m b e r o f s m a lle r fa c to rie s a n d s u b s ta n tia l in v e s tm e n ts in se c u ritie s . A t 1 1 :3 0 a m th e m a rk e t p ric e o f M o rtla k e s shares is 35 cents. The m a rk e t is in e ffic ie n t. The p ric e e s ta b lis h e d a t 1 1 :1 5 a m was an

ov er re a c tio n to th e new s, and,

g iv e n th e in fo r m a tio n a va ila b le to th e m a rk e t a t 1 1 :1 5 am , i t s h o u ld have b e en re co g n ise d a t t h a t tim e as an o v e rre a c tio n . C o m p e titio n b e tw e e n in fo rm e d p o te n tia l b u ye rs s h o u ld have p re v e n te d such a lo w p ric e o c c u rrin g , n o tw ith s ta n d in g th e fa c t t h a t p o o rly in fo rm e d sellers h a d p a n icke d . As in th e p re v io u s e xa m p le , th is e xa m p le can be in te rp re te d in te rm s o f excess p r o fits a n d tra d in g strateg ies. The b u y e r a t 11 :1 5 a m has m ad e an excess p r o f it o f 30 ce n ts p e r share. The b u y e r a t 10 :4 5 am

OVERREACTION

biased response of a price to information in which the initial price movement can be expected to be reversed

has m ade a loss o n th e day o f 65 cen ts p e r share, b u t th is loss c a n n o t be ca lle d excess. I f th e m a rk e t o fte n ove rrea cts to b a d new s, th e fo llo w in g tra d in g ru le w ill be successful: p u rcha se shares im m e d ia te ly a co m p a n y m akes an u n a n tic ip a te d a n n o u n c e m e n t o f b a d new s. The m a rk e t w ill a t f ir s t o ve rre a ct, a n d th e shares w ill rise in p ric e w h e n th e m a rk e t rea pp raise s th e in fo r m a tio n in a m o re ra tio n a l fa s h io n . A second k in d o f biase d re a c tio n is an

u n d e rrea ctio n . In th is case th e m a rk e t re sp o n d s g ra d u a lly to

a piece o f ne w in fo r m a tio n , m o v in g to w a rd s th e n e w e q u ilib r iu m p ric e in a p re d ic ta b le series o f steps.

UNDERREACTION

biased response of a price to information in which the initial price movement can be expected to continue

This w ill create observable price trends. The trading strategy in this case would be to buy immediately, if the news is good, and to sell im m ediately i f the news is bad.

I LEARNING OBJECTIVE 2 Understand the methods used to test for market efficiency INFORMATION EFFICIENCY

situation in which prices accurately reflect available information

TESTS OF RETURN PREDICTABILITY

research method designed to detect systematic patterns in asset prices EVENT STUDY

research method that analyses the behaviour of a security’s price around the time of a significant event such as the public announcement of the company’s profit TESTS FOR PRIVATE

1 6 .2 .3 1 Categories of capital market efficiency As suggested earlier, the EMH implies th a t investors cannot earn abnormal returns by using inform ation th a t is already available. This im plication has been the basis fo r most empirical tests o f the hypothesis. The concept o f efficiency inherent in this defin itio n may be described as in form ation efficiency, as it relates to the im pounding o f inform a tion in to m arket prices. I t does n o t directly address questions concerning the allocative or operational efficiency o f capital markets. Fama (1970) suggested a m ethod o f characterising the efficiency o f a m arket on the basis o f the type o f in fo rm a tio n incorporated in to the prices o f assets traded on the market. Assets traded on a m arket th a t was weak-form efficient were traded at prices th a t incorporated all inform a tion contained in the past record o f asset prices. I f a m arket was sem i-strong-form efficient, then prices reflected n o t only all info rm a tio n contained in past price series b ut also all other publicly available inform ation. When asset prices reflected all privately held inform ation, in addition to th a t which was publicly available, then the m arket was said to be strong-form efficient. The inform a tion content o f each successive classification is cumulative. Therefore the second classification includes all previous price inform ation, as well as all other publicly available inform ation, while the th ird classification includes all publicly available info rm a tio n and all privately held inform ation. The im plication o f strong-form efficiency is th a t an investor cannot earn abnormal returns from having inside inform ation. In a later review o f the literature, Fama (1991) proposed an alternative categorisation o f capital m arket efficiency. Instead o f classifying a m arkets efficiency on the basis o f the type o f inform ation impounded into the prices o f assets traded in the market, Fama suggested th a t categories could be formed on the basis o f the research methodology used to assess the efficiency o f the m arket. The three research methodologies he identified were:

a

te sts o f return predictability, which are employed to ascertain whether future returns can be predictedonthebasisofpastinform ationsuchaspastreturns,tim e-of-the-yearorbook-to-m arket ratios b event studies, which involve the analysis o f the behaviour o f a security s returns around the tim e o f a significant event such as the public announcement o f the company s p ro fit, dividend details or in te n tio n to acquire another company c te sts fo r private inform ation, which are designed to test w hether investors can trade profitably by m aking investm ent decisions on the basis o f inform a tion th a t is n ot publicly available.

INFORMATION

research method that tests whether systematic profits can be generated by making investment decisions on the basis of private information

In Sections 16.3 to 16.5 we consider the way in which these three methodologies have been used to test the efficiency o f various markets, particularly w ith respect to the Australian capital m arket. In Section 16.6 we examine the evidence w ith respect to macro-efficiency and in Section 16.7 consider the evidence from behavioural finance. Im plications fo r investors and financial managers o f the evidence o f the extent to which markets are efficient are then considered in Section 16.8. Before we move on, however, we make it clear in the next section th a t tests o f m arket efficiency are also tests o f the model used in those tests.

1 6 .2 .4 1 M arket efficiency and the joint test problem ABNORM AL RETURNS

returns in excess of the return expected from a security

JOINT TEST PROBLEM

problem that any test of market efficiency is simultaneously a test of some model of ’normal’ asset pricing

I f a security m arket is inefficient, then opportunities may exist fo r investors aware o f the inefficiency to earn systematic abnorm al returns. Abnorm al returns can be defined as returns in excess o f the return one could norm ally expect from investm ent in the asset. In Chapter 7 we discussed how an assets expected return can be estimated by employing an asset p ricing model th a t links the assets characteristics to the investors required return from the asset. For instance, the capital asset p ricing model (CAPM) links an assets expected return to its systematic risk as measured by beta. Therefore, the CAPM is one way that we can estimate the fo rm a l* retu rn on a security. The jo in t te st problem arises because any test fo r the presence o f systematic abnormal returns is simultaneously a test o f both the efficiency o f the m arket and the v a lid ity o f the asset pricing model used to estimate expected (or ‘norm al’）returns. Hence, any apparent evidence o f m arket inefficiency may instead be the result o f an incorrectly specified asset pricing model.

C hapter sixteen C apital

market efficiency

Tests of return predictability m In an efficient market, investors should be unable to generate positive abnormal returns systematically through an ability to forecast future price movements accurately. Researchers who have examined this aspect o f m arket efficiency have been p rim a rily concerned w ith the follow ing three issues: a

b

c

The relationship between p a s t an d future returns. I f investors can systematically generate positive abnormal returns from a security merely by n otin g the returns generated by th a t security in the past, then this is an indication o f m arket inefficiency, because the inform a tion contained in the past return series is n o t fu lly reflected in current prices, The presence o f seaso n al effects in returns. Testing fo r the presence o f seasonal effects in returns involves an analysis o f w hether future returns are related to the period in tim e over which the return is generated. Predicting future returns on the b asis o f other forecast variables. In an efficient market, asset prices reflect all inform a tion currently available. There have been numerous studies th a t have tested for a systematic relationship between returns and asset characteristics such as the company s size, book-to-market ratio or dividend yield.

LEARNING OBJECTIVE 3 Understand the evidence provided by tests of market efficiency and the extent to which that evidence supports or does not support market efficiency

16.3.1 | The relationship between past and future returns Short-term patterns A common way o f testing fo r short-term patterns in returns is to test fo r the presence o f serial correlation. Serial correlation tests measure the correlation between successive price changes or, more frequently, the correlation between returns in one period and returns in a p rio r period. Positive correlation indicates that there are trends in price movements, while negative correlation indicates a tendency towards reversals in price movements. Either result would indicate the possible existence o f potentially profitable trading strategies. Both Conrad and Kaul (1988) and Lo and MacKinlay (1988) found evidence o f positive serial correlation in weekly returns o f US shares. However, both studies also found th a t the level o f serial correlation was small— probably too small to generate profitable trading opportunities. Furtherm ore, Lo and MacKinlay (1999) found less evidence o f positive serial correlation over later periods. In Australia, Brailsford and Faff (1993) examined the daily returns from an index consisting o f shares from 50 o f the m ost actively traded companies listed on the Australian Stock Exchange. They also reported evidence o f small positive serial correlation in returns.

Long-term patterns While there is only weak evidence o f serial correlation in daily or weekly returns, in the medium term there is strong evidence th a t shares w ith the best recent performance outperform shares w ith the worst recent performance. Using US data from 1963 to 1989, Jegadeesh and Titm an (1993) identified better­ perform ing shares (the winners) and poorer-perform ing shares (the losers) over a period o f 6 months. They then tracked the performance o f these shares over the follow ing 6 months. On average, the biggest winners outperform ed the biggest losers by 10 per cent per annum. Sim ilar evidence o f this m o m e n tu m effect have also been reported by Brock, Lakonishok and LeBaron (1992), M oskowitz and G rinblatt (1999), Lo, Mamaysky and Wang (2000) and George and Hwang (2004). In particular, George and Hwang show that shares th a t are close to or at th e ir 52-week high outperform shares th a t are far from th eir 52-week high. Given th a t 52-week-high prices are readily available in newspapers and from websites, this study suggests th a t abnormal returns may be earned using simple strategies and readily available inform ation. Evidence o f m om entum is widespread, w ith G riffin, J i and M a rtin (2003) finding it in m ost international markets, and Hameed and Kusnadi (2002) and Brown, Yan Du, Rhee and Zhang (2008) finding it in Asian markets. In Australia, evidence o f m om entum has been found in a range o f studies, including Brailsford and O’Brien (2008) ，Bettman, Maher and Sault (2009), and Docherty, Chan and Easton (2013). I t is also pervasive across a num ber o f asset classes, w ith M oskowitz, Ooi and Pedersen

M O M EN TU M EFFECT

effect in which good or bad performance of shares continues over time

B usiness finance

(2012) reporting evidence o f m om entum n ot only in equities markets b ut also in bond, currency and commodities markets. W hile m om entum is pervasive, there is disagreement as to its cause. Conrad and Kaul (1998) suggest th a t winners are riskier than losers, so winners earn higher returns simply because they are riskier. But this argum ent is refuted by Grundy and M a rtin (2001). A nother argument, presented by Barberis, Shleifer and Vishny (1998) and Hong and Stein (1999), is th a t investors underreact to inform a tion and place too much emphasis on recent share price performance. G rinblatt, Titm an and Wermers (1995) suggest th a t fund managers are more likely to buy past winners and dump past losers, and they tend to do this at the same time, thus generating mom entum. W hile there is disagreement as to its cause, even Eugene Fama has accepted th a t o f all the potential embarrassments to m arket efficiency, m om entum is the prim ary one’ （ Fama and Litterm an, 2012). W hile there is evidence o f a m om entum effect in the m edium term , there is also evidence that this effect is reversed over long periods. DeBondt and Thaler (1985 and 1987), Chopra, Lakonishok and R itter (1992), Lee and Swaminathan (2000) and Jegadeesh and Titm an (2001) have documented long-term reversals in share prices. These studies identified better-perform ing and poorer-perform ing shares over several years. On average, the winners turned in to losers and the losers became winners.

Seasonal patterns in returns give rise to the possibility o f predicting returns based on those patterns. M any studies have tested whether there are daily or m onthly patterns in share returns.

Daily return patterns French (1980) reported th a t a daily index o f US share prices over the period 1953 to 1977 showed that, on average, returns on Mondays were negative, while returns on Fridays were positive. I f this were true, why would anyone buy shares on a Friday afternoon? W hy n o t w ait u n til late Monday when, on average, the price would be lower? The result was puzzling b ut was replicated in later studies. For example, Lakonishok and Sm idt (1988) studied 90 years o f US data (from 1897 to 1987) and found negative average Monday returns over the period as a whole, and in all 10 subperiods th a t they studied. W hat could explain these findings? One suggested possible explanation is th a t companies tend to release bad news over the weekend (see, fo r example, Damodaran 1989). However, if this is the explanation, then it suggests th a t markets are n o t perfectly efficient because prices do n ot adjust to reflect the fact th a t companies have this tendency to release bad news over the weekend.3 N or is the phenomenon purely American. Ball and Bowers (1988) reported evidence o f a ^negative Tuesday* over the period 1974 to 1984. Is i t coincidence th a t when it is Tuesday in Australia, i t is Monday in America? O ther international comparisons tu rn up fu rth e r results: Canadas pattern is very like that o f the US; the UK has a negative Monday, b u t its Friday is only m arginally positive; France, Japan and Singapore have negative Tuesdays.4A common thread is th a t every country has some kind o f daily pattern, but n ot necessarily the same pattern as th a t found in other countries and, im p orta ntly, n ot necessarily the same pattern is observed over long periods o f time. For example, Rubinstein (2001) reports the disappearance o f the Monday effect from the US m arket over the period 1988 to 1998. Indeed, over the same period, he reports th a t M onday is actually the best-perform ing day o f the week, while Thursday has become the worst. Similarly, over the period 1985 to 2013 the average retu rn on the Australian m arket on a Tuesday was positive, b ut it was s till the w orst-perform ing day o f the week.5

M onthly return patterns Rozeff and Kinney (1976) reported th a t the average retu rn on US shares in January was more than five times larger than the average o f returns in the other 11 m onths. W hy didn’t a lo t o f investors buy in

3

4 5

Other possible explanations include: settlement procedures (see Lakonishok & Levi 1982); that there are patterns in trades occurring at the asking price; and that there are patterns in the trading activity of individual (as against institutional) shareholders. Except for small firms, the size of the Monday effect seems to have declined in recent years. See Aitken et al. (1995) and Chan, Leung and Wang (2004). Condoyanni, O'Hanlon and Ward (1988). See also Jaffe and Westerfield (1985). Over the period 1985 to 2013, the average per cent returns on the Australian market, categorised by day of the week, were Monday (0.039), Tuesdays (0.028), Wednesday (0.082), Thursday (0.063) and Friday (0.042).

C hapter sixteen C apital

December to benefit from this so-called Jan uary e ffect? Their actions would be expected to increase the December price level and eventually elim inate the high January return. This effect has also been found in other countries. One study o f stock markets in 17 countries (including the US) found th a t January was the highest return m onth in 14 countries (Gultekin & Gultekin 1983). In Australia over the period 1958 to 1981 the strongest m on thly effects fo r the m arket as a whole were for December and January. Together, these 2 m onths contributed, on average, 6.6 percentage points, while the other 10 m onths contributed a to ta l o f only 6.3 percentage points. In other words, 2 m onths contributed more than half o f the to ta l retu rn fo r the year fo r the m arket as a whole.6 Over the period 1982 to 2013 there was a different pattern: the highest average returns were in A p ril, July and December.7 I t is not clear why any particular m onth should be different from other months. One possible explanation investigated thoroughly is ta x lo ss sellin g. The end o f a tax year could induce heavy selling pressure in the last m onth, causing lower prices, followed by a rebound in prices in the firs t m onth o f the new tax year. As the US has a tax year ending in December, this m ight explain the US January effect. In Australia, tax loss selling by domestic investors would produce high returns in July, while in the UK, high returns would occur in A p ril. A lthough high returns are indeed observed at these times, Australia and the UK have at various tim es had strong January effects, which are n ot predicted by the tax loss selling hypothesis. Therefore, tax effects provide, at best, a partial explanation.8 The January effect is also closely related to the ‘size’ effect discussed in Section 16.3.3.

market efficiency

JANUARY EFFECT

observation that, on average, share prices increase more in January than in other months

TAX LOSS SELLING

investment strategy in which the tax rules make it attractive for an investor to sell certain shares just before the end of the tax year

1 6 .3 .3 1 Predicting future returns on the basis of other forecast variables A range o f studies has reported that a number o f variables may be used to predict future returns. These variables include a company s dividend yield, its price-earnings ratio, whether i t has repurchased or issued shares, the level o f its accounting accruals, its asset growth, its size, and the ratio o f the book value o f its equity to the m arket value o f its equity. For sim plicity this last factor is often called the company s book-to-market ratio. Studies th a t have examined these variables w ill be discussed in tu rn . We w ill then provide a discussion o f the interrelationship between these factors.

Dividend yield A share s dividend yield is the value o f the dividend (per share) divided by the share price. A number o f

DIVIDEND YIELD

US studies have found th a t dividend yield helps to explain returns, even after adjustm ent fo r systematic risk.9 Typically, these studies fin d th a t beta-adjusted returns are higher, the higher the dividend yield— that is, there is a relationship between returns and dividend yields th a t cannot be explained by the capital asset pricing model. Sim ilar results have been found using Australian data fo r the period 1960 to 1969 (Ball et al. 1979) and fo r the period 1975 to 1998 (Boudry & Gray 2003).

dividend per share divided by the share price

Price-earnings ratio The share price divided by earnings per share is usually called the p r ic e -e a r n in g s ra tio , or the *P/E ratio’，and is used in decision making by investm ent analysts. In 1977 Basu reported th a t the P/E ratio helps to explain returns even after adjustm ent fo r systematic risk. Specifically, risk-adjusted returns were higher, the lower the P/E ratio. Basus results were supported in a larger and more detailed study o f US shares by Reinganum (1983). There is now a considerable literature suggesting th a t shares w ith low P/E ratios earn higher returns. In Australia, this relationship has been documented by Anderson, Lynch and M athiou (1990).

6 7 8 9

See Brown, Keim, Kleidon and Marsh (1983). The high January return also occurred in Australia in the earlier period of 1936 to 1957; see Brailsford and Easton (1991). Over the period 1982 to 2013, the average monthly rates of return were 3.4 per cent, 2.4 per cent and 2.3 per cent in April, July and December respectively. The next highest average monthly rate of return was 1.7 per cent in November. For a detailed and entertaining review, see Haugen and Lakonishok (1988). For a brief survey of these studies, see Keim (1988, p. 19).

PRICE-EARNINGS RATIO

share price divided by earnings per share

Net share issues A num ber o f US studies have found th a t returns after adjustm ent fo r systematic risk are higher for companies th a t have repurchased or bought back th e ir shares (see, fo r example, Ikenberry, Lakonishok & Vermaelen 1995). O ther studies have found th a t returns are lower fo r companies that have issued shares (see, fo r example, Loughran & R itter 1995, Daniel & Titm an 2006 and P ontiff & Woodgate 2008). In aggregate, these studies document a negative relationship between net share issues and returns.

Accounting accruals Under accrual accounting, companies record revenues and expenses when they are incurred, regardless o f when cash is exchanged. In an im p o rta n t study Sloan (1996) found th a t companies w ith high net positive accruals, th a t is, where non-cash revenues exceeded non-cash expenses, earned lower risk-adjusted returns. Since the original Sloan study, this finding has been confirmed many times in the accounting literature. Pincus, Rajgopal and Venkatachalam (2005) confirm its existence in Australia, Canada and the UK as well as in the US. Some fu rth e r evidence o f this negative relationship between accounting accruals and risk-adjusted returns has also been found in Australia by Anderson et al. (2009), Gray, Koh and Tong (2009) and Clinch et al. (2012).

Asset growth Cooper, Gulen and Shill (2008) report a very strong negative association between grow th in net assets and risk-adjusted returns fo r US shares. This association has been confirmed in Australia by Bettman, Kosev and Sault (2011) and Gray and Johnson (2011).

Size One o f the m ost intensively studied o f all the variables th a t have been used to forecast returns is size, where size is measured by the total m arket value o f a company s shares. Future returns are predictable in th a t returns on the shares o f small companies exceed the returns on the shares o f larger companies both before and after adjusting fo r systematic risk. Put simply, returns on small-company shares are *too high*. This relationship was firs t documented fo r US companies and it has since been observed in the share prices o f Australian, Canadian, Japanese and UK companies.10 Figure 16.1 shows the performance o f portfolios form ed by dividing Australian shares into quintiles based on company size each year from 1975 to 2010. The p o rtfo lio form ed from shares in the smallest companies earned a m on thly average return o f 3.2 per cent while the p o rtfo lio formed from shares in the largest companies earned a m on thly average return o f only 0.6 per cent. Many studies, including th a t by Brown et al. (1983), have shown th a t this relationship remains after adjusting fo r systematic risk. This relationship has also been investigated in Australia by Beedles, Dodd and Officer (1988), who found th a t it remains present in the data, even when different measurement techniques are used. However, they identified several factors th a t may p a rtly explain it. In particular, they reported th a t shares in small companies trade less frequently than shares in larger companies. This finding is consistent w ith shareholders in small companies requiring a higher expected retu rn to compensate for the lower liq u id ity o f th e ir investm ent. W hile the cause o f the relationship is unclear, it is well documented th a t the size effect is linked to the January effect. In the US, this relationship is strong, w ith approximately h a lf the difference in the returns on the shares o f small and large companies being due to the higher reported returns to small companies in January (Keim 1983).11 Loosely speaking, i f just 1 m onth (January) is ignored, h a lf o f the size effect disappears. In Australia, the relationship appears to have changed quite significantly over the years. Gaunt, Gray and M clvor (2000) report th a t the higher retu rn on small companies was prevalent across each calendar m onth when tested using a sample period from 1974 to 1985. However, their analysis o f the period from 1986 to 1997 showed th a t while the size effect was s till present in returns generally, there was no evidence o f a relationship between size and retu rn in January. 10 Among the earliest US studies are Banz (1981) and Reinganum (1981); for a survey, see Keim (1988). 11 See also Reinganum (1983).

C hapter sixteen C apital

market efficiency

Average monthly return for five size-based portfolios: 1975-2010

Source: Compiled using the database from Australian Research Council/Acorn Capital Linkage Project Grant LP0560381 (Chief Investigators Howard Chan, Robert Faff and Paul Kofman). We thank the Chief Investigators for data access and Paul Docherty for the analysis.

Book-to-market ratio The book value o f a company s equity is the value o f the shareholders1stake in the company, as measured by accounting data. I t appears in a company s financial statements and thus is readily available. The market value o f equity is sim ply the m arket’s valuation o f the shareholders’ stake in the company: i t is the share price m ultiplie d by the num ber o f shares on issue. Security analysts frequently calculate the ratio o f the book value o f a company s equity to the m arket value o f its equity. For sim plicity, this ratio is often called the company s book-to-m arket ratio. What m ight explain why a company has a low or high book-to-m arket ratio? One possible explanation is that a company w ith a low book-to-m arket ratio may be a company th a t the m arket judges to have good prospects (hence its ‘high’ m arket value) while a company w ith a high book-to-m arket ratio may be a company that has had good years in the past (hence its ‘h igh’ book value) b ut which the m arket now judges to have poor prospects. Because a company s book-to-m arket ratio is p ublicly available at low cost, this inform ation should be reflected in its current share price, i f the m arket is efficient. Fama and French (1992) documented th a t in the US, over the period 1963 to 1990, there was a relationship between the book-to-m arket ratio and future share returns. Specifically, companies w ith low book-to-market ratios tended to earn low returns, while companies w ith high book-to-m arket ratios tended to earn high returns. Significantly, Fama and French showed th a t this difference was not attributable to differences in systematic risk. W hile some subsequent w ork has suggested th a t some o f Fama and Frenchs results may have been due to a survivorship bias in th e ir data (Kothari, Shanken & Sloan 1995), other w ork has cast doubt on the significance o f any such bias (Chan, Jegadeesh & Lakonishok 1995; Fama & French 1996b). Figure 16.2 shows the perform ance o f p o rtfo lio s form ed by d iv id in g A ustralian shares in to quintiles based on th e ir book-to-m arket ratio each year fro m 1975 to 2010. The p o rtfo lio form ed from the companies w ith the highest book-to-m arket ratios earned a m o n th ly re tu rn o f 1.5 per cent, while the p o rtfo lio form ed fro m companies w ith the lowest book-to-m arket ratios earned a m o n th ly retu rn o f only 1.1 per cent. As fo r the size factor, m any studies, inclu ding those by H alliw ell, Heaney and Sawicki (1999) and Gaunt (2004), have shown th a t th is relationship remains a fte r a djusting fo r systematic risk.

B O O K 'TO -M A R K E T RATIO

book value of a company’s equity divided by market value of the company’s equity

0 . 2 ----- ---------------- 0 .0 -I---------^

---------1---------^

1

2

： •■----------沐丨，.----------- . --------------' ---------1---------^

---------1--------- ^

3

4

5

Book-to-market quintile: 1 = high, 5 = low

Source: Compiled using the database from Australian Research Council/Acorn Capital Linkage Project Grant LP0560381 (Chief Investigators Howard Chan, Robert Faff and Paul Kofman). We thank the Chief Investigators for data access and Paul Docherty for the analysis.

Interrelationship between factors used to predict future returns Given the number o f variables th a t have been found to be able to predict returns, i t is im p o rta n t to examine possible interrelationships between these factors. As discussed in Section 7.7, in an im p o rta n t study, Fama and French (1992) showed th a t many o f these factors are dominated by the size and bookto-m arket factors. Specifically, dividend yield and price-earnings ratio are n o t useful in predicting future returns after allowing fo r the more dom inant effects o f the size and book-to-m arket factors. The dominance o f both size and book-to-m arket factors in Australia over the period 1982 to 2006 has been supported by Brailsford, Gaunt and O’Brien (2012). However, n o t all factors are dom inated by the size and book-to-m arket factors. For example, Fama and French (2008) reported th a t net share issues, accounting accruals and asset grow th remain im p o rta n t in predicting future returns even after allowing fo r the size and book-to-m arket factors. W hile there is a high level o f agreement th a t various factors may be used to predict future returns, there is much less agreement on the im plications o f th a t evidence fo r m arket efficiency. The reason is the jo in t test problem discussed in Section 16.2.4. For example, as discussed in Section 7.7, some studies suggest th a t small companies and those w ith high book-to-m arket ratios may be riskier than large companies and those w ith low book-to-m arket ratios. Fama and French (1996a) argue th a t smaller companies are more likely to default than larger companies. Further, they argue th a t this risk is likely to be systematic in th a t small companies as a group are more exposed to default during economic downturns. As a result, investors in small companies w ill require a risk premium. Similarly, Zhang (2005) argues th a t companies w ith high book-to-m arket ratios w ill on average have higher levels o f physical capacity. Much o f this physical capacity w ill represent excess capacity during economic dow nturns and therefore expose such companies to increased risk. However, La Porta et al. (1997) note th a t when companies w ith low book-to-m arket ratios announce th e ir earnings, th e ir share prices on average fall. Conversely, when companies w ith high book-to-market ratios announce th eir earnings, th e ir share prices on average rise. They in te rp re t th is result as being due to m arket inefficiency. Specifically, they suggest th a t the share m arket overestimates the growth potential o f companies w ith low book-to-m arket ratios. This overestim ation results in an increase in th e ir share price relative to th e ir book value. W hen earnings are released, the m arket is on average disappointed and hence share prices fall. The opposite is true fo r companies w ith high book-to-market ratios.

C hapter sixteen C apital

Event studies The efficient m arket hypothesis requires th a t security prices adjust instantaneously and w ith o u t bias to an event, such as the public announcement o f new inform a tion relevant to the security s value. It follows that abnormal returns should n ot be expected to be earned from a subsequent analysis o f such inform ation. Voluminous research has been conducted w ith a view to testing whether there are any post-event abnormal returns associated w ith the public release o f inform ation. These same studies are frequently used to evaluate the inform a tion content o f particular types o f inform ation, such as p ro fit announcements and dividend announcements.12 The inform a tion content is measured by the presence o f abnormal returns both p rio r to, at the tim e of, and subsequent to, the announcement. Such a test is generally called an event study. I f markets are efficient, the price change measures as accurately as possible the *true value* o f the inform ation to investors. M any people believe th a t event studies are among the clearest and most reliable tests o f m arket efficiency. An inform a tion release (events is identified and the share price response is then studied to test its consistency w ith the hypothesis o f m arket efficiency.13

There are many variants o f event study methodology. Rather than provide details o f each variant, we illustrate the m ajor issues involved by using the announcement o f annual p ro fit as an example o f an event*. For each announcement the follow ing three questions need to be answered: a b c

W hat is the (new) inform ation? When was it announced? Were there abnormal returns associated w ith its announcement? We now consider each question.

a

An annual p ro fit figure provides inform a tion only i f the announced or reported p ro fit differs from the p ro fit expected by investors. This is because, in an efficient m arket, the effects o f the expected p ro fit w ill already be reflected in the share price before the announcement. Only the unexpected part o f the reported p ro fit should cause the share price to react. I t is therefore necessary to estimate the expected annual p ro fit so th a t we can derive an estimate o f the unexpected component. For example, it could be assumed th a t the expected annual p ro fit is equal to the previous years p ro fit. I f the reported p ro fit is greater than expected, then the unexpected component is positive, the event is classified as good news, and the m arket s response should also be positive. The reverse applies i f the reported p ro fit is less than expected (see Finance in Action on ‘Dividend surprise’), b It is im p orta nt to id e n tify the tim e o f the event accurately, ideally in this case the exact m om ent at which the annual p ro fit became public knowledge. This is im p o rta n t because the m arket may react in anticipation o f the announcement as investors revise th e ir expectations. The m arket should also react at the tim e o f the announcement to any unanticipated inform ation. However, the m arket should n ot continue to react after the announcement because its response should be instantaneous and unbiased. c It is necessary to calculate the response o f the m arket to the announcement. In essence, this response is the percentage change in share price in excess o f (or below) the percentage change that would norm ally be expected. Therefore, some model o f ^normal* security price movement is needed. As highlighted in Section 16.2.4, the jo in t test problem inevitably arises because event studies are simultaneously tests o f m arket efficiency and the pricing model used to estimate what is ‘norm al’.

12 For an extensive discussion of accounting-related issues, see Brown (1994). 13 See Fama (1991, especially pp. 1601-2) for further discussion.

market efficiency

j

B usiness finance

Finance in

DIVIDEND SURPRISE__________________________________________

A C T IO N

N ew s k

n

=

In e x a m in in g th e s h a r e m a r k e t r e a c tio n t o e a r n in g s a n d d iv id e n d a n n o u n c e m e n ts , it is im p o r t a n t to c o m p a r e th e a n n o u n c e m e n t w it h th e e x p e c ta tio n s t h a t p e r ta in e d b e f o r e th e a n n o u n c e m e n t, a s th e f o llo w in g e x c e r p t f r o m a n a r t ic le b y M a lc o lm M a id e n e x p la in s . F o rte s c u e M e t a ls lift e d n e t p r o f it b y 1 2 p e r c e n t to U S $ 1 . 7 5 b illio n in th e y e a r to J u n e , b u t it w a s its d e c is io n to d e c la r e a 10
a s h a r e in 2 0 1 1 - 2 0 1 2 b u t s u s p e n d e d

p a y m e n ts in th e D e c e m b e r h a lf a f t e r a p lu n g e in th e ir o n o r e p r ic e f o r c e d it in to d e b t r e n e g o t ia t io n s . It re s e t its d e b t a n d th e ir o n o r e p r ic e b o u n c e d , b u t th e r e w e r e s till b r o k e r s p r e d ic t in g n o d iv id e n d a t a ll f o r th e J u n e h a lf. D iv id e n d s u r p r is e is o n e o f th e e m e r g in g th e m e s o f th e p r o f it s e a s o n . G o ld m a n S a c h s n o te d a t th e s ta r t o f th is w e e k t h a t th e r a t io o f p o s it iv e d iv id e n d s u r p r is e s to n e g a tiv e d iv id e n d s u r p r is e s w a s 2 . 6 to 1, th e h ig h e s t s in c e 2 0 0 9 w h e n it b e g a n t r a c k in g th e d a t a .

Source: 'Dividend surprise7, Malcolm Maiden, Sydney Morning Herald, 23 August 2013.

The problem associated w ith measuring 'normal* returns can be neatly sidestepped i f we examine price behaviour on an intraday basis. This is because the expected retu rn o f a security over a very short tim e interval, such as a half-hour, is effectively zero. For example, A itken et al. (1995) studied the share return behaviour fo r a sample o f Australian companies during the 23 half-hourly trading intervals preceding, and the 25 half-hourly intervals subsequent to, the announcement o f p ro fit. They separated th e ir sample into separate ‘good news’ and ‘bad news’ subsamples on the basis o f whether or not the p ro fit announced exceeded analysts1forecasts. The results relating to announcements made by 78 o f the largest companies listed on the Australian Stock Exchange are illustrated in Figure 16.3. I t is im m ediately apparent from Figure 16.3 th a t the m ajority o f the m arkets reaction to the release o f either good, or *bad, news occurs in the firs t half-hour follow ing the release o f the inform a tion to the market. This contention is fu rth e r supported by the finding th a t the only half-hourly mean return th a t is statistically d ifferent from zero is the retu rn occurring im m ediately after the in fo rm a tio n release. W hile some event studies use intraday data, others examine returns over much longer periods. As a result, these studies need a systematic approach to measuring the expected retu rn o f a security. A simple way o f measuring expected returns is to use some variant o f the m arket model.14 The standard m arket model— which we discussed in Section 7.6.3— is specified as follows: Rjt = a t- + PjRMt+ uit where Rjr = rate o f retu rn on security z in period t RMt = rate o f retu rn on the m arket index in period t Qj = constant in regression equation /3j = slope o f regression equation— th a t is, beta value o f security z uit = disturbance term Factors th a t affect the whole m arket— such as war, drought, m onetary policy and exchange rate changes— are captured by the term RMt. The rem aining— th a t is, abnormal— return is therefore attributed to company-specific factors, such as the public release o f inform a tion relating to the company. Suppose th a t Equation 16.1 is estimated using m on thly data and the follow ing estimate is obtained: /?" = 0.005 + 1.25/?ay/ + Abnorm al returns, AR} on security z in a later m onth t are measured by: ARjt = Rjt —0.005 —1.25RMl

14 While the market model is used here for simplicity, expected returns are often calculated by adjusting not only for the market return but also the dominant factors that were discussed in Section 16.3.3 as being able to predict returns, namely firm size and the book-to-market ratio.

C hapter sixteen C apital

|ure 16.3 Mean abnormal intraday returns associated with profit announcements of 'good news' and (b) 'bad news'*i

Source: Intraday Price Response and Order Imbalance Surrounding Earnings Releases, A S X Perspective 1, 1995, pp. 31-5.

Suppose that, in the m onth o f the p ro fit announcement fo r company z, the return on the shares o f i was 8 per cent and the retu rn on the m arket index th a t m onth was 2 per cent. Then the abnormal return in m onth zero, the announcement m onth, is: AR0 = 0.08 - 0.005 - (1.25)(0.02) = 0.05 This may be interpreted as follows: during the m onth, this security returned 8 per cent to investors, o f which 5 percentage points were due to company-specific events, such as the p ro fit announcement. However, as m entioned earlier, p art o f the test involves estim ating and examining abnormal returns before and after the announcement, as well as the abnormal returns at the tim e o f the announcement. Typically, this involves estim ating and examining abnormal returns for, say, each o f the 12 m onths before the event, and fo r each o f the 6 m onths after the event. This completes the procedure fo r one company s announcement date. The to ta l sample w ill consist o f a large number o f companies and announcement dates. For each announcement date the procedure is repeated fo r the company announcing on th a t date. Each announcement date in the sample is labelled Time zero; points in tim e before the announcement are labelled -1 , -2 , - 3 , - 1 2 , and points in tim e after the announcement are labelled +1, +2, +6. This is known as event time*. A t each p o in t in event time,

market efficiency

the abnormal returns are calculated. For example, at Time zero a large positive abnormal retu rn would be expected fo r companies announcing p rofits classified as good news*. A t each p o in t in event tim e the average abnormal retu rn across companies is calculated. The average abnormal returns are then summed over event tim e. The procedures are illustrated in the sim plified case shown in Example 16.1.

E xample 16.1 C o m p a n ie s A , B a n d C a n n o u n c e d , a t d iffe r e n t d a te s , p ro fits th a t w e r e h ig h e r th a n e x p e c te d (see T a b le 1 6 .1 ) . 15

TABLE 16.1 Abnormal returns Month relative to announcement date

A(% )

B(%)

C(%)

Average (%)

Cumulative averaqe (%)

-12

1.0

-1.4

2.1

0.57

0.57

-11

4.2

0.9

-1.2

1.30

1.87

-10

-0.2

-3.6

0.4

-1.13

0.74

-9

1.2

-2.2

4.4

1.13

1.87

-8

0.6

-2.2

2.1

0.17

2.04

-7

-1.8

1.1

3.1

0.80

2.84

-6

0.0

1.9

0.4

0.77

3.61

-5

0.4

-0.4

-0.9

-0.30

3.31

-4

1.0

7.6

-1.2

2.47

5.78

-3

-0.2

2.6

3.1

1.83

7.61

-2

-0.3

-0.7

1.1

0.03

7.64

-1

0.9

2.1

-0.6

0.80

8.44

0

5.1

7.9

4.2

5.73

14.17

+1

-0.2

1.4

-0.6

0.20

14.37

+2

0.6

-3.2

1.9

-0.23

14.14

+3

1.2

0.1

-0.5

0.27

14.41

+4

-0.8

0.4

-0.9

-0.43

13.98

+5

0.0

-1.2

1.1

-0.03

13.95

+6

0.5

-1.9

3.0

0.53

14.48

T his e x p la in s th e h ig h a b n o r m a l re tu rn s fo r e a c h c o m p a n y a t T im e z e r o . F o r A , B a n d C , th e a b n o r m a l re tu rn s a v e r a g e d 5 . 7 3 p e r c e n t a t T im e z e ro . It is lik e ly th a t th e m a rk e t w a s a n tic ip a t in g g o o d n e w s . T h e e v id e n c e o f th is a n tic ip a t io n is th e p r e d o m in a n c e o f p o s itiv e a v e r a g e a b n o r m a l re tu rn s in th e 1 2 m o n th s b e fo r e th e a n n o u n c e m e n t. H o w e v e r, f o llo w in g th e a n n o u n c e m e n t, th e a v e r a g e a b n o r m a l re tu rn s a re c lo s e to z e r o , b u t d o n o t h a v e a d e te c ta b le tre n d . T h is p a tte rn is ty p ic a l o f a n e ffic ie n t m a rk e t in th a t th e re is a n in s ta n ta n e o u s r e a c tio n a t th e a n n o u n c e m e n t d a te to th e u n a n tic ip a te d c o m p o n e n t o f th e in fo r m a tio n a n d n o s u b s e q u e n t d r if t in th e a v e r a g e a b n o r m a l re tu rn s . T h e fin a l c o lu m n in T a b le 1 6 .1

s h o w s th e c u m u la tiv e a v e r a g e a b n o r m a l re tu rn s , w h ic h a r e p lo tte d in F ig u re 1 6 .4 .

15 This hypothetical example is very simple in that with a sample size of only three companies, the results, in reality, are unlikely to be so well behaved.

C hapter sixteen C apital

Figure 16.4 Cumulative average abnormal returns

l l l I% S ) En J oEJOU D a DJa>0a> 0 nEnu aj

-Q 05

0 _ 1 2 - 1 1 -1 0 -9 -8 -7 -6 -5 -4 -3 -2 -1

0

1 2

3

4

5

6

Month relative to announcement date (event time)

1 6 .4 .2 1 Evide nee: profit and dividend announcements in Australia To illustrate the empirical evidence found in event studies we consider some o f the evidence on the reaction o f share prices in Australia to p ro fit and dividend announcements. In Australia, announcements of p ro fit are nearly always accompanied by simultaneous announcements o f dividends. Thus, it is useful to examine both the p ro fit and the dividend inform a tion in an empirical test. Brown, Finn and Hancock (1977) conducted a study o f dividend announcements by Australian companies fo r the period January 1963 to December 1969. In the firs t part o f th e ir study they examined the abnormal returns calculated on a m onthly basis fo r the 12 m onths on each side o f an annual dividend announcement. A fte r adjusting for rights issues, bonus issues and other changes in capital, three groups were formed: one comprising shares in companies th a t had announced an increase in dividend per share (DPS), one comprising shares in companies that had announced a decrease in DPS and one comprising shares in companies whose DPS had remained constant. The cumulative average abnormal returns fo r each o f these groups are shown in Figure 16.5. The results suggest th a t an increase (decrease) in DPS results in an increase (decrease) in abnormal returns. In particular, the results suggest th a t a decrease in DPS had significant inform a tion content and that, on average, investors expected an increase in DPS. The results also indicate th a t much o f the inform ation content o f dividend announcements had been obtained earlier from other sources. Overall, these results are consistent w ith m arket efficiency. Recognising th a t dividend and p ro fit announcements usually occur simultaneously, Brown, Finn and Hancock divided each o f the three groups in to tw o subgroups, depending on whether profits increased or decreased. The cumulative average abnormal returns (CAR) associated w ith each subgroup are shown in Figure 16.6.

market efficiency

B usiness finance

Figure 16.5 Cumulative average abnormal returns

Figure 16.6 Cumulative average abnormal returns for each of the six subgroups CAR (%) ------------- profit increase profit decrease

20 DPS increase (N = 209) / —

^

^ --------------;----------

’ DPS constant ( N = 199) ___________________________________ Month relative to announcement 0

一

—

3

6

9

12

DPS decrease [ N = 19) \

、 、 '

、 、 '

- 20-

DPS constant ( N = 16 6 ) DPS decrease (N = 50)

-30-

The evidence suggests th a t the inform a tion content o f the tw o sources o f in fo rm a tio n is increased when they are in agreement. The highest positive abnormal returns are associated w ith the simultaneous announcement o f p ro fit and DPS increases. Similarly, the lowest (most negative) abnormal returns are associated w ith the simultaneous announcement o f p ro fit and DPS decreases. Where the signals are m ixed— fo r example, p ro fit increase w ith DPS decrease— abnormal returns fall between these two extremes. In general, these results support m arket efficiency. The share price reaction to simultaneous p ro fit and dividend announcements was investigated fu rth e r by Easton and Sinclair (1989). Using nearly 900 half-yearly announcements by Australian companies in the period 1978 to 1980, they applied a technique that, in a statistical sense, can isolate the m arkets

C hapter sixteen C apital

reaction to the p ro fit announcement from the m arkets reaction to the dividend announcement. They found th a t both types o f announcement caused a reaction, b ut th a t the reaction to dividends was weaker than the reaction to profits. In a subsequent study using the same sample, Easton (1991) conducted a more form al examination o f the reaction to dividend and p ro fit announcements and found th a t the share price response depends n ot only on the separate dividend and p ro fit signals b u t also on the interaction between the signals. In other words, the m arket appears to take account o f the interrelation o f the p ro fit and dividend inform ation.

Many other types o f events have been studied in Australia, and a voluminous set o f events has been studied in the US and other markets. In Australia, the events th a t have been studied range from capitalisation changes (bonus issues, rights issues and share splits) and takeovers, to the impact o f large trades by institutio na l investors.16 W hile many event studies are undertaken fo r reasons other than to test m arket efficiency, often some inference concerning m arket efficiency can be drawn. Usually, the inference is that prices have responded rapidly to the event studied. For example, Fama (1991, pp. 1601-2) argued that this ‘result is so common th a t this w ork now devotes little space to m arket efficiency. The fact th a t quick adjustment is consistent w ith efficiency is noted, and then the studies move on to other issues1. Over the past 20 years there has been much evidence presented which suggests th a t there is some underreaction to new in fo rm a tio n — in particular, the new inform a tion provided in p ro fit announcements. For example, studies by Bartov, Radhakrishnan and K rinsky (2000), M ikhail, W alther and W illis (2003) and Battalio and Mendenhall (2005) show th a t share prices continue to d rift upwards after good p ro fit news has been released, while they d rift downwards follow ing bad p ro fit news.

Tests for private inform ation A strict view o f the EMH requires th a t abnormal returns are n o t available even to investors who have private (inside) inform a tion about a company. However, by definition, it is usually d iffic u lt to id e n tify the date on which private info rm a tio n becomes available, and therefore the event study m ethodology often cannot be applied directly to studies concerned w ith the im pact o f private inform ation. An alternative methodology is to examine the trading o f those who m ig ht have access to private in fo rm a tio n — such as company directors, fu nd managers and investm ent analysts— and determine i f they are able to earn positive abnormal returns. An early study by Seyhun (1986) o f management and director trades reported th a t while small abnormal returns were possible from selling shares after these insiders disclosed th a t they had sold shares, abnormal returns were insufficient to offset transaction costs. However, subsequent studies suggest greater evidence o f inefficiency. Bettis, Vickery and Vickrey (1997) found th a t investors who focused only on large trades made by top executives, rather than all directors, were able to earn abnormal returns. Further, over the period 1975 to 1995, Lakonishok and Lee (2001) found th a t companies w ith substantial selling by directors had share returns o f 14.4 per cent over the subsequent 12 m onths, which was significantly lower than the 22.2 per cent earned by companies w ith substantial buying by directors. However, they found th a t the lin k between insiders* trading and subsequent returns was greatest fo r small companies and th a t there was almost no relationship fo r larger companies. In Australia the Corporations Act 2001, which governs the behaviour o f company directors, provides researchers w ith an o p p o rtu n ity to test the EMH w ith respect to private inform ation. The Act imposes an obligation on company directors to disclose to the Australian Securities Exchange changes in th e ir interests in th e ir own companies w ith in 14 days o f the change occurring. I f the Australian share m arket were inefficient, then we would expect th a t company directors, who can be assumed to have access to private inform a tion about th e ir company s prospects, would be able to tim e the purchase (sale) o f th e ir shares before a future increase (decrease) in the share price. 16

S tu d ie s t h a t h a v e e x a m in e d r ig h t s is s u e s in c lu d e t h o s e b y B a la c h a n d r a n , F a f f a n d T h e o b a ld ( 2 0 0 8 ) a n d B a la c h a n d r a n e t al. ( 2 0 1 2 ); s t u d ie s e x a m in in g t a k e o v e r s in c lu d e t h o s e b y B ro w n a n d D a S ilv a R o s a ( 1 9 8 8 ) a n d D a S ilv a R o s a a n d W a lte r ( 2 0 0 4 ) ; w h ile s t u d ie s e x a m in in g b lo c k t r a d e s in c lu d e t h o s e b y F rin o , J a r n e c ic a n d L e p o n e ( 2 0 0 7 a n d 2 0 0 9 ) .

market efficiency

B usiness finance

Uylangco, Easton and Faff (2010) tested the relationship between directors1 trades and share price performance in Australia, and found th a t while directors* purchases were on average followed by abnormal gains o f only 0.2 per cent, directors’ sales avoided a future abnormal loss o f 1.1 per cent. They also found th a t w hile small abnormal returns were possible from selling shares after directors disclosed th a t they had sold shares, these abnormal returns were insufficient to offset transaction costs. A nother strand o f the literature has evaluated the performance o f fund managers and other professional investors* on the principle th a t i f they have access to in fo rm a tio n th a t is n o t reflected in prices, they should display superior investm ent performance. The US evidence presents a mixed picture, w ith some studies suggesting th a t professional investors are able to show superior investment performance and others finding th a t they are unable to do so. Elton et al. (1993) concluded that, after co ntrolling fo r the size o f the companies th a t managers invested in (as detailed in Section 16.3.3, companies w ith small m arket capitalisation on average provide greater returns than companies w ith large m arket capitalisation), and after controlling fo r the m ix o f shares and bonds in the p ortfolio, fund managers were n o t able to generate superior performance. However, Kosowski et al. (2006) found th a t a m in o rity o f fund managers were able to generate superior returns. A num ber o f Australian studies have also examined the performance o f m utual funds, u n it trusts and superannuation funds.17 None o f these studies concluded th a t funds in general were able to earn abnormal returns. Similarly, Ferreira et al. (2011) examined m utual funds in 27 countries and found th a t on average they underperform m arket indexes by 0.20 per cent per annum. These studies can be interpreted as supporting m arket efficiency i f it is assumed th a t the fu nd managers have access to private info rm a tio n b u t cannot use i t to earn abnormal returns. However, in the lig h t o f other evidence, an alternative interpretatio n is th a t this evidence has little bearing on m arket efficiency. This interpretation would deny th a t fund managers have access to private inform ation, or, i f they do have such access, they do n o t use i t to advantage. US studies have also evaluated the performance o f investm ent analysts. Womack (1996) examined changes in analysts* recommendations and found that positive changes were associated w ith increased share prices o f approximately 5 per cent, while negative changes were associated w ith share price decreases o f approximately 11 per cent. Jegadeesh et al. (2004) also found th a t changes in the consensus o f analysts* recommendations were associated w ith permanent share price changes. The fact th a t these changes were permanent suggests th a t the price changes were due to in fo rm a tio n revealed by the analysts* recommendations and n ot sim ply due to buying and selling pressure caused by the recommendations. Barber et al. (2001) examined the level o f the consensus o f analysts* recommendations. They found that companies fo r which the consensus o f analysts’ recommendations was a ‘buy’ outperform ed companies for which the consensus o f analysts* recommendations was a sell*. However, they noted th a t the transaction costs o f buying and selling shares th a t would be required to act on these recommendations would be high and likely to prevent the earning o f abnormal returns. A num ber o f Australian studies have also evaluated the performance o f investm ent analysts. Brown and W alter (1982) analysed confidential buy and sell recommendations made by analysts. On a risk-adjusted basis, these recommendations outperform ed the market. I f the analysts employed private inform a tion when m aking th e ir recommendations, then these results are contrary to m arket efficiency. Finn (1984) evaluated the performance o f recommendations made by analysts employed by a large in s titu tio n a l investor. He found that, i f acted on, these recommendations would have resulted in abnormal returns. This result is consistent w ith th a t o f Brown and Walter. Both studies found that the analysts* ability to id e n tify shares th a t should be sold exceeded th e ir a b ility to id e n tify shares that should be purchased. Interestingly, the in s titu tio n a l investor studied by Finn earned negative abnormal returns, w hich is consistent w ith much o f the previous evidence on the performance o f fund managers. Finns results suggest that analysts employed by the in s titu tio n a l investor may have had access to private inform ation, b ut th a t the in s titu tio n failed to act quickly enough to benefit from the inform a tion . Chan, Brown and Ho (2006) support the lin k between share price performance and broker recommendations in th e ir exam ination o f a sample o f 5000 recommendations made in relation to Australian-listed companies. The evidence relating to Australian and US share markets supports the conclusion th a t neither m arket is efficient w ith respect to asset prices reflecting all privately held inform ation. This is n ot surprising. Inside info rm a tio n w ill be costly (and often impossible) fo r an outsider to obtain and, because o f legal implications, may prove costly fo r an insider to use. W hile we would n o t expect an efficient market to

17 See, fo r example, Hallahan and Faff (1999), Sawicki and Ong (2000), Gallagher (2001) and Frino and Gallagher (2002).

C hapter sixteen C apital

market efficiency

reward the use o f zero-cost in fo rm a tio n — such as inform a tion th a t is already publicly available— it may reward the use o f costly inform ation.

16.6 M arket efficiency at the macro level1 8 The evidence presented in the previous sections o f this chapter has all related to m arket micro-efficiency. That evidence suggests, on balance, th a t markets are highly m icro efficient. However, as noted earlier, this does n ot mean th a t markets are necessarily macro efficient. Unfortunately, much less evidence exists as to whether the m arket as a whole reflects all available in fo rm a tio n — whether, fo r example, the share market is fa irly priced compared w ith a less risky asset class such as bonds. However, several studies have examined whether it is possible to predict market-wide returns. Seminal studies are those by Keim and Stambaugh (1986) and Campbell and Shiller (1988a, 1988b). Keim and Stambaugh calculated a d efa u lt spread*, which is the yield on riskie r corporate bonds minus the yield on relatively safe corporate bonds. They found that m arket-wide share returns were higher follow ing periods when the default spread was high. Campbell and Shiller found th a t future market-wide returns were positively related to the current market-wide average earnings yield (where earnings yield is equal to earnings per share divided by price per share). However, the key d ifficu lty is in the interpretatio n o f the results. When m arket-wide risk is higher, investors in bonds w ill demand compensation fo r this risk and the default spread w ill also be higher. Similarly, fo r a given earnings per share, price per share w ill be lower in periods when risk is higher. Therefore, lower prices per share and the resultant higher earnings yields may be positively related to future returns because o f the basic ris k -re tu rn relationship— th a t is, higher risk needs to be compensated w ith higher expected returns. Is the claimed p redictability o f market-wide returns due to m arket inefficiency or is it due to changes over tim e in market-wide risk? A ttem p ting to answer this question runs headlong in to the jo in t test problem discussed in Section 16.2.4. It is, therefore, a question th a t may never have a definitive answer.

Behavioural finance and market efficiency Shleifer (2000) has defined behavioural finance as the ‘study o f human fa llib ility in competitive m arkets’. Behavioural finance suggests th a t once we account properly fo r the impact o f investor sentim ent on m arket prices, we w ill find th a t markets are n ot only inefficient b u t should never be expected to be otherwise. To illustrate how behavioural finance has challenged trad ition al perceptions o f market behaviour, Shleifer summarises, and then responds to, the three arguments th a t provide the theoretical foundations o f the EMH. a

b C

I f all participants in a m arket are rational, then all assets w ill be priced rationally, I f there are investors who behave irrationally, then th e ir trades w ill be random and u ltim ately cancel each other out, leaving prices unaffected. I f irrational investors, as a group, exhibit a bias in the way in which they price assets, then any pricing bias w ill u ltim ately be elim inated by rational arbitrageurs who enter the m arket to take advantage o f deviations o f m arket prices from fundam ental values. Furtherm ore, com petition between arbitrageurs w ill ensure th a t this adjustm ent occurs quickly.

Behavioural finance has suggested, by reference to existing psychological theory and evidence, a number o f models th a t explain why investors may n ot behave in a rational manner and, furtherm ore, why there may be lim its to arbitrage th a t may prevent rational investors from entering the m arket to eliminate the impact th a t these irra tion al investors have on prices.19

18 19

Th e m a t e r ia l c o v e re d in S e c t io n 1 6 .6 a n d s o m e o f th e m a t e r ia l in S e c t io n 1 6 .7 is d is c u s s e d in E a s t o n a n d K e r in ( 2 0 1 0 ) . F o r a s u r v e y t h a t d is c u s s e s th e p s y c h o lo g ic a l t h e o r y a n d e v id e n c e , s e e B a r b e r is a n d T h a le r ( 2 0 0 3 ) . F o r d i s c u s s io n s o f th e lim its to a r b itr a g e , s e e D e lo n g e t al. ( 1 9 9 0 ) a n d S h le ife r a n d V ish n y ( 1 9 9 7 ).

LEARNING OBJECTIVE 4 Understand the difference between micro and macro market efficiency

LEARNING OBJECTIVE 5 Understand the relevance of behavioural finance to market efficiency

B usiness finance

BUBBLE

period in which prices rise strongly, departing from their ’true value’, frequently followed by a sudden decrease in prices

Some o f these models have been used to seek to explain why market-wide share prices (and the prices in other asset classes) m ig ht display bubbles. Various definitions o f a ‘bubble’ have been proposed, but it is usually suggested th a t the follow ing two features constitute a bubble (see Flood and Garber 1980; Blanchard 1979). First, prices show a strong tendency to rise fo r a period, possibly followed by a decrease, which may be quite sudden. Second, as a result, the price departs from the true, fundam ental value o f the asset. W hile the firs t o f these features seems to be readily observable in stock markets— fo r example, in the crashes o f October 1929 and October 1987— the mere presence o f the firs t does not, o f course, im ply the presence o f the second. Prices changing random ly w ill occasionally produce, purely by chance, episodes displaying the firs t feature. These episodes would probably appear to be bubbles, but they may n ot in reality be bubbles in the sense th a t we have suggested because the assets values have n ot departed from th e ir fundam ental value. A situation often cited as an example o f such a bubble was the sharply rising m arket fo r shares in internet-based companies th a t occurred in the late 1990s— the so-called ‘dotcom bubble’. D uring this tim e there were numerous examples o f rapidly increasing prices fo r shares in companies th a t had never recorded a p ro fit and, perhaps more im portantly, did n ot look like generating a p ro fit in the near future. There are at least two plausible explanations fo r this bubble-type price behaviour. Proponents o f behavioural finance may suggest th a t a bubble is an example o f positive feedback trading*, where investors are keen to buy after a series o f price rises and to sell follow ing price falls. Hence, price rises occur not because o f any change in the m arkets expectation o f future returns b ut sim ply because the price has recently risen. Far from dampening the impact o f this irra tion al trading behaviour, i t can be fu rth e r argued th a t arbitrageurs actually contribute to the bubble by seeking to p ro fit n o t from any departure in prices from fundam ental values b ut instead in anticipation o f the prices continuing to increase. An alternative explanation suggests th a t bubbles may in fact be consistent w ith an efficient market. To illustrate this concept o f a rational bubble, suppose th a t a share price depends in p a rt on its expected rate o f change. Therefore, it has a ^igh * price because it is expected to go higher still. In the presence o f such se lf-fulfilling prophecy, prices may increase, even though there is no change in the ‘fundam entals’. However, even these prices may be ‘rational’ in the sense th a t m arket participants fo rm unbiased expectations. I t may also be noted th a t a large m arket-wide price change per se does n o t constitute a bubble, nor does it prove m arket inefficiency. An example using the global financial crisis may be used to illustrate this point. The S&P/ASX 200 Index fell by 54 per cent between its all-tim e high o f 6828.7 on 1 November 2007 and its subsequent (to date) low o f 3145.5 on 6 March 2009. W hile a fa ll o f 54 per cent may at firs t view appear im plausibly large, such a fa ll may be consistent w ith reasonable estimates o f changes in investors’ required rate o f retu rn and in expected dividend grow th rates. For example, using the simple dividend grow th model from Section 4.3.2 (see Equation 4.8), the present value o f $1 o f annual dividend income w ith an annual cost o f equity capital o f 10 per cent and an expected annual grow th rate in dividends o f 5 per cent is $21. By comparison, the present value o f $1 o f annual dividend income w ith an annual cost o f equity capital o f 13 per cent and an expected annual grow th rate in dividends o f 2 per cent is $9.27— a fall o f 56 per cent. In essence, it may be argued th a t the global financial crisis was a period o f great uncertainty th a t caused investors to revise upwards the rate o f return they required to compensate them fo r the increased risk they perceived and to revise downwards th e ir estimates o f future dividend growth. In addition to seeking to explain bubbles, behavioural finance has also been used to tr y to provide explanations fo r other apparent inefficiencies. We discussed in Section 16.3.1 the findings o f DeBondt and Thaler (1985 and 1987) th a t indicated th a t shares th a t have historically perform ed well (poorly) w ill subsequently p erform poorly (well). One interpretatio n o f these findings is th a t investors overvalue companies th a t have exhibited superior performance in the past and undervalue companies th a t have a history o f in fe rio r performance. Such irra tion al behaviour may be explained by w hat is referred to in the psychological literature as the ‘representativeness heuristic’. This concept suggests th a t in form ing their beliefs, individuals may be too quick in ide ntifyin g a company as an ‘excellent’ or a ‘te rrib le ’ investm ent w ith o u t properly accounting fo r the probability o f the company belonging to th a t extreme group o f investments. Hence, an investor assessing the uncertain future o f a company w ith a h isto ry o f superior performance may tend to overweight the importance o f th a t immediate past performance in achieving future superior returns, w hile failing to properly recognise the relatively small pro ba bility o f any company achieving such superior performance in the future. W hy m ig ht overreaction persist in the long term instead o f being offset by the arbitrage activity o f rational investors? One reason is th a t when prices are, at least in part, determ ined by investors behaving irrationally, arbitrage is inherently risky, as the

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market efficiency

unpredictable nature o f irra tion al investors may mean th a t prices w ill n o t revert to th e ir fundam ental value in the short term. There is now a range o f studies th a t have provided results th a t are consistent w ith behavioural finance models. For example, Chopra, Lakonishok and R itte r (1992) found th a t shares th a t have perform ed the best tend to fall in price when earnings are announced, suggesting th a t investors are affected by the representativeness heuristic and th a t earnings announcements cause them to revise th e ir over-optim istic beliefs. Also, La Porta et al. (1997) show th a t the lower returns to companies w ith lower book-to-m arket ratios m ight in part be explicable by irra tion al investor behaviour. One reason fo r shares having a low book-to-market ratio is th a t investors believe th a t the shares have higher potential fo r growth, therefore justifying a higher m arket price compared w ith book value. But La Porta et al. show th a t companies w ith high book-to-market ratios outperform those w ith low book-to-m arket ratios in the days surrounding earnings announcements. They argue that this result is consistent w ith investors being overly optim istic about the growth prospects o f companies w ith low book-to-m arket ratios. Investors then revise these beliefs when earnings are announced. The extent to which the combined effects o f investor irra tio n a lity and lim its to arbitrage result in markets being less than fu lly efficient remains a key focus o f research in finance. Survey articles supporting the behavioural finance position include those by Shleifer (2000), H irshleifer (2001), Shiller (2002) and Barberis and Thaler (2003), while survey articles th a t conclude th a t markets are highly efficient include those by Fama (1998), Rubinstein (2001) and M alkiel (2003).

16.8 Implications of the evidence with respect to market efficiency The evidence on m arket efficiency is complex and subject to many qualifications. Nevertheless, there is considerable evidence to suggest th a t markets often perform well in reflecting available inform a tion and respond quickly to new inform ation. This evidence provides im p o rta n t im plications fo r investors in securities and fo r financial managers.

16.8.1 I Implications for investors in securities There are a number o f techniques th a t are used to evaluate investm ents in securities. The veracity o f these techniques given the evidence on m arket efficiency is discussed under the follow ing headings: • • • •

charting, or technical analysis fundam ental analysis random selection o f securities buy-and-hold policies. We then offer some comments on try in g to beat the m arket.

Charting, or technical analysis Some security analysts p lo t a share s historical price record on a chart. On the basis o f such a chart, predictions are made as to the likely future short-term course o f prices. For example, a rising trend may be detected, or perhaps a presumed cycle o f peaks and troughs may be predicted to continue. The evidence from tests o f serial correlation suggests th a t simple short-term repetitive patterns are unlikely to be present. I t is possible th a t more complex patterns are present, b u t attem pts to detect these patterns by judgm ent and visual inspection are prone to self-delusion. Thus, Batten and Ellis (1996), using Australian data, found, after allowing fo r transaction costs, th a t technical trading rules did n o t yield abnormal profits. However, Lo, Mamaysky and Wang (2000), using sophisticated statistical techniques th a t can recognise patterns, found_ using US data— th a t certain patterns had modest predictive power. Further, persuasive and persistent evidence o f m om entum in returns over longer periods suggests th a t charting over longer tim e periods may yield abnormal profits.

LEARNING OBJECTIVE 6 Understand the implications of the evidence on market efficiency for investors and financial managers

Fundamental analysis O ther security analysts believe th a t the m arket either ignores some publicly available inform ation or systematically m isinterprets th a t inform ation. These analysts m aintain that sometimes the market is shortsighted and a share price cannot be justified on the basis o f the company s ^undam entar features, such as its earnings record, or its net asset backing, which determine the share’s ‘true value’. Consequently, they believe th a t a careful analysis o f available info rm a tio n may reveal mispriced securities, and therefore abnormal returns may be made by the skilled fundam ental analyst. In a m arket th a t is efficient, all publicly available inform a tion is reflected in the market price. Fundamental inform a tion is publicly available at a cost o f approximately zero. In a competitive market, the retu rn to using zero-cost inform a tion is expected to be zero. On its own, therefore, the analysis o f such info rm a tio n should n o t yield abnormal returns in an efficient market. The em pirical evidence presented in this chapter suggests th a t while markets are n o t fu lly efficient they are nevertheless very efficient. The analysis presented in Section 16.3.3 in particular, however, does suggest th a t fundam ental inform a tion about a company, such as its dividend yield, earnings, size, book value relative to m arket value, asset grow th and level o f accounting accruals, may be o f some value in predicting returns. However, the security analyst ind ustry is nevertheless a very com petitive industry and it is only those analysts who have the skills to use this inform a tion better than th e ir peers who are likely to be able to generate abnormal returns. A t its simplest level i t needs to be stressed th a t fundam ental analysis needs to do more than id e n tify good companies th a t w ill be good investments. It is about id e n tifyin g companies th a t are better investments than the m arket consensus considers them to be. Achieving this outcome using publicly available fundam ental inform a tion w ill always be difficult. The evidence th a t markets may be macro inefficient may be used to support the so-called top-down approach to fundam ental investm ent analysis. This approach begins w ith a broad allocation o f investment funds between asset classes including shares, bonds and real estate. There is much evidence to suggest that the asset allocation decision is o f considerable importance. For example, Brinson, Singer and Geebower (1991) rep ort th a t 91.5 per cent o f the difference in returns achieved by investm ent funds is due to this decision. This approach is consistent w ith a claim that, fo r example, the stock m arket as a whole may be overpriced compared w ith its longer-term value, even though the m arket may be micro efficient and that individual shares w ith in th a t m arket may be properly priced relative to each other.

Random selection of securities I t is sometimes suggested th a t i f markets are fu lly efficient and all securities are therefore correctly* priced, investors m ig ht as well choose th e ir investments randomly. However, this is n o t correct advice even if markets are fu lly efficient. First, returns on a large p o rtfo lio o f randomly selected securities w ill be highly correlated w ith returns on the m arket p ortfolio; th a t is, a p o rtfo lio o f all risky assets. Therefore, the risk o f such a p o rtfo lio w ill be close to the risk o f the m arket p ortfolio. This may n o t suit the risk preferences o f the investor. Second, investors should consider th e ir tax position when selecting investments, which is unlikely to be the case i f investments were selected randomly.

Buy-and-hold policies B U Y -A N D -H O LD POLICY

investment strategy in which shares are bought and then retained in the investor’s portfolio for a long period

In a sim ilar vein, it is sometimes suggested th a t i f markets are fu lly efficient then a buy-and-hold policy is the best investm ent strategy. It is true that, fo r many investors, the evidence th a t markets are efficient suggests th a t try in g to beat the m arket is inadvisable, because such an attem pt cannot be expected to succeed, and w ill generate higher transaction costs. _Abuy-and-hold strategy is supported by the results o f research by Barber and Odean (2000). Using a sample o f more than 60000 households from a large US discount brokerage firm , Barber and Odean found th a t fo r the period February 1991 to December 1996 the 20 per cent o f households th a t traded the m ost earned a net return after transaction costs o f 10 per cent per annum, compared w ith the average fo r all households o f 18 per cent per annum. In a later study, Barber and Odean (2001) found that men traded 45 per cent more than women and earned a return net o f transaction costs th a t was 1.4 per cent per annum less than th a t earned by women. However, this evidence does n o t mean th a t a buy-and-hold policy is always optim al fo r all investors. First, as share prices change over tim e, there w ill be changes in the p ro po rtio n o f the p o rtfo lio th a t a

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market efficiency

given shareholding represents. Thus, the risk o f the p o rtfo lio is also likely to have changed. There w ill be fu rth e r changes in the p o rtfo lio s risk i f the risks o f individual securities change over tim e. The result may well be th a t the p o rtfo lio ’s risk w ill diverge from the investor’s desired risk level. The solution is to rebalance the portfolio, and this w ill usually require the sale o f some securities and the purchase o f others. An inflexible buy-and-hold policy is n ot optim al. Second, some investors may occasionally come upon private info rm a tio n about a company. It has already been stated th a t there is evidence suggesting th a t the m arket is n o t efficient w ith respect to selected pieces o f inform ation. Thus, there w ill be private inform ation th a t is n o t reflected in prices, and trading on the basis o f such inform a tion may therefore yield excess returns. The possibility th a t an investor may discover private inform a tion provides a justification fo r studying public inform ation, such as th a t found in company annual reports. How can private in fo rm a tio n be identified and evaluated, w ith o u t some knowledge o f the company s characteristics?

Beating the market The evidence on the extent to which markets are efficient is increasingly complex and mixed. Nevertheless, w ith most evidence suggesting th a t at best a m in o rity o f fund managers are able to generate abnormal returns, it is n ot sensible fo r the average investor to tr y to beat the m arket. Obviously, i f an investor has private inform ation th a t is n o t yet reflected in the share price, then beating the m arket becomes a d istinct possibility. But average investors do n ot often have such inform ation. This suggests th a t m ost investors, most o f the time, would do well to follow a passive investm ent approach. By this we mean th a t most investors should adopt a long-term view, hold a diversified p o rtfo lio and trade infrequently. As noted by the Economic Sciences Prize Committee when awarding the 2013 Prize jo in tly to Eugene Fama, one o f the outcomes o f the efficient markets literature is the rise o f passive investm ent funds that hold diversified portfolios and attem pt to match market-wide index returns. The firs t such passive funds started to emerge in the 1970s and today account fo r 41 per cent o f funds invested in to m utual funds.20 Vanguard Investments* site www.vanguard.com.au contains detailed in fo rm a tio n on p o rtfo lio indexing.

The evidence concerning m arket efficiency also provides strong im plications fo r financial managers. Some o f those im plications are considered under the follow ing headings: • • • •

project selection communicating w ith the stock m arket using share price as a measure o f company performance repurchasing existing securities or issuing new securities.

Project selection Evidence suggests th a t markets respond quickly to new inform ation, including inform a tion th a t is released by company management. I f investing in a project really does increase the company’s ‘true value’, the company s share price w ill reflect this fact when the in fo rm a tio n becomes available to the market.

Communicating with the stock market As mentioned above, markets respond quickly to inform ation. However, the m arkets reactions w ill not be unthinking, mechanical responses, since such responses would be identifiable as underreactions or overreactions. Managers m ust therefore expect th a t announcements o f factors such as p ro fit, dividends, takeovers, new security issues and capital reconstructions w ill elicit a price response th a t represents the m arkets collective view o f the true situation.21

20

S e e U n d e rsta n d in g A s s e t P rices, c o m p ile d b y th e E c o n o m ic S c ie n c e s P riz e , C o m m it te e o f th e R o y a l S w e d is h A c a d e m y o f S c ie n c e s ( 2 0 1 3 , p . 4 3 ).

21

F o r fu r t h e r d is c u s s io n , s e e S te w a r d a n d G la s s m a n ( 1 9 8 4 ) a n d H e a ly a n d P a le p u ( 1 9 9 2 ).

Iw w w l

Using share price as a measure of com pany performance The evidence concerning m arket efficiency suggests th a t the current share price is, i f n ot the best available estimate o f a company’s ‘true value’，then certainly a good estimate. The historical share price record (taking in to account the effects o f dividends and changes in capital) w ill be an accurate statement o f the record o f the company s performance. This is n ot to say th a t the company s management is entirely responsible fo r this record, b ut presumably i t m ust bear significant responsibility fo r it.

Repurchasing existing securities or issuing new securities As discussed in Section 16.3.3, there is evidence th a t m arkets are n ot fu lly efficient w ith respect to the tim in g o f repurchases and new share issues, and th a t shares tend to perform well follow ing share repurchases and poorly follow ing new share issues. This result may be due to managers having private inform a tion th a t enables them to repurchase shares when prices are low and to issue new shares when prices are high. I f so, then investors who sell th e ir shares back to the company via share repurchases tend to lose when compared w ith those shareholders who retain th e ir shares. Similarly, those shareholders who invest in new shares tend to lose when compared w ith existing shareholders. O f course, investors tend to be aware o f these incentives, so announcements o f share repurchases tend to cause prices to rise (see Ikenberry, Lakonishok & Vermaelen 1995 fo r US evidence and Otchere & Ross 2002 fo r Australian evidence), while announcements o f new share issues tend to cause prices to fall (see Manuel, Brooks & Schadler 1993 fo r US evidence and Denhert 1993 fo r Australian evidence).

The financial m anager and evidence with respect to market efficiency Given the complex nature o f the evidence concerning m arket efficiency, how should financial managers react? In particular, w hat are the im plications o f apparent m arket inefficiencies fo r the financial manager? We consider th a t the general body o f evidence supporting m arket efficiency s till provides a useful guide to financial managers. •

•

•

•

22

Managers should be aware th a t there are reasons to expect that, unless people are fa m ilia r w ith the research literature, they w ill systematically tend to underestimate the level o f m arket efficiency. There are many reasons fo r this tendency, including: - the d ifficu lty in distinguishing a b ility from luck - the presence o f vested interests in denying th a t markets are efficient - the fact th a t people tend to forget losses and embellish th e ir w ins.22 M arkets can be expected to respond positively to good news and negatively to bad news. Therefore, news o f successful operations and o f wise decisions by management is expected to increase share prices, while news o f losses, mistakes and failure w ill decrease share prices. The perfom iarice o f companies and, im p licitly, the performance o f management, may ultim ately be judged by the stock market. On the question o f evidence th a t suggests th a t markets are n o t perfectly efficient, there may often be few alternatives to behaving as if the stock m arket is highly efficient. For example, i f the financial manager o f a small company interprets the evidence on the size effect to mean th a t the company may be undervalued, i t is d iffic u lt to see exactly how this should guide his or her actions unless there is also some knowledge o f what causes the underpricing and when the underpricing may be expected to cease. I f the manager decides n o t to raise new capital by way o f a share issue, is a debt issue necessarily a superior choice? W hat i f debt issued by small companies is even more underpriced than shares issued by small companies? It should always be remembered th a t efficiency tests are jo in t tests o f the assumed asset pricing m odel and o f the efficiency o f the market. M ost o f the asset pricing models th a t have been used are quite simple and it would n o t be surprising to learn th a t they do n ot w ork well when applied to extreme* cases, such as the smallest companies.

F o r a lo n g e r c a ta lo g u e o f r e a s o n s a n d a d e t a ile d d is c u s s io n , s e e B o w m a n a n d B u c h a n a n ( 1 9 9 5 ) .

C hapter sixteen C apital

market efficiency

An efficient capital market has been defined as one in which the prices of securities ’fully reflect' all available information. This requires that the reaction of market prices to new information should be instantaneous and unbiased. If such conditions exist, it will not be possible (except by chance) to employ either past information or a mechanical trading strategy to generate returns in excess of the returns warranted by the level of risk involved. In short, consistent excess profits will not be made. Market efficiency may be classified according to the three research methodologies employed to assess the efficiency of a market: • tests of return predictability are undertaken to ascertain whether future returns can be predicted on the basis of factors such as past returns, the time of the year or the company's book-to-market ratio • event studies are employed to analyse the behaviour of a security's returns around the time of a significant event such as the public announcementof a company’s profit, its dividends or its intention to acquire another company • tests for private information are designed to assess whether investors can trade profitably by making their investment decisions on the basis of information that is not publicly available.

Each of these testing methodologies has provided evidence with respect to market efficiency that is complex and mixed. In reviewing the evidence on market efficiency it is also necessary to make a distinction between micro­ efficiency and macro-efficiency. There are a number of implications of the theory and evidence on capital market efficiency. • In an efficient market, charting and fundamental analysis will not succeed since both involve the analysis of only past information, which should already be reflected in the market price. However, this does not mean that securities should be selected randomly or that a buy-andhold policy is always best for all investors. It does, however, suggest that investors should not try to 'beat the market' unless they possess inside information that is not yet reflected in the price. • Likewise, an efficient market is not easily misled and company managers can expect the share price to respond to news of their successes and failures. • While the evidence with respect to market effi­ ciency is complex and mixed it is suggested that, in normal circumstances, market efficiency is a useful way to approach the study of price behaviour, and to organise our knowledge of capital markets.

CHAPTER SIXTEEN REVIEW

SUMMARY

KEY TERMS abnormal returns 480 book-to-market ratio 485 bubble 496 buy-and-hold policy 498 dividend yield 483 efficient market hypothesis (EMH) event study 480 information efficiency 480 January effect 483

478

joint test problem 480 momentum effect 481 overreaction 479 price-earnings ratio 483 tax loss selling 483 tests for private information 480 tests of return predictability 480 underreaction 479

QUESTIONS [L O I] What is an 'efficient capital market7? Illustrate your answer with an example. [LO 1] The EMH implies that o il financial assets are always correctly priced. Is this statement correct? Give reasons. 3

[L O I] W hat would cause a capital market to be efficient?

4

[LO 2] W hat are the objectives of tests of return predictability? Outline the empirical evidence from these tests.

501

B usiness finance

5

[L O 2 】D e s ig n a n e m p ir ic a l te st o f th e e ffe c t o f c o m p a n ie s ' d iv id e n d a n n o u n c e m e n ts o n s e c u rity p ric e s . W h a t a r e s o m e o f th e p ro b le m s in c o n s tru c tin g a v a lid test?

6

[L O 2 ] B rie fly o u tlin e th e e m p ir ic a l e v id e n c e fro m e v e n t stu d ie s .

7

[L O 2 ] As it is im possible to determ ine when p riva te inform ation becomes a vailable, it is im possible to test

8

[L O 3 ] In te rp re t th e f o llo w in g sta te m e n ts in te rm s o f th e ir im p lic a tio n s fo r m a rk e t e ffic ie n c y .

w hether a m arket is efficient w ith respect to this inform ation. D iscuss.

9

a)

Shores in risky companies g ive higher returns than shores in safe companies.

b)

The shares in a com pany increase in p rice in the p e rio d before that in w hich a takeover b id is announced for the company.

c)

Tax-exempt governm ent bonds are issued a t lo w e r interest rates than taxable governm ent bonds.

d)

C om pany directors tend to moke profits from investments in the shores o f companies with w hich they are associated.

e)

There is evidence that share prices fo llo w a trend.

[L O 3 ] S u p p o s e th a t M e g a n M c D o n a ld h a s u n d e rta k e n a s tu d y o f th e e ffic ie n c y o f th e s to c k m a rk e t's re a c tio n to th e a n n o u n c e m e n t o f c h a n g e s in steel p ric e s . S p e c ific a lly , she fin d s th a t s h a re p ric e s a p p e a r to c o n tin u e re a c tin g fo r s o m e m o n th s a fte r th e a n n o u n c e m e n t. A d v is e M e g a n o n th e a lte r n a tiv e in te rp re ta tio n s h e r s tu d y m ig h t b e g iv e n .

10

[ L 0 3 ] D iscu ss th e e x te n t to w h ic h th e g lo b a l f in a n c ia l c ris is m a y h a v e a d d e d to o u r u n d e r s ta n d in g o f th e

11

[L O 3 ] P u lb a h Is la n d R e so u rce s ju st a n n o u n c e d a fa ll in its a n n u a l e a r n in g s , y e t its s h a re p r ic e ro s e . Is th is

e v id e n c e o n m a rk e t e ffic ie n c y .

r e a c tio n c o n s is te n t w ith th e m a rk e t b e in g e ffic ie n t? B rie fly e x p la in y o u r a n s w e r.

12

[L〇3 ]

Y ou k n o w th a t th e c o m p a n y Lake M a c q u a r ie Life style s Ltd is v e r y w e ll ru n . O n a s c a le o f 1 (w o rs t) to

1 0 (b e st), y o u w o u ld g iv e it a s c o re o f 8 . T he m a rk e t c o n s e n s u s e v a lu a tio n is th a t th e m a n a g e m e n t s c o re is 9 . If y o u c o n s id e r th a t m a rk e ts a r e e ffic ie n t w ith re s p e c t to such c o n s e n s u s in fo r m a tio n , w o u ld y o u b u y o r sell s h a re s in th is c o m p a n y ? B rie fly e x p la in y o u r a n s w e r. 13

[L O 3 ] E x p la in w h a t is m e a n t b y th e te rm 'm o m e n tu m ' as it is u se d in th e fin a n c e lite ra tu re .

14

[L O 4 ] D iscu ss w h a t is m e a n t b y m ic ro m a rk e t e ffic ie n c y a n d m a c r o m a rk e t e ffic ie n c y .

15

[L O 5 ] B e h a v io u r a l f in a n c e rests o n th e p r o p o s itio n s th a t s o m e in v e s to rs s o m e tim e s a c t ir r a tio n a lly a n d th a t th e re a r e lim its to a r b it r a g e . W h y a r e b o th p r o p o s itio n s n e e d e d ?

16

[L O 6 ] E m pirical evidence suggests that professional investment m anagers d o not earn positive a b n orm al

returns. Is th is tru e ? D iscu ss th e im p lic a tio n s o f th is e v id e n c e . 17

[ L 0 6 ] In a n a r tic le in th e M e lb o u r n e A g e n e w s p a p e r o n 9 S e p te m b e r 2 0 0 3 e n title d 'W r it e - o f f o r rip -o ff as $ 5 5 b n g o e s w e s t7, A la n K o h le r s ta te d th a t 'th e A u s tr a lia n e c o n o m y m ig h t b e d o in g w e ll a n d th e s h a re m a rk e t r e c o v e r in g , b u t a w ild e p id e m ic o f w rite -o ffs a m o n g lis te d c o m p a n ie s is c o s tin g s h a re h o ld e rs p le n ty 7. To w h a t e x te n t is th is s ta te m e n t lik e ly to b e tru e in a n e ffic ie n t m a rk e t?

18

[L O 6 ]

W h a t a r e th e im p lic a tio n s o f th e e m p ir ic a l e v id e n c e o n m a rk e t e f fic ie n c y fo r:

a)

te c h n ic a l a n a ly s is

b)

fu n d a m e n ta l a n a ly s is ?

19

[L O 6 ]

A s s u m in g th a t y o u h a v e $1 m illio n to in v e s t, h o w w o u ld y o u s tru c tu re y o u r in v e s tm e n t? W h y ?

20

[L O 6 ]

O u t lin e th e im p o r ta n c e o f m a rk e t e ffic ie n c y f o r th e a s s u m e d o b je c tiv e o f m a x im is in g th e m a rk e t

v a lu e o f a c o m p a n y ’s e q u ity .

21

[L O 6 ]

If c a p ita l markets are efficient, it mokes no difference w hich securities a c o m p a n y issues. D iscu ss th is

s ta te m e n t.

22

[L O 6 ]

W h a t a r e th e im p lic a tio n s o f th e e v id e n c e o n m a rk e t e f fic ie n c y fo r th o s e w h o s u p p o r t g r e a te r

re g u la tio n o f c o r p o r a te d is c lo s u re ? 23

The significance o f calendar-based patterns in returns lies not so much in their size as in the fact that they exist a t a ll. D iscu ss th is s ta te m e n t.

[L O 6 ]

C hapter sixteen C apital

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CHAPTER CONTENTS 17.1

Introduction

508

W h a t is a futures contract?

509

The Australian Securities Exchange

512

17.4

Determinants of futures prices

513

17.5

Futures m arket strategies: speculating and hedging

515

IHH

17.6

17.7

Financial futures on the Australian Securities Exchange: the 9 0-day bank-accepted bill futures contract

I 17.8

17.9

| 17.11

Financial futures on the Australian Securities Exchange: the 30-day interbank cash rate futures contract

535

Financial futures on the Australian Securities Exchange: the share price index S&P/ASX 2 0 0 (SPI 200) futures contract

536

Valuation o f fin an cia l futures contracts

540

Forward-rate agreements

542

525

17.12

Swaps

544

Financial futures on the Australian Securities Exchange: the 10-year Treasury bond futures contract 532

17.13

Currency swaps

551

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

understand w ha t a futures contract is and how futures markets are organised

2

understand the system o f deposits, m argins and marking-to-market used by futures exchanges

3

have a basic understanding o f the determinants o f futures prices

4

understand and explain speculation and hedging strategies using futures contracts

5

understand and explain the reasons w h y hedging w ith futures contracts may be im perfect

6

understand and explain the features o f the m ajor fin an cia l futures contracts traded on the Australian Securities Exchange

7

explain speculation and hedging strategies using the m ajor financial futures contracts traded on the Australian Securities Exchange

8

understand the valuation o f 90-day bank-accepted bill futures contracts and share price index futures contracts

9

understand and explain the uses o f forw ard-rate agreements

10 identify the characteristics and uses o f interest rate swaps and currency swaps.

B usiness finance

Introduction

FUTURES CONTRACT an agreement to trade in an asset in the future that can be itself traded on an exchange

j

| WWW

HEDGERS individuals and companies who enter into contracts in order to reduce risk

SPECULATORS individuals and companies who enter into contracts in order to profit from correctly anticipating price movements

In this chapter we discuss futures contracts and swaps. They are sim ilar in th a t b oth are agreements between tw o parties which require each p arty to com m it to future transaction(s) on term s and conditions determ ined at the start o f the contract. However, there are differences between them; fo r example, a futures contract requires the parties to agree to one future transaction, whereas a swap requires the parties to agree to more than one future transaction. A fu tu res contract is an agreement which provides th a t something w ill be bought or sold in the future at a fixed price. In short, the price is decided today, b u t the transaction is to occur later. Such contracts are traded on various futures exchanges around the world. The largest and m ost famous futures exchanges are in Chicago but there are also exchanges in many other cities, including New York, London, Paris, Hong Kong, Singapore, Tokyo, Osaka and Sydney. Much o f the m aterial in this chapter relates to futures contracts traded on the Australian Securities Exchange, although the principles discussed also have application to contracts traded on other futures exchanges. Trading in futures contracts on a fo rm a lly organised exchange can be traced to the middle o f last century, when the Chicago Board o f Trade (now p a rt o f CME Group, w w w .cm egroup.com ) introduced a futures contract on corn. Such a contract enables farmers to sell th e ir corn *in advance* and a farm er therefore knows the price he or she w ill receive fo r the crop before it is harvested and sold. In Australia, the firs t futures contract was on greasy wool and was introduced in 1960. U n til the early 1970s, v irtu a lly all futures contracts traded on the various exchanges around the w orld were futures contracts on commodities. In 1972 the w o rld s firs t futures contract on a foreign currency was traded, followed in 1975 by the firs t futures contract on a debt instru m e nt. In 1982 trading began in a futures contract on an index o f stock m arket prices. Australia d id n o t lag far behind, introducing futures on a debt instru m e nt in 1979, on foreign currency in 1980 and on a share price index in 1983. These financial futures, as they are called, have grown very rapidly in im portance and nearly all futures trading on the Australian Securities Exchange is now in financial futures rather than com m odity futures. In this chapter, we focus on financial futures and, in particular, on the opportunities they provide fo r financial managers. However, because they are often more readily understood, we use com m odity futures to illustrate some o f the principles. Futures contracts can be used fo r hedging purposes and speculative purposes. H edgers wish to lock in, today, the price o f the com m odity, in w hich they w ill need to deal in the future, so th a t they are not affected by any fu tu re changes in the m arket price o f the comm odity. For example, a fa rm e r (or a flo u r m iller) could wish to fix, in advance, the price to be received (or paid) fo r wheat. Sim ilarly, a company planning to lend (or borrow ) could wish to fix, in advance, the interest rate to be received (or paid). The goal o f the hedger is to co ntrol ris k and this goal can be at least p a rtly achieved by appropriate trading in a relevant futures contract. Sp ecu lato rs have no wish to deal in the 'co m m o dity1itself, but are w illin g to trade in futures contracts in the hope o f p ro fitin g from correctly a n ticip a tin g movements in the futures price. The m otive o f the speculator is to p ro fit through bearing risks th a t others do not wish to bear. Successful speculation can be extrem ely profitable. O f course, unsuccessful speculation can be extrem ely expensive. A swap is an agreement between tw o counterparties to exchange sets o f future cash flows. There are two m ain types o f swaps: interest rate swaps and currency swaps. For example, an interest rate swap may require Party A to pay Party B amounts calculated using a long-term fixed interest rate and also require Party B to pay Party A amounts calculated using a sequence o f sh ort-term (boating*) interest rates. A currency swap has a sim ilar structure, b u t a m ajor difference is th a t the payments between the parties are in different currencies. For example, a currency swap may require Party A to pay Party B amounts in US dollars calculated using a US dollar fixed interest rate, and also require Party B to pay Party A amounts in Australian dollars calculated using an Australian dollar fixed interest rate. Swaps are o f much more recent origin than futures contracts. The firs t swap contracts were designed in the early 1980s and the volume o f trading has grown very rapidly in the ensuing years.

C hapter seventeen Futures

contracts a n d swaps

17.2 W h a t is a futures contract? 17.2.1 I Forward contracts and futures contracts Forward contracts

p re d a te

futures contracts

b y c e n tu rie s , b u t are s t ill c o m m o n , p a r tic u la r ly in fo re ig n

exchange. F u tu re s c o n tra c ts d e ve lo p e d o u t o f fo rw a rd c o n tra c ts , so w e b e g in b y c o n s id e rin g a fo rw a rd

LEARNING OBJECTIVE 1 Understand what a futures contract is and how futures markets are organised

c o n tra c t o n a c o m m o d ity . A f o r w a r d c o n t r a c t is an a g re e m e n t b e tw e e n tw o p a rtie s th a t, o n a s ta te d fu tu r e da te, one o f th e p a rtie s w ill b u y a n d th e o th e r p a r ty w ill sell, an u n d e rly in g asset a t a p ric e de cid e d tod ay. F o r e x a m p le , su p p o se t h a t I o w n a n o u n c e o f g o ld , w h ic h to d a y (1 M a rc h ) is w o r th $ 1 4 0 0 . H o w e v e r, I p la n to s e ll m y g o ld s o m e tim e in th e n e a r fu tu r e . S up po se f u r t h e r t h a t y o u k n o w (to d a y ) t h a t o n 1 A p r il y o u w i ll n e ed to b u y a n o u n c e o f g o ld to use in y o u r je w e lle r y -m a k in g b u s in e s s . W e m ig h t th e re fo re agree to d a y to th e f o llo w in g c o n tra c t: o n 1 A p r il, I w i ll d e liv e r o n e o u n c e o f g o ld to y o u a t y o u r p re m is e s a n d y o u w i ll p a y m e, o n t h a t d a te , $ 1 4 1 0 . T h is is a 1 - m o n th fo r w a r d c o n tra c t o n g o ld . I t has th e f o llo w in g fe a tu re s : a

The fo rw a rd p ric e ($ 1 4 1 0 ) is de cid ed n o w (1 M a rc h ) b u t th e tra n s a c tio n is to o c c u r o n a n o m in a te d

b

The d e ta ils o f th e c o m m o d ity , w h ic h is th e su b je c t o f th e c o n tra c t, are s p e lt o u t ( in th is case,

FORWARD CONTRACT

agreement between two parties that, on a stated future date, one of the parties will buy and the other party will sell an underlying asset at a price decided today

fu tu re da te (1 A p ril). one ounce o f g o ld to be d e liv e re d to y o u r p re m ise s), c

The c o n tra c t is a p riv a te c o n tra c t b e tw e e n y o u a n d m e. I c a n n o t pass o n to a n yo n e else m y re s p o n s ib ility to d e liv e r a n ou nce o f g o ld in 1 m o n th s tim e a n d lik e w is e y o u c a n n o t pass o n to anyone else y o u r re s p o n s ib ility to accept d e liv e ry o f th e g o ld a n d to p a y $ 1 4 1 0 f o r it . A

futures contract

o n g o ld w i ll also have fe a tu re s (a) a n d (b) in t h is li s t — t h a t is, th e p ric e w i ll be

de cid ed n o w f o r a tra n s a c tio n to o c c u r a t a la te r d a te in a c o m m o d ity (o r o th e r ite m ) w h ic h has b e en c a re fu lly d e fin e d . H o w e ve r, fe a tu re (c) is n o t tr u e o f a fu tu re s c o n tra c t. A fu tu re s c o n tra c t is n o t a p e rs o n a lis e d a g re e m e n t. F u tu re s c o n tra c ts are alw ays a g ree d to th r o u g h a n exch an ge a n d , m o s t im p o r ta n tly , can be d is c o n tin u e d (c lo s e d o u t* o r Reversed*) a t a n y tim e th r o u g h a f u r t h e r tra n s a c tio n o n th e exchange. E x a c tly h o w t h is is d o n e is e x p la in e d la te r. A t t h is stage, th e im p o r t a n t p o in t to n o te is th a t a fu tu re s c o n tra c t is lik e a fo r w a r d c o n tra c t t h a t can be tra d e d o n a n e xch a n g e .1

1 7 .2 .2 1 How a futures market is organised B efore t u r n in g to a d e s c rip tio n o f h o w fu tu re s tr a d in g o n th e A u s tra lia n S e c u ritie s E xcha ng e is o rg a n ise d , th e im p o r t a n t p o in ts are e x p la in e d in th e m y th ic a l e x a m p le o f th e D e a k in F u tu re s E xcha ng e d e scrib e d here. In o th e r w o rd s , th e fo llo w in g is a s im p lifie d d is c u s s io n o f h o w fu tu re s m a rk e ts o p e ra te . Suppose t h a t th e D e a k in F u tu re s E xchange is o ffe rin g , f o r th e f ir s t tim e , fu tu re s c o n tra c ts o n go ld . The c o n tra c t d o c u m e n t d e fin e s th e a m o u n t a n d p u r it y o f th e g o ld , w h o is q u a lifie d to c e r tify its p u r ity , w h e n i t is to be d e live re d , th e place w h e re i t is to be d e liv e re d a n d o th e r such d e ta ils . There m a y be several d iffe re n t c o n tra c ts , each s p e c ify in g a d iffe re n t m a t u r ity da te. O f course, th e one im p o r t a n t fe a tu re n o t spe cifie d b y th e exchange is th e fu tu re s p rice . T his is d e te rm in e d b y m a rk e t forces. C o n s id e r th e D e a k in g o ld fu tu re s c o n tra c t, w h ic h re q u ire s t h a t o ne o u n ce o f g o ld be d e liv e re d o n 1 A p r il (to d a y b e in g 1 M a rc h ). O n 1 M a rc h , a p e rs o n n a m e d B1 e n te rs th e exchange a n d o ffe rs to b u y one ou n ce o f g o ld f o r $ 1 4 1 0 o n 1 A p ril. In o th e r w o rd s , B1 has o ffe re d to e n te r in to on e D e a k in A p r il g o ld fu tu re s c o n tra c t to b u y a t a p rice o f $ 1 4 1 0 . A n o th e r p e rso n , n a m e d S I, is a t th e exchange a n d is w illin g to e n te r in to on e A p r il g o ld fu tu re s c o n tra c t to se ll a t a p ric e o f $ 1 4 1 0 . T h e re fo re , B1 a n d S I agree, a n d th e A p r il g o ld fu tu re s p ric e a t th e D e a k in F u tu re s Exchange is c u rre n tly $ 1 4 1 0 .

1

For a detailed comparison, and for empirical evidence on price differences between futures and forwards, see Cox, Ingersoll and Ross (1981), Cornell and Reinganum (1981) and French (1983).

4 ^ ^

i

B usiness finance

The next step in the procedure is crucial to an understanding o f futures markets. A company, Deakin Clearing House Ltd, which is a subsidiary o f the Deakin Futures Exchange, now interposes its e lf between B1 and S I: the agreement between B1 and S I becomes tw o contracts, which, fo r convenience, we w ill call Contract la and Contract l b . 2 These contracts are as follows. •

•

Contract la is between B1 and the clearing house. Under this contract, B1 agrees to pay the clearing house $1410 on 1 A p ril and the clearing house agrees to deliver one ounce o f gold to B1 on 1 April. In short, the clearing house plays the role o f seller in B is contract to buy. Contract l b is a contract between S I and the clearing house. Under this contract, the clearing house agrees to pay S I $1410 on 1 A p ril and S I agrees to deliver one ounce o f gold to the clearing house on 1 A p ril. In short, the clearing house plays the role o f buyer in S is contract to sell.

There is no longer any agreement or contract between B1 and S I. Indeed, B1 and S I need n ot even know each o the rs identity. Instead, B1 looks to the clearing house to deliver the gold and S I looks to the clearing house to pay the agreed price. Note that, provided the clearing house has fa ith in the financial strength and honesty o f B1 and SI, it is in a riskless position. I t owes* $1410 to S I, b u t is owed, $1410 by B l. It owes* one ounce o f gold to B1 b u t is owed5one ounce o f gold by S I. The n et position o f the clearing house is therefore zero in b oth money and gold. A few m inutes after B l and S I agree on a futures price o f $1410, a new buyer, B2, and a new seller, S2, meet in the exchange and a new price of, say, $1411 is established. The clearing house follows the same procedure, creating tw o new contracts, 2a and 2b. It becomes the seller to B2 (Contract 2a) and the buyer fo r S2 (Contract 2b). The net position o f the clearing house is s till zero. New buyers and sellers come and go all day at the Deakin Futures Exchange. If, at the close o f business on 1 March, 37 A p ril gold futures contracts have been bought and sold, Deakin Clearing House has 74 obligations: 37 to buy and 37 to sell, w ith , as always, a net position o f zero. D u rin g the day, prices have responded to m arket forces and have ranged between, say, $1408 and $1415, closing at $1414. As tim e passes, more contracts are bought and sold. Now suppose that, on 8 March, B l observes th a t the then current price fo r A p ril gold futures is $1420. Recall th a t under the terms o f Contract la , B l w ill be e ntitle d to buy gold at $1410 per ounce. Sellers are at present entering futures contracts to sell at $1420. Therefore, on current indications, B l has a paper* p ro fit o f $10. W ith a futures contract, B l is able to realise this p ro fit, and, having done so, w ill be free o f all fu rth e r obligations. The mechanism by which this is achieved is as follows. On 8 March, B l enters the futures exchange as a seller. For example, B l may become S200, the seller in the 200th A p ril contract traded. In the exchange, S200 and B200 agree on a price of, say, $1420. The clearing house becomes a seller to B200 (Contract 200a) and a buyer fo r S200 (Contract 200b). Therefore, on 8 March, B is financial position may be summarised as follows: B l owes the clearing house: $1410 B l (who is also S200) is owed by the clearing house: $1420 Therefore, the clearing house owes B l $10

(Contract la ) (Contract 200b)

In effect, B l is able to offset his original contract as a buyer by entering another contract as a seller, taking the p ro fit (or loss) which results. I t is this offsetting procedure th a t perm its futures traders to ‘close o u t’ （ or ‘reverse’）th e ir contracts before the m a tu rity date. The ‘closing o ut’ procedure is feasible only because the two contracts are identical (except fo r the price) and both are w ith the same party, namely the clearing house. For example, the firs t A p ril gold contract is the same as the tw o-hundredth A p ril gold contract, except fo r the price. There would be little p o in t in the clearing house delivering the gold to B l to fu lfil the term s o f Contract la , only to have B l (in his role as S200) redeliver the same gold to the clearing house a m om ent later to fu lfil the terms o f Contract 200b. Instead, B l is released o f all obligations and keeps the $10 pro fit. Note the follow ing five points about this procedure: a

b

2

Because the clearing house becomes the counterparty in every contract, it is n ot necessary fo r buyers and sellers to know the id e n tity or credit-worthiness o f the other buyers and sellers. For example, it is n o t necessary fo r B200 to know th a t S200 is, in fact, an existing buyer (that is, th a t S200 is also B l) who wants to sell in order to reverse his existing bought position. Similarly, as B200s contract is w ith the clearing house, it is n ot necessary fo r B200 to know the id e n tity o f S200. However, it is necessary fo r S200 to in fo rm the clearing house th a t he (S200) is in fact the same person as B l. Otherwise, instead o f the offsetting procedure described earlier, B l w ill find that he This is the easiest way to visualise what occurs. For a detailed description of the strict legal position, see Markovic (1989).

C hapter seventeen Futures

has two ongoing contracts: as the buyer in Contract la and as the seller in Contract 200b. I f he does not n o tify the clearing house, both contracts w ill run through to 1 A p ril and then be settled, c Even though the contract was n ot due to be settled u n til 1 A p ril, B1 has in fact ended his involvement on 8 March. Moreover, no gold was ever delivered to, or by, B l. No gold changed hands. This is usual in futures markets. Generally speaking, only about 2 per cent o f contracts end in delivery o f the com m odity1, the other 98 per cent being closed out by the offsetting procedure (Howard & Jameson 1997). d Persons who have already agreed to sell can also reverse out o f th e ir positions. For example, B200 could in fact be a person who has already agreed to sell (S57, say) and is seeking to offset her existing sold position w ith a bought position. In this way, a person can firs t enter in to a contract to sell and subsequently enter in to a contract to buy and at no tim e is it necessary fo r the person who has agreed to sell to own the item th a t is the subject o f the futures contract. First entering into a contract to sell and later entering in to a contract to buy is referred to as s h o r t s e llin g and the ability to short sell is essential fo r the smooth functioning o f futures markets, e The websites o f securities markets that trade futures contracts report the Volume* o f futures contracts traded the previous day, as well as the number o f ‘open positions’. These terms are often misunderstood, so i t is w o rth explaining th e ir meanings. The Volume traded* refers to the number o f contracts that have been agreed to over a particular period, such as during the previous day. Therefore, volume is a ‘flow ’ concept; it is something measured over an interval o f tim e. The number o f ‘open positions’ is the num ber o f contracts s till in force (that is, which are yet to be closed out) at a certain time, such as at the close o f business on the previous day. The num ber o f open positions is a stock* concept; it is something measured at a particular p o in t in time. Both measures indicate the level o f interest in the contract and the ease w ith which a trading partner can be found.

contracts a n d swaps

SHORT SELLING

process of first entering into a contract to sell and later entering into a contract to buy

The foregoing description o f how a futures m arket functions is much simpler than the reality. For example, in real futures exchanges, ordinary traders are perm itted to trade only through brokers. However, this is n ot central to an understanding o f how futures exchanges operate. O f the many other differences between real futures exchanges and the m ythical Deakin Futures Exchange, two in particular stand out: a b

Deakin has no system o f deposits and margins, Deakin has no m ark-to-m arket rule.

In reality, futures exchanges always have feature (a) and usually have feature (b). These two features are explained in the next section.

In the example in Section 17.2.2, the futures trader B l made a p ro fit o f $10 because the futures price rose by $10 between 1 March and 8 March. Where does the $10 come from? The answer lies in the system o f deposits, margins and the m ark-to-m arket rule. The clearing house requires all traders to deposit a certain sum o f money w ith the clearing house before they enter in to th e ir firs t contract. Each intending trader is required to have an account and the first entry in the account is the deposit paid by the intending trader. A t the close o f each trading day, the clearing house calculates whether the trader has gained or lost since the close o f the previous trading day. I f a gain has been made, the clearing house adds the gain to the traders account balance. I f a loss has been made, the clearing house subtracts the loss from the traders account balance. This process is called m a rk in g -to -m a rk e t because each day the trader’s financial position is ‘m arked’_ th a t is, adjusted— according to the change in the ‘m arket’一 th a t is, the movement in the m arket price o f th a t futures contract since the previous m arking date.3 The deposit system just described does n ot protect the clearing house i f the follow ing situation arises. Suppose th a t a trader has entered in to a futures contract as a seller and subsequently the futures price has increased steadily. Each day, the traders account is marked to m arket. Because the trader is steadily making losses, the deposit is being steadily eroded. I f this continues long enough the deposit w ill vanish and the clearing house w ill be in the unhappy position o f having to tru s t the trader to make good any

3

There is an obvious exception. Logically, a newly opened position should be adjusted by the difference between the agreed price and the price at the close of trading. Thereafter, the daily adjustment is as described in the text.

kC LEARNING OBJECTIVE 2 Understand the system of deposits, margins and marking-to-market used by futures exchanges

M A R K IN G -TO -M A R K E T

process of adjusting traders' account balances to reflect changes in market prices

B usiness finance

f u r t h e r losses. The sam e s itu a tio n c o u ld also a rise i f a tra d e r e n te re d in to a fu tu re s c o n tra c t as a b u y e r a n d th e p ric e s u b s e q u e n tly fe ll s ig n ific a n tly . To p r o te c t it s e lf a g a in s t th is s itu a tio n , a c le a rin g h o u s e w i ll ha ve a s y s te m o f ‘m a rg in c a lls ’. F o r e x a m p le , th e D e a k in C le a rin g H o u s e c o u ld re q u ire t h a t f u r t h e r fu n d s be d e p o s ite d w h e n e v e r a t r a d e r s a c c o u n t b a la n ce is e ro d e d by, say, 25 p e r c e n t. T h a t is, i f th e b a la n ce o f th e a c c o u n t fa lls b e lo w an a m o u n t e q u a l to 75 p e r c e n t o f th e re q u ire d in i t i a l d e p o s it, th e tra d e r is re q u ire d to re s to re th e a c c o u n t b a la n ce to th e a m o u n t o f th e in i t i a l d e p o s it. The d e m a n d t h a t e x tra fu n d s be d e p o s ite d is M AR G IN CALL

demand for extra funds to be deposited into a trader's account

k n o w n as a

m argin call.

I f a tr a d e r does n o t re s p o n d to a m a r g in c a ll w it h in , say, 2 d a ys, th e c le a rin g

h o u s e w i l l close o u t th e tr a d e r s p o s itio n . The c le a rin g h o u s e faces a s lig h t r is k in t h is case. I f th e fu tu re s p ric e s h o u ld m o v e v e r y q u ic k ly d u r in g th e

2 -d a y

re s p o n s e p e rio d , th e lo ss s u s ta in e d b y th e

tr a d e r c o u ld exceed th e r e m a in in g fu n d s in th e tr a d e r s a c c o u n t. The c le a rin g h o u s e is th e n ju s t an u n s e c u re d c r e d ito r o f th e tra d e r.

A fu tu re s c o n tra c t does n o t re q u ire a p a y m e n t o n in it ia t io n so i t is cle a r t h a t th e p re s e n t va lu e o f a fu tu re s c o n tra c t m u s t be z e ro .4 In o th e r w o rd s , th e fu tu re s p ric e is th e p ric e a t w h ic h b o th b u y e r and s e lle r are w illin g to agree to th e te rm s o f th e c o n tra c t, w it h n e ith e r p a r ty s e e k in g a n y im m e d ia te p a y m e n t fr o m th e o th e r. F o r exa m p le , i f th e c u r r e n t fu tu re s p ric e w ere th o u g h t to be to o lo w , a p ro s p e c tiv e b u y e r w o u ld , i f necessary, be w illin g to p a y a p o te n tia l s e lle r to agree to th e fu tu re s c o n tra c t a t th e c u rre n t fu tu re s p ric e . The p re s e n t va lu e o f such a c o n tra c t w o u ld n o t be zero. H o w e ve r, t h is is n o t th e w a y a fu tu re s m a rk e t behaves w h e n th e c u rre n t fu tu re s p ric e is th o u g h t to be to o lo w . In s te a d o f p a y in g m o n e y

today, b u y e rs

b id u p th e

futures p ric e

u n t il a s e lle r is in d u c e d ( fo r zero p a y m e n t to d a y ) to agree to th e

fu tu re s c o n tra c t a t th e h ig h e r p ric e . T h e re fo re , th e p re s e n t v a lu e o f th e fu tu re s c o n tra c t w o u ld a g a in be zero. A c c o rd in g ly , i t is, in a sense, im p o s s ib le to ca lcu la te a ra te o f r e tu r n o n a fu tu re s c o n tra c t. I f th e o u tla y is zero, a n y su b s e q u e n t g a in is a n in f in it e

percentage loss.

percentage g a in

a n d a n y su b s e q u e n t loss is an in fin it e

In p ra c tic e , som e tra d e rs ca lcu la te pe rce n ta g e r e tu rn s re la tiv e to th e d e p o s it re q u ire d ,

b u t th e re is n o p a r tic u la r ly c o m p e llin g re a so n to do so.

The Australian Securities Exchange F u tu re s t r a d in g in A u s tr a lia n b e g a n in 1 9 6 0 w it h th e o p e n in g o f th e S y d n e y G reasy W o o l F u tu re s E xcha ng e, w it h th e n a m e b e in g ch a n g e d to th e S yd n e y F u tu re s E xch a n g e in 1 9 7 2 .5 Since 1 9 9 9 , a ll t r a d in g has b e e n c o n d u c te d u s in g an e le c tro n ic t r a d in g s y s te m . I n 2 0 0 6 th e S yd n e y F u tu re s E xch a n g e m e rg e d w it h th e A u s tr a lia n S to c k E xch a n g e to f o r m th e A u s tr a lia n S e c u ritie s E xchange (A S X ). I n 2 0 1 0 i t a d o p te d th e n a m e A S X G ro u p . The exchange o ffe re d o n ly w o o l fu tu re s c o n tra c ts u n t il 1 9 7 5 , w h e n a c o n tra c t o n c a ttle was in tro d u c e d . Since th e n c o n tra c ts o n a ran ge o f c o m m o d itie s have b e e n tra d e d , w it h th e exchange n o w o ffe rin g c o n tra c ts o n e le c tric ity , n a tu ra l gas a n d w o o l. H o w e ve r, the se c o n tra c ts m a ke u p o n ly a s m a ll p ro p o rtio n o f th o se tra d e d o n th e exch an ge .6 V ir t u a lly a ll fu tu re s t r a d in g o n th e A S X is in c o n tra c ts o n ‘fin a n c ia l c o m m o d itie s ’. The f ir s t such c o n tra c t to be tra d e d o n th e A S X w as t h a t o n 9 0 -d a y b a n k -a c c e p te d b ills in tr o d u c e d in 1 9 7 9 . U sers o f th is c o n tra c t in c lu d e b a n k s , m e rc h a n t b a n k s , b u ild in g s o c ie tie s , fin a n c e c o m p a n ie s a n d in d u s tr ia l co m p a n ie s . In fa c t, a n y p a r t y p la n n in g to b o r r o w o r le n d s ig n ific a n t su m s o f m o n e y f o r r e la tiv e ly s h o r t p e rio d s c o u ld f in d a b a n k b i ll fu tu re s c o n tra c t u s e fu l. The in tr o d u c tio n o f th e b a n k b i ll c o n tra c t was th e f ir s t s te p a lo n g th e p a th t h a t le d to th e exch an ge b e in g tr a n s fo r m e d f r o m a m a rk e t s e rv in g m a in ly r u r a l in te re s ts to a m a r k e t t h a t p la ys a s u b s ta n tia l ro le in th e fin a n c e in d u s tr y . O th e r fin a n c ia l fu tu re s t h a t have p ro v e d su cce ssfu l are th e sh a re p ric e in d e x c o n tra c t (th e ‘SPI 2 0 0 c o n tra c t’ f o r s h o rt) in tro d u c e d in 1 9 8 3 , th e 1 0 -y e a r T re a s u ry b o n d c o n tra c t in tr o d u c e d in 1 9 8 4 , th e 3 -y e a r T re a s u ry 4 5 6

Recall that the deposit is not the value of the contract; it simply provides a guarantee that the traders obligations will be met. For a detailed history, see Carew (1993). For a comprehensive treatment of the futures contracts traded on the Australian Securities Exchange, see Frino and Jarnecic (2005). In the 2012-13 financial year trading in these contracts accounted for less than half of one per cent of the total volume of trading in futures contracts on the ASX.

C hapter seventeen Futures

contracts a n d swaps

b o n d c o n tra c t in tro d u c e d in 1 9 8 8 , a n d th e 3 0 -d a y in te r b a n k cash ra te c o n tra c t in tr o d u c e d in 2 0 0 3 . The v o lu m e o f t r a d in g in th e se f o u r c o n tra c ts , to g e th e r w it h t r a d in g in th e 9 0 -d a y b a n k -a c c e p te d b ills c o n tra c t, t o ta lle d m o re th a n 1 1 1 m illio n in th e 2 0 1 2 - 1 3 fin a n c ia l year. These fin a n c ia l fu tu r e s are discussed in d e ta il la te r in th e c h a p te r. A u s tra lia ’s f ir s t o p tio n -o n -fu tu re s c o n tra c t was in tro d u c e d in 1 9 8 2 . A

contract

call option on

a

fu tu res

gives th e o p tio n b u y e r th e r ig h t (b u t n o t th e o b lig a tio n ) to e n te r in to th e fu tu re s c o n tra c t as a

b u ye r at a p re d e te rm in e d p rice . S im ila rly , a

put option on a fu tu res contract

gives th e o p tio n b u y e r

th e r ig h t (b u t n o t th e o b lig a tio n ) to e n te r in to th e fu tu re s c o n tra c t as a s e lle r a t a p re d e te rm in e d p rice . O p tio n s have p ro v e d p o p u la r w it h tra d e rs .7 The A SX operates its o w n c le a rin g house f o r fu tu re s tra n s a c tio n s . The m a jo r fu n c tio n s o f th is c le a rin g house are to :

CALL OPTION O N A FUTURES CONTRACT

option that gives the buyer the right to enter into the futures contract as a buyer at a predetermined price PUT OPTION O N A FUTURES CONTRACT

•

e sta b lish a n d c o lle c t d e p o s its

•

call in m a rg in s as re q u ire d

•

a p p o rtio n th e ga in s a n d losses (m a rk -to -m a rk e t ru le ). The c le a rin g ho use v a rie s m in im u m c o n tra c t d e p o s its , d e p e n d in g o n m a rk e t c o n d itio n s . F o r e xa m ple,

option that gives the buyer the right to enter into the futures contract as a seller at a predetermined price

th e g re a te r th e p ric e v o la tility , th e g re a te r th e ris k , a n d th e re fo re th e g re a te r th e d e p o s it re q u ire d . To give an in d ic a tio n o f th e ty p ic a l sum s in v o lv e d , som e o f th e s ta n d a rd d e p o s its re q u ire d o f m e m b e rs as a t M a rch 2 0 1 4 w ere as s h o w n in Table 1 7 .1 .8

TABLE 17.1 Major Australian securities exchange contracts: March 2014 Deposit per contract ($)

Contract type

Approxim ate value underlying one contract ($)

90-day ba nk b ills

600

993 000

3-year Treasury bonds

750

109 000

2 400

115 000

225

2 500

5 500

135 000

10-year T reasury bonds 30-day in te rb a n k cash rate Share price in de x

Determinants of futures prices m So fa r we have n o t tr ie d to e x p la in (o r m o d e l) fu tu re s prices. I t has s im p ly been s ta te d t h a t m a rk e t forces d e te rm in e th e fu tu re s p rice . F ro m a m a n a g e m e n t v ie w p o in t, th e re is m u c h to re c o m m e n d th is ap pro ach. M anagers tra d e in fu tu re s c o n tra c ts in o rd e r to c o n tro l ris k , a n d th e o n ly w a y to u n d e rta k e th e necessary tra n s a c tio n s is to agree to b u y (o r sell) a t th e fu tu re s p ric e d e te rm in e d b y th e m a rk e t. W h e th e r th is m a rk e t p ric e accords w ith som e m o d e l o f fu tu re s p r ic in g is, o n th is vie w , la rg e ly irre le v a n t. N e verthe less, i t is b e n e fic ia l to have som e u n d e rs ta n d in g o f th e d e te rm in a n ts o f fu tu re s prices.

LEARNING OBJECTIVE 3 Have a basic understanding of the determinants of futures prices

A u s e fu l in s ig h t in to som e o f th e forces u n d e rly in g fu tu re s p r ic in g is p ro v id e d b y th e fo llo w in g th e o re m :

The futures price for a late-delivery contract must be less than (or equal to) the futures price for an equivalent early-delivery contract, plus the carrying cost. The

carrying cost is

th e c o s t o f h o ld in g a c o m m o d ity fr o m one tim e p e rio d to a n o th e r. I t in c lu d e s an

in te re s t fa c to r (th e o p p o r tu n ity co st o f fu n d s used to fin a n c e th e h o ld in g o f th e c o m m o d ity ) and, in th e case o f p h ysica l c o m m o d itie s , th e costs o f in s u ra n c e a n d storage. The lo g ic u n d e rly in g th e th e o re m can re a d ily be seen in E xa m p le 17.1.

7 8

In the 2012-13 financial year over 4 million futures option contracts were traded on the ASX. These contracts are in fact option contracts, rather than futures contracts. These and other option contracts are discussed in Chapter 18. The members, in turn, require their clients to lodge deposits.

CARRYING COST

cost of holding a commodity for a specified period of time

6e

E xample 17.1 T h e g o ld fu tu re s p r ic e f o r m a tu r ity in J a n u a r y is $ 1 4 5 0 p e r o u n c e a n d th e g o ld fu tu re s p r ic e fo r m a t u r ity in F e b r u a r y is $ 1 4 6 0 p e r o u n c e . A s s u m e t h a t th e c a r r y in g c o s t f o r g o ld is $ 7 p e r o u n c e p e r m o n th , p a y a b le a t th e e n d o f th e m o n th . A t r a d e r c o u ld e x p lo it th e s e p r ic e s b y e n te r in g in to a c o n t r a c t to b u y in J a n u a r y a n d e n te r in g in to a c o n t r a c t to s e ll in F e b r u a r y . W h e n th e J a n u a r y m a t u r ity d a te a r r iv e s , th e t r a d e r a c c e p ts d e liv e r y o f th e g o ld a n d p a y s th e a g r e e d p r ic e o f $1 4 5 0 . T h e t r a d e r th e n s to re s th e g o ld f o r 1 m o n th . In F e b r u a r y , th e tr a d e r d e liv e r s (sells) th e g o ld a t th e a g r e e d p r ic e o f $ 1 4 6 0 a n d p a y s th e c a r r y in g c o s t o f $ 7 , g iv in g a n e t c a s h in f lo w o f $ 1 4 5 3

in

F e b r u a r y . T h e re s u ltin g p r o fit o f $ 3 is a 'p u r e 7 p r o f i t — t h a t is, in e x c e s s o f th e o p p o r t u n it y c o s t — s in c e th e $ 7 c a r r y in g c o s t c o v e rs th e o p p o r t u n it y c o s t o f h o ld in g th e g o ld . O f c o u rs e , o th e r tr a d e r s w i ll u n d e r ta k e s im ila r a c tiv itie s a n d w i ll c o n tin u e to d o so u n til th e g a p b e tw e e n th e J a n u a r y a n d F e b r u a r y fu tu re s p r ic e s is $ 7 o r le ss. F o r e x a m p le , th e m a r k e t m a y se t a J a n u a r y fu tu re s p r ic e o f $ 1 4 5 1 a n d a F e b r u a r y fu tu re s p r ic e o f $ 1 4 5 7 . A t th is p o in t, th e p r ic e o f th e la te - d e liv e r y c o n tr a c t ($ 1 4 5 7 ) is less th a n o r e q u a l to th e p r ic e o f th e e a r ly - d e liv e r y c o n t r a c t ( $ 1 4 5 1 ) , p lu s th e c a r r y in g c o s t ( $ 7 ) . T h is is th e re s u lt s ta te d in th e th e o r e m .

A li m it in g case o f t h is th e o re m is o f sp e cia l s ig n ific a n c e . In th e lim it , th e e a rly -d e liv e ry c o n tra c t SPOT PRICE

price of the commodity when the buyer pays immediately and the seller delivers immediately

c o u ld be f o r im m e d ia te d e liv e ry ; in o th e r w o rd s , its te r m to m a t u r ity c o u ld be zero. The

sp o t price

is

th e p ric e p a id in a s ta n d a rd c o m m o d ity p u rc h a s e — t h a t is, i t is th e p ric e o f th e c o m m o d ity w h e n th e b u y e r pays im m e d ia te ly a n d th e s e lle r d e liv e rs im m e d ia te ly . T h e re fo re , to p re v e n t a rb itra g e , th e s p o t p ric e s h o u ld be v e ry close to th e p ric e o f a fu tu re s c o n tra c t w it h a te r m to m a t u r it y o f zero . S u b s titu tin g ‘th e s p o t p ric e ’ f o r ‘th e fu tu re s p ric e f o r an e q u iv a le n t e a rly -d e liv e ry c o n tra c t’，th e th e o re m becom es:

A futures price must be less than (or equal to) the current spot price, plus the carrying cost. In th is way, th e th e o re m p ro v id e s a m a x im u m p ric e f o r th e fu tu re s c o n tra c t, g iv e n th e c u rre n t s p o t p ric e a n d th e c a rry in g cost. A lg e b ra ica lly, i t can be w r it t e n as:

F<S + C F = fu tu re s

w h e re

5

p ric e

= c u rre n t s p o t p ric e

C = c a rry in g

cost

W e n o w set fu tu re s c o n tra c ts b r ie fly to one side a n d d ire c t o u r a tte n tio n to th e m a rk e t in th e c o m m o d ity its e lf. S uppose t h a t th e c u rre n t s p o t p ric e o f g o ld is $ 1 4 5 0 p e r ounce a n d th a t, ta k in g in to a cco u n t th e e xp ected o u tp u t o f g o ld m in e s , th e fo re c a s t d e m a n d f o r je w e lle ry , th e p o litic a l s itu a tio n in S o u th A fric a (a g o ld -p ro d u c in g c o u n try ) an d, in p rin c ip le , a n y o th e r fa c to r th o u g h t to be re le v a n t, a tra d e r fo re ca sts t h a t in 1 m o n th s tim e , th e s p o t p ric e o f g o ld w ill be a t le a s t eq ua l to to d a y s s p o t p ric e ($ 1 4 5 0 ) a n d p o s s ib ly m u c h m o re . In o th e r w o rd s , i t is fo re c a s t t h a t th e s p o t p ric e o f g o ld w i ll increase. A ssum e, f o r e xa m ple, t h a t th e p ric e is fo re c a s t to be $ 1 4 8 0 p e r ounce in 1 m o n th s tim e . In th is case, i t is p re d ic te d t h a t a tra d e r c o u ld b u y g o ld , h o ld i t f o r 1 m o n th a n d th e n se ll i t f o r $ 1 4 8 0 . N e t o f th e c a rry in g co st o f $7, th e p re d ic te d p r o f it is $23. Is th is la rg e e n o u g h to in d u c e a tra d e r to a d o p t th is s tra te g y? Perhaps so, p e rh a p s n o t. U n lik e th e in v e s tm e n t s tra te g y u n d e rly in g th e th e o re m , th is is a r is k y p ro p o s itio n and p e rh a p s $2 3 is n o t e n o u g h to co m p e n sa te f o r th e r is k in v o lv e d . H o w e ve r, th e re w ill c le a rly be som e le vel o f p re d ic te d p r o f it fro m h o ld in g g o ld , w h ic h w ill in d u c e g o ld p u rcha ses— t h a t is, g o ld w ill be p u rch a se d if:

S + C + risk factor < E(S) S = c u rre n t

w h e re

17.2

s p o t p ric e

C = c a rry in g c ost

E(S )

= e xp ected fu tu r e s p o t p ric e

G o ld w ill be b o u g h t, a n d th e s p o t p ric e w ill increase, u n t il E q u a tio n 17 .2 n o lo n g e r h o ld s — th a t is, u n til:

E(S)

< S -I- C +

riskfactor

17.3

C hapter seventeen Futures

E q u a tio n 1 7 .3 th e re fo re p ro v id e s th e m a x im u m v a lu e t h a t th e e x p e c te d s p o t p ric e ,

E(S)f

contracts a n d swaps

can

be, g iv e n th e c u r r e n t s p o t p ric e , th e c a r r y in g c o s t a n d a r is k fa c to r. S im ila rly , E q u a tio n 17 .1 p ro v id e s th e m a x im u m v a lu e t h a t th e fu tu re s p ric e

F can

be, g iv e n th e c u r r e n t s p o t p ric e a n d th e

c a rry in g cost. F in a lly , can i 7 a n d E ⑸

be lin k e d ? S up po se, f o r e x a m p le , t h a t F w as $ 1 4 5 1 a n d

£ ⑸

w as $ 1 4 8 0 .

I t is lik e ly th a t, in th e h o p e o f p r o f it , so m e o n e w o u ld be w illin g to b u y a fu tu r e s c o n tra c t, p o s s ib ly w it h th e in t e n t io n o f a c c e p tin g d e liv e ry o n th e m a t u r it y d a te a n d th e n im m e d ia te ly re s e llin g th e g o ld . A g a in , t h is is a r is k y s tra te g y , b u t a fo re c a s t p r o f it o f $ 2 9 m a y be e n o u g h to in d u c e so m e o n e to t r y it . In fa c t, th e re is a g ro u p o f a n a ly s ts w h o b e lie v e t h a t fu tu re s p ric e s a n d e x p e c te d s p o t p ric e s are v e ry c lo se ly re la te d . This t r a d itio n a l th e o r y can be a d a p te d to fin a n c ia l fu tu re s . O ne w a y in w h ic h th is m ig h t be do ne is discussed b r ie fly in S e ctio n 17 .9. A s b o th a p re lu d e to th is d iscu ssio n , a n d as a to p ic o f co n sid e ra b le im p o rta n c e in its o w n r ig h t, w e f ir s t discuss in som e d e ta il h o w fu tu re s c o n tra c ts (e sp e cia lly fin a n c ia l fu tu re s c o n tra c ts ) can be used.

17.5

Futures market strategies: speculating and hedging

17.5.1 | Introduction T ra d itio n a lly , p a r tic ip a n ts in fu tu re s m a rk e ts h a ve b e e n d iv id e d in t o tw o g ro u p s : s p e c u la to rs a n d h e d g e rs .9 A

speculator in

t h is c o n te x t is so m e o n e w h o has tra d e d in a fu tu r e s c o n tra c t b u t w h o has n o

d ire c t in te r e s t in th e ‘c o m m o d ity ’ u n d e r ly in g th e fu tu re s c o n tra c t. F o r e x a m p le , i f so m e o n e tra d e s a g o ld fu tu re s c o n tra c t b u t o w n s n o g o ld a n d does n o t in te n d to b u y any, th e fu tu re s m a rk e t tra n s a c tio n is p u re ly s p e c u la tiv e . A

hedger is

so m e o n e w h o has tra d e d in a fu tu re s c o n tra c t a n d ha s a g e n u in e *

in te re s t in th e C o m m o d ity * u n d e r ly in g th e fu tu re s c o n tra c t. F o r e x a m p le , i f a je w e lle ry m a n u fa c tu re r tra d e s a fu tu re s c o n tra c t o n g o ld , th e fu tu re s m a rk e t tra n s a c tio n p ro v id e s a h e d g e a g a in s t changes in g o ld prices. In s h o rt, th e d is tin c t io n b e tw e e n a s p e c u la to r a n d a h e d g e r in fu tu re s c o n tra c ts is s im p ly th is : a s p e c u la to r is a ffe c te d b y th e fu tu re s p ric e ( b u t n o t th e s p o t p ric e ) o f th e ‘c o m m o d ity ’，w h e re a s a h e d g e r is a ffe c te d b y

both

th e fu tu re s p ric e a n d th e s p o t p ric e o f th e c o m m o d ity ,. By t r a d in g in

fu tu re s c o n tra c ts th e s p e c u la to r is e xp o se d to th e ris k s o f changes in th e fu tu re s p ric e ; th is is a r is k to w h ic h he o r she w o u ld n o t o th e rw is e ha ve b e e n e xp o se d . B y t r a d in g in fu tu re s c o n tra c ts , th e he d g e r, to o , is e xp o se d to th e sam e ris k s o f cha ng es in th e fu tu r e s p ric e b u t o n ly in an a t t e m p t to

offset th e

p re -e x is tin g r is k o f changes in th e
9

A third group, arbitrageurs, can also be distinguished. As discussed in Section 1.5.7, an arbitrage is a set of simultaneous transactions in different markets that guarantees a risk-free profit. The transactions in Example 17.1 were an arbitrage involving futures prices, spot prices and carrying costs. Arbitrage is discussed further in Sections 17.6.3 and 17.10. 10 For a survey, see Kolb and Overdahl (2006).

m LEARNING OBJECTIVE 4 Understand and explain speculation and hedging strategies using futures contracts

17 .5 .2 1 Speculating In th e s im p le s t case, a s p e c u la to r ho pe s to :

a

ta k e a lo n g p o s itio n — t h a t is, b u y — w h e n th e fu tu re s p ric e is ‘lo w ’，re v e rs in g o u t— t h a t is, s e llin g

b

ta k e a s h o rt p o s itio n — t h a t is, s e ll— w h e n th e fu tu re s p ric e is ‘h ig h ’, re v e rs in g o u t— t h a t is, b u y in g

la te r— w h e n th e fu tu re s p ric e has in crea sed;

and/or

la te r— w h e n th e fu tu re s p ric e has decreased. In e ith e r case, th e s p e c u la to r ga in s. O f course, i f th e o p p o s ite occurs, th e s p e c u la to r loses. This is s h o w n in Table 17.2.

TABLE 17.2 Basics Deculation outcomes If futures contract is held

If futures prices subsequently Increase

Decrease

Long

G ain

Loss

S h o rt

Loss

G ain

The tim e p e rio d o v e r w h ic h a s p e c u la to r hopes to g a in w ill v a ry d e p e n d in g o n th e ty p e o f s p e c u la tio n . I t is c o m m o n to d is tin g u is h fiv e ty p e s o f s p e c u la tio n .

Scalping The tim e p e rio d d u r in g w h ic h a

scalper

h o ld s a fu tu r e s c o n tra c t is e x tre m e ly s h o r t a n d is u s u a lly

m e a s u re d in m in u te s o r seconds. F o r t h is re a so n , o n ly tra d e rs w h o h a ve d ire c t access to th e e le c tro n ic t r a d in g s y s te m a n d are p e r m it te d to tra d e o n t h e ir o w n a c c o u n t can be sca lp e rs. I n e ffe c t, scalpers t r y to d e v e lo p a c o n tin u o u s ly u p d a te d *fe e r f o r th e m a rk e t, a n t ic ip a t in g a n d e x p lo it in g p e rc e iv e d s h o r t- t e r m excesses o f s u p p ly o r d e m a n d . S calpers p e r fo r m th e u s e fu l f u n c t io n o f p r o v id in g liq u id it y to th e m a rk e t.

Spreading SPREAD

long (bought) position in one maturity date, paired with a short (sold) position in another maturity date

A

sp read

is a lo n g (b o u g h t) p o s itio n in o n e m a t u r it y d a te , p a ire d w it h a s h o r t (s o ld ) p o s it io n in

a n o th e r m a t u r it y d a te . A n e x a m p le is a b o u g h t M a rc h b a n k b i ll fu tu re s c o n tra c t a n d a s o ld J u n e b a n k b i ll fu tu r e s c o n tra c t. S p e c u la to rs w i ll a d o p t t h is s p re a d i f th e y b e lie v e t h a t th e c u r r e n t d iffe re n c e b e tw e e n th e tw o fu tu r e s p ric e s is to o w id e . S p e c u la to rs w i ll g a in i f th e d iffe re n c e (o r ‘s p re a d ’ ） n a rro w s . I t is a s im p le m a t t e r to s h o w th is . L e t th e c u r r e n t— t h a t is, T im e 0 — fu tu r e s p ric e o f th e M a rc h c o n tra c t be F (0 , M ). S im ila rly , le t th e c u r r e n t — t h a t is, T im e 0 — fu tu r e s p ric e o f th e J u n e c o n tra c t be F (0 , J ). The s p re a d a t T im e 0 is: F ( 0 ,J ) - F ( 0 ,M ) S im ila rly , th e spre ad a t T im e 1 is: F (1 ,J )-F (1 .M ) B e tw e e n T im e 0 a n d T im e 1, th e b o u g h t p o s itio n in th e M a rc h c o n tra c t w i ll p ro d u c e a g a in of: F (1 ,M )-F (0 ,M )

17.4

S im ila rly , o v e r th e sam e tim e p e rio d , th e s o ld p o s itio n in th e J u n e c o n tra c t w ill p ro d u c e a g a in of: F ( 0 , J ) - F ( 1 .J )

17.5

N o te t h a t th e 0 a n d th e 1 in E q u a tio n 1 7 .5 are re v e rs e d c o m p a re d w it h E q u a tio n 1 7 .4 . T his is because E q u a tio n 1 7 .4 give s th e g a in f r o m a b o u g h t p o s itio n , w h ile E q u a tio n 1 7 .5 g iv e s th e g a in fr o m a s o ld p o s itio n .

C hapter seventeen Futures

contracts a n d swaps

A s old p o s itio n ge ne rates a g a in i f th e fu tu re s p ric e fa lls — t h a t is, if:

F(1,J)
G is

g iv e n b y th e s u m o f E q u a tio n s 1 7 .4 a n d 17.5:

G = F (l, M) - F(0, M) + F(0,1) - F (l, J) = [F (0 ,J)-F (0 ,M )]-[F (1 ,J)- F (1 ,M )] = [spread at T im e 0] less [spread a t T im e 1] > 0 i f [spread at T im e 0] exceeds [spread at T im e 1] In th is case, th e n , th e spre ad s p e c u la to r w ill g a in i f th e spre ad a t T im e 1 is n a rro w e r th a n th e spread a t T im e 0. The spre ad s p e c u la to r p e rfo rm s th e u s e fu l fu n c tio n o f k e e p in g in lin e th e p rice s o f d iffe re n t fu tu re s c o n tra c ts o n th e sam e c o m m o d ity . The spre ad s p e c u la to r m a y h o ld a fu tu re s p o s itio n f o r any p e rio d , b u t w ill o fte n do so f o r o n ly a m a tte r o f h o u rs , o r p e rh a p s days.

Straddling A

straddle

is s im ila r in co n c e p t to a spre ad b u t re fe rs to p o s itio n s in fu tu re s c o n tra c ts o n d iffe re n t

c o m m o d itie s , ra th e r th a n fu tu re s c o n tra c ts o n th e sam e c o m m o d ity f o r d iffe re n t m o n th s . F o r exa m ple, a tra d e r m ig h t b u y a M a rc h b a n k b ill c o n tra c t a n d se ll a M a rc h b o n d c o n tra c t. The reasons f o r s tra d d lin g are s im ila r to th o s e f o r sp re a d in g .

Day trading Day traders are

p re p a re d to tra d e as th e y see f i t d u rin g a tra d in g day, b u t re g a rd an o v e rn ig h t p o s itio n as

to o risky. Q u ite s im p ly , to o m u c h can h a p p e n w h ile th e exchange is closed.

Long-term/overnight position taking This is b o th th e s im p le s t a n d th e ris k ie s t ty p e o f s p e c u la tio n . S p e cu la to rs fo r m a v ie w t h a t th e c u rre n t fu tu re s p ric e is to o lo w (o r to o h ig h ), tra d e a cco rd in g ly, a n d w a it f o r e ve n ts to p ro v e th e m r ig h t. I t can be a q u ic k w a y to ric h e s — o r rags.

1 7 .5 .3 1 Hedging The essence o f h e d g in g is e a sily e x p la in e d . C o n sid e r, f o r exa m ple, a g ra z ie r w h o in te n d s to se ll h is c a ttle in several m o n th s * tim e . He is a ffe cte d b y m o v e m e n ts in th e s p o t p ric e o f c a ttle , g a in in g i f i t increases (since h is c a ttle becom e m o re v a lu a b le ) a n d lo s in g i f i t decreases (since h is c a ttle becom e less v a lu a b le ). I f he w ishes to be p ro te c te d a g a in s t th e se changes, he can sell c a ttle fu tu re s — t h a t is, he becom es w h a t is k n o w n as a s h o rt hedger. The p o s itio n o f th e s h o r t h e d g e r is s h o w n in Table 17 .3.

SHORT HEDGER

hedger who hedges by means of selling futures contracts today

TABLE 17.3 Short hedging outcomes If prices rise

If prices fall

S h o rt fu tu re s co n tra ct

Loss

G ain

C attle— lo n g in spot

G ain

Loss

N et re su lt

A p p ro x im a te ly zero

A p p ro x im a te ly zero

The n e t re s u lt is a p p ro x im a te ly zero. T h e re fo re , th e h e d g e r achieves h is o b je c tiv e , in t h a t w h e th e r prices ris e o r fa ll, th e re is l i t t le o r n o e ffe c t o n th e hedger. N o te , th o u g h , t h a t th e re s u lt is s h o w n as o n ly a p p ro x im a te ly zero. W h y n o t p re c is e ly zero? There are m a n y reasons w h y a p e rfe c t hedge is m o s t u n lik e ly b u t b e fo re lo o k in g a t som e o f th e reasons, w e need to c o n s id e r hedges ach ie ved b y b u y in g fu tu re s co n tra c ts . Such a hedge is ca lle d a lo n g he dg e— a n d i f th e p o s itio n o f a lo n g h e d g e r is s im p ly th e exa ct

LONG HEDGER

reverse o f th e p o s itio n o f th e s h o rt hedger, th e o u tco m e s f o r th e lo n g h e d g e r are as s h o w n in Table 17 .4.

hedger who hedges by means of buying futures contracts today

H o w eve r, o n clo se r in s p e c tio n , i t s h o u ld be cle a r t h a t th e lo n g h e d g e rs p o s itio n is n o t n e ce ssa rily s im p ly th e reverse o f th e s h o rt h e d g e rs p o s itio n . F o r exa m p le , co m p a re th e p o s itio n o f a lo n g hedger, such as a m a n u fa c tu re r o f b e e f sausages, w ith t h a t o f a s h o rt hedger, such as a g ra zie r. There can be no

4^^

B usiness finance

TABLE 17.4 Long hedging outcomes If prices rise

If prices fall

Long fu tu re s co n tra ct

G ain

Loss

C a ttle — s h o rt in spot

Loss

Gain

N e t re su lt

A p p ro x im a te ly zero

A p p ro x im a te ly zero

d o u b t t h a t a g ra z ie r ga in s i f s p o t c a ttle p rice s rise . F o r e xa m p le , i f s p o t c a ttle p rice s ris e fr o m $ 1 0 /k g to $ 1 2 /k g , a g ra z ie r b e n e fits b y $ 2 /k g m u ltip lie d b y th e n u m b e r o f k ilo g ra m s o f c a ttle o w n e d . The g ra z ie rs w e a lth has ris e n b y th a t a m o u n t. Is a sausage m a n u fa c tu re r $ 2 /k g p o o re r? I t is n o t cle ar t h a t th e an sw e r to th is q u e s tio n is ‘yes’. To a g ra zie r, c a ttle are o b v io u s ly assets a n d hence i t is c o rre c t to t h in k o f th e g ra z ie r as h a v in g a lo n g p o s itio n in th e s p o t m a rk e t f o r c a ttle ; b u t to a sausage m a n u fa c tu re r, c a ttle are n o t lik e ly to be lia b ilitie s . I f a sausage m a n u fa c tu re r has s h o rt s o ld c a ttle , th e n c a ttle m ig h t be lia b ilitie s , b u t in p ra c tic e i t is im p o s s ib le (o r a t le a s t v e ry d iffic u lt) to s e ll c o m m o d itie s s h o rt. H o w e ve r, f o r s im p lic ity , we w ill tre a t lo n g h e d g in g as s im p ly th e reverse o f s h o rt h e d g in g .11

¥ LEARNING OBJECTIVE 5 Understand and explain the reasons why hedging with futures contracts may be imperfect

1 7 .5 .4 1 Some reasons w hy hedging with futures is imperfect In th is s e c tio n w e discuss th re e reasons w h y h e d g in g w it h fu tu re s c o n tra c ts m a y be im p e rfe c t. These are im p e rfe c t convergence, basis r is k a n d s p e c ific a tio n diffe re nce s.

Imperfect convergence S up po se t h a t a je w e lle ry m a n u fa c tu re r is c o m m itte d to b u y in g a n o u n ce o f g o ld o n 2 7 M a rc h a n d i t so h a p p e n s t h a t th e re is a fu tu re s c o n tra c t t h a t p re c is e ly m a tc h e s t h is ne ed . T h a t is , th e re is a fu tu r e s c o n tra c t t h a t sp e c ifie s an o u n ce o f g o ld o f th e sam e q u a lit y a n d a t th e sam e lo c a tio n as th e m a n u fa c tu r e r re q u ire s , a n d th e m a t u r it y d a te o f th e fu tu r e s c o n tra c t is 2 7 M a rc h . E ven in t h is case a p e rfe c t hedge m a y n o t be p o s s ib le because o f th e p ro b le m o f im p e r fe c t c o n v e rg e n c e b e tw e e n s p o t a n d fu tu r e s p rice s. L o g ic a lly , th e p ric e o f a fu tu r e s c o n tra c t w i t h ze ro t im e to m a t u r it y o u g h t to be e q u a l to th e s p o t p ric e . I f t h is w e re n o t so, th e n in p r in c ip le a n in s ta n ta n e o u s p r o f it c o u ld be m ad e. F o r e x a m p le , i f th e s p o t p ric e w e re th e lo w e r on e, a tr a d e r c o u ld s im u lta n e o u s ly b u y in th e s p o t m a rk e t a n d se ll in th e fu tu r e s m a rk e t, d e liv e r in g th e c o m m o d ity p u rc h a s e d in s a tis fa c tio n o f th e fu tu re s m a rk e t c o m m itm e n t. H o w e v e r, in r e a lity th e fu tu r e s p ric e a t m a t u r it y can be s lig h t ly d iff e r e n t f r o m th e s p o t p ric e o n th e m a t u r it y d a te . I n s h o r t, th e c o n v e rg e n c e b e tw e e n th e s p o t p ric e a n d th e fu tu re s p ric e as th e m a t u r it y d a te a p p ro a ch e s can be im p e r fe c t. Y e t i t m a y n o t be p o s s ib le to p r o f it f r o m th is d iffe re n c e . F o r e x a m p le , tra n s a c tio n co sts c o u ld p re v e n t th e o p p o r t u n it y f r o m b e in g e x p lo ite d . T his w i ll a ffe c t th e q u a lity o f a h e dg e, b u t ty p ic a lly th e p ro b le m s h o u ld n o t be v e r y s e rio u s because co n ve rg e n ce is g e n e ra lly close, e ve n th o u g h n o t p e rfe c t. C o n s id e r ag a in th e je w e lle ry m a n u fa c tu re r w h o has b o u g h t g o ld fu tu re s . Suppose t h a t she faces th e fo llo w in g s itu a tio n a n d has closed o u t h e r c o n tra c t: F u tu re s p ric e (w h e n b o u g h t):

$1400

F u tu re s p ric e (a t m a tu r ity ) :

$1460

S p o t p ric e (o n fu tu re s m a t u r ity da te ): $ 1 4 6 2 The je w e lle r y m a n u fa c tu re r w i ll ha ve a fu tu r e s p r o f it o f $ 6 0 to a d d to th e p ric e o f $ 1 4 0 0 she k n e w she w o u ld ha ve to pay, b u t w i ll be $2 s h o r t o f th e $ 1 4 6 2 n e e d e d to b u y g o ld (s p o t). In o t h e r w o rd s , th e g o ld e n d s u p c o s tin g h e r $ 1 4 0 2 in s te a d o f $ 1 4 0 0 as w as p la n n e d . T h is, a d m itte d ly , is im p e rfe c t, b u t th e p ro b le m is n o t s e rio u s . C e r ta in ly i t is b e tte r to h a ve to f in d $ 2 u n e x p e c te d ly , th a n to have to fin d $ 6 2 u n e x p e c te d ly . 11 A slightly different approach to long hedging is to think of the long hedger as gaining or losing on the spot, relative to the forward price of the commodity. Of course, forward prices may be unobservable.

C hapter seventeen Futures

contracts a n d swaps

Basis risk By d e fin itio n , a h e d g e r is p la n n in g to tra n s a c t in th e s p o t m a rk e t a t som e f u tu r e tim e . H o w e ve r, i t is u n u s u a l f o r th e date o f th e p la n n e d s p o t tra n s a c tio n to co in c id e w ith th e m a t u r ity da te o f a fu tu re s c o n tra c t. A t an y g iv e n tim e , a fu tu re s exchange w ill o ffe r o n ly a re s tric te d n u m b e r o f m a t u r ity da te s— so m e tim e s o n ly fo u r o r five. A s a re s u lt, th e re is o n ly a s m a ll chance t h a t th e d a te o f th e p la n n e d s p o t tra n s a c tio n w ill co in cid e w ith a fu tu re s c o n tra c t m a t u r ity da te. W h e n th e dates do n o t co in cid e , th e he d g e r m u s t reverse o u t o f th e fu tu re s c o n tra c t b e fo re i t m a tu re s , an d, w h e n th is a c tio n is re q u ire d , hedgers face a ris k k n o w n as ‘basis r is k ’. W e d e fin e th e b a s is a t a n y g iv e n tim e as th e s p o t p ric e S a t t h a t tim e o f a

BASIS

c o m m o d ity t h a t m atche s e x a c tly th e c o m m o d ity d e fin e d in th e fu tu re s c o n tra c t, m in u s th e fu tu re s p ric e

spot price at a point in time minus the futures price (for delivery at some later date) at that point in time

F a t th a t

tim e ( fo r d e liv e ry o f th e c o m m o d ity a t som e la te r t im e ).12 T h ere fore, th e basis

B a t T im e

0 is:

5(0) = S (0 )-F (0 ) S im ila rly , th e basis a t som e la te r tim e , say, T im e 1, is:

B(l) = S (l)-F (l) N o w co n s id e r a s h o rt h e d g e r a n d assum e t h a t th e ‘c o m m o d ity ’ h e ld b y th e s h o rt h e d g e r can be sto re d costlessly. A s h o rt h e d g e r m akes a g a in (loss) o n th e fu tu re s c o n tra c t i f th e fu tu re s p ric e decreases (increases) a n d a g a in (loss) o n h o ld in g th e c o m m o d ity i f th e s p o t p ric e increases (decreases). T here fore, in th e in te rv a l b e tw e e n T im e 0 a n d T im e 1: T o ta l g a in to s h o rt h e d g e r = g a in m ad e o n fu tu re s + g a in m a d e o n spo t = [ F ( 0 ) - F ( 1 ) ] + [S (1 ) - S ( 0 ) ]

= [S (l)-F(l)]-[S(0)-F(0)} = B(l)-B(0) = ch a n g e in basis b e tw e e n T im e 0 a n d T im e 1 The p o in t is sim p le : th e change in th e b asis o v e r a g iv e n tim e p e rio d is n o t, in ge ne ral, p re c is e ly zero. Yet a p e rfe c t hedge is one in w h ic h th e w e a lth o f th e h e d g e r is im m u n e to th e m o v e m e n t o f prices. I t fo llo w s th a t a h e dg er does n o t, in fa c t, e lim in a te a ll ris k . There re m a in s basis ris k . I t is im p o r ta n t to u n d e rs ta n d th is p o in t. H o w e ve r, i t is also im p o r t a n t to place basis r is k in c o n te x t.

In general, fu tu re s

p ric e s a n d s p o t p ric e s te n d to m o v e to g e th e r. O f course, th is te n d e n c y is n o t p e rfe c t

a n d f o r som e a g ric u ltu ra l c o m m o d itie s i t m a y n o t even be close to p e rfe c t. F o r exa m p le , i f a b u m p e r h a rv e s t is e xp e cte d n e x t season b u t, s im u lta n e o u s ly , u n e x p e c te d s h o rta g e s in th e s p o t m a rk e t de ve lo p tod ay, th e n fu tu re s p ric e s m ig h t fa ll a t th e sam e tim e as s p o t p rice s rise . B u t th is ty p e o f s itu a tio n is th e e xce p tio n . In g e ne ral, w h a te v e r causes s p o t p rice s to in crea se (o r decrease) w ill also te n d to cause fu tu re s p rice s to increase (o r decrease). E x a m p le 17 .2 illu s tra te s basis ris k .

Exam ple

17.2

S u p p o s e th a t s o m e d r a m a t ic e v e n t c a u s e s a la r g e fa ll in s p o t p ric e s , a n d s u p p o s e th a t th is s a m e e v e n t c a u s e s a s im ila r, b u t s lig h tly s m a lle r, fa ll in fu tu re s p ric e s , a s s h o w n in T a b le 1 7 . 5 . G iv e n th e d a ta in T a b le 1 7 . 5 , w h a t is th e g a in o r lo ss fo r a s h o rt h e d g e r?

TABLE 17.5 Example of basis risk Prices ($)

L A t Time 0

A t Time 1

Gain (+) or loss (-)

Spot (long)

1026

806

-2 2 0

Futures (sh o rt)

1040

825

+215

G ain (+) o r loss ( - ) made b y s h o rt hedger

-5

continued 12 Conventions vary. Basis is usually defined as *spot minus futures*, but sometimes it is defined as 'futures minus spot', particularly when the futures contract is on a financial asset.

4 ^ ^

continued

SOLUTION In th e ta b le , T im e 0 is th e d a te o n w h ic h th e h e d g e is set u p a n d T im e 1 is th e d a te o n w h ic h th e s p o t tr a n s a c tio n is m a d e a n d th e h e d g e is lifte d . A s s h o w n in th e ta b le , th e h e d g e is n o t p e rfe c t, a s th e re is a n e t loss o f $ 5 , w h ic h is e q u a l to th e c h a n g e in th e b a s is :

Change in basis = 8 (1 )-8 (0 ) = [S (1 )-F (1 )]-[S (0 )-F (0 )] = [$ 8 0 6 - $ 8 25 ] - [$ 1026 - $ 1040] = _ $ 1 9 _ [_ $ 1 4 ] = -$ 5 H o w e v e r, a loss o f $ 5 is t r iv ia l w h e n c o m p a r e d w ith th e loss o f $ 2 2 0 th a t w o u ld h a v e b e e n in c u r r e d h a d n o fu tu re s c o n tra c t b e e n e n te re d in to . B a sis ris k is m u ch less th a n p r ic e risk. In th is e x a m p le a s h o rt h e d g e r fa c e d a n in it ia l b a s is o f - $ 1 4 th a t la te r fe ll to - $ 1 9 a n d th e o u tc o m e w a s a loss o f $ 5 . T a b le 1 7 . 6 sets o u t th e fu ll r a n g e o f p o s s ib ilitie s .

TABLE 17.6 Hedging outcomes and basis changes O u tc o m e if ba sis(a) D e s c rip tio n

S h o rt hedger

P o sitio n s

1

In cre a se s

D e cre a se s

Gain

Loss

Loss

G ain

F utures (s h o rt) C o m m o d ity (long)

Long hedger

F utures (long) C o m m o d ity (s h o rt)

(a) Basis is defined as spot price less futures price.

Specification differences ‘S p e c ific a tio n d iffe re n c e s ’ re fe rs to th e fa c t t h a t th e s p e c ific a tio n o f th e ‘c o m m o d ity ’ t h a t is th e su b je ct o f th e fu tu re s c o n tra c t m a y n o t p re c is e ly c o rre s p o n d to th e s p e c ific a tio n o f th e ‘c o m m o d ity ’ t h a t is o f in te re s t to a hedger. F o r exa m ple, a h e d g e r m a y be in te re s te d in a p a rtic u la r grade o f w o o l t h a t is s lig h tly d iffe re n t fr o m th e grade o f w o o l sp e cifie d in th e fu tu re s c o n tra c t. A lte rn a tiv e ly , a h e d g e r m a y be in te re s te d in b u y in g w o o l to be d e liv e re d to a c e rta in lo c a tio n . H o w e ve r, th is lo c a tio n m a y be o n ly one o f a n u m b e r o f lo c a tio n s acceptable f o r d e liv e ry u n d e r a fu tu re s c o n tra c t, o r i t m a y n o t even be one o f th e acceptable lo c a tio n s . S im ila r o b s e rv a tio n s are re le v a n t to fin a n c ia l fu tu re s . Som e exa m ples are as fo llo w s : •

A b o rro w e r m a y in te n d to issue 1 2 0 -d a y b a n k b ills , b u t th e fu tu re s c o n tra c t specifies 9 0 -d a y b a n k b ills .

•

A n in v e s to r m a y o w n a d iv e rs ifie d p o r tfo lio , w h ic h is s im ila r, b u t n o t id e n tic a l, to th e shares in th e

•

A le n d e r m a y in te n d to in v e s t in 5 -y e a r co m p a n y d e b e n tu re s , b u t th e fu tu re s c o n tra c t specifies

share p ric e in d e x t h a t th e fu tu re s c o n tra c t specifies. 3 -y e a r g o v e rn m e n t b o n d s. In fa c t, o n ly ra re ly is a h e d g e r able to fin d a fu tu re s c o n tra c t w h ose s p e c ific a tio n is

precisely th e

same

as th e c o m m o d ity t h a t is o f in te re s t to th e hedger. S p e c ific a tio n d iffe re n ce s in tro d u c e a f u r t h e r e le m e n t o f im p e rfe c tio n in th e h e d g in g process. This is illu s tra te d in E xa m p le 17.3.

Exam ple

17.3

A s s u m e th a t a je w e lle r y m a n u fa c tu r e r in te n d s to b u y o n e o u n c e o f h ig h - g r a d e g o ld b u t th e fu tu re s c o n t r a c t s p e c ifie s o n e o u n c e o f p r e m iu m - g r a d e g o ld . N e v e r th e le s s , a s a h e d g e , h e e n te rs in to o n e fu tu re s c o n t r a c t to b u y p r e m iu m - g r a d e g o ld . S u p p o s e t h a t th e f o llo w in g T a b le 1 7 . 7 , o c c u r. W h a t is th e g a in o r loss f o r th e je w e lle r y m a n u fa c tu re r?

p r ic e s , s h o w n in

C hapter seventeen Futures

contracts a n d swaps

TABLE 17.7 Prices for Example 17.3 P rices ($ ) A t T im e 0

G o ld

A t T im e

H igh grade— spot

1450

1493

P rem ium grade— spot

1480

1520

Prem ium grade— fu tu re s

1490

1528

SOLUTION 'L o s s ' o n s p o t

= $ 1 4 9 3 - $ 1 4 5 0 = $ 4 3 (loss)

G a in o n fu tu re s = $ 1 5 2 8 - $ 1 4 9 0 = $ 3 8 (g a in ) N e t re s u lt:

$ 5 (loss)

B e c a u s e a s m a ll loss h a s re s u lte d , th e h e d g e is im p e rfe c t. T w o c o m p o n e n ts o f th e loss c a n b e id e n tifie d :

Basis risk, w h ic h c a u s e d a lo ss o f $ 2 . A t T im e 0 , th e b a s is , m e a s u re d a s th e s p o t p r ic e m in u s th e

a)

fu tu re s p ric e , w a s - $ 1 0 . A t T im e 1, it w a s - $ 8 . In o th e r w o r d s , w h e r e a s th e s p o t p r ic e in c re a s e d b y $ 4 0 , th e fu tu re s p r ic e in c re a s e d b y o n ly $ 3 8 .

Specification differences, w h ic h c a u s e d a fu rth e r loss o f $ 3 . A t T im e 0 , th e p r ic e g a p b e tw e e n th e

b)

tw o g r a d e s o f g o ld w a s $ 3 0 , b u t a t T im e 1, it w a s o n ly $ 2 7 . In o th e r w o r d s , th e g r a d e s o u g h t b y th e h e d g e r h a s b e c o m e m o re e x p e n s iv e re la tiv e to th e g r a d e o f g o ld u n d e r ly in g th e fu tu re s c o n tra c t. A g a in , h o w e v e r, c o m p a r e d w ith n o h e d g e (in w h ic h c a s e a loss o f $ 4 3 w o u ld h a v e b e e n in c u rre d ), th e re s u lt is q u ite g o o d , e v e n th o u g h th e h e d g e is im p e rfe c t.

1 7 .5 .5 1 Hedging and regretting The p re v io u s exa m ples have be en c o n s tru c te d to s h o w h o w h e d g in g can reduce losses t h a t w o u ld o th e rw is e have been in c u rre d . H o w eve r, b y its v e ry n a tu re , h e d g in g also reduces p r o fits w h ic h w o u ld o th e rw is e have been m ade. C o n sid e r th e e xa m p le o f M eg an , a c o rp o ra te tre a s u re r, w h o ta ke s o u t a s h o rt hedge to p ro te c t a g a in st p ric e fa lls. Prices in fa c t ris e as d isp la ye d in Table 17.8.

TABLE 17.8 A short hedge P rices ($ ) A t T im e 0

A t T im e 1

Spot price (long)

430

500

Futures price (sh o rt)

440

510

C o m m o d ity

In th is case, th e re is a g a in o n th e s p o t o f $ 7 0 a n d an o f f s e t t in g lo ss o n th e fu tu re s o f $ 7 0 . The hedge has p e rfo rm e d p e rfe c tly ; i t p ro d u c e d im m u n it y to p ric e m o v e m e n ts . O f co u rse , i t is o b v io u s th a t,

in retrospect,

M e g a n s c o m p a n y w o u ld ha ve b e e n b e t te r o f f b y $ 7 0 i f she h a d n o t ta k e n o u t th e

hedge. She m a y n e e d to e x p la in to h e r boss th e s im p le m essage o f h e d g in g w it h fu tu re s c o n tra c ts : to have p r o te c tio n a g a in s t losses a fu tu r e s h e d g e r m u s t be w illin g to fo rg o p r o fits t h a t w o u ld o th e rw is e have be en m ade.

4^^

B usiness finance

1 7 .5 .6 1 Selecting the number of futures contracts In th e exa m ples w e have discussed, th e n u m b e r o f fu tu re s c o n tra c ts to be used in th e hedge was ob vio us. H o w e ve r, in p ra c tic e th is is n o t alw ays th e case a n d he dg ers n e ed to a d o p t a s y s te m a tic a p pro ach in d e c id in g h o w m a n y fu tu re s c o n tra c ts th e y s h o u ld b u y o r sell. I f a h e d g e r e n te rs in to to o fe w (o r to o m a n y) fu tu re s c o n tra c ts , th e p o s itio n is ris k ie r th a n d e s ire d .13 Suppose t h a t a h e d g e r has an in te re s t in p o s itio n , th e n

Ns is

Ns u n its

o f a c o m m o d ity 1. I f th is in te re s t is a lo n g (s h o rt)

p o s itiv e (n e g a tive ). Suppose f u r t h e r t h a t /"fu tu re s c o n tra c ts have b e e n e n te re d in to ,

NF u n its o f th e c o m m o d ity . I f a lo n g (s h o rt) p o s itio n is h e ld in fu tu re s fis p o s itiv e (n e g a tive ). The g a in G to th e h e d g e r is: G = Ns x (cha ng e in sp o t p ric e p e r u n it) -\-fNp x (ch a n g e in fu tu re s p ric e p e r u n it)

each o f w h ic h covers

c o n tra c ts ,

th e n

= ^ s (5 i - 5

〇)

-\-fNF(Fi

-F

〇)

w h e re S〇 = s p o t p ric e p e r u n it w h e n th e hedge is e n te re d (‘to d a y ’） F 〇 = fu tu re s p ric e p e r u n it w h e n th e hedge is e n te re d (^odayO

^1

= s p o t p ric e p e r u n it w h e n th e hedge is lift e d = fu tu re s p ric e p e r u n it w h e n th e hedge is lift e d

The tild e (〜）is used to e m p ha sise t h a t th e s u b se q u e n t p rice s are ra n d o m v a ria b le s — t h a t is, t h e ir value is u n c e rta in . O b v io u s ly , w h e n th e hedge is lif t e d a n d th e s p o t tra n s a c tio n is m ade, th e o u tco m e s 5 X a n d

F1w ill

be

k n o w n w it h c e rta in ty . T h ere fore, w ith h in d s ig h t, th e id e a l n u m b e r o f fu tu re s c o n tra c ts fr o m a h e d g in g v ie w p o in t w ill be o b v io u s a n d can be fo u n d b y s e ttin g G eq ua l to zero a n d re a rra n g in g E q u a tio n 17.6. This gives: ^ ( 5 ! -S o ) ■

Nf(F] -F ) 〇

H o w e ve r, in p ra ctice , th is e q u a tio n c a n n o t be used because

Sr a n d F1 are

n o t k n o w n a t th e tim e th e

hedge is se t up. In e v ita b ly , th e re fo re , d e c id in g h o w m a n y fu tu re s c o n tra c ts s h o u ld be e n te re d in to re q u ire s som e a s s u m p tio n o r fo re ca st t h a t relates changes in th e fu tu re s p ric e to changes in th e s p o t p rice . This w ill u s u a lly in v o lv e som e e rro r. U s in g E q u a tio n 17.6, th e g a in p e r u n it o f c o m m o d ity is g, w h ere :

Ns N o w d e fin e

Ns h = fN F/N Si w h e re h is

th e *hedge ratio *, w h ic h is th e n u m b e r o f u n its cove red b y fu tu re s

c o n tra c ts p e r u n it o f s p o t c o m m o d ity . T here fore:

g=

(S i - S 〇 ) +

h(F\

The c o m p o n e n ts

-F

〇)

oig rese m ble

a tw o -a s s e t p o r tfo lio , a n d th e va ria n c e (ris k ) is g iv e n b y :14

V a r(g ) = V ar(S ! - S〇 ) + V a r [h ( f , - F 〇 ) ] + 2C ov [ ( § ! - S〇 ) , h ( f , - F 〇 ) ] = V a r^ S ,) +

h2Var(P^

+

2hCov(su F ^

W e a ssu m e t h a t th e h e d g e r w i l l cho ose th e h e d g e r a t io f in d h o w to ach ie ve t h is g o a l w e d iffe r e n tia te V a r(

g)

h so

as to m in im is e th e v a ria n c e o f g .15 To

w it h re s p e c t to

h,

a n d s e t th e d e riv a tiv e e q u a l

to zero :

13

N o te t h a t s im p ly in c r e a sin g th e n u m b e r o f fu t u r e s c o n tr a c t s in a n a t t e m p t 4to m a k e s u r e e n o u g h a r e h eld * d o e s n o t so lv e t h is p r o b le m . F o r e x a m p le , i f b u y in g n in e fu t u r e s c o n t r a c t s w o u ld p r o d u c e a p e r f e c t h e d g e , b u t 1 0 c o n tr a c t s a r e b o u g h t , th e h e d g e r is o n e f u t u r e s c o n tr a c t lo n g o n a n e t b a s i s . T h a t is , th e h e d g e r is in fa c t a lo n g s p e c u l a t o r in r e la t io n t o o n e c o n tr a c t, a n d h e n c e w ill m a k e a lo s s i f fu t u r e s p r ic e s fa ll.

14

C a lc u la t in g th e r is k o f a p o r t fo lio is e x p la in e d in d e t a il in C h a p t e r 7.

15

A s w e h a v e s t a t e d , t h is is m e r e ly a n a s s u m p t io n . In g e n e r a l, it is e x p e c te d t h a t fin a n c ia l m a r k e t s w ill p r ic e a s s e t s s o t h a t th e r e is a t r a d e - o ff b e tw e e n r isk a n d e x p e c te d r e t u r n . D e p e n d in g o n th e d e c is io n m a k e r s p r e f e r e n c e s a s b e tw e e n r isk a n d e x p e c te d r e tu rn , a r isk - m in im isin g s t r a t e g y m a y o r m a y n o t b e o p t im a l.

令

C hapter seventeen Futures

W a r逆

=

dh

2hVar{Fi) + 2 C o v (S ], F 〇

The ris k -m in im is in g va lu e o f

h* =

h is

= 0

th u s

h* w h ere :

_ C o v (S i 1 F i)

17.7

V a r(F 〇 A n e stim a te o f o f th e hedge ra tio r

h* can be fo u n d ht th e o p tim u m

fr o m re g re ssin g s p o t p rice s a g a in s t fu tu re s prices. U s in g th e d e fin itio n n u m b e r o f fu tu re s c o n tra c ts to e n te r in to is

f*

w here:

= ~

Nf

S u b s titu tin g fr o m E q u a tio n 1 7 .7 gives:

NsCovCs^F,) 1 ~ Nf V a r(F 〇

17.8

E q u a tio n 17.8 suggests t h a t th e n u m b e r o f fu tu re s c o n tra c ts to e n te r in to depends o n fo u r factors: a

N s, th e n u m b e r o f u n its o f th e c o m m o d ity a t r is k in th e s p o t m a rk e t

b

NFf th e

C

C o v ( S i,F i) , w h ic h de scrib es th e re la tio n s h ip b e tw e e n s p o t a n d fu tu re s p rice s

d

V a r(F i), w h ic h describes th e v a r ia b ility o f fu tu re s prices.

n u m b e r o f u n its o f th e c o m m o d ity u n d e rly in g one fu tu re s c o n tra c t

A n in te re s tin g spe cia l case arises i f i t is assu m ed t h a t s p o t a n d fu tu re s p rice s m o ve e q u ip ro p o rtio n a te ly — t h a t is, an

x per

c e n t change in th e s p o t p ric e w ill alw ays be m a tc h e d b y an

x per

cent

change in th e fu tu re s p rice . Then: ( 5 !- S 〇)

=

(F x-F p)

S〇

F〇

w h ic h on re a rra n g e m e n t gives:

an d th e re fo re :

Cov(Si,F1) = C o v ^ F i ,F ,^ =

吾

C o v (内

，朽

）

= ^ V a r(F ,)

户 0

S u b s titu tin g in E q u a tio n 1 7 .8 , th e o p tim u m n u m b e r o f fu tu re s c o n tra c ts

NsS /F Var(Fi) Nf V a r(F 〇 Ns S Nf Fq 〇

f*

is:

〇

〇

17.9

The a p p lic a tio n o f E q u a tio n 17 .9 is illu s tra te d in E xa m p le 17.4.

Exam ple

17.4

G o s s G o ld o w n s 1 1 9 o u n c e s o f g o ld a n d is c o m m itte d to s e llin g th e g o ld in 3 w e e k s ' tim e . T he s p o t p ric e (to d a y ) is $ 1 3 0 7 p e r o u n c e a n d th e fu tu re s p ric e fo r d e liv e r y in 7 w e e k s ' tim e is $ 1 3 1 6 p e r o u n c e . O n e futures c o n tra c t c o v e rs 3 o u n c e s o f g o ld . G o s s G o ld w a n ts to h e d g e u s in g future s a n d n e e d s to d e c id e o n the n u m b e r o f future s c o n tra c ts it s h o u ld enter.

continued

contracts a n d swaps

continued

SOLUTION A s a firs t p a ss a t th e p r o b le m , G o s s G o ld is w illin g to a s s u m e th a t a 1 p e r c e n t c h a n g e in th e s p o t p r ic e w ill b e m a tc h e d b y a 1 p e r c e n t c h a n g e in th e fu tu re s p ric e . U s in g E q u a tio n 1 7 . 9 , th e n u m b e r o f fu tu re s c o n tra c ts is: p

= _N sS g

NF Fo 119 $ 1 3 0 7 $1316 = -3 9 .4 0

T hus, G o s s G o ld s h o u ld sell 3 9 fu tu re s c o n tra c ts .

A v a r ia tio n o n th is s im p le a p p ro a c h w h e n a p p lie d to b o n d fu tu re s is illu s tr a te d in E x a m p le 1 7 .1 1 .

F in a n c e in

ACTION

METALLGESELLSCHAFT________________________________________ T h e G e r m a n c o m p a n y M e ta llg e s e lls c h a ft A G p r o v id e s a c a s e o f a n a p p a r e n t h e d g in g s tra te g y t h a t w e n t t e r r ib ly w r o n g . 16 In 1 9 9 3 th is 1 0 0 - y e a r - o ld c o m p a n y w a s th e fo u r t e e n t h - la r g e s t c o r p o r a t io n in G e r m a n y , w ith 5 8 0 0 0 e m p lo y e e s a n d 2 5 1 s u b s id ia r ie s w o r ld w id e . It w a s in v o lv e d in a r a n g e o f b u s in e s s e s b u t p r i m a r il y in m in in g , m e ta ls a n d e n e r g y p r o d u c ts . In la te 1 9 9 3 a n d e a r ly 1 9 9 4 , it in c u r r e d lo s s e s in fu tu re s t r a d in g o f a p p r o x im a t e ly U S $ 1 .3 b illio n . T h is w a s e q u a l to a b o u t h a lf o f its v a lu e a t t h a t tim e . T h e s e lo s s e s w e r e in c u r r e d b y a U S s u b s id ia r y o f th e c o m p a n y c a lle d M G R e fin in g a n d M a r k e t in g ( M G R M ) . In 1 9 9 2 M G R M d e v e lo p e d a m a r k e tin g s tr a te g y in w h ic h it o f f e r e d U S firm s lo n g -te rm fix e d - p r ic e c o n tra c ts o n g a s o lin e , h e a tin g o il a n d d ie s e l fu e l. M G R M 's c u s to m e rs w e r e a b le to lo c k in t h e ir p u r c h a s e p r ic e f o r u p t o 1 0 y e a r s p r o v id e d th e y a g r e e d to b u y fr o m M G R M . To h e d g e a g a in s t th e ris k o f o il p r ic e ris e s , M G R M e n te r e d in to b o u g h t p o s it io n s in fu tu re s c o n t r a c t s t r a d e d o n th e N e w Y o rk M e r c a n t ile E x c h a n g e . H o w e v e r , a s th e s e fu tu r e s c o n tr a c ts h a d r e la t iv e ly s h o r t te rm s to m a tu r ity , th e y h a d to b e r o lle d o v e r a s e a c h c o n t r a c t e x p ir e d . M G R M s e ttle d e x p ir in g c o n tr a c ts a n d p u r c h a s e d th e n e x t s h o r te s t m a t u r ity c o n t r a c t . T h is s t r a t e g y w o r k s s u c c e s s fu lly p r o v id e d th e m o r e d is t a n t fu tu re s p r ic e s a r e lo w e r t h a n th e s p o t p r ic e o r n e a r b y fu tu r e s p r ic e . U n fo r tu n a te ly , in la t e - 1 9 9 3 o il p r ic e s b e g a n f a llin g . D u r in g 1 9 9 3 p r ic e s o f o il f e ll b y a lm o s t o n e - th ir d . M G R M 's b o u g h t p o s it io n s in th e fu tu r e s m a r k e t in c u r r e d lo s s e s , r e s u lt in g in la r g e m a r g in c a lls . A s th e p r ic e o f o il w a s f a llin g , th e f ir m w a s g a in in g o n its f ix e d - p r ic e s u p p ly c o n tr a c ts , b u t u n f o r t u n a t e ly th o s e g a in s c o u ld n o t b e r e a lis e d u n til th e o il w a s d e liv e r e d . A s n o te d a b o v e , in s o m e c a s e s th is w a s u p to 1 0 y e a r s in th e fu tu re . F a c e d w it h u n r e a lis e d g a in s in its f ix e d - p r ic e s u p p ly c o n tr a c ts a n d m a s s iv e lo s s e s in th e fu tu re s m a r k e t, th e p a r e n t c o m p a n y c h o s e to liq u id a t e its fu tu re s p o s it io n s . U n fo r tu n a te ly , d u r in g th e n e x t 6 m o n th s o il p r ic e s r e c o v e r e d a ll o f t h e ir lo s t g r o u n d . T h is m e a n t t h a t M R G M 's f ix e d p r ic e s u p p ly c o n t r a c t s t h a t w e r e n o w u n h e d g e d in c u r r e d fu r t h e r lo s s e s f o r th e c o m p a n y . S o m e e x p e r ts c o n s id e r t h a t M G R M w a s in f a c t s p e c u la t in g . O th e r s a r g u e t h a t it h a d a n e f f e c t iv e h e d g e in p la c e a n d c o u ld h a v e r a is e d th e c a s h to m e e t its m a r g in c a lls w it h o u t liq u id a t in g its p o s it io n s . W h e t h e r t h r o u g h s p e c u la t io n o r a n u n s u c c e s s fu l h e d g in g s tra te g y , th e p a r e n t c o m p a n y r e p o r t e d a lo s s o f m o r e th a n U S $ 1 . 7 b i lli o n f o r th e f in a n c ia l y e a r e n d in g S e p te m b e r 1 9 9 4 .

16 For details of the losses incurred by Metallgesellschaft, see Chance and Brooks (2010, p. 576) and Sheedy and McCracken (1997, pp. 42-7).

4^^

C hapter seventeen Futures

contracts a n d swaps

Financial futures on the Australian Securities Exchange: the 90-day bank-accepted bill futures contract

17.6

As m e n tio n e d in S e ctio n 1 7 .3 , m o s t fu tu re s c o n tra c ts tra d e d on th e A S X are fin a n c ia l fu tu re s , ra th e r th a n c o m m o d ity fu tu re s . In th is a n d th e fo llo w in g tw o se ctio n s, p rin c ip le s t h a t w e have d e ve lo p e d an d e xp la in e d in te rm s o f c o m m o d ity fu tu re s are a p p lie d to A S X fin a n c ia l fu tu re s . M o re space is d e v o te d to bank-a ccepte d b ill fu tu re s th a n to th e o th e rs , because th e re is s im p ly m o re m a te ria l to c o ve r a n d because b a n k b ill fu tu re s are used to e x p la in th e m a jo r p rin c ip le s .

17.6.1 | A brief review of bank bills17 A

bank bill

is a s h o r t- te rm d e b t in s tr u m e n t t h a t is re a d ily tra d e a b le . B a n k b ills are g e n e ra lly issu ed

fo r s ta n d a rd fix e d te rm s (such as 9 0 days o r 18 0 days) a n d a t s ta n d a rd face values (such as $ 1 0 0 0 0 0 , $ 5 0 0 0 0 0 o r $ 1 0 0 0 0 0 0 ). The face va lu e is re p a id a t m a tu rity . P rio r to m a t u r ity a b ill is p ric e d a cco rd in g to th e p rin c ip le s o f s im p le in te re s t. E q u a tio n 1 7 .1 0 show s th e b ill p r ic in g fo rm u la used in th is ch a p te r.

V

P:

R R V 9

1 + (/)(r/3 6 5 )

w h ere P = b ill p rice

V = face value z = n o m in a l a n n u a l y ie ld (also k n o w n as th e b ill ra te ) t = te rm (in days) re m a in in g to b ills m a t u r ity date This is illu s tra te d in E xa m p le 17.5.

Exam ple

17.5

A b ill w ith 9 0 d a y s r e m a in in g to m a tu rity , p r ic e d to y ie ld 6 . 8 8 p e r c e n t p e r a n n u m a n d w ith a fa c e v a lu e o f $1 m illio n re q u ire s a p r ic e o f:

p

6^

$1000000 _ 1 + (0 .0 6 8 8 1 (9 0 /3 6 5 ) = $ 9 8 3 3 1 8 .6 1

If th e y ie ld w e r e to in c re a s e by, say, 0 . 2 5 p e r c e n t p e r a n n u m to 7 .1 3 p e r c e n t p e r a n n u m , th e n th e p ric e d e c re a s e s a s fo llo w s :

n

$1000000 1 + (0 .0 7 1 3 1 (9 0 /3 6 5 ) $ 9 8 2 7 2 2 .9 2

This re p re s e n ts a c a p it a l loss o f $ 5 9 5 . 6 9 to th e in v e s to r (le n d e r). S im ila rly , if y ie ld s d e c re a s e , p ric e s in c re a s e . A n 'e q u iv a le n t ’ fa ll in y ie ld o f 0 . 2 5 p e r c e n t p e r a n n u m , to 6 . 6 3 p e r c e n t p e r a n n u m , w ill p r o d u c e a p r ic e in c re a s e a s fo llo w s :

n

$1000000 1 + (0 .0 6 6 3 1 (9 0 /3 6 5 ) $ 9 8 3 9 1 5 .0 1

T his re p re s e n ts a c a p it a l g a in o f $ 5 9 6 . 4 0 to th e in v e s to r (le n d e r). N o te th a t b e c a u s e o f th e n o n ­ lin e a r re la tio n s h ip b e tw e e n y ie ld s a n d b o n d p ric e s , th e c a p it a l g a in is a little la r g e r th a n th e c a p it a l loss fo r th e s a m e s h ift in y ie ld .

17 For further details, see Section 10.5.3.

4^^

B usiness finance

F o r m a n y p u rp o s e s ，a b a n k b ill is th e sam e as a n y o th e r ‘c o m m o d ity ’. I t has a m a rk e t p ric e a n d th is p ric e changes fr o m d a y to day a cco rd in g to m a rk e t forces. There is, th e re fo re , n o reason w h y th e re c a n n o t be a fu tu re s c o n tra c t o n 9 0 -d a y b a n k b ills .

17.6.1 | Specification of the bank-accepted bill futures contract The b a n k-a cce p te d b ill fu tu re s c o n tra c t has th e fo llo w in g m a jo r fea tu res. LEARNING OBJECTIVE 6 Understand and explain the features of the major financial futures contracts traded on the Australian Securities Exchange

Contract unit The c o n tra c t u n it is a 9 0 -d a y b a n k b ill w it h a face va lu e o f $1 m illio n , o r n e g o tia b le c e rtific a te s o f d e p o s it w it h a face va lu e o f

$1

m illio n issu ed b y an a p p ro v e d b a n k.

Settlement The c o n tra c t is d e liv e ra b le — t h a t is, sellers can d e liv e r b a n k b ills in s a tis fa c tio n o f t h e ir fu tu re s c o n tra c t re s p o n s ib ilitie s . T echn ica lly, b ills t h a t have a te r m as s h o rt as 85 days o r as lo n g as 95 days are acceptable. H o w e ve r, b ills s h o rte r th a n 90 days are w o r th m o re th a n 9 0 -d a y b ills because th e y are d is c o u n te d w ith resp ect to a s h o rte r tim e p e rio d . T h ere fore, b u ye rs m u s t pa y a li t t le m o re th a n th e s ta te d fu tu re s p ric e in t h a t case. S im ila rly , i f sellers d e liv e r a b ill lo n g e r th a n 90 days, th e n b u ye rs p a y a l i t t le less th a n th e y w o u ld f o r a 9 0 -d a y b ill. A ls o , b a n k n e g o tia b le c e rtific a te s o f d e p o s it can be s u b s titu te d f o r b a n k b ills . The s e ttle m e n t da te is th e second F rid a y o f th e m a t u r ity (d e liv e ry ) m o n th .

Quotations O n e h u n d re d m in u s th e a n n u a l p e rcen ta ge y ie ld to tw o d e c im a l places.

Termination of trading T ra d in g ceases a t 12 n o o n o n th e bu sin ess day im m e d ia te ly p r io r to th e s e ttle m e n t date. I t is im p o r t a n t to rea lise t h a t a b a n k b ill fu tu re s c o n tra c t is n o t a c o n tra c t o n a n y p re s e n tly e x is tin g 9 0 -d a y b a n k b ill because to m o r r o w an e x is tin g 9 0 -d a y b a n k b ill w ill be an 8 9 -d a y b a n k b ill a n d th e n e x t day a n

88 -d a y b a n k b ill,

a n d so on.

To illu s tra te th e n a tu re o f th e b a n k b ill fu tu re s c o n tra c t, c o n s id e r th e p ric e o f 9 7 .4 5 f o r th e D e cem b er (2 0 1 3 ) b a n k b ill fu tu re s c o n tra c t p ro v id e d o n th e A u s tra lia n S e cu ritie s E xchange w e b s ite a fte r th e close o f tra d in g o n 4 O c to b e r 2 0 1 3 (see F ig u re 17 .1 ). The re p o rte d p ric e o f 9 7 .4 5 re fe rs to th e p ric e in th e la s t tra d e o n t h a t day a n d re p re se n ts 1 0 0 m in u s th e a n n u a l pe rce n ta g e y ie ld . In o th e r w o rd s, th e a n n u a l y ie ld is: 1 0 0 -9 7 .4 5 = 2 .5 5 % = 0.0255 U s in g E q u a tio n 1 7 .1 0 , th e d o lla r p ric e im p lic it in th is fu tu re s c o n tra c t is th e re fo re :

$ 1 0 0 0 000*2013 1 + (0 .0 2 5 5 )(9 0 /3 6 5 ) = $ 9 9 3 7 5 1 .6 2 The s e ttle m e n t da te is th e second F rid a y o f D e ce m b e r 2 0 1 3 — t h a t is, 13 D e ce m b e r 2 0 1 3 . The b a n k b ill in v o lv e d has 90 days to ru n ; th is 9 0 -d a y p e rio d is to

begin on 13 December 2 0 1 3 .

T h e re fo re , th e b a n k b ill

in v o lv e d is one t h a t m a tu re s o n 13 M a rc h 2 0 1 4 . The te rm o f th e fu tu re s c o n tra c t e xp ire s o n 13 D ecem ber 2 0 1 3 , w h ic h is 70 days a fte r i t was e n te re d in to o n 4 O c to b e r 2 0 1 3 . To c la r ify th is , suppose t h a t a tra d e r b o u g h t one such c o n tra c t o n 4 O cto b e r, h e ld i t to s e ttle m e n t day (1 3 D e cem b er), accepted d e liv e ry o f th e b ill o n t h a t d a y a n d th e n h e ld th e b ill to it s m a t u r ity date. Ig n o rin g cash flo w s due to d e p o sits, m a rg in s a n d th e m a rk -to -m a rk e t ru le , th e cash flo w s in v o lv e d are as s h o w n in F igu re 17.1. The y ie ld e a rn e d o v e r th e 9 0 -d a y p e rio d fr o m 13 D e ce m b e r 2 0 1 3 to 13 M a rc h 2 0 1 4 is, as i t m u s t be, 2.5 5 p e r c e n t p e r a n n u m . By e n te rin g th e fu tu re s c o n tra c t, a p a r tic u la r y ie ld (2 .5 5 p e r c e n t p e r a n n u m )

C hapter seventeen Futures

contracts a n d swaps

Major cash flows in a bank-accepted bill futures contract 70

160

4 October 201 3

13 December 2013

13 March 2014

Enter futures contract at price of $97.45

Accept delivery pay $993 751.62

Bill matures collect $ 1 0 0 0 0 0 0

has b e en lo c k e d in o n 4 O c to b e r 2 0 1 3 f o r th e 9 0 -d a y p e rio d t h a t b e g in s o n 13 D e cem b er 2 0 1 3 a n d ends o n 13 M a rc h 20 14 . O f course m o s t tra d e rs d o n o t h o ld a fu tu re s c o n tra c t u n t il s e ttle m e n t. T y p ic a lly th e b u y e r in th is e xa m ple w o u ld so o n reverse o u t b y a sale. I f, f o r exa m ple, th e re v e rs in g sale w e re m ade a t th e c lo sin g p ric e on 11 O c to b e r th e p ric e , as p ro v id e d b y th e A S X w e b site , w o u ld have been 9 7 .4 1 . The y ie ld in d ic a te d is 1 0 0 - 9 7 .4 1 = 2 .5 9 p e r c e n t and, a g a in u s in g E q u a tio n 1 7 .1 0 , th e d o lla r p ric e is:

p_

$ 10 0 0 000

_ 1 + (0.0259) (9 0 /3 6 5 ) = $ 9 9 3 654.22 Ig n o rin g tra n s a c tio n costs, th is gives a loss o f $ 9 7 .4 0 .

1 7 .6 .2 1 Uses of the bank bill futures contract The b a n k b ill c o n tra c t can be use d in s p e c u la tio n , h e d g in g a n d a rb itra g e .

Speculation with bank bill futures A ll fu tu re s c o n tra c ts le n d th e m se lve s to s p e c u la tio n . There is n o th in g spe cia l to e x p la in a b o u t th is . I f tra d e rs can fo re ca st th e s u b se q u e n t course o f th e b a n k b i ll fu tu re s p ric e , th e y can m a ke m o n e y s im p ly b y b u y in g (s e llin g ) w h e n th e fu tu re s p ric e is lo w (h ig h ).

Hedging with bank bill futures As has been e x p la in e d , s im p le h e d g in g in v o lv e s a fu tu re s tra n s a c tio n , w h ic h la rg e ly o ffs e ts a r is k to w h ic h th e h e dg er is a lre a d y exposed. T his is illu s tra te d in d e ta il in E xa m p le 17.6.

Exam ple

17.6

S e v e ra l w e e k s a g o , th e fin a n c ia l c o n tro lle r o f A n n a m a y Ltd d e c id e d th a t th e c o m p a n y sh o u ld b o r r o w b y issu in g a 9 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n . A s th e fu n d s w e re n o t n e e d e d fo r a n o th e r 2 w e e k s , it w a s d e c id e d th a t th e issue w o u ld n o t b e m a d e u n til th e 2 w e e k s h a d p a s s e d . In h e r p la n n in g , th e fin a n c ia l c o n tro lle r a s s u m e d th a t th e 9 0 - d a y b a n k b ill ra te w o u ld n o t c h a n g e fro m its th e n c u rre n t le vel o f 4 . 4 0 p e r c e n t p e r a n n u m . H o w e v e r, she w a s a w a r e th a t a risk w a s in v o lv e d a n d th e re fo re d e c id e d th a t A n n a m a y s h o u ld p ro te c t itse lf a g a in s t a n in c re a s e in b ill ra te s b y s e llin g o n e b a n k b ill fu tu re s c o n tra c t. This w a s d o n e a t a p ric e o f 9 5 . 7 8 . D u rin g th e n e x t 2 w e e k s th e fin a n c ia l c o n tro lle r w a s a m a z e d to see th e 9 0 - d a y b ill ra te c lim b ra p id ly . A n n a m a y e v e n tu a lly issu ed a b ill a t a ra te o f 5 . 5 0 p e r c e n t p e r a n n u m a n d lifte d the h e d g e b y re v e rs in g its future s p o s itio n a t a p ric e o f 9 4 . 7 0 . The fin a n c ia l c o n tro lle r is a s k e d to p ro v id e a re p o r t to th e B o a rd o f D ire c to rs o n th e fo llo w in g m atters: a)

th e (gro ss) d o lla r s h o rtfa ll th a t A n n a m a y w o u ld h a v e fa c e d if a fu tu re s c o n tra c t h a d n o t b e e n e n te re d in to

b)

th e g a in o r loss m a d e o n th e fu tu re s c o n tra c t ( ig n o r in g tra n s a c tio n costs)

continued

LEARNING OBJECTIVE 7 Explain speculation and hedging strategies using the major financial futures contracts traded on the Australian Securities Exchange

B usiness finance

continued c)

th e n e t d o lla r s h o rtfa ll

d)

a n e x p la n a t io n o f (c) in te rm s o f b a s is risk

e)

a b r ie f a s s e s s m e n t o f th e e ffe c tiv e n e s s o f th e h e d g e .

SOLUTION T h e a n s w e rs to th e s e q u e s tio n s a r e a s fo llo w s :

Dl

,u

•

$100 0000

Planned borrowinq = ---------------------------------1 + (0 .0 4 4 0 ) ( 9 0 /3 6 5 ) = $ 9 8 9 2 6 7 .1 3

n) ul

A . ,, $1000000 Actual borrowinq = ---------------------------------1 + (0 .0 5 5 0 ) ( 9 0 /3 6 5 ) $ 9 8 6 6 1 9 .8 1 D o lla r shortfall (gross) = $ 9 8 9 2 6 7 . 1 3 - $ 9 8 6 6 1 9 . 8 1 = $ 2 6 4 7 .3 2

b)

T h e re is a n o tio n a l s a le a t 9 5 . 7 8 — th a t is, a t 4 . 2 2 p e r c e n t p e r a n n u m — f o llo w e d b y a n o tio n a l p u rc h a s e a t 9 4 . 7 0 — th a t is, a t 5 . 3 0 p e r c e n t p e r a n n u m . N o tio n a l in flo w from sale :

$ 10 0 0 0 0 0 1 + (0 .0 4 2 2 ) ( 9 0 /3 6 5 ) $ 9 8 9 7 0 1 .6 8

$ 10 0 0 0 0 0

N o tio n a l o u tflo w from purchase

1 + ( 0 .0 5 3 0 ) ( 9 0 /3 6 5 ) $ 9 8 7 1 0 0 .0 9 Result from futures = $ 9 8 9 7 0 1 .6 8 - $ 9 8 7 1 0 0 .0 9 = $ 2 6 0 1 .5 9 (gain) c)

N e t d o lla r s h o rtfa ll = $ 2 6 4 7 . 3 2 - $ 2 6 0 1 . 5 9

d)

B a sis is s p o t p r ic e less fu tu re s p r ic e . W h e n th e h e d g e w a s e n te re d , th e b a s is w a s :

= $ 4 5 .7 3

(Price at y ie ld o f 4 .4 0 % ) less (price a t yie ld o f 4 .2 2 % ) = $ 9 8 9 2 6 7 .1 3 - $ 9 8 9 7 0 1 .6 8 = -$ 4 3 4 .5 5 W h e n th e h e d g e w a s lifte d , th e b a s is w a s : (Price at y ie ld o f 5 .5 0 % ) less (price a t y ie ld o f 5 .3 0 % ) = $ 9 8 6 6 1 9 .8 1 - $ 9 8 7 1 0 0 .0 9 = - $ 4 8 0 .2 8 C h a n g e in basis = (later basis) less (ea rlie r basis) = -$ 4 8 0 .2 8 - ( - $ 4 3 4 .5 5 ) = -$ 4 5 .7 3 A s a s h o rt h e d g e r's n e t re s u lt is g iv e n b y th e c h a n g e in th e b a s is , th is in d ic a te s th a t th e h e d g e r's n e t re s u lt is a loss o f $ 4 5 . 7 3 , w h ic h is th e re s u lt c a lc u la te d in p a r t ( c ) .18

18 See Table 17.6. Note that Annamay Ltd has been a little unlucky. Given that, at maturity, a futures price must be very close to the spot price, it follows that, on average, the basis will tend towards zero as time passes and the maturity date becomes closer. However, in this example, the basis has gone from -$434.55 to -$480.28—that is, it has moved further away from zero.

C hapter seventeen Futures

e)

W it h o u t th e h e d g e , th e d o lla r s h o rtfa ll w o u ld h a v e b e e n $ 2 6 4 7 . 3 2 . W it h th e h e d g e , th e n e t d o lla r s h o rtfa ll is o n ly $ 4 5 . 7 3 , a r e d u c tio n o f 9 8 . 3 p e r c e n t. T he re s u lt c a n a ls o (e q u iv a le n tly ) b e a sse ssed in te rm s o f y ie ld s . A n n a m a y 's to ta l fu n d s in flo w is th e a m o u n t b o r r o w e d p lu s th e n e t g a in o n th e fu tu re s c o n tra c t. T h is is:

$ 9 8 6 6 1 9 .8 1 + $ 2 6 0 1 .5 9 = $ 9 8 9 2 2 1 .4 0 T he re p a y m e n t r e q u ire d is $1 m illio n in 9 0 d a y s ' tim e . T h e im p lie d a n n u a l n o m in a l y ie ld is:

/ $1 0 0 0 0 0 0

V $ 9 8 9 2 2 1 .4 0

^ ~

365 ) X ~90

= 4.419% T his c o m p a re s w ith a p la n n e d b o r r o w in g ra te o f 4 . 4 0 p e r c e n t. C le a r ly th e h e d g e h a s b e e n e ffe c tiv e .

In E xam p le 17 .6, A n n a m a y L td in te n d e d to issue a s e c u rity , w h ic h , w it h th e e x c e p tio n o f th e in te n d e d date o f issue, m a tc h e d p re c is e ly th e s e c u rity s p e c ifie d in th e fu tu re s c o n tra c t. In o th e r w o rd s, b o th th e s e c u rity o f in te re s t to A n n a m a y a n d th e s e c u rity s p e c ifie d in th e fu tu re s c o n tra c t w e re 9 0 -d a y b a n kaccepted b ills . A close m a tc h b e tw e e n th e s e c u rity o f in te re s t to th e h e d g e r a n d th e s e c u rity s p e c ifie d in th e fu tu re s c o n tra c t increases th e lik e ly q u a lity o f th e hedge. H o w e ve r, as e x p la in e d in S e ctio n 17 .5.4, th e re are o fte n s p e c ific a tio n diffe re nce s* b e tw e e n th e h e d g e rs needs a n d th e fu tu re s c o n tra c t. T his is illu s tra te d in E xam p le 17.7.

Example 17.7 S u p p o s e th a t, in s te a d o f 9 0 - d a y b a n k b ills , A n n a m a y Ltd h a d p la n n e d to issu e 1 2 0 - d a y b a n k b ills . A s th e re is n o fu tu re s c o n tr a c t o n 1 2 0 - d a y b a n k b ills , A n n a m a y w o u ld s till h a v e h e d g e d u s in g th e 9 0 - d a y b a n k b ill c o n tra c t. A s s u m e th a t a ll o th e r fa c ts r e m a in th e s a m e a n d th e re le v a n t d a ta a r e as s h o w n in T a b le 1 7 .9 .

TABLE 17.9 Yields for Example 17.7 ：

B a n k b ills

Y ie ld w h e n h e d g e

Y ie ld w h e n h e d g e

e n te re d (% p .a .)

lifte d [% p .a .)

90-day ba nk b ills

4.40

5.50

1 2 0 -day ba nk b ills

4.55

5.70

90-day ba nk b ill fu tu re s

4.22

5.30

T he fin a n c ia l c o n tr o lle r is r e q u ire d to r e p o r t o n th e f o llo w in g m a tte rs : a)

th e (gross) d o lla r s h o rtfa ll th a t A n n a m a y w o u ld h a v e fa c e d if a fu tu re s c o n tra c t h a d n o t b e e n e n te re d in to

b)

th e g a in o r loss m a d e o n th e fu tu re s c o n tra c t ( ig n o r in g tr a n s a c tio n costs)

c)

th e n e t d o lla r s h o rtfa ll

d)

a n e x p la n a tio n o f (c) in te rm s o f b a s is ris k a n d s p e c ific a tio n d iffe re n c e s

e)

a b r ie f a s s e s s m e n t o f th e e ffe c tiv e n e s s o f th e h e d g e .

continued

contracts a n d swaps

B usiness finance

continued

SOLUTION T he a n s w e rs to th e se q u e s tio n s a r e a s fo llo w s :

a)

$1000000

:

Planned borrowing

1 + (0 .0 4 5 5 )(1 2 0 /3 6 5 ) $985 2 6 1 .5 7

$ 10 0 0 0 0 0

Actual borrowing

1 + (0 .0 5 7 0 )(1 2 0 /3 6 5 ) = $ 9 8 1 6 0 4 .9 9 Dollar shortfall (gross) = $ 9 85 2 6 1 .5 7 - $981 6 0 4 .9 9 = $ 3 6 5 6 .5 8 b)

A s th is c a lc u la tio n in v o lv e s o n ly th e fu tu re s c o n tra c t, it is th e s a m e a s in E x a m p le 1 7 . 6 — th a t is, th e re s u lt is a g a in o f $ 2 6 0 1 . 5 9 .

c)

N e t d o lla r s h o rtfa ll = $ 3 6 5 6 . 5 8 - $ 2 6 0 1 . 5 9 = $ 1 0 5 4 .9 9

d)

T h is n e t s h o rtfa ll c a n b e b ro k e n in to c o m p o n e n ts re fle c tin g b a s is ris k a n d s p e c ific a tio n d iffe re n c e s . T h e la tte r a ris e s b e c a u s e A n n a m a y h a s risks r e la te d to 1 2 0 - d a y b ills b u t is u s in g fu tu re s o n 9 0 - d a y b ills to h e d g e a g a in s t th e se risks. T a b le 1 7 . 1 0 s h o w s th e re su lts in d e t a il. A ll p ric e s a r e c a lc u la te d u s in g E q u a tio n 1 7 . 1 0 .

TABLE 17.10 Basis risk and specification differences in Example 17.7 D e s c rip tio n

P rice w h e n h e d g e

P rice w h e n h e d g e lifte d

C hange

($ )

($ )

e n te re d ($>

1. Basis risk 90-day b a nk b ill (spot)

9 8 9 2 6 7 .1 3

9 8 6 6 1 9 .8 1

Bank b ill fu tu re s

989 701.68

9 8 7 1 0 0 .0 9

-4 3 4 .5 5

-4 8 0 .2 8

985 261.57

9 8 1 6 0 4 .9 9

9 8 9 2 6 7 .1 3

9 8 6 6 1 9 .8 1

-4 0 0 5 .5 6

- 5 014.82

-4 5 .7 3

2. Specification differences

1 2 0 -day b a n k b ill

(spot)

90-day b a n k b ill (spot)

-1 0 0 9 .2 6 -1 0 5 4 .9 9

e)

T he h e d g e h a s r e d u c e d th e d o lla r s h o rtfa ll fro m $ 3 6 5 6 . 5 8 to $ 1 0 5 4 . 9 9 ; th is is a re d u c tio n o f 7 1 .1

p e r c e n t. T he n o m in a l a n n u a l y ie ld is:

(

$ 1 0000 0 0 _________ 〇 x ^ = 4 . 8 8 1 % V $ 9 8 1 6 0 4 .9 9 + $ 2 6 0 1 .5 9 J 12 0 T h is c o m p a re s w ith a p la n n e d y ie ld o f 4 . 5 5 0 p e r c e n t. A lth o u g h th e h e d g e h a s b e e n q u ite e ffe c tiv e , its p e r fo r m a n c e fa lls s h o rt o f th e e x c e lle n t p e r fo r m a n c e in E x a m p le 1 7 . 6 .

In b o th E xam p le s 1 7 .6 a n d 1 7 .7 th e h e d g e r e s ta b lis h e d a s h o rt fu tu re s p o s itio n — t h a t is, th e hedge was a ch ie ved b y f ir s t e n te rin g a fu tu re s c o n tra c t to sell. E xa m p le 1 7 .8 illu s tra te s a hedge t h a t re q u ire s t h a t a b a n k b ill fu tu re s c o n tra c t be h e ld lo n g — th a t is, th e fu tu re s c o n tra c t is f ir s t b o u g h t a n d s u b s e q u e n tly sold.

C hapter seventeen Futures

Exam ple

contracts a n d swaps

17.8

The C h e s te rh e a to n In v e s tm e n t F und c h o s e to h e d g e w h e n it w a s to ld to e x p e c t a n in flo w o f a r o u n d $1 m illio n in 2 m o n th s ’ tim e , to b e in v e s te d in 9 0 - d a y b a n k b ills . W h e n th e h e d g e w a s e n te re d , y ie ld s p e r a n n u m w e r e 8 . 4 5 p e r c e n t (spo t) a n d 8 . 8 0 p e r c e n t (fu tu re s). W h e n th e h e d g e w a s lifte d , y ie ld s w e r e 7 . 1 5 p e r c e n t (spo t) a n d 7 . 3 8 p e r c e n t (fu tu re s ). D e s c rib e a n a p p r o p r ia te h e d g e , a n d assess its e ffe c tiv e n e s s in th e lig h t o f s u b s e q u e n t y ie ld s , ig n o r in g tra n s a c tio n costs.

SOLUTION The C h e s te rh e a to n In v e s tm e n t F u n d b u y s a b a n k b ill fu tu re s c o n tra c t. T h e n o tio n a l p u rc h a s e p r ic e is $ 9 7 8 7 6 2 . 2 0 a n d th e n o tio n a l s e llin g p r ic e is $ 9 8 2 1 2 7 . 9 6 , g iv in g a g a in o f $ 3 3 6 5 . 7 6 . W h e n th e h e d g e is lifte d , 9 0 - d a y b a n k b ills o ffe r a y ie ld o f 7 . 1 5 p e r c e n t. T h is im p lie s a p r ic e o f $ 9 8 2 6 7 5 . 3 0 . U s in g

its g a in

fro m

th e fu tu re s c o n tra c t, C h e s te rh e a to n c a n

b u y such a b ill fo r a n e t o u tla y o f

$ 9 7 9 3 0 9 . 5 4 , im p ly in g th a t its a n n u a l y ie ld w ill b e :

/

$ 1 000000

365

V $9 79 3 0 9 .5 4

8.568%

"90~

T h is is in fa c t s lig h tly h ig h e r th a n th e p la n n e d ra te o f 8 . 4 5 0 p e r c e n t. T h e fa c t th a t th is is n o t e q u a l to th e p la n n e d ra te in d ic a te s th a t n o t a ll risks w e r e e lim in a te d b y th e h e d g e , b u t it is c le a r th a t th is h e d g e h a s b e e n v e r y e ffe c tiv e .

Arbitrage with bank bill futures As we m e n tio n e d e a rlie r, an a rb itra g e is a set o f s im u lta n e o u s tra n s a c tio n s in d iffe re n t m a rk e ts t h a t guarantees a ris k -fre e p r o fit. A lth o u g h th e w o rd ‘a rb itra g e ’ is s o m e tim e s used v e ry loosely, i t is used in th is c h a p te r in its precise sense. F o r exa m p le , i f an in v e s to r is assured o f a p o s itiv e re tu rn , a t n o ris k , fro m a n e t in v e s tm e n t o f ze ro d o lla rs , th e n a rb itra g e has been achieved. O b v io u s ly i f m a rk e ts are e ffic ie n t, a rb itra g e s h o u ld n o t be p o ssib le . I f th e re are n o tra n s a c tio n costs a n d in v e s to rs can b o rro w o r le n d a t th e same m a rk e t y ie ld s, th e n th e re w i ll be an a rb itra g e o p p o r tu n ity p re s e n t unless:

(1 w h ere

itj )

+ z » ( l H-

t = th e

=

1

17.11

+ /r

m a t u r ity da te o f th e fu tu re s c o n tra c t

t it T= th e (fu tu re s )19 y ie ld f o r a fu tu re s c o n tra c t, iT= th e (s p o t) y ie ld o n a b ill m a tu r in g a t date T z't = th e (s p o t) y ie ld o n a b ill m a tu rin g a t da te

m a tu r in g a t d a te t, o n a b ill m a tu rin g a t a la te r d a te

T

The lo g ic b e h in d E q u a tio n 1 7 .1 1 is th e sam e as t h a t used in S e ctio n 4 .6 .3 to e x p la in th e e x p e c ta tio n s th e o ry o f th e te rm s tru c tu re o f in te re s t rates. Suppose th a t, o n da te zero, an in v e s to r in v e s ts $1 a t a y ie ld of

it f o r a p e rio d

t,

th e proceeds o f h is in v e s tm e n t a t a y ie ld o f

sum o f $ 1 (1 +

of

it )(1

t days +

a n d s im u lta n e o u s ly buys a fu tu re s c o n tra c t t h a t e n title s h im to in v e s t, o n date

itT). T h is

it T T here fore,

a t da te T, th e in v e s to r has an a ccu m u la te d

a m o u n t is p e rfe c tly foreseeable o n da te zero. C le a rly th e in v e s to r s h o u ld

com pare th is a m o u n t w it h th e a c c u m u la te d s u m i f o n da te zero he in s te a d in v e s ts in a b ill t h a t m a tu re s o n date T a n d o ffe rs a y ie ld o f

iT. O n

an in v e s tm e n t o f $1 th is w ill p ro d u ce an a c c u m u la te d su m o f $ 1 (1 +

iT).

The in v e s to r w ill choose th e a lte rn a tiv e t h a t p ro d u ce s th e g re a te r su m o n d a te T. Because c o m p e titio n be tw ee n tra d e rs s h o u ld e lim in a te a rb itra g e o p p o rtu n itie s , i t is e xp ected t h a t b o th a lte rn a tiv e s s h o u ld y ie ld th e sam e a c c u m u la te d su m . T h e re fo re E q u a tio n 1 7 .1 1 s h o u ld h o ld . E q u a tio n 1 7 .1 1 im p lie s t h a t th e fu tu re s y ie ld

l + it

it T, w h ic h

w ill p re v e n t a rb itra g e , is:

17.12

19 Strictly speaking, it T should be a forward yield, but this difference does not significantly affect the gist of the argument. The forward contract matures on date t; the underlying ‘commodity’ is a bank bill that is delivered on date t and matures on date T. In the context of a bank bill futures contract traded on the Australian Securities Exchange it is required that T - t = 9 0 days.

4^^

cash and carry reverse cash and carry is

I f th e a c tu a l fu tu re s y ie ld is less th a n t h is y ie ld , a n a rb itra g e o p e ra tio n k n o w n as is fe a s ib le . I f th e o p p o s ite is tr u e , th e n a n a rb itra g e o p e ra tio n k n o w n as

fe a s ib le .20 A n im p o r t a n t c o n c lu s io n to d ra w is t h a t th e b a n k b i l l fu tu r e s p ric e m u s t be c lo s e ly re la te d to c u r r e n t b i ll y ie ld s .

Financial futures on the Australian Securities Exchange: the 10-year Treasury bond futures contract21

1 7 .7

W h e re a s th e b a n k b ill c o n tra c t is s u ita b le f o r s p e c u la tio n , h e d g in g a n d a rb itra g e in s h o r t- te r m in te re s t ra te s, th e 1 0 -y e a r T re a s u ry b o n d c o n tra c t is d e s ig n e d f o r s im ila r o p e ra tio n s in v o lv in g lo n g -te rm in te r e s t ra te s.

17.7.1 | A brief review of bond pricing A b o n d pays a series o f eq u a l in te re s t p a y m e n ts a t eq ua l tim e in te rv a ls th r o u g h o u t its life . These p a y m e n ts are k n o w n as cou po ns. A t m a t u r ity th e face va lu e is re p a id . In A u s tra lia m o s t g o v e rn m e n t b o n d s pa y in te re s t tw ic e each year. B on ds can be b o u g h t a n d sold, a n d p rice s ris e a n d fa ll a c c o rd in g to m a rk e t forces. G ive n a b o n d p ric e i t is alw ays p o ssib le to calcula te th e y ie ld to m a tu r ity , w h ic h is s im p ly th e b o n d s in te r n a l ra te o f re tu rn . A lte rn a tiv e ly , g iv e n a re q u ire d y ie ld to m a tu r ity , a b o n d p ric e can alw ays be calcula ted. In A u s tra lia , i t is u s u a l to q u o te b o th c o u p o n in te re s t rates a n d y ie ld s o n an a n n u a l basis, even th o u g h a ll c a lc u la tio n s ta k e in to a c c o u n t th e fa c t t h a t cash flo w s are in fa c t h a lf-y e a rly . The a n n u a l rates are s im p ly d o u b le th e h a lf-y e a r rates. A s ta n d a rd b o n d -p ric in g f o rm u la is:

" w h e re

i [

(1

P =bond

+

〇

nJ

(1

+

17.13

i)n

p ric e

C = c o u p o n p a y m e n t p e r h a lf-y e a r z = h a lf-y e a rly y ie ld

n = n u m b e r o f h a lf-y e a rs V = face value

to m a t u r ity

E q u a tio n 1 7 .1 3 is illu s tra te d in E xa m p le 17.9.

Exam ple

17.9

C o n s id e r a b o n d w ith e x a c tly 3 y e a r s to m a tu rity , a fa c e v a lu e o f $ 1 0 0 a n d a c o u p o n in te re s t ra te o f 6 .6

p e r c e n t p e r a n n u m , p a y a b le h a lf-y e a rly . If th e r e q u ire d y ie ld is 7 . 2 p e r c e n t p e r a n n u m , w h a t is

th e p r ic e o f th e b o n d ?

SOLUTION T he h a lf- y e a r ly c o u p o n p a y m e n t is:

0.5 x $100x0.066 = $3.30

20 Details of these arbitrages are beyond the scope of this book. Briefly, in a cash-and-carry operation the investor simultaneously (on date zero) issues t-day bills, buys T-day bills and sells the futures contract. On date t, the bills held have become (T - t)-day bills and are delivered in order to settle the sold futures position; the sum received will be more than enough to pay out the maturing bills issued. In a reverse cash-and-carry operation the investor simultaneously (on date zero) issues T-day bills, buys t-day bills, and buys the futures contract. On date t, the funds from the maturing bills are used to buy the bills received under the terms of the futures contract. On date T, funds from the maturing bills held will be more than sufficient to pay out the maturing bills issued. 21 The 3-year Treasury bond futures contract is similar in concept and may be used in similar fashion to the 10-year contract.

C hapter seventeen Futures

contracts a n d swaps

The re q u ire d y ie ld p e r h a lf-y e a r is: 0.5 x 0 .0 7 2 = 0 .0 3 6 Using E quation 17.1 3 , the p ric e P is: p _ $ 3 .3 0 ^

1

0 .0 3 6 V

\ +

$100

(1.03 6)6 / + (1.03 6)6

= $ 1 7 .5 2 6 6 1 2 + $ 8 0 .8 8 0 0 6 1 = $ 9 8 .4 0 6 6 7 3

O b vio u sly, i f m a rk e t in te re s t rates fa ll, th e n so do re q u ire d yie ld s , a n d c o n s e q u e n tly b o n d p rice s rise. Conversely, i f y ie ld s rise, th e n b o n d p rice s fa ll.

1 7 .7 .2 1Specification of the 10-year bond futures contract 1 0 -yea r b o n d

The a b

fu tu re s c o n tra c t has th e fo llo w in g m a jo r fe a tu re s:

Contract unit. The c o n tra c t u n it is a 1 0 -y e a r g o v e rn m e n t b o n d a c o u p o n ra te o f 6 p e r c e n t p e r a n n u m (payable h a lf-y e a rly ), Settlement. The c o n tra c t is s e ttle d b y cash, n o t b y d e liv e ry . A ll

w it h a face va lu e o f $ 1 0 0 0 0 0 , o ffe rin g c o n tra c ts s t ill in existe nce a t th e close

o f tra d in g are closed o u t b y th e c le a rin g house. In e ffe c t th e c le a rin g h o u se assum es t h a t a ll tra d e rs have closed o u t. The p ric e use d to close o u t is a p ro x y m a rk e t p ric e , w h ic h is c a lc u la te d b y o b ta in in g fro m

10

b o n d dealers th e y ie ld a t w h ic h th e y w o u ld b u y a n d se ll b o n d s o n a b a s k e t o f m a tu r itie s set

d o w n in advance b y th e exchange. The tw o h ig h e s t b u y in g y ie ld s a n d th e tw o lo w e s t s e llin g y ie ld s are discard ed a n d th e re m a in in g y ie ld s are averaged. T his average y ie ld is th e n c o n v e rte d to a s e ttle m e n t pric e u s in g E q u a tio n 1 7 .1 3 , th e b o n d -p ric in g fo rm u la . C

Quotations. L ik e

th e b a n k b i ll c o n tra c t, th e b o n d c o n tra c t is q u o te d as 1 0 0 m in u s th e a n n u a l

percentage y ie ld , b u t has a m in im u m flu c tu a tio n o f 0 .0 0 5 . d

Termination of trading. T ra d in g

ceases a t 12 n o o n o n th e f ifte e n th day o f th e c o n tra c t m o n th , o r th e

n e x t tra d in g day i f t h a t is n o t a bu sin ess day. S e ttle m e n t d a y is th e b u sin e ss day fo llo w in g th e date on w h ic h tra d in g ceases. To illu s tra te th e p r ic in g o f th e 1 0 -y e a r b o n d fu tu re s c o n tra c t, c o n s id e r th e p ric e o f 9 6 .0 1 f o r th e D ecem ber (2 0 1 3 ) 1 0 -y e a r b o n d fu tu re s c o n tra c t p ro v id e d o n th e A u s tra lia n S e cu ritie s E xchange w ebsite a fte r th e close o f tra d in g o n 4 O c to b e r 2 0 1 3 . The im p lie d y ie ld is 1 0 0 - 9 6 .0 1 = 3 .9 9 p e r c e n t p e r a n n u m , o r 1 .9 9 5 p e r c e n t p e r h a lf-y e a r. The face va lu e is $ 1 0 0 0 0 0 . The h a lf-y e a rly co u p o n ra te is 0.5 x

6

p e r ce n t = 3 p e r cen t. T h e re fo re , each c o u p o n p a y m e n t is $ 3 0 0 0 . The te r m is 10 years, o r 20 h a lf-y e a rs . U sin g E q u a tio n 1 7 .1 3 , th e d o lla r p rice , P, im p lic it in th is fu tu re s p ric e is:

1

$3000 0.01995

\

(1.0 19 9 5 )20/

$10 0 000 (1.0 19 9 5 )20

= $ 4 9 077.98 + $ 6 7 3 6 3 .1 4 = $ 1 1 6 4 4 1 .1 2 I t is clear th a t, w h e n u s in g E q u a tio n 1 7 .1 3 f o r th e 1 0 -y e a r b o n d fu tu re s c o n tra c t, C is alw ays $ 3 0 0 0 and

V is

alw ays $ 1 0 0 000.

m

1 7 .7 .3 1 Uses of the 10-year bond futures contract The 1 0 -ye a r b o n d fu tu re s c o n tra c t can be used in s im ila r w ays to th o s e e x p la in e d f o r th e b a n k b ill c o n tra c t an d th e re fo re we do n o t e x p la in the se w ays in f u ll d e ta il.

Speculation with 10-year bond futures As always, sp e cu la to rs are h o p in g to p r o f it b y c o rre c tly a n tic ip a tin g p ric e changes. F o r e xa m p le , i f a lo n g p o s itio n is e n te re d in to a t a fu tu re s p ric e o f 9 6 .0 1 a n d re ve rse d o u t a t 9 6 .0 6 , a g a in is m ade. As s h o w n in

LEARNING OBJECTIVE 7 Explain speculation and hedging strategies using the major financial futures contracts traded on the Australian Securities Exchange

th e p re v io u s c a lc u la tio n s , a fu tu re s p ric e o f 9 6 .0 1 c o rre sp o n d s to a d o lla r p ric e o f $ 1 1 6 4 4 1 .1 2 . A p ric e o f 9 6 .0 6

co rre s p o n d s to a h a lf-y e a rly y ie ld o f 1 .9 7 p e r c e n t a n d hence to a d o lla r p ric e o f: _ $3000

1

$100 000

(1.01 97 )20

(1 .0 1 9 7 )20

} _

0.0197 = $ 1 1 6 8 9 0 .8 4

The g a in is th e re fo re $ 1 1 6 8 9 0 .8 4 - $ 1 1 6 4 4 1 .1 2 = $ 4 4 9 .7 2 .

Hedging with 10-year bond futures The 1 0 -y e a r b o n d fu tu re s c o n tra c t can be a u s e fu l h e d g in g in s tr u m e n t w h e re th e re is an e x p o su re to cha ng es in lo n g - te r m fix e d in te r e s t ra te s. F o r e x a m p le , an in v e s to r w h o h o ld s lo n g - te r m b o n d s o r d e b e n tu re s w i ll s u ffe r a c a p ita l lo ss i f y ie ld s in cre a se . Such a n in v e s to r m ig h t c o n s id e r s e llin g b o n d fu tu re s . S im ila rly , a c o m p a n y t h a t p la n s to b o r r o w fu n d s in th e f u t u r e o n a lo n g - te r m fix e d in te r e s t ba sis w i ll lo se i f y ie ld s in c re a s e b e fo re th e fu n d s are b o rro w e d . A g a in , s e llin g b o n d fu tu re s c o u ld be c o n s id e re d . A lte r n a tiv e ly , an in v e s to r w h o p la n s to b u y b o n d s , o r a c o m p a n y t h a t has issu e d d e b e n tu re s b u t is p la n n in g to re p u rc h a s e th e m , c o u ld c o n s id e r b u y in g b o n d fu tu re s . These are e s s e n tia lly s tr a ig h tfo r w a r d a p p lic a tio n s , as d e m o n s tra te d in E x a m p le 1 7 .1 0 .

Exam ple

17.

W a n t d o u g h Ltd is c o m m itte d to is s u in g 7 -y e a r, 8 p e r c e n t p e r a n n u m d e b e n tu re s in 2 m o n th s 7 tim e a n d p la n s to b o r r o w $ 5 m illio n . T he d e b e n tu re s w ill p a y in te re s t tw ic e p e r a n n u m . W a n t d o u g h d e c id e s to h e d g e u s in g fu tu re s c o n tra c ts o n 1 0 -y e a r g o v e r n m e n t b o n d s . T hese a r e c u r r e n tly p r ic e d a t 9 5 . 0 0 . W a n t d o u g h a ssu m e s th a t a n x p e r c e n t c h a n g e in th e fu tu re s y ie ld w ill b e m a tc h e d b y a n x p e r c e n t c h a n g e in th e r e q u ire d ra te o f re tu rn o n its d e b e n tu re s . T h e p r o b le m is to d e s ig n a s u ita b le h e d g e .

SOLUTION W a n td o u g h sells 1 0 -y e a r b o n d fu tu re s. It w ill still e n c o u n te r b a s is risk a n d it a ls o fa c e s s p e c ific a tio n d iffe re n c e s in th a t th e re a re im p o r ta n t d iffe re n c e s b e tw e e n 1 0 -y e a r 6 p e r c e n t g o v e rn m e n t b o n d s a n d 7 -y e a r 8 p e r c e n t c o m p a n y d e b e n tu re s . N o t m u ch c a n b e d o n e a b o u t b a s is risk, b u t risks s te m m in g fro m s p e c ific a tio n d iffe re n c e s c a n b e p a r tly c o n tro lle d b y c a r e fu lly s e le c tin g th e n u m b e r o f fu tu re s c o n tra c ts to b e s o ld . S u p p o s e th a t th e fu tu re s p ric e fa lls fro m 9 5 . 0 0 to 9 4 . 0 0 , d u e to , say, a 1 p e r c e n t rise in c u rre n t y ie ld s o n g o v e rn m e n t b o n d s . U s in g E q u a tio n 1 7 . 1 3 , th e c o n tra c t v a lu e w o u ld fa ll b y $ 7 7 9 4 . 5 8 (fro m $ 1 0 7 7 9 4 . 5 8 to $ 1 0 0 0 0 0 ) . N o w s u p p o s e th a t, s im u lta n e o u s ly , th e re q u ire d y ie ld o n th e d e b e n tu re s a ls o rise s b y 1 p e r c e n t fro m 8 p e r c e n t p e r a n n u m to 9 p e r c e n t p e r a n n u m . U s in g E q u a tio n 1 7 . 1 3 , a n d a s s u m in g th a t th e p r o p o s e d c o u p o n ra te o f 8 p e r c e n t is m a in ta in e d , th e fu n d s ra is e d w o u ld b e :

$200000 0 .0 4 5

1 ______ 1_ [

(1 .0 4 5 )14

$5 0 0 0 0 0 0 (1 .0 4 5 )14

= $ 4 7 4 4 4 2 9 .3 7 T h e re fo re , th e re w o u ld b e a s h o rtfa ll o f $ 2 5 5 5 7 0 . 6 3 . T he n u m b e r o f c o n tra c ts r e q u ire d to h e d g e th is s h o r tfa ll w o u ld th e re fo re b e :

$ 2 5 5 5 7 0 .6 3 $ 7 7 9 4 .5 8 = 3 3 contracts T h e re fo re , W a n t d o u g h s h o u ld sell 3 3 fu tu re s c o n tra c ts .

The use o f 1 0 -ye a r b o n d fu tu re s c o n tra c ts f o r a h e d g in g p u rp o s e is illu s tra te d in E x a m p le 1 7 .1 1 , w h ic h is a c o n tin u a tio n o f E xa m p le 17 .10.

Exam ple

1 7 .1 1

S u p p o s e th a t W a n t d o u g h sells 3 3 b o n d fu tu re s c o n tra c ts a t th e c u r r e n t fu tu re s p r ic e o f 9 5 . 0 0 a n d th a t w h e n th e d e b e n tu re s a r e issu e d th e fu tu re s p r ic e is 9 4 . 5 8 a n d th e r e q u ire d y ie ld o n th e d e b e n tu re s is 8 .5 0

p e r c e n t p e r a n n u m . T h e p r o b le m is to assess th e e ffe c tiv e n e s s o f th e h e d g e .

C hapter seventeen Futures

contracts a n d swaps

SOLUTION U s in g E q u a tio n 1 7 . 1 3 , th e c h a n g e in th e fu tu re s p r ic e is $ 3 3 6 2 . 1 3 p e r c o n tra c t, g iv in g a p r o fit o f $1 1 0 9 5 0 fro m 3 3 c o n tra c ts . A g a in , u s in g E q u a tio n

1 7 . 1 3 , if th e r e q u ire d y ie ld is 8 . 5 0 p e r c e n t

p e r a n n u m ( 4 . 2 5 p e r c e n t p e r h a lf-y e a r), th e n 7 - y e a r d e b e n tu re s w ith a fa c e v a lu e o f $ 5 m illio n o ffe r in g a c o u p o n ra te o f 4 p e r c e n t p e r h a lf-y e a r w ill ra is e $ 4 8 7 0 1 1 4 , th e re b y g iv in g a g ro s s s h o rtfa ll o f $ 1 2 9 8 8 6 . A fte r ta k in g a c c o u n t o f th e p r o fit o n fu tu re s , th e n e t s h o rtfa ll is $ 1 8 9 3 6 . T h e re fo re , th e fu tu re s h e d g e h a s e lim in a te d m o re th a n 8 5 p e r c e n t o f th e s h o rtfa ll th a t o th e r w is e w o u ld h a v e o c c u r r e d . M o s t o f th e o th e r 1 5 p e r c e n t is d u e to th e fa c t th a t, w h ile th e fu tu re s p ric e changed b y 0 .4 2

(fro m 9 5 . 0 0 to 9 4 . 5 8 ) , th e d e b e n tu re y ie ld c h a n g e d b y 0 . 5 0

p e r c e n t (fro m

8 . 0 0 p e r c e n t to 8 . 5 0 p e r c e n t). A s d is c u s s e d in E x a m p le 1 7 . 1 0 , W a n t d o u g h 's a s s u m p tio n w a s o n e fo r o n e : if th e d e b e n tu re y ie ld c h a n g e d b y o n e p e r c e n ta g e p o in t th e fu tu re s y ie ld w o u ld a ls o c h a n g e b y o n e p e rc e n ta g e p o in t. H a d th e r e q u ire d d e b e n tu re y ie ld c h a n g e d to 8 . 4 2 p e r c e n t (in s te a d o f to 8 .5 0

p e r ce n t) th e g ro s s fu n d s s h o rtfa ll w o u ld h a v e b e e n $ 1 0 9 3 9 1

a n d th e re w o u ld th e n h a v e b e e n

a s m a ll n e t g a in o f $ 1 5 5 9 . The d e ta il o f the se c a lc u la tio n s is less im p o r ta n t th a n th e re c o g n itio n th a t it is n o t c o rre c t s im p ly to h e d g e th e fa c e v a lu e . H a d th is b e e n d o n e , 5 0 fu tu re s c o n tra c ts w o u ld h a v e b e e n s o ld (b e c a u s e $ 5 0 0 0 0 0 0 / $ ! 0 0 0 0 0 = 5 0 ) . T his w o u ld h a v e e x p o s e d th e c o m p a n y to n e t losses if y ie ld s h a d fa lle n .

17.8

Financial futures on the Australian Securities Exchange: the 30-day interbank cash rate futures contract

The 3 0 -d a y in te rb a n k cash ra te fu tu re s c o n tra c t has th e fo llo w in g m a jo r fe a tu re s: a

Contract unit. The c o n tra c t u n it is th e average m o n th ly in te rb a n k o v e rn ig h t cash ra te payable o n a n o tio n a l su m o f $3 0 0 0 0 0 0 . T h e re fo re , a 0 .0 1 p e r c e n t increase (decrease) in th e cash ra te w ill re s u lt in an in crea sed (decreased) in te re s t p a y m e n t o f $3 0 0 0 0 0 0 x 0 .0 0 0 1 x (3 0 /3 6 5 ) = $ 2 4 .6 5 7 5 . This a m o u n t is ro u n d e d to $ 2 4 .6 6 .

b

Settlement. The c o n tra c t is s e ttle d b y cash. A ll c o n tra c ts s t ill in existe nce a t th e close o f tra d in g are closed o u t b y th e c le a rin g house. The cash s e ttle m e n t p ric e is e q u a l to 1 0 0 m in u s th e m o n th ly average o f th e in te rb a n k o v e rn ig h t cash ra te f o r th e c o n tra c t m o n th . The m o n th ly average is fo u n d b y ta k in g th e su m o f th e d a ily in te rb a n k o v e rn ig h t cash rates, as p u b lis h e d b y th e R eserve B a n k o f A u s tra lia , a n d d iv id in g b y th e n u m b e r o f days f o r t h a t m o n th .22

c

Quotations. The 3 0 -d a y in te r b a n k cash ra te c o n tra c t is q u o te d as 1 0 0 m in u s th e cash s e ttle m e n t ra te an d has a m in im u m flu c tu a tio n o f 0 .0 0 5 .

d

Termination o f trading. T ra d in g ceases a t 4 :3 0 p m o n th e la s t bu sin ess d a y o f th e c o n tra c t m o n th . S e ttle m e n t da y is th e second bu sin ess d a y a fte r th e la s t tra d in g day. L ike th e b a n k b ill c o n tra c t, th is c o n tra c t is s u ita b le f o r s p e c u la tio n , h e d g in g a n d a rb itra g e in s h o rt­

te rm in te re s t rates. S p e c u la tio n u s in g th e 3 0 -d a y in te rb a n k cash ra te c o n tra c t is illu s tra te d in E xa m p le 17 .12.

Exam ple

17.

O n 2 6 J u ly 2 0 1 3 , th e c lo s in g p r ic e o f th e A u g u s t 2 0 1 3 3 0 - d a y in te r b a n k c a s h ra te c o n tra c t w a s 9 7 . 4 0 . T h is e q u a te s to a n a v e r a g e o v e r n ig h t c a s h ra te o f 2 . 6 0 p e r c e n t. T h e R e se rve B a n k o f A u s tr a lia

6^

(RBA) h a d a b o a r d m e e tin g s c h e d u le d fo r 6 A u g u s t 2 0 1 3 a n d th e c u r r e n t o v e r n ig h t c a s h ra te w a s 2 . 7 5 p e r c e n t p e r a n n u m . S u p p o s e L a u ra b e lie v e d th a t th e R BA w o u ld m a k e th e d e c is io n to d e c re a s e

continued 22 Note that although the contract s title refers to the ^O-day interbank cash rate1, its price is calculated by reference to the average cash rate over the whole expiry month of the contract. For example, a contract expiring in August will have a settlement price determined over the 31 days of August.

4^^

B usiness finance

continued in te re s t ra te s to 2 . 5 0 p e r c e n t a t its 6 A u g u s t 2 0 1 3 m e e tin g . S he th e re fo re d e c id e d to b u y 2 0 0 3 0 - d a y in te r b a n k c a s h ra te c o n tra c ts o n 2 6 July. A t its m e e tin g o n 6 A u g u s t th e R BA d e c re a s e d th e c a s h ra te to 2 . 5 0 p e r c e n t a n d o n th a t d a y th e c lo s in g p r ic e o f th e A u g u s t 2 0 1 3 3 0 - d a y c a s h ra te c o n tr a c t w a s 9 7 . 4 5 5 . If L a u ra re v e rs e d o u t h e r p o s itio n o n 6 A u g u s t, h e r to ta l g a in c o u ld b e c a lc u la te d a s fo llo w s : N o t io n a l p u rc h a s e a t: 2 0 0 x 9 7 . 4 0 x $ 2 4 . 6 6 = $ 4 8 0 3 7 6 . 8 0 (o u tflo w ) N o t io n a l s a le a t: 2 0 0 x 9 7 . 4 5 5 x $ 2 4 . 6 6

= $ 4 8 0 6 4 8 . 0 6 (in flo w )

G a in (n e t in flo w ) : A s d e t a ile d

$ 2 7 1 .2 6

o n th e A u s t r a lia n

S e c u ritie s E x c h a n g e w e b s ite , th is c o n t r a c t m a y a ls o b e u s e d

to fo r e c a s t c h a n g e s in th e R B A t a r g e t c a s h ra te . F o r e x a m p le , a s n o te d a b o v e , th e R B A h a d a s c h e d u le d b o a r d

m e e tin g o n 6 A u g u s t 2 0 1 3

a n d o n 2 6 J u ly 2 0 1 3

th e c lo s in g

p r ic e o f th e

3 0 - d a y c a s h r a te c o n t r a c t w a s 9 7 . 4 0 , e q u a tin g to a y ie ld o f 2 . 6 0 p e r c e n t p e r a n n u m . T h e re fo re , th e e x p e c t e d a v e r a g e t a r g e t c a s h r a te f o r th e 3 1

days o f August 2 0 1 3

im p lie d b y th e 3 0 - d a y

I n te r b a n k C a s h R a te F u tu re s C o n t r a c t w a s 2 . 6 0 p e r c e n t p e r a n n u m . S u p p o s e w e a s s u m e th a t th e R B A d e c is io n w a s e ith e r to le a v e th e t a r g e t c a s h r a te u n c h a n g e d a t 2 . 7 5 p e r c e n t p e r a n n u m o r d e c r e a s e it to 2 . 5 0 p e r c e n t p e r a n n u m . T h e n a s a t 2 6 J u ly w e k n o w (o r m ig h t a s s u m e ) th e f o llo w in g in fo r m a t io n : •

T he e x p e c te d a v e r a g e ta r g e t c a s h ra te f o r th e 31

days o f A ugust 2 0 1 3

is 2 . 6 0 p e r c e n t p e r

annum . •

T he ta r g e t c a s h ra te f o r 6 d a y s (fro m 1 A u g u s t to 6 A u g u s t) w ill b e 2 . 7 5 p e r c e n t p e r a n n u m .

•

T h e t a r g e t c a s h ra te f o r th e 2 5 d a y s fro m 7 A u g u s t to 3 1 A u g u s t w o u ld b e e ith e r 2 . 5 0 o r 2 . 7 5 per cent per annum . T he p r o b a b ilit y o f ra te s r e m a in in g u n c h a n g e d (p) m a y th e re fo r e b e c a lc u la te d a s:

(

吾 ）X 2.75+ [ p x ( 菩 )

X 2 . 75 + ( l - p l x

信

) X 2.50] =2.60

T h e re fo re , o n 2 6 J u ly 2 0 1 3 th e im p lie d p r o b a b ilit y o f a c h a n g e in th e ta r g e t c a s h ra te (1 — p ) w a s 7 4 p e r c e n t.23,24

17.9 Financial futures on the Australian LEARNING OBJECTIVE 6 Understand and explain the features of the major financial futures contracts traded on the Australian Securities Exchange

Securities Exchange: the share price index S&P/ASX 2 0 0 (SPI 200) futures contract 17.9.1 | A brief review of Australian Securities Exchange indices The A u s tr a lia n S e c u ritie s E xch a n g e (A S X ) c a lc u la te s a n u m b e r o f in d ic e s t h a t p ro v id e s u m m a ry m e a su re s o f th e m o v e m e n t o f sha re p ric e s . In a d d itio n to in d u s tr y - s p e c ific in d ic e s , in d ic e s are c a lc u la te d to p ro v id e m ea sure s o f m a rk e t-w id e m o v e m e n ts . M o v e m e n ts in th e se in d ic e s p ro v id e a c le a r in d ic a t io n o f m o v e m e n ts in th e g e n e ra l le v e l o f sh a re p ric e s . C o n s e q u e n tly , th e p e rc e n ta g e change

23 It may also be seen that the closing price of the August 2013 30-day cash rate contract of 97.45 on 6 August 2013, after the RBA Board had met, reflected an expected average target cash rate for the 31 days of August 2013 of 100 - 97.45 or 2.55 per cent. This figure equates to a cash rate of 2.75 per cent for the first 6 days of August and an expected cash rate of 2.50 per cent for the remaining 25 days. 24 The approach of using the 30-day interbank cash rate in the manner suggested by the Australian Securities Exchange (see www.asx.com.au/prices/targetratetracker.htm) to predict changes in the RBA cash rate can be overly simplistic, as demonstrated by Easton and Pinder (2007).

4^^

C hapter seventeen Futures

contracts a n d swaps

in th e in d e x is lik e ly to a p p ro x im a te c lo s e ly th e p e rc e n ta g e cha ng e in th e v a lu e o f a w e ll-d iv e rs ifie d p o r tf o lio o f A u s tr a lia n lis te d shares. O n e su ch in d e x is th e A ll O rd in a rie s In d e x . T h is in d e x is ba sed o n an average o f th e sha re p ric e s o f th e 5 0 0 la rg e s t c o m p a n ie s (as m e a s u re d b y m a rk e t c a p ita lis a tio n ) t h a t are lis te d o n th e A SX. The sh a re p ric e in d e x fu tu re s c o n tra c t t h a t is tra d e d o n th e A S X is based o n th e S & P /A S X 2 0 0 In d e x (SPI 2 0 0 ). T h is in d e x is ba se d o n an average o f th e sha re p ric e s o f th e 2 0 0 co m p a n ie s lis te d o n th e A S X t h a t ha ve th e la rg e s t m a r k e t c a p ita lis a tio n a n d th e h ig h e s t v o lu m e o f shares tra d e d .25

1 7.9.2! Specification of the S&P/ASX 200 futures contract The S & P /A S X 2 0 0 (SPI 2 0 0 ) fu tu re s c o n tra c t has th e fo llo w in g m a jo r fea tu res: a b

Contract unit. The c o n tra c t u n it is th e v a lu e o f th e S & P /A S X 2 0 0 In d e x , m u ltip lie d b y $25. Settlement. The c o n tra c t is n o t d e live ra b le . A ll c o n tra c ts s t ill in existe nce a t th e close o f tra d in g

are

closed o u t b y th e c le a rin g ho use a t th e re le v a n t in d e x v alue , ca lcu la te d to one d e c im a l place. The cash s e ttle m e n t p ric e is th e ‘spe cia l o p e n in g q u o ta tio n ’ o f th e S & P /A S X 2 0 0 In d e x o n th e la s t tra d in g day. This special o p e n in g q u o ta tio n is c a lc u la te d u s in g th e f ir s t tra d e d p ric e o f each c o m p o n e n t share o f th e in d e x o n th e la s t tra d in g day. c

Quotations. The

c o n tra c t is q u o te d as th e v a lu e o f th e S & P /A S X 2 0 0 In d e x . I t is q u o te d to one f u ll

in d e x p o in t. d

Termination of trading. T ra d in g

ceases a t 12 n o o n o n th e t h ir d T h u rsd a y o f th e c o n tra c t m o n th .

S e ttle m e n t day is th e f ir s t b u sin e ss d a y fo llo w in g th e cessa tion o f tra d in g . F o r exam ple, th e p ric e o f th e D e ce m b e r (2 0 1 3 ) SPI 2 0 0 c o n tra c t p ro v id e d o n th e A u s tra lia n S e c u ritie s Exchange w e b s ite a fte r th e close o f tra d in g o n 4 O c to b e r 2 0 1 3 was 5 2 0 4 . T his m ea ns t h a t in d o lla r te rm s th e c o n tra c t p ric e o n 4 O c to b e r 2 0 1 3 was 5 2 0 4 x $ 2 5 = $ 1 3 0 1 0 0 .

17.9.3! Uses of the S&P/ASX 200 futures contract Speculation with SPI 2 0 0 futures Because th e SPI 20 0 fu tu re s p ric e is h ig h ly c o rre la te d w it h th e S & P /A S X 2 0 0 In d e x , i t is a s im p le m a tte r to use SPI 20 0 fu tu re s f o r s p e c u la tiv e p u rp o se s. T his is illu s tra te d in E xa m p le 1 7 .1 3 .

Exam ple

LEARNING OBJECTIVE 7 Explain speculation and hedging strategies using the major financial futures contracts traded on the Australian Securities Exchange

17.13

O n 4 O c to b e r 2 0 1 3 th e S & P /A S X 2 0 0 In d e x c lo s e d a t 5 2 0 8 a n d th e D e c e m b e r ( 2 0 1 3 ) SPI 2 0 0 fu tu re s p ric e w a s 5 2 0 4 . S u p p o s e th a t a s p e c u la to r b e lie v e s th a t s h a re p ric e s a r e lik e ly to ris e in th e fo llo w in g d a y s a n d sh e th e re fo r e d e c id e s to b u y D e c e m b e r SPI 2 0 0 fu tu re s . O n 2 4 O c t o b e r 2 0 1 3 th e s p e c u la to r fin d s th a t th e S & P /A S X 2 0 0 In d e x h a s ris e n to 5 3 7 3 a n d th e D e c e m b e r SPI 2 0 0 fu tu re s p r ic e h a s ris e n to 5 3 6 9 . T h e p o s itio n is re v e rs e d o u t b y ta k in g a s o ld p o s itio n a t 5 3 6 9 . A lth o u g h th e s p e c u la to r ’s g a in h a s a c c r u e d o v e r tim e b y a p p lic a t io n o f th e m a rk -to -m a rk e t ru le , th e to ta l g a in c a n b e c a lc u la te d a s fo llo w s : N o tio n a l p u rc h a s e a t: 5 2 0 4 x $ 2 5 = $ 1 3 0 1 0 0 (o u tflo w ) N o tio n a l s a le a t: G a in (ne t in flo w ) :

5 3 6 9 x $ 2 5 = $ 1 3 4 2 2 5 (in flo w ) $

4125

Hedging with SPI 2 0 0 futures A lth o u g h s p e c u la tio n is th e m o s t o b v io u s a p p lic a tio n o f SPI 2 0 0 fu tu re s , th e re are also h e d g in g uses. E xam p le 1 7 .1 4 p ro v id e s a s im p le a p p lic a tio n .26

25 Details of the indices calculated by the Australian Securities Exchange may be obtained from the Australian Securities Exchange website www.asx.com.au. 26 For a more advanced discussion, see Figlewski and Kon (1982).

4^^

Exam ple

17.

M ic h a e l S a in t m a n a g e s a p o r tf o lio o f A u s tr a lia n s h a re s w ith a c u rre n t m a rk e t v a lu e o f $ 1 5 1 0 7 0 0 0 . T he p o r t f o lio is to b e s o ld in 4 w e e k s ' tim e . T h e SPI 2 0 0 fu tu re s p r ic e t o d a y is 5 4 2 1 . T he fo llo w in g tw o p r o b le m s a re re le v a n t: a) b)

S a in t re q u ire s a s s is ta n c e in d e s ig n in g a n a p p r o p r ia te h e d g e . Later, th e p o r tf o lio is s o ld f o r $ 1 4 4 4 4 5 0 0 a n d th e fu tu re s p o s itio n is re v e rs e d o u t a t a p r ic e o f 5 1 5 9 . S a in t w is h e s to assess th e e ffe c tiv e n e s s o f th e h e d g e .

SOLUTION P o s s ib le s o lu tio n s to th e se p ro b le m s a r e a s fo llo w s : a)

T he fu tu re s p r ic e a t th e in itia tio n o f th e h e d g e is 5 4 2 1 x $ 2 5 = $ 1 3 5 5 2 5 . To d e s ig n a h e d g e , so m e a s s u m p tio n s m ust b e m a d e a b o u t th e re la tio n s h ip b e tw e e n c h a n g e s in th e v a lu e o f th e p o r tf o lio a n d c h a n g e s in th e SPI 2 0 0 fu tu re s p r ic e . F o r e x a m p le , it m ig h t b e a s s u m e d th a t p r o p o r tio n a te c h a n g e s in th e p o r tf o lio 's v a lu e w o u ld b e m a tc h e d b y p r o p o r tio n a t e c h a n g e s in th e fu tu re s p ric e . In o th e r w o r d s , in d e s ig n in g th is h e d g e it is a s s u m e d th a t if th e p o r tf o lio 's v a lu e d e c re a s e s b y x p e r c e n t, th e n so a ls o w ill th e SPI 2 0 0 fu tu re s p r ic e d e c re a s e b y x p e r c e n t. U s in g E q u a tio n 1 7 . 9 , th e n u m b e r o f fu tu re s c o n tra c ts in d ic a te d is:

f* _ Ns so - n 'fTo v a lu e o f s p o t p o s itio n v a lu e o f o n e fu tu re s c o n tra c t _ $15107000 =5421

x $25

= - l 1 1 .4 7

%-111 T h a t is, 1 1 1 fu tu re s c o n tra c ts s h o u ld b e s o ld , b) T h e e ffe c tiv e n e s s o f th e h e d g e is s u m m a ris e d in T a b le 1 7 . 1 1 . TABLE

1 7 .1 1

H e d g in g o u t c o m e in E x a m p le

D a te

1 7 .1 4

SPI 2 0 0 fu tu re s p ric e

SPI 2 0 0 fu tu re s p r ic e fo r

P o rtfo lio v a lu e

p e r c o n tra c t (in d e x

111 c o n tra c ts

($ )

fo rm )

($)

W h e n hedge entered

5421 (sold)

15 043 275

15107000

W h e n hedge lifte d

5159 (bo ug ht)

14316225

14444500

G ain (loss)

727050

(6 6 2 5 0 0 )

T h e re fo re th e h e d g e h a s , in fa c t, re s u lte d in a n e t g a in o f: $727050 - $662500 = $64550 T h e re a r e t w o re a s o n s w h y th e re s u lt is n o t p re c is e ly z e r o . First, th e n u m b e r o f c o n tra c ts s o ld w a s 1 1 1 n o t 1 1 1 . 4 7 . H o w e v e r, th is is a m in o r f a c to r in th is e x a m p le . If it h a d b e e n p o s s ib le to sell 1 1 1 . 4 7 c o n tra c ts th e n e t g a in w o u ld in fa c t h a v e b e e n $ 6 7 6 2 8 . 5 0 . S e c o n d , w h ile th e p o r tf o lio v a lu e d e c re a s e d b y 4 . 3 9 p e r c e n t, th e SPI 2 0 0 fu tu re s p r ic e d e c re a s e d b y 4 . 8 3 p e r c e n t. T h e re fo re , th e loss o n th e p o r tf o lio w a s m o re th a n o ffs e t b y th e g a in o n th e s o ld fu tu re s c o n tra c ts . T h e re a r e t w o fa c to rs th a t a re lik e ly to e x p la in th e d iffe re n c e b e tw e e n th e fu tu re s p r ic e fa ll o f 4 . 8 3 p e r c e n t a n d th e p o r tf o lio fa ll o f 4 . 3 9 p e r c e n t. T h e se a r e b a s is ris k a n d s p e c ific a tio n d iffe re n c e s b e tw e e n th e c o m p o s itio n o f th e S & P /A S X 2 0 0 In d e x a n d th e c o m p o s itio n o f M ic h a e l S a in t's p o r tf o lio . In c lu d e d in th e la tte r is th e p o s s ib ility o f d iv id e n d s b e in g r e c e iv e d , w h e r e a s th e S & P /A S X 2 0 0 In d e x d o e s n o t in c lu d e re in v e s te d d iv id e n d s .

C hapter seventeen Futures

contracts a n d swaps

O b v io u s ly , it is f a ir ly c ru d e to a s s u m e th a t th e re w ill b e e q u a l p r o p o r tio n a t e c h a n g e s in th e p o r tfo lio 's v a lu e a n d th e SPI 2 0 0 fu tu re s p r ic e . A s lig h tly m o re s o p h is tic a te d a p p r o a c h is to a p p ly E q u a tio n 1 7 7 , w h ic h g iv e s th e ris k -m in im is in g h e d g e r a tio , h *:

C o v IS ^ ^ ) V a rlM In th e c a s e o f SPI 2 0 0 fu tu re s , E q u a tio n 1 7 . 7 is m o re r e c o g n is a b le if re w ritte n a s:

C ow(Rp ,R f )

Wqt[Rf) w h e re Rp = re tu rn s o n th e h e d g e r s p o r tf o lio o f sh a re s

Rp = re tu rn s o n th e SPI 2 0 0 fu tu re s c o n tra c t A n e s tim a te o f h * is fo u n d b y p e r fo r m in g th e re g re s s io n : R p t = Q p + P p R p f + fJf

17.14

T he e s tim a te p p is a n e s tim a te o f h * . N o te th a t w h ile p p w ill b e o f th e s a m e o r d e r o f m a g n itu d e as th e a s s e t 'b e ta s 7 w e d is c u s s e d in C h a p te r 7 , th e h e d g in g b e ta in E q u a tio n 1 7 . 1 4 is a d iffe re n t c o n c e p t. A h e d g in g b e ta is e s tim a te d b y re g re s s in g p o r tf o lio re tu rn s o n SPI 2 0 0 fu tu re s ; a n a sse t b e ta is e s tim a te d b y re g re s s in g p o r tf o lio re tu rn s o n th e S & P /A S X 2 0 0 In d e x itse lf.

BARINGS______________________________________________________

F in a n c e in

A C T IO N

A w e ll- d o c u m e n te d c a s e o f e x t r a o r d in a r y s p e c u la tio n is t h a t o f th e 2 4 0 - y e a r - o ld B ritis h b a n k , B a rin g s , th a t c o lla p s e d in 1 9 9 5 d u e to th e lo sses in c u r r e d b y th e S in g a p o r e - b a s e d t r a d e r N ic k L e e s o n .27 N ic k L e e s o n g a in e d a p o w e r f u l r e p u t a t io n w it h in th e b a n k b y a p p a r e n t ly g e n e r a t in g m a s s iv e p r o fits . H e d id th is b y b u y in g J a p a n e s e s to c k in d e x fu tu re s c o n t r a c t s t h a t w e r e t r a d e d o n th e S in g a p o r e I n t e r n a t io n a l M o n e t a r y E x c h a n g e (S IM E X ) a n d s im u lt a n e o u s ly s e llin g c o n t r a c t s w ith id e n t ic a l s p e c if ic a tio n s o n th e O s a k a E x c h a n g e . T h is a r b it r a g e a c t iv it y in v o lv e s little ris k a n d w o u ld b e e x p e c t e d to g e n e r a t e a n u m b e r o f s m a ll g a in s a n d s m a ll lo s s e s r e s u ltin g fr o m s lig h t d iff e r e n c e s in th e p r ic e s o f th e c o n t r a c t o n th e t w o e x c h a n g e s . H o w e v e r , L e e s o n w a s a b le to h id e h is lo s s e s in a s p e c ia l a c c o u n t. A s a r e s u lt, it a p p e a r e d t h a t h e w a s g e n e r a t in g h u g e p r o fits . F o r e x a m p le , in 1 9 9 4 h e r e p o r t e d p r o fits o f £ 2 8 m illio n b u t h a d h id d e n lo s s e s o f £ 1 8 0 m illio n . In e a r ly 1 9 9 5 , L e e s o n e s t a b lis h e d lo n g p o s it io n s in th e J a p a n e s e s to c k in d e x fu tu re s c o n t r a c t . T h is m e a n t t h a t h e w o u ld p r o f it if th e J a p a n e s e s to c k m a r k e t ro s e . H o w e v e r , o n 1 7 J a n u a r y 1 9 9 5 a n e a r t h q u a k e h it th e J a p a n e s e c it y o f K o b e a n d th e J a p a n e s e s to c k m a r k e t fe ll b y a p p r o x im a t e ly 1 3 p e r c e n t o v e r th e n e x t 5 w e e k s . L e e s o n t r ie d to r e c o v e r th e r e s u lta n t lo s s e s b y t a k in g m o r e lo n g p o s it io n s in th e J a p a n e s e s to c k in d e x fu tu re s c o n t r a c t a n d a t o n e p o in t in m id - F e b r u a r y h e h a d e n t e r e d b o u g h t p o s it io n s t o th e v a lu e o f U S $ 3 b illio n . O n 1 3 F e b r u a r y 1 9 9 5 , a n in v e s t ig a t io n s o f f ic e r a r r iv e d fr o m L o n d o n c h a r g e d w it h th e ta s k o f f in d in g o u t w h y th e b a n k w a s b e in g r e q u ir e d to m a k e m a r g in c a lls o n th e s e fu tu r e s c o n t r a c t s th a t h a d n o w r e a c h e d e x t r a o r d i n a r y a m o u n ts . O n 2 3 F e b r u a r y , h e s p o k e w it h L e e s o n , w h o f le d S in g a p o r e th e n e x t d a y , le a v in g b e h in d lo s s e s o f a r o u n d U S $ 1 . 4 b illio n .

27 For details of the collapse of Barings Bank, see Chance and Brooks (2010, p. 579), Leeson and Whitley (1996) and Sheedy and McCracken (1997, pp. 36-41). The movie R o gu e T ra d e r (1998) tells the story of the collapse of Barings Bank.

4^^

B usiness finance

F in a n c e in

SOCIETE GENERALE___________________________________________

A C T IO N

N ew s

T h e la r g e s t lo ss r e p o r t e d d u e to u n a u th o r is e d t r a d in g w a s r e p o r t e d b y th e F re n c h b a n k S o c ie te G e n e r a le in J a n u a r y 2 0 0 8 . 28 In J a n u a r y 2 0 0 8 , th e F re n c h b a n k S o c ie te G e n e r a le r e p o r t e d lo s s e s o f 4 . 9 b i lli o n e u r o s d u e to th e a c t iv it ie s o f t r a d e r J e r o m e K e r v ie l. K e r v ie l h a d w o r k e d f o r s e v e r a l y e a r s in th e b a n k 's b a c k o f f i c e — w h e r e t r a n s a c t io n s a r e p r o c e s s e d a n d c o n t r o lle d — b e f o r e b e in g e m p lo y e d a s a t r a d e r in e a r ly 2 0 0 5 . H is jo b a s a t r a d e r w a s to h e d g e th e b a n k ’s a c t iv itie s b y t a k in g p o s it io n s in s h a r e fu tu r e s m a rk e ts t h a t w e r e th e o p p o s it e o f th e b a n k 's e x is tin g p o s itio n s . H o w e v e r , K e r v ie l a ls o u s e d h is e x p e r ie n c e o f w o r k in g in th e b a n k ’s b a c k o f f ic e to h id e m a s s iv e s p e c u la t io n t h a t h e u n d e r to o k b y t r a d in g in E u r o p e a n s h a r e m a r k e t fu tu r e s c o n tra c ts . H e m a d e u n a u th o r is e d t r a d e s to th e v a lu e o f 3 0 b illio n e u r o s in 2 0 0 7 , u n a u th o r is e d t r a d e s t h a t re s u lte d in a p r o f it o f 1 . 4 b illio n e u r o s b y th e e n d o f th e y e a r . In a n n o u n c in g th e f r a u d in J a n u a r y 2 0 0 8 , S o c ie te G e n e r a le s ta te d t h a t K e r v ie l h a d e s t a b lis h e d fu tu re s m a r k e t p o s it io n s w o r t h a p p r o x im a t e ly 5 0 b illio n e u r o s . B y w a y o f c o m p a r is o n , th e b a n k 's v a lu e w a s e s tim a te d a s a p p r o x im a t e ly 3 5 b i lli o n e u r o s . T h e c o m p a n y c lo s e d o u t th e p o s it io n s a t a lo s s o f 6 . 3 b illio n e u ro s , r e s u ltin g in a n e t lo s s o f 4 . 9 b illio n e u ro s a f t e r t a k in g in to a c c o u n t th e 1 . 4 b illio n e u r o p r o f it t h a t K e r v ie l h a d m a d e in 2 0 0 7 . T h e c o r p o r a t e g o v e r n a n c e fa ilu r e s o f th e B a r in g s c a s e a n d t h a t o f S o c ie te G e n e r a le d is p la y c o n s id e r a b le s im ila r ity , a n d h ig h lig h t th e n e e d f o r c le a r ris k m a n a g e m e n t c o n t r o ls — c o n t r o ls t h a t in c lu d e c o m p le te s e p a r a t io n o f th e r e p o r t in g a n d t r a d in g ro le s .

Valuation of financial futures contracts In S e c tio n 1 7 .4 w e an alysed som e o f th e d e te rm in a n ts o f fu tu re s price s. T h a t a n a lysis a p p lie s to fu tu re s c o n tra c ts o n p h y s ic a l c o m m o d itie s a n d to fu tu re s c o n tra c ts o n fin a n c ia l ‘c o m m o d itie s ’. I n th is s e c tio n we b u ild o n t h a t an alysis, b u t n a rro w o u r focu s to b a n k-a cce p te d b ill fu tu re s c o n tra c ts a n d share p ric e in d e x fu tu re s c o n tra c ts . E q u a tio n 17 .1 p ro v id e d a re s tr ic tio n o n th e v a lu a tio n o f a fu tu re s c o n tra c t: F<S + C w h e re

F = fu tu re s p ric e S = c u rre n t s p o t p ric e C = c a rry in g cost

I f th e c o m m o d ity can re a d ily be so ld s h o rt, a n d i f th e o p p o r tu n it y c ost o f in v e s tm e n t is th e o n ly fo r m o f c a rry in g cost, th e n i t can be s h o w n t h a t E q u a tio n 1 7 .1 s h o u ld h o ld as an e q u a lity :

7.15

17.10.1 | Valuation of bank bill futures contracts I f i t is assum ed t h a t b a n k b ills can be so ld s h o rt, th e n E q u a tio n 1 7 .1 5 s h o u ld a p p ly to b a n k b ill fu tu re s .29 In th is case i t is u s u a l to express C in te rm s o f th e y ie ld LEARNING OBJECTIVE 8 Understand the valuation of 90-day bank-accepted bill futures contracts and share price index futures contracts

it a p p lic a b le t o

th e te r m

t o f th e

fu tu re s c o n tra c t—

t h a t is, th e c a rry in g co st is:

C= Sit

28 For discussion of the unauthorised trading reported by Societe Generale, see various editions of the A u str a lia n F in a n c ia l R eview (January 2008 to October 2010). 29 This assumption is not as unreasonable as it may appear. When a bank bill is issued, it is effectively sold at its market price and it is subsequently repurchased at its face value.

C hapter seventeen Futures

contracts a n d swaps

S u b s titu tin g E q u a tio n 1 7 .1 6 in to E q u a tio n 1 7 .1 5 gives:

F = S (l + it) Im p lic itly , th e p r ic in g o f b a n k b ill fu tu re s was also c o n sid e re d in th e d iscu ssio n o f a rb itra g e in S e ctio n 17 .6.3. h .T

w here

This c o n c lu d e d w ith E q u a tio n 17 .12:

1 4- i T

=

1 + it

t = th e

m a t u r ity d a te o f th e fu tu re s c o n tra c t

it T= th e (fu tu re s ) y ie ld f o r a fu tu re s c o n tra c t, m a tu r in g a t da te t, o n a b ill m a tu r in g a t a la te r d a te iT

= th e

(s p o t) y ie ld o n a b ill m a tu rin g a t d a te

it = th e (s p o t) y ie ld o n a b ill m a tu rin g a t d a te

T

T t

E q u a tio n 1 7 .1 2 is c o n s is te n t w ith E q u a tio n 1 7 .1 7 . I f th e b ill u n d e rly in g th e fu tu re s c o n tra c t has a face value o f

V d o lla rs ,

th e n b y d e fin itio n :

17.18 1 + h .T S u b s titu tin g E q u a tio n 1 7 .1 2 in to E q u a tio n 1 7 .1 8 gives:

1

17.19

+

The s p o t p ric e S o f a T -day b ill t h a t also has a face v a lu e o f

V is

■

b y d e fin itio n :

17.20 1 +

/t

S u b s titu tin g E q u a tio n 1 7 .2 0 in to E q u a tio n 1 7 .1 9 gives:

F = S (\ + it) This is th e re s u lt s ta te d in E q u a tio n 17 .17. A c c o rd in g to th is e q u a tio n th e b a n k b ill fu tu re s p ric e is s im p ly th e s p o t p ric e o f th e re le v a n t b a n k b ill, a ccu m u la te d a t th e y ie ld a p p lica b le to th e te r m o f th e fu tu re s c o n tra c t. The R e le va n t b a n k b i l i 1 is

not u s u a lly

a 9 0 -d a y b a n k b ill. F o r exa m ple, i f a b a n k b ill fu tu re s c o n tra c t m a tu re s in 3 0 days* tim e , th e

re le va n t b a n k b ill c u r r e n tly has a te rm o f 1 2 0 days. H e an ey a n d L a y to n (1 9 9 6 ), u s in g A u s tra lia n d a ta , p ro v id e evidence t h a t is c o n s is te n t w ith th e p ro p o s itio n t h a t E q u a tio n 1 7 .1 7 is a re lia b le re p re s e n ta tio n o f th e re la tio n s h ip b e tw e e n b a n k b ill fu tu re s a n d s p o t prices.

1 7 .1 0 .2 1 Valuation of share price index futures contracts The v a lu a tio n o f share p ric e in d e x fu tu re s can be a p p ro a ch e d in a s im ila r m a n n e r. T his p ro b le m is s lig h tly m ore co m p le x because d iv id e n d s are p a id o n m o s t shares in th e in d e x , b u t th e c a lc u la tio n o f th e share p ric e in d e x excludes d iv id e n d s . A s in th e d is c u s s io n o f b ill fu tu re s , w e c o n tin u e to ig n o re th e m a rk -to -m a rk e t ru le , an d in s te a d assum e t h a t th e cash flo w s o c c u r o n ly o n D a te 1, th e e x p iry d a te o f th e fu tu re s c o n tra c t. Suppose th a t o n D ate 0 an in v e s to r b u ys a ll th e shares in th e in d e x a t a to t a l c o st o f S〇 , a n d also b o rro w s a sum o f m o n e y e q u a l to

PV(D)} th e

p re s e n t v a lu e o f th e d iv id e n d s t h a t th e shares w ill g e ne rate o n D a te 1.

A ll th e shares in th e in d e x are s u b s e q u e n tly so ld o n D a te 1 a t t h e ir same date, th e lo a n is re p a id a n d d iv id e n d s o f

D are

then c u rre n t

TABLE 17.12 Strategy producing a future cash flow of

Buy in de x B orro w

PV(D)

T otal

Sv

O n th e

S]

O n D a te 1

O n D a te 0 A c tio n

s p o t va lu e o f

collecte d. P u ttin g th is in ta b u la r fo rm :

C a s h flo w

- S〇 +PV(D)

PV(D)-S0

A c tio n

Sell in de x

C a s h flo w

4

Repay loan

-D

C ollect divide nd s

+D

T otal

5a

4^^

B usiness finance

As an a lte rn a tiv e , suppose t h a t o n D a te 0 th e in v e s to r b u ys share p ric e in d e x fu tu re s (p rice F 〇 ) th a t m a tu re o n D a te 1 a n d also d e p o s its (le n d s) th e s u m o f

Fq -~ — to

e a rn in te re s t a t a ra te

r.

O n D ate 1, th e

fu tu re s c o n tra c t is s e ttle d a n d th e d e p o s it (p lu s in te re s t) is w ith d ra w n . The fu tu re s c o n tra c t is s e ttle d b y a n o tio n a l sale a t

Fv

th e fu tu re s p ric e o n D a te 1. H o w e ve r, as D a te 1 is th e e x p iry d a te o f th e fu tu re s

F1= S2, th e s p o t p ric e on F-^ - F = S1- F〇 . P u ttin g t h is in ta b u la r fo rm :

c o n tra c t, convergence b e tw e e n s p o t p rice s a n d fu tu re s p rice s s h o u ld e n sure t h a t D ate 1. The cash flo w fr o m th e fu tu re s c o n tra c t is th e re fo re

〇

TABLE 17.13 Alternative strategy producing a future cash flow of O n D a te 0

O n D a te 1

A c tio n

C a sh f lo w

A c tio n

C a sh flo w

B uy fu tu re s

0

S ettle fu tu re s

S1~ F 0

〇

W ith d ra w deposit

+F 〇

+ r

plus in te re s t

D e p o sit

1

厂

0

+

F 1

r

F

〇

T otal

1

T otal

+ r

Si

The p o in t to n o te a b o u t Tables 1 7 .1 2 a n d 1 7 .1 3 is t h a t b o th in d ic a te a n e t cash in flo w o f o n D a te 1 . 〇 f course i t is n o t k n o w n w h a t

夕上

d o lla rs

w i ll be, b u t i t is k n o w n t h a t b o th ta b le s — t h a t is, b o th

in v e s tm e n ts — w ill gene rate th e sam e fu tu re cash flo w . T h e re fo re , b o th in v e s tm e n ts s h o u ld cost th e same o n D a te 0:

PV{D)-S0 = - - ^ 1 + /• S o lv in g f o r th e fu tu re s p ric e

F a n d,

since th e y are n o lo n g e r needed, d ro p p in g th e s u b s c rip ts , gives:

F = [S-PV(D)](\-^r)

17.21

E q u a tio n 1 7 .2 1 a n d E q u a tio n 1 7 .1 7 have th e sam e fo rm , exce pt t h a t E q u a tio n 1 7 .2 1 has a s im p le a d ju s tm e n t t h a t take s in to a cco u n t th e c o m p lic a tio n caused b y d iv id e n d s . E q u a tio n 1 7 .2 1 im p lie s th a t th e share p ric e in d e x fu tu re s p ric e w ill g e n e ra lly exceed th e c u rre n t in d e x value , b u t m a y n o t do so i f in te re s t rates are lo w re la tiv e to th e d iv id e n d y ie ld f r o m th e shares t h a t c o m p ris e th e in d e x . C u m m in g s a n d F rin o (2 0 0 8 ) p ro v id e evide nce f o r th e A u s tra lia n m a rk e t th a t, a fte r a llo w in g f o r ta x a tio n effects, E q u a tio n 1 7 .2 1 is a re lia b le re p re s e n ta tio n o f th e re la tio n s h ip b e tw e e n share p ric e in d e x fu tu re s p rice s a n d s p o t share p ric e in d e x values.

V

17.11

Forward-rate agreements

F o rw a rd -ra te a g re e m e n ts (F R A s) are p riv a te a g re e m e n ts b e tw e e n tw o p a rtie s . U s u a lly a t le a s t one o f th e

LEARNING OBJECTIVE 9

p a rtie s is a b a n k o r o th e r fin a n c ia l in s titu t io n . F R As are n o t fu tu re s c o n tra c ts b u t w e discuss th e m in th is

Understand and explain the uses of forward-rate agreements

t h a t if, o n a sp e cifie d fu tu r e da te, in te re s t rates are ^ow*, th e n P a rty A m u s t p a y cash to P a rty B— and

c h a p te r because th e y are o fte n used as an a lte rn a tiv e to in te re s t-ra te fu tu re s c o n tra c ts . Lo o se ly sp e a kin g , an FR A w o rk s as fo llo w s . Suppose P a rty A a n d P a rty B e n te r in to a n F R A. This m eans th e lo w e r th e in te re s t rates have fa lle n , th e m o re cash A m u s t p a y B. H o w e ve r, th e reve rse also ho ld s. If, o n th e sp e c ifie d fu tu re date, in te re s t rates are ^ ig h * , th e n B m u s t p a y cash to A — a g ain, th e h ig h e r th e in te re s t rates have becom e, th e m o re cash B m u s t p a y to A . In e ffe c t, such a c o n tra c t p ro v id e s b o th p a rtie s w ith a g u a ra n te e d in te re s t ra te in th e fu tu re . Thus, f o r exa m ple, P a rty A m ig h t be a co m p a n y p la n n in g to b o rro w o n th e e x p iry d a te o f th e FR A. I f in te re s t ra te s ris e b e fo re th e lo a n is m ad e, th e F R A gives A a cash in flo w t o co m p e n sa te f o r th e h ig h e r in te re s t rate. I f, in s te a d , in te re s t rates fa ll d u r in g th e p e rio d , th e FRA re q u ire s A to m ake a cash p a y m e n t, b u t t h is is c o m p e n sa te d b y th e lo w e r in te re s t ra te t h a t w ill be charged o n th e fu n d s b o rro w e d . W e n o w t u r n to E xa m p le 1 7 .1 5 , w h ic h p ro v id e s a d e ta ile d e x p la n a tio n o f h o w FRAs w o rk .

4^^

C hapter seventeen Futures

Exam ple

17.

C o m p a n y A in te n d s to b o r r o w $1 m illio n in 3 m o n th s 7 tim e . T h is w ill b e r e p a id (w ith in te rest) in a lu m p sum , 1 8 0 d a y s la te r. R e p a y m e n t w ill th e re fo re o c c u r a p p r o x im a te ly 9 m o n th s fro m n o w . A t p re se n t, th e in te re st ra te o n a

1 8 0 - d a y lo a n is a b o u t 9 . 4 0 p e r c e n t p e r a n n u m . C o m p a n y A fe a rs th a t in

3 m o n th s 7 tim e th is ra te m ig h t h a v e rise n s u b s ta n tia lly . T h e re fo re , C o m p a n y A a p p r o a c h e s B a n k B to set u p a fo r w a r d - r a te a g re e m e n t (FRA). T he b a n k a g re e s , se ttin g a c o n tra c t ra te o f 9 . 5 0 p e r c e n t p e r a n n u m . T his m e a n s th a t if, in 3 m o n th s ' tim e w h e n th e FRA e x p ire s , th e 1 8 0 - d a y b a n k b ill ra te e x c e e d s 9 .5 0

p e r c e n t, B a n k B w ill p a y C o m p a n y A e n o u g h c a sh to c o m p e n s a te . In re tu rn , C o m p a n y A ha s

a g re e d th a t if, a t th a t tim e , th e 1 8 0 - d a y b a n k b ill ra te is less th a n 9 . 5 0 p e r c e n t p e r a n n u m , C o m p a n y A w ill p a y e n o u g h c a s h to B a n k B to c o m p e n s a te . N o te th a t th e c a s h f lo w re p re s e n ts o n ly a difference in in te re st p a y m e n ts , n o t th e to ta l in te re s t p a y m e n t. F urthe r, n o p a y m e n t o f p r in c ip a l is in v o lv e d . To s h o w h o w th e c a s h f lo w in a n FRA is c a lc u la te d , a s s u m e th a t w h e n th e FRA e x p ire s th e m a rk e t in te re s t ra te f o r a te rm o f 1 8 0 d a y s is 1 0 . 2 5

p e r c e n t p e r a n n u m . N o tio n a lly , th e FR A c o m m its

C o m p a n y A to th e f o llo w in g c a s h flo w s . A t d a te o f FRA e x p ir y :

$1000000 1 + (0 .0 9 5 0 )(1 8 0 /3 6 5 ) $ 9 5 5 2 4 7 . 3 2 = sum b o r r o w e d 1 8 0 d a y s a fte r FRA e x p ir y : o u tflo w (re p a y m e n t) o f $1 0 0 0 0 0 0 H o w e v e r, a t th e FRA's e x p ir y d a te , th e p re s e n t v a lu e o f th is o u t flo w is o n ly :

$1000000 1 + (0 .1 0 2 5 )(1 8 0 /3 6 5 ) = $951 884.21 S in c e in te re s t ra te s h a v e in c re a s e d , B a n k B w ill h a v e to p a y C o m p a n y A a sum s u ffic ie n t to c o m p e n s a te C o m p a n y A f o r th e in c re a s e . T he s e ttle m e n t a m o u n t is e q u a l to th e d iffe re n c e b e tw e e n th e p re s e n t v a lu e o f $1 0 0 0 0 0 0 d is c o u n te d a t th e in te re s t ra te s p e c ifie d in th e FR A o f 9 . 5 0 p e r c e n t a n d th e p re s e n t v a lu e o f $ 1 0 0 0 0 0 0 d is c o u n te d a t th e c u rre n t m a rk e t in te re s t ra te (see C a r e w 1 9 9 4 ) . T h a t is:

r

.

$1000000

$1000000

1 + (0 .0 9 5 )(1 8 0 /3 6 5 )

1 + (0.1025) (1 8 0 /3 6 5 )

Settlement am ount = -------------------------------------------------------------------------------

= $ 9 5 5 2 4 7 .3 2 - $ 9 5 1 884.21 = $ 3 3 6 3 .1 1 U n d e r th e te rm s o f th e FRA, B a n k B p a y s C o m p a n y A th e sum o f $ 3 3 6 3 . 1 1 . M o r e g e n e r a lly th e s e ttle m e n t a m o u n t Q is:

Q

- _____________ 1 F

1 + lit/365)

—

17.22

1 + (rf/3 6 5 )

w h e re F = fa c e v a lu e / = th e in te re s t ra te s p e c ifie d in th e FRA r = c u rre n t m a rk e t in te re s t ra te

t = num ber o f days T he e ffe c t o f th e FRA is th a t C o m p a n y A is a b le to b o r r o w a t a n e t c o s t o f 9 . 5 0 p e r c e n t p e r a n n u m , d e s p ite th e in c re a s e in in te re s t ra te s . H o w e v e r, th e a c tu a l b o r r o w in g b y C o m p a n y A w ill s till ta k e p la c e a t th e c u rre n t m a rk e t ra te o f 1 0 . 2 5 p e r c e n t. C o m p a n y A c a n b o r r o w $ 9 5 1 8 8 4 . 2 1

fo r 1 8 0 d a y s

a t a n in te re s t ra te o f 1 0 . 2 5 p e r c e n t p e r a n n u m ; a d d in g to th is a m o u n t th e in flo w o f $ 3 3 6 3 . 1 1 fro m B a n k B, C o m p a n y A w ill h a v e fu n d s o f $ 9 5 5 2 4 7 . 3 2 a v a ila b le . T he r e p a y m e n t r e q u ire d is:

$951 884.21 [1 + (0 .1 0 2 5 )(1 8 0 /3 6 5 )] = $ 1 0 0 0 0 0 0 O f c o u rs e , th is is th e s a m e a s th e a m o u n t r e q u ire d to r e p a y a lo a n o f $ 9 5 5 2 4 7 . 3 2 a t 9 . 5 0 p e r c e n t p e r a n n u m o v e r 1 8 0 d a y s , a s r e q u ire d b y C o m p a n y A . T h a t is, C o m p a n y A h a s lo c k e d in a n in te re s t ra te o f 9 . 5 0 p e r c e n t o n its fu tu re b o r r o w in g s .

contracts a n d swaps

6

B usiness finance

F R A s a re a ls o e n t e r e d in t o b e t w e e n b a n k s a n d d e p o s i t o r s . In t h is c a s e , th e b a n k p a y s th e d e p o s it o r i f in t e r e s t r a t e s d e c r e a s e d u r in g th e life o f th e F R A , a n d th e d e p o s i t o r p a y s th e b a n k i f i n t e r e s t r a t e s in c r e a s e d u r in g th e life o f th e F R A . H o w e v e r, in m o s t F R A s th e c lie n t is a p r o s p e c t iv e b o r r o w e r se e k in g p r o t e c tio n a g a i n s t r i s i n g in t e r e s t r a t e s , r a t h e r t h a n a p r o s p e c t iv e d e p o s i t o r s e e k in g p r o t e c tio n a g a in s t fa llin g in t e r e s t r a t e s . F in a lly , m a n y F R A s a r e a g r e e m e n t s b e tw e e n b a n k s , r a t h e r t h a n a g r e e m e n t s b e tw e e n c lie n ts a n d b a n k s . M a n y c o m p a n ie s , p a r tic u la r ly t h o s e t h a t a r e s m a ll o r m e d iu m in s iz e , p r e f e r to u s e a n F R A r a th e r t h a n a f u t u r e s c o n tr a c t. T h is is la r g e ly b e c a u s e a n F R A c a n b e t a ilo r e d m o r e c lo s e ly t o t h e ir sp e c ific n e e d s in r e la t io n to a m o u n t, t im in g a n d c h o ic e o f i n t e r e s t ra te . In a d d it io n , F R A s d o n o t n o r m a lly im p o s e th e s a m e c o m p le x d e p o s i t a n d m a r g in r e q u ir e m e n t s a s e x is t in f u t u r e s c o n t r a c t s . H o w e v e r, la r g e r c o m p a n ie s , a n d p a r tic u la r ly c o m p a n ie s in th e fin a n c e in d u s tr y , m a y p r e fe r a f u t u r e s c o n t r a c t b e c a u s e i t o ffe r s th e fle x ib ility o f b e in g a b le to r e v e r s e o u t a t a n y tim e th r o u g h a t r a n s a c t io n o n LEARNING OBJECTIVE 10 Identify the characteristics and uses of interest rate swaps and currency swaps

th e f u t u r e s e x c h a n g e . In d e e d , b a n k s a n d o t h e r fin a n c ia l i n s t i t u t i o n s u s e f u t u r e s c o n t r a c t s to h e d g e th e r is k s th e y c r e a te b y e n t e r in g in t o F R A s w ith th e ir c lie n ts.

17.12

SWAP

an agreement between two counterparties to exchange sets of future cash flows INTEREST RATE SWAP

agreement between two counterparties to exchange interest payments for a specific period, related to an agreed principal amount. The most common type of interest rate swap involves an exchange of a set of fixed-interest payments for a set of floatinginterest payments. All payments are in the same currency

17.1 2.1 | W h a t is a swap? A

sw ap i s

a n a g r e e m e n t b e tw e e n tw o c o u n t e r p a r t ie s to e x c h a n g e s e t s o f fu t u r e c a s h flo w s. Th e tw o m a jo r

f o r m s o f sw a p c o n t r a c t s a r e

in terest rate sw aps

and

currency sw aps.30 In

a n i n t e r e s t r a te sw a p , a s e t

o f fu t u r e c a s h flo w s c a lc u la te d u s in g fu t u r e flo a t in g i n t e r e s t r a t e s a r e s w a p p e d f o r a s e t o f fu t u r e c a s h flo w s c a lc u la te d u s i n g a fix e d in t e r e s t ra te . B o th s e t s o f c a s h flo w s a r e in th e s a m e c u rre n c y . A flo a t in g in t e r e s t r a t e , w h ic h is a ls o k n o w n a s a v a r ia b le o r a d ju s t a b le i n t e r e s t r a te , is o n e t h a t c h a n g e s a s tim e p a s s e s , w h e r e a s a fix e d i n t e r e s t r a te h a s th e s a m e v a lu e t h r o u g h o u t a c o n tr a c t. In a c u r r e n c y sw a p , a s e t o f fu tu r e c a s h flo w s c a lc u la te d u s in g a n in t e r e s t r a te in o n e c u rre n c y is s w a p p e d f o r a s e t o f fu t u r e c a s h flo w s c a lc u la te d u s in g a n i n t e r e s t r a t e in a n o t h e r c u rre n c y . In m o s t c u rre n c y s w a p s , lo a n p r in c ip a ls a r e a ls o e x c h a n g e d . In t h is s e c t io n w e f o c u s o n i n t e r e s t r a te s w a p s ; c u r r e n c y s w a p s a r e d i s c u s s e d in S e c t io n 1 7 .1 3 . S w a p s a re p o s s ib ly th e m o s t s ig n ific a n t fin a n c ia l in v e n tio n o f th e p a s t 4 0 y e a r s . F r o m a t r a d in g v o lu m e o f n e a r z e r o in 1 9 8 1 , w ith in 1 0 y e a r s th e v o lu m e w a s in th e h u n d r e d s o f b illio n s o f U S d o lla r s an n u ally . In J u n e 2 0 1 3 , th e g r o s s m a r k e t v a lu e o f in t e r e s t r a te s w a p s o u t s t a n d in g w a s U S $ 1 3 .6 6 trillio n , w h ile th e c o r r e s p o n d in g fig u re fo r c u rre n c y s w a p s w a s U S $ 1 .1 3 trillio n (B a n k fo r I n te r n a tio n a l S e t t le m e n ts , T ab le 1 9 ,

www.bis.org).31 F ig u r e s p r e p a r e d fo r th e A u s tr a lia n F in a n c ia l M a r k e ts A s s o c ia tio n in d ic a te t h a t th e tu r n o v e r o f sw a p s in th e A u s tr a lia n m a r k e t in 2 0 1 2 - 1 3 w a s $ 1 0 4 8 0 b illio n , o f w h ich $ 7 4 8 1 b illio n , o r 7 1 p e r ce n t, w a s in t e r e s t r a te sw a p s (A u stra lia n F in a n c ia l M a r k e ts A s s o c ia tio n 2 0 1 3 ,

www.afma.com.au).

1 7 .1 2 .2 1 Interest rate swaps S u p p o s e y o u a r e a p p r o a c h e d b y P a r ty A , w h o in v it e s y o u to p a r t ic ip a t e in th e f o llo w in g fin a n c ia l g am e *. CURRENCY SWAP

agreement between two counterparties to exchange sets of interest payments for a specific period, related to agreed principal amounts in two different currencies. Usually, there is also an exchange of loan principals at the start and almost always a re-exchange of principals at the end of the agreement

P a r ty A o f f e r s to p a y y o u th r e e c a s h flo w s — th e f ir s t w ill b e p a id 1 y e a r f r o m n o w , t h e s e c o n d w ill b e p a id 2 y e a r s f r o m n o w a n d th e t h ir d w ill b e p a id 3 y e a r s fr o m n o w . T h e se c a s h flo w s w ill m im ic th e in t e r e s t p a y m e n t s t h a t w o u ld b e p a y a b le o n a 3 - y e a r flo a t in g - r a te lo a n o f $ 1 m illio n . S p e c ific a lly : •

th e f ir s t c a s h flo w w ill b e c a lc u la te d b y m u ltip ly in g $ 1 m illio n b y t o d a y s 1 - y e a r in t e r b a n k in t e r e s t r a t e 32, w h ic h is 5 .0 p e r c e n t;

•

th e s e c o n d c a s h flo w w ill b e c a lc u la te d b y m u ltip ly in g $ 1 m illio n b y th e 1 - y e a r in t e r b a n k in t e r e s t r a te t h a t w ill b e o b s e r v e d 1 y e a r fr o m to d a y ; a n d

30 Terminology varies. Currency swaps are also called ‘cross-currency swaps’ and ‘cross-currency basis swaps’. Other types of swaps include commodity swaps and credit default swaps. 31 To give these impressive amounts some context, the gross market value of forward-rate agreements (FRAs) outstanding was US$0.17 trillion. Australia’s gross domestic product in 2013 was about US$1.6 trillion. US gross domestic product in 2013 was about US$15.7 trillion. 32 An interbank interest rate is the rate applicable to deposits lodged by one bank with another bank. The interbank market is active and interbank interest rates are determined by market forces.

C hapter seventeen F utures

•

c o n t r a c t s a n d swaps

th e th ir d c a s h flo w w ill b e c a lc u la te d b y m u ltip ly in g $ 1 m illio n b y th e 1 - y e a r in t e r b a n k i n t e r e s t r a te t h a t w ill b e o b s e r v e d 2 y e a r s fr o m to d a y . O f c o u r s e , P a r ty A w a n t s s o m e t h in g f r o m y o u in r e tu r n : y o u a r e r e q u ir e d to m a k e p a y m e n ts to P a rty

A o n th e s a m e fu t u r e d a t e s . Y o u r p a y m e n t s w ill m im ic th e i n t e r e s t p a y m e n t s t h a t w o u ld b e p a y a b le o n a th re e - y e a r fix e d - ra te lo a n o f $ 1 m illio n . T h a t is , e a c h o f y o u r p a y m e n t s w ill b e $ 1 m illio n m u ltip lie d b y a fix e d in t e r e s t ra te , s. P a r ty A a s k s y o u : w h a t v a lu e o f s w o u ld in d u c e y o u to p a r t ic ip a t e in t h is g a m e ? The p r o p o s e d g a m e is illu s t r a t e d in F ig u re 1 7 .2 .

N O TIO N A L PRINCIPAL (OR N O TIO N A L am ount

) OF A N

INTEREST RATE SWAP

In F ig u r e 1 7 .2 , b x is t h e 1 - y e a r i n t e r b a n k i n t e r e s t r a t e o b s e r v e d o n d a t e 1 a n d b 2 is th e 1 - y e a r in t e r b a n k i n t e r e s t r a t e o b s e r v e d o n d a t e 2 . N a tu r a lly , y o u w o u ld lik e t h e f ix e d i n t e r e s t r a t e , s, to b e a s lo w a s p o s s ib l e , w h ile P a r t y A w o u ld lik e s to b e a s h ig h a s p o s s ib l e . S u p p o s e y o u a n d P a r t y A a g r e e t h a t s w ill b e 5 .1 0 p e r c e n t . T h is g a m e p r o d u c e s t h e s a m e c a s h flo w s a s a 3 - y e a r ‘p la i n v a n il l a ’ o r
n o t io n a l p r in c ip a l ( o r n o t io n a l a m o u n t)

T h e s e f e a t u r e s a r e i l l u s t r a t e d in E x a m p l e 1 7 .1 6 .

each gross swap payment is calculated by multiplying an interest rate by the notional amount. The notional amount corresponds to the principal of the loan interest flows that the swap mimics. In nearly all cases, the notional amount in an interest rate swap is never paid

Example 17. E x a c tly 3 y e a rs a g o , c o u n te r p a r tie s A a n d B e n te re d in to a p la in v a n illa in te re s t ra te s w a p . C o u n te r p a r ty A w a s th e re c e iv e -fix e d c o u n te r p a r ty a n d c o u n te r p a r ty B w a s th e p a y - fix e d c o u n te r p a r ty . T h e n o tio n a l a m o u n t w a s $1 m illio n . T he s p e c ifie d f lo a t in g ra te w a s th e 1 -y e a r in te r b a n k in te re s t ra te . T he a g r e e d fix e d s w a p ra te w a s 5 . 1 0 p e r c e n t. T h re e y e a rs a g o , th e 1 -y e a r in te r b a n k in te re s t ra te w a s 5 . 0 0 p e r c e n t; 2 y e a rs a g o it w a s 5 . 2 5 p e r c e n t; 1 y e a r a g o it w a s 4 . 9 0 p e r c e n t a n d t o d a y it is 4 . 6 0 p e r c e n t. W h a t n e t c a s h flo w s d id th e s w a p p ro d u c e ? The n e t c a s h flo w s a r e s h o w n in T a b le 1 7 . 1 4 .

TABLE 17.14 Cash flows in an interest rate swap Date

1-year inter­

Floating-rate gro ss

Fixed-rate gross

N et swap paym ent

bank rate

swap paym ent

swap paym ent

m ade

(A owes B)

(B ow es A)

(°/〇

p-a.)

Three y ears a g o (D ate 0)

5 .0 0

—

—

—

Tw o y ears a g o (D ate 1)

5 .2 5

0 .0 5 0 0 x $ l m =

0 .0 5 1 0 x $ l m =

$ 1 0 0 0 (B p a id A)

$50000

$51000 c o n tin u e d

33 To keep the game* simple, we have used annual swap payments. In practice, swaps that on initiation have a term of 3 years or less will generally specify quarterly cash flows, while longer-term swaps will specify half-yearly cash flows.

6

B usiness finance

Table 17.14 continued Date

BBSW BBSW is the bank bill reference rate and is the standard benchmark for the floating-rate cash flows in short-term interest rate swaps in Australia. It is a set of representative market interest rates for bank bills and similar securities, quoted on a per annum basis using exact day-counts. Six BBSW rates are calculated daily at approximately 10:10 am Sydney time for terms of 1 ,2 , 3, 4, 5 and 6 months

O ne y e a r a g o (D ate 2)

T o d ay (D ate 3)

l-year inter­

Floating-rate gross

Fixed-rate gross

N et swap payment

bank rate

swap paym ent

swap paym ent

m ade

( % p.a.)

(A owes B)

(B owes A)

4 .9 0

0 .0 5 2 5 x $ l m =

0 .0 5 1 0 x $ l m =

$52500

$51000

0 .0 4 9 0 x $ l m =

0 .0 5 1 0 x $ l m = $51000

4 .6 0

$49000

$ 1 5 0 0 (A p a id B)

$ 2 0 0 0 (B p a id A)

A s s h o w n in T a b le 1 7 . 1 4 , w h e n th e fix e d ra te is less th a n th e f lo a t in g ra te , th e g ro s s s w a p p a y m e n t o w e d b y c o u n te r p a r ty A — th e p a y - fix e d c o u n t e r p a r t y — is less th a n th e g ro s s s w a p p a y m e n t o w e d b y c o u n te r p a r ty B. H e n c e , th e n e t c a s h f lo w is fro m B to A . W h e n th e fix e d ra te is g r e a te r th a n th e flo a tin g ra te , th e o p p o s ite o c c u rs : A 's g ro s s s w a p p a y m e n t is g r e a te r th a n B 's, so th e n e t c a s h f lo w is fro m

入

to B. N o te th a t t o d a y 's 1 -y e a r in te r b a n k ra te is n o t re le v a n t.

E x a m p le 1 7 .1 6 is s lig h tly s im p le r t h a n re a lity . In p ra c tic e , s h o r t - t e r m s w a p s u s u a lly s p e c ify q u a r te r ly s w a p p a y m e n ts . T y p ically , in A u s tr a lia , th e flo a t in g r a te in a s h o r t - t e r m s w a p is d e fin e d a s th e 3 - m o n th BBSW in t e r e s t r a t e 一 u s u a lly r e fe r r e d to a s ‘3 - m o n th B B S W ’ 一 w h ic h is a r e p r e s e n t a t iv e m e a s u r e o f m a r k e t in t e r e s t r a t e s c a lc u la te d e v e r y b u s i n e s s d a y f o r 3 - m o n t h s e c u r itie s g u a r a n t e e d b y m a jo r A u s tr a lia n b a n k s . B B S W r a t e s a r e q u o t e d a s a n a n n u a l s im p le i n t e r e s t r a te a n d e x a c t d a y - c o u n ts a r e u s e d . A m o r e r e a listic e x a m p le is p r o v id e d in E x a m p le 1 7 .1 7 .

Example 17. On

1 A p r il 2 0 1 4 , c o u n te r p a r tie s A a n d B e n te r in to a n in te re s t ra te s w a p . T he n o tio n a l a m o u n t

is $ 1 0 m illio n a n d c a s h flo w s a r e to b e m a d e q u a r t e r ly f o r 1 y e a r. C o u n te r p a r ty A a g re e s to p a y c o u n te r p a r ty B flo a tin g - r a te p a y m e n ts c a lc u la te d a c c o r d in g to 3 -m o n th B B S W . C o u n te r p a r t y B a g re e s to p a y c o u n te r p a r ty A fix e d -ra te p a y m e n ts a t 9 . 0 0 p e r c e n t p e r a n n u m . A y e a r la te r th e a g r e e m e n t h a s e n d e d a n d A 's fin a n c ia l m a n a g e r c a lls f o r a r e p o r t o n th e c a s h flo w s th a t w e r e m a d e in th e s w a p . O n 1 A p r il 2 0 1 4 , w h e n th e s w a p w a s e n te re d in to , 3 -m o n th B B S W w a s 7 . 6 0 p e r c e n t p e r a n n u m . S u b s e q u e n tly , o n th e f o llo w in g d a te s , 3 -m o n th B B S W w a s : •

1 J u ly 2 0 1 4

8 .7 0

per cent

•

1 O c to b e r 2 0 1 4

9 .3 5

per cent

•

1 J a n u a ry 2 0 1 5

9 .2 5

p e r c e n t.

T he r e p o r t c o u ld ta k e th e fo rm s h o w n in T a b le 1 7 . 1 5 . 34

TABLE 17.15 Counterparty A: report on interest rate swap Date

Days in

3-month

Floating-rate gross

period

BBSW

swap paym ent

Fixed-rate gro ss swap paym ent

ended

( % p.a.)

(A owes B)

(B owes A)

1 A pril 2 0 1 4

—

7 .6 0

—

—

1 J u ly 2 0 1 4

91

8 .7 0

1 O c to b e r 2 0 1 4

92

9 .3 5

Sw ap payment m ade

—

0 .0 7 6 x 9 1 / 3 6 5 x

0 .0 9 x 9 1 / 3 6 5 x

$ 1 0 m = $ 1 8 9 4 7 9 .4 5

$ 1 0 m = $ 2 2 4 3 8 3 .5 6

(B p aid A)

0 .0 8 7 x 9 2 / 3 6 5 x

0 .0 9 x 9 2 / 3 6 5 x

$ 7 5 6 1 .6 5

$ 1 0 m = $ 2 1 9 2 8 7 .6 7

$ 1 0 m = $ 2 2 6 8 4 9 .3 2

(B p aid A)

$ 3 4 9 0 4 .1 1

continued

34 In this example, we have assumed that payments are made on non-business days such as weekends and public holidays such as 1 January 2015. In practice, this is not the case.

C hapter seventeen Futures

c o n t r a c t s a n d swaps

Table 17.15 continued Date

i 1 Ja n u a r y 2 0 1 5

1 A pril 2 0 1 5

Days in

3-m onth

Floating-rate gro ss

Fixed-rate gro ss swap

Sw ap paym ent

period

BBSW

swap paym ent

paym ent

m ade

ended

( % p.a.)

(A owes B)

(B owes A)

i

92

90

9 .2 5

—

0 .0 9 3 5 x 9 2 / 3 6 5 x

0 .0 9 x 9 2 / 3 6 5 x

$ 8 8 2 1 .9 2

$ 1 0 m = $ 2 3 5 6 7 1 .2 4

$ 1 0 m = $ 2 2 6 8 4 9 .3 2

(A p a id B)

0 .0 9 2 5 x 9 0 / 3 6 5 x

0 .0 9 x 9 0 / 3 6 5 x

$ 6 1 6 4 .3 8

$ 1 0 m = $ 2 2 8 0 8 2 .1 9

$ 1 0 m = $ 2 2 1 9 1 7 .8 1

(A p a id B)

W h ile E x a m p le s 1 7 .1 6 a n d 1 7 .1 7 s e t o u t th e m e c h a n ic s o f i n t e r e s t r a te s w a p s th e y d o n o t m a k e c le a r th e m o tiv a t io n s f o r su c h t r a n s a c t io n s . I n t e r e s t r a t e s w a p s m a y b e u s e d f o r th r e e m a in p u r p o s e s : 1

s p e c u la tin g

2

h e d g in g

3

r e d u c in g b o r r o w in g c o s t s . We n o w d is c u s s e a c h o f t h e s e u s e s . In d o in g s o , w e w ill a s s u m e t h a t th e g r o s s sw a p p a y m e n ts a r e m a d e ,

ev en t h o u g h in p r a c tic e o n ly a n e t s w a p p a y m e n t is m a d e . T h is a s s u m p t i o n w ill m a k e th e d is c u s s io n e a s ie r to fo llo w b u t in n o w ay a ffe c t s i t s s u b s t a n c e .

Speculating S u p p o s e t h a t tw o c o m p a n ie s , B N R a n d A A , e n t e r in t o a 4 - y e a r i n t e r e s t r a te s w a p in w h ic h B N R is th e p a y -fix e d c o u n t e r p a r t y a n d A A is th e r e c e iv e -fix e d c o u n te r p a r ty . Th e n o t io n a l a m o u n t o f th e s w a p is $ 1 0 0 m illio n a n d sw a p p a y m e n t s a r e m a d e e v e r y 6 m o n t h s . The fix e d s w a p r a te is 3 .0 5 p e r c e n t p e r h a lfy e a r a n d th e f lo a t in g sw a p r a t e is 6 - m o n th B B S W p e r h a lf- y e a r .35 Th e sw a p is illu s t r a t e d in F ig u r e 1 7 .3 .

In t h is sw a p , B N R is th e p a y - fix e d c o u n t e r p a r t y a n d h e n c e w ill re c e iv e flo a t in g - r a te sw a p p a y m e n ts . I f B N R is s p e c u la t in g , th e n B N R m u s t b e p r e d ic tin g t h a t i n t e r e s t r a t e s w ill r is e . I f t h is p r e d ic tio n p r o v e s to b e c o rre c t, th e n th e flo a t in g r a t e sw a p p a y m e n t s t h a t B N R r e c e iv e s fr o m A A w ill in c r e a s e b u t th e fix ed r a te sw a p p a y m e n ts t h a t B N R p a y s to A A w ill n o t in c r e a s e . H en ce , h ig h e r i n t e r e s t r a t e s w o rk in B N R s fa v o u r. O f c o u r s e , i f B N R s p r e d ic tio n p r o v e s to b e in c o r r e c t, a n d i n t e r e s t r a t e s d e c r e a s e , th e n B N R lo s e s . A A m a y a lso b e sp e c u la tin g o n th e fu tu r e c o u rse o f in te r e s t ra te s . If th is is th e c a se , A A m u s t b e p re d ic tin g th a t in te r e s t r a te s w ill fall. I f t h is p re d ic tio n p ro v e s to b e c o rre c t, th e n th e flo a tin g - ra te sw a p p a y m e n ts th a t AA p a y s to B N R w ill d e c re a se b u t th e fix e d -ra te sw a p p a y m e n ts t h a t A A re ceiv e s fr o m B N R w ill n o t d e c re a se . H en ce, low er in te r e s t r a te s w o rk in A A s fa v o u r. I f A A s p re d ic tio n p ro v e s to b e in c o rre c t, th e n A A lo se s. O f c o u r s e , th e p r e d ic tio n s m a d e b y B N R a n d A A c a n n o t b o t h b e c o r r e c t. B u t e a c h c o u n t e r p a r t y h a s s p e c u la te d in a w ay t h a t is c o n s is t e n t w ith i t s p r e d ic tio n s .

Hedging S u p p o se th a t C o m p a n y A A is a b a n k a n d it h a s re c e n tly re ceiv e d a su r g e o f $ 1 0 0 m illio n in 4 -y e a r fix e d -ra te d e p o sits. In te r e st o n th e se d e p o s it s is p a id a t th e fix e d ra te o f 5 .9 0 p e r c e n t p e r a n n u m , p ay a b le h alf-yearly. T h at is, th e in te r e s t c o s t fo r A A is 2 .9 5 p e r c e n t p e r h alf-y e ar, w h ich r e s u lts in h a lf-y e a rly in te r e s t p a y m e n ts 35 In this example, we follow the usual practice in Australia of specifying the floating rate in a swap without any margin for credit risk. To simplify the discussion we use the term 'half-year* as if it were always exactly 0.5 of a year. In fact, in the financial markets, the length of a given half-year depends on when it starts and ends. The number of days in a half-year can be as low as 181 or as high as 184. Hence, the fraction of a year represented by a given half-year is between 181/365 and 184/365; that is, between 0.498590 and 0.504110.

4^^

B usiness finance

o f 0 .0 2 9 5 x $ 1 0 0 m illio n , w h ich e q u a ls $ 2 9 5 0 0 0 0 . B u t s u p p o s e a ls o t h a t m o s t o f A A s b o r r o w e r s— t h a t is, p e o p le to w h o m A A h a s le n t m o n e y — h a v e b o rr o w e d fr o m th e b a n k o n a flo a tin g - ra te b a s is . H en ce, A A h a s fix e d -ra te d e p o s it c o s t s b u t flo a tin g - ra te lo a n re v e n u e s. I f in te r e s t r a te s fall in th e fu tu re , A A w ill b e in tro u b le: its c o s t o f d e p o s it s is fix e d b u t its re v e n u e fr o m lo a n s w ill d e c lin e in lin e w ith th e fall in th e flo a tin g in te r e s t rate. W ith th e s a m e c o s t a n d lo w e r re v e n u e s, A A s p r o fita b ility a n d /o r its so lv e n c y w ill b e je o p a r d ise d . T o h e d g e t h is r is k , A A e n t e r s in t o th e in t e r e s t r a te sw a p i ll u s t r a t e d in F ig u r e 1 7 .3 . The o u tc o m e is s h o w n in F ig u r e 1 7 .4 .

A s s h o w n in F ig u r e 1 7 .4 , e v e ry h a lf- y e a r A A p a y s i t s l e n d e r s in t e r e s t a t th e fix e d r a t e o f 2 .9 5 p e r ce n t. It a ls o m a k e s sw a p p a y m e n t s o f 6 - m o n th B B S W p e r h a lf- y e a r to B N R a n d re c e iv e s sw a p p a y m e n t s o f 3 .0 5 p e r c e n t p e r h a lf- y e a r fr o m B N R . H e n c e , A A s h a lf- y e a r ly n e t c a s h o u tflo w is g iv e n b y: $ 1 0 0 0 0 0 0 0 0 x (2 .9 5 % + 6 - m o n t h B B SW p e r h a l f - y e a r - 3 .0 5 % ) = $ 1 0 0 0 0 0 0 0 0 x (6 - m o n th B B SW p e r h a lf- y e a r - 0 .1 0 % ) L o o k e d a t fr o m A A s v ie w p o in t, th e sw a p c o n v e r t s th e $ 1 0 0 m illio n f r o m a fix e d - r a te lia b ility o n w h ic h it p a y s 2 .9 5 p e r c e n t p e r h a lf- y e a r to a flo a t in g - r a te lia b ility o n w h ic h it p a y s 6 - m o n t h B B S W p e r h a lf- y e a r m in u s 0 .1 p e r c e n t p e r h a lf-y e a r. B y s w itc h in g fr o m fix e d - r a te b o r r o w in g t o flo a t in g - r a te b o r r o w in g , A A r e d u c e s i t s r is k . I f in t e r e s t r a t e s r is e , i t s c o s t s w ill r is e b u t s o a l s o w ill i t s r e v e n u e s . I f in t e r e s t r a t e s fa ll, i t s r e v e n u e s w ill fa ll b u t s o a ls o w ill i t s c o s t s . H e n c e , i t s p r o f ita b ilit y a n d liq u id ity w ill n o t su ffe r. B N R m a y a ls o h a v e e n t e r e d in to t h is sw a p to h e d g e in t e r e s t r a t e r isk . F o r e x a m p le , B N R m a y h a v e a p r e ­ e x is t in g flo a t in g - r a te lo a n b u t p r e - e x is t in g fix e d - r a te r e v e n u e s . T h is m is m a tc h is risk y . The in t e r e s t r a te s w a p c o n v e r t s B N R f r o m b e in g a f lo a tin g - r a te b o r r o w e r to b e in g a fix e d - r a te b o rr o w e r, h e n c e e lim in a tin g th e r is k y m is m a tc h .

Reducing borrow ing costs In s o m e c ir c u m s t a n c e s , a n i n t e r e s t r a t e s w a p c a n r e d u c e th e b o r r o w in g c o s t s o f b o t h p a r t i e s to th e sw a p . T o s e e t h is , s u p p o s e t h a t b o t h B N R a n d A A h a v e p r e - e x is t in g d e b t s . A s in th e p r e v io u s c a s e , A A is a b a n k a n d h a s a fix e d - r a te lia b ility to p a y $ 2 9 5 0 0 0 0 e v e r y 6 m o n t h s o n d e p o s i t s o f $ 1 0 0 m illio n . B N R w ish e s to b o r r o w o n a fix e d - ra te b a s i s b u t d o e s n o t h a v e a d e b t r a t i n g fr o m a n y o f th e d e b t - r a t in g a g e n c ie s .36 W ith o u t a d e b t r a t in g , B N R f in d s i t im p o s s ib le o r e x p e n s iv e to is s u e i t s o w n fix e d - r a te d e b t s e c u r itie s . H o w e v e r, B N R is a b le to b o r r o w $ 1 0 0 m illio n f r o m i t s b a n k o n a flo a tin g - r a te b a s i s . S p e c ific a lly , th e lo a n r e q u ir e s B N R to m a k e h a lf-y e a rly in t e r e s t p a y m e n t s f o r 4 y e a r s a t 6 - m o n t h B B S W p e r h a lf- y e a r p lu s a b a s is p o in t

0.01 per cent, often abbreviated to 1 bp

c r e d it- r is k m a r g in o f 0 .2 5 p e r c e n t (o r 2 5

b a s is p o in t s )

e v e r y 6 m o n t h s .37

B N R a n d A A e n t e r in t o t h e i n t e r e s t r a t e s w a p i l l u s t r a t e d in F ig u r e 1 7 .3 . T h e o u t c o m e is i ll u s t r a t e d in F ig u r e 1 7 .5 . 36 The major agencies are Standard & Poors, Moody s and Fitch. For further details, see Section 4.7. 37 Typically, interest rates are quoted on an annual basis. In practice, the interest rate on BNRs loan would be described as being 6-month BBSW plus a margin of 50 basis points per annum, with interest payable half-yearly. One basis point is 0.01 per cent per annum. On a half-yearly basis, this rate is 6-month BBSW per half-year plus 25 basis points per half-year.

C hapter seventeen F utures

The sw a p r e q u ir e s th e fo llo w in g g r o s s sw a p p a y m e n t s e v e ry s ix m o n t h s : •

A A p a y s B N R th e s u m o f $ 1 0 0 m illio n x 6 - m o n t h B B S W p e r h a lf- y e a r ; a n d

•

B N R p a y s A A th e s u m o f $ 1 0 0 m illio n x 3 .0 5 p e r c e n t, w h ic h e q u a ls $ 3 0 5 0 0 0 0 . A s sh o w n in F ig u r e 1 7 .5 , e v e r y h a lf- y e a r B N R p a y s i t s le n d e r i n t e r e s t a t th e f lo a t in g r a te o f 6 - m o n th

B B SW p e r h a lf- y e a r + 0 .2 5 p e r c e n t. I t a ls o m a k e s sw a p p a y m e n t s o f 3 .0 5 p e r c e n t to A A a n d re c e iv e s sw a p p a y m e n ts o f 6 - m o n th B B SW p e r h a lf- y e a r f r o m A A . H e n c e , B N R s h a lf- y e a r ly n e t c a s h o u tflo w is 3 .3 0 p e r c e n t o f $ 1 0 0 m illio n , o r $ 3 3 0 0 0 0 0 , c o m p r is e d a s fo llo w s: $ 1 0 0 0 0 0 0 0 0 x [ (6 - m o n th B B SW p e r h a lf - y e a r + 0 .2 5 % ) + 3 .0 5 % - 6 - m o n t h B B SW p e r h a lf-y e a r] = $ 1 0 0 0 0 0 0 0 0 x 3 .3 0 % = $3 3 0 0 0 00 B y e n te r in g in to t h is i n t e r e s t r a te sw a p , B N R h a s in e ffe c t s w itc h e d f r o m b e in g a flo a t in g - r a te b o r r o w e r p a y in g 6 - m o n th B B SW p e r h a lf- y e a r + 0 .2 5 p e r c e n t p e r h a lf- y e a r to a fix e d - r a te b o r r o w e r p a y in g 3 .3 0 p e r c e n t p e r h a lf-y e a r. A s s h o w n in o u r d i s c u s s i o n o f h e d g in g , fr o m A A s v ie w p o in t th e sw a p c o n v e r t s th e $ 1 0 0 m illio n fr o m a fix e d -ra te lia b ility to a flo a t in g - r a te lia b ility . I t s n e t c o s t is 6 - m o n th B B S W p e r h a lf- y e a r m in u s 0 .1 0 p e r c e n t p e r h a lf-y e a r. T o ill u s t r a t e h o w t h i s i n t e r e s t r a t e s w a p c o u ld r e d u c e t h e b o r r o w in g c o s t s o f b o t h c o m p a n ie s , s u p p o s e t h a t , b e f o r e e n t e r i n g in t o th e s w a p , B N R c o u ld h a v e b o r r o w e d a t a fix e d i n t e r e s t r a t e o f 3 .3 2 5 p e r c e n t p e r h a lf- y e a r , w h ile A A c o u ld h a v e b o r r o w e d a t a f l o a t in g i n t e r e s t r a t e o f 6 - m o n t h B B S W p e r h a lf- y e a r . B u t , a s w e s h o w e d a b o v e , t h e p o s t - s w a p b o r r o w in g c o s t s w e re a fix e d r a t e o f 3 .3 0 p e r c e n t p e r h a lf- y e a r f o r B N R a n d a f l o a t in g r a t e o f 6 - m o n t h B B S W p e r h a lf - y e a r m i n u s 0 .1 p e r c e n t p e r h a lf- y e a r f o r A A . T h u s, t h e s w a p h a s r e d u c e d B N R s f ix e d - r a t e b o r r o w in g c o s t b y 0 .0 2 5 p e r c e n t p e r h a lf- y e a r a n d r e d u c e d A A s f l o a t i n g r a t e b o r r o w i n g c o s t b y 0 . 1 0 0 p e r c e n t p e r h a lf- y e a r . T h e s i t u a t i o n is s u m m a r is e d in T a b le 1 7 .1 6 .

TABLE 17.16 Pre-swap and post-swap interest rates (per half-year) faced by companies BNR and A A P re -s w a p

F ix e d in te r e s t ra te p e r h a lf-y e a r

F lo a tin g in te r e s t ra te p e r h alf-y ear

C om p an y B N R

3 .3 2 5 %

6 -m o n th BB SW p e r h alf-y e ar + 0 .2 5 0 %

C om p an y AA

2 .9 5 0 %

6 -m o n th BB SW p e r h alf-y ear

D ifferen ce

0 .3 7 5 %

0 .2 5 0 %

continued

c o n t r a c t s a n d swaps

B usiness finance

Table 17.16 continued

F ix e d in te r e s t rate C o m p an y B N R

3 .3 0 0 % 6 -m o n th BB SW p e r h alf-y e ar - 0 .1 0 0 %

C o m p an y AA C o st sa v in g

F lo a tin g in te r e s t rate

3 .3 2 5 % - 3 .3 0 0 % = 0 .0 2 5 %

6 -m o n th BB SW p e r h alf-y e ar - (6 -m o n th BB SW p e r h alf-y e ar - 0 .1 0 0 % ) = 0 .1 0 0 %

A s s h o w n in T a b le 1 7 .1 6 , b o t h p a r t i e s a c h ie v e lo w e r b o r r o w i n g c o s t s . B N R s p r e f e r e n c e is to b o r r o w a t a fix e d i n t e r e s t r a t e . I f i t d o e s s o b y g o i n g d ir e c t ly t o t h e f ix e d - r a t e l o a n m a r k e t th e c o s t w ill b e 3 .3 2 5 p e r c e n t p e r h a lf- y e a r . B u t i f i t d o e s s o in d ir e c tly , b y f i r s t b o r r o w in g a t a f l o a t in g i n t e r e s t r a t e a n d t h e n e n t e r i n g in t o t h e i n t e r e s t r a t e s w a p , i t s c o s t w ill b e 3 .3 0 0 p e r c e n t p e r h a lf- y e a r . B N R t h e r e f o r e s a v e s 0 .0 2 5 p e r c e n t p e r h a lf- y e a r . S im ila r ly , A A r e d u c e s i t s f l o a t in g - r a t e c o s t f r o m 6 - m o n t h B B S W p e r h a lfy e a r i f it g o e s t h e d ir e c t r o u t e , o r t o 6 - m o n t h B B S W p e r h a lf - y e a r - 0 . 1 0 0 p e r c e n t p e r h a lf - y e a r b y g o i n g t h e in d ir e c t r o u t e . A A t h e r e f o r e s a v e s 0 .1 0 0 p e r c e n t p e r h a lf - y e a r . T h e t o t a l c o s t s a v in g a c h ie v e d b y t h e t w o p a r t i e s i s 0 .0 2 5 + 0 .1 0 0 = 0 .1 2 5 p e r c e n t p e r h a lf- y e a r . W o u ld B N R g o to all t h a t e f f o r t to sa v e a m e r e 0 .0 2 5 p e r c e n t p e r h a lf- y e a r ? Y es. T h e lo a n p r in c ip a l is $ 1 0 0 m illio n , s o 0 .0 2 5 p e r c e n t p e r h a lf-y e a r c o r r e s p o n d s to $ 2 5 0 0 0 p e r h a lf-y e a r. I g n o r in g d is c o u n tin g , o v e r 4 y e a r s th is is a s a v in g o f $ 2 0 0 0 0 0 . E v e n a la r g e c o m p a n y w ill n o t w a n t to fo r g o a s a v in g o f $ 2 0 0 0 0 0 . In a d d itio n , th e e f f o r t re q u ir e d is n o t v e r y g r e a t. F o r m a n y la r g e c o m p a n ie s , e n t e r in g in t o a n in t e r e s t ra te sw a p is a v e r y s t r a ig h t f o r w a r d tr a n s a c t io n . In t e r e s t r a te s w a p s a r e s t a n d a r d is e d c o n tr a c ts a n d a r e fr e q u e n tly t r a d e d b e tw e e n b a n k s a n d a ls o b e tw e e n b a n k s a n d la r g e c o m p a n ie s . L iq u id ity is h ig h a n d t r a n s a c t io n c o s t s a re low . A A w ill a ls o m a k e th e e f f o r t b e c a u s e i t s c o s t s a v in g s a re e v e n g r e a t e r th a n t h o s e a v a ila b le to B N R . A s s h o w n in T a b le 1 7 .1 6 , th e f ix e d - r a te d iffe r e n c e b e t w e e n th e c o m p a n ie s i s 0 .3 7 5 p e r c e n t p e r h a lfy e a r, w h ile th e f lo a t in g - r a te d iffe r e n c e is 0 .2 5 0 p e r c e n t p e r h a lf- y e a r . It i s n o a c c id e n t t h a t th e d iffe r e n c e in t h e s e d if f e r e n c e s — g iv e n b y 0 .3 7 5 m in u s 0 . 2 5 0 — i s e q u a l to th e t o t a l c o s t s a v in g s o f 0 .1 2 5 p e r c e n t p e r h a lf- y e a r . I t c a n b e s h o w n t h a t i t is a lw a y s th e c a s e . T o s e e t h i s , im a g in e t h a t t h e f ix e d sw a p p a y m e n ts w e re s e t a t 2 .9 5 p e r c e n t p e r h a lf - y e a r (f o r B N R p a y in g A A ) a n d th e f l o a t in g s w a p p a y m e n t s w e re s e t a t 6 - m o n t h B B S W p e r h a lf- y e a r + 0 .2 5 p e r c e n t ( f o r A A p a y in g B N R ). T h e s e s w a p p a y m e n t s a r e e q u a l to th e tw o c o u n t e r p a r t ie s * b o r r o w in g r a t e s , t h u s r e s u lt i n g in a s t r a i g h t s w a p o f d e b t s . T h e r e fo re , a f t e r th e s w a p , B N R w o u ld p a y a fix e d r a t e o f 2 .9 5 0 p e r c e n t p e r h a lf- y e a r w h ile A A w o u ld p a y a f l o a t in g r a t e o f 6 - m o n t h B B S W p e r h a lf- y e a r + 0 .2 5 0 p e r c e n t p e r h a lf- y e a r . T h is o u t c o m e is a s a v in g o f 0 .3 7 5 p e r c e n t p e r h a lf - y e a r fo r B N R b u t a n a d d it i o n a l c o st o f 0 .2 5 0 p e r c e n t p e r h a lf - y e a r f o r A A . T h e t o t a l h a lf- y e a r ly s a v in g s a v a ila b le a r e t h e r e f o r e 0 .3 7 5 p e r c e n t m in u s 0 .2 5 0 p e r c e n t, w h ic h e q u a ls 0 .1 2 5 p e r c e n t. O f c o u r s e A A w o u ld n o t a g r e e to th e s e sw a p p a y m e n ts b u t th e c a lc u la tio n s s h o w t h a t a t o t a l sa v in g o f 0 .1 2 5 p e r c e n t is a c h ie v a b le . Th e o n ly t h in g w r o n g w ith th e s t r a ig h t sw a p is t h a t th e d iv isio n o f th is sa v in g b e tw e e n th e tw o c o u n t e r p a r t ie s is u n e q u a l; in fa c t, it is s o u n e q u a l th a t A A w o u ld lo se . T o m a k e th e sw a p a ttr a c tiv e to b o t h c o u n t e r p a r t ie s r e q u ir e s t h a t m o r e o f th e t o t a l s a v in g o f 0 .1 2 5 p e r c e n t p e r h a lf-y e a r flo w s to AA. In th is p a r tic u la r c a s e , th e so lu tio n a d o p t e d is t o s e t B N R s sw a p p a y m e n ts e q u a l to 3 .0 5 0 p e r c e n t p e r h a lf- y e a r a n d to s e t A A s sw a p p a y m e n ts e q u a l to 6 - m o n th B B SW p e r h a lf-y e a r. W h a t m a t t e r s h e re is th e n e t sw a p p a y m e n t. F o r e x a m p le , th e s a m e r e s u lt c o u ld b e a c h ie v e d b y a d d in g , say , 1 p e r c e n t to b o t h sw a p p a y m e n ts , s o th a t B N R s sw a p p a y m e n t is e q u a l to 4 .0 5 0 p e r c e n t p e r h a lf-y e a r a n d A A s sw a p p a y m e n t is e q u a l t o 6 - m o n th B B SW p e r h a lf-y e a r + 1 p e r c e n t p e r h a lf-y e a r. Th e e x t r a 1 p e r c e n t a d d e d to B N R s sw a p p a y m e n t is s im p ly ‘h a n d e d b a c k ’ to B N R b y th e e x t r a 1 p e r c e n t a d d e d to AA’s sw a p p a y m e n t. In p r a c tic e , i t i s s o m e t i m e s th e c a s e t h a t s t r o n g e r b o r r o w e r s lik e A A h a v e a g r e a t e r c o s t a d v a n t a g e o v e r w e a k e r b o r r o w e r s lik e B N R in fix e d - r a te b o r r o w in g t h a n in f lo a t in g - r a te b o r r o w in g . In t h e s e c a s e s , th e re w ill b e a p o s it iv e d iffe r e n c e - in - d iffe r e n c e s a n d th e r e fo r e th e r e i s s c o p e f o r a c h ie v in g c o s t s a v in g s f o r b o th c o u n t e r p a r t ie s t h r o u g h th e m e c h a n is m o f a n a p p r o p r ia te ly d e s ig n e d in t e r e s t r a te s w a p . In s o m e c a s e s , w e a k e r b o r r o w e r s m a y fin d t h a t th e y c a n o b t a in flo a t in g - r a te fin a n c e b u t n o t fix e d - r a te fin a n c e . F o r th e s e c o m p a n ie s , fix e d - r a te f u n d in g is a c h ie v a b le o n ly b y b o r r o w in g a t a f lo a t in g r a te a n d th e n u s i n g a n in t e r e s t r a te sw a p to sw itc h to a fix e d r a te . T h is e x p la n a t io n is b a s e d o n th e a r g u m e n t t h a t w h ile th e s t r o n g e r c o u n t e r p a r t y h a s a n a b so lu te c o s t a d v a n t a g e in b o t h f o r m s o f b o r r o w in g , it is lik e ly t o h a v e a c o m p a rativ e a d v a n t a g e in fix e d - r a te b o rr o w in g .

C hapter seventeen F utures

c o n t r a c t s a n d swaps

The t o t a l c o s t is th e r e fo r e m in im is e d b y th e s t r o n g e r c o u n t e r p a r t y in itia lly b o r r o w in g a t a fix e d in t e r e s t ra te , w h ile th e w e a k e r c o u n t e r p a r t y in itia lly b o r r o w s a t a flo a t in g i n t e r e s t r a te . Th e sw a p p a y m e n ts a re c h o se n to e n s u r e t h a t b o t h c o u n t e r p a r t ie s h a v e a p o s it iv e s h a r e o f th e t o t a l c o s t s a v in g a v a ila b le .38 A lth o u g h m a n y o f th e e a r ly in t e r e s t r a te s w a p s w e re d e s ig n e d in t h is w ay, it w o u ld b e u n u s u a l t o d a y to fin d tw o p a r t ie s lin k e d in t h is w a y to a c h ie v e s im u lt a n e o u s s a v in g s fo r b o t h p a r t i e s . S w a p s n o w a r e u s u a lly in te r m e d ia te d . T h a t is , in s t e a d o f B N R a n d A A b e in g d ire c tly lin k e d b y a s w a p , B N R w o u ld e n t e r in to a sw a p w ith a b a n k , w h ile A A w o u ld a ls o e n t e r in to a sw a p w ith a b a n k . A n a n a lo g y m a y h e lp . B a n k s b o r r o w fro m th e ir d e p o s i t o r s a n d le n d to t h e ir b o r r o w e r s . B u t a b a n k d o e s n o t m a t c h a n y p a r tic u la r b o r r o w e r w ith a n y p a r tic u la r d e p o s it o r . F o r e x a m p le , a b a n k n e v e r s a y s to a p o t e n t ia l d e p o s it o r , b e f o r e w e a c c e p t y o u r d e p o s it w e w ill f ir s t c h e c k t h a t th e r e is a m a t c h in g p o t e n t i a l b o rr o w e r*. N e it h e r d o e s a b a n k e v e r s a y to a p o t e n tia l b o rr o w e r, ‘b e fo r e w e a p p r o v e y o u r lo a n w e w ill f ir s t c h e c k t h a t th e r e i s a m a t c h in g p o t e n tia l d e p o sito r*. In s te a d , a b a n k k e e p s a b a la n c e b e tw e e n i t s to ta l d e p o s i t s a n d i t s to ta l lo a n s . S im ila rly , b a n k s p a r tic ip a t in g in th e sw a p m a r k e t a t t e m p t to b a la n c e t h e ir t o t a l p a id s w a p p o s i t io n s (th e ir c a s h o u tflo w s) a n d th e ir t o t a l received sw a p p o s i t io n s (th e ir c a s h in flo w s ). H e n c e , in th e sw a p m a r k e t, m o s t a c tiv e p a r t ic ip a n t s w ill e n t e r in t o a s w a p w it h o u t h a v in g a p a r tic u la r o f f s e t t i n g lo a n in m in d . In A u s tr a lia , m a n y i s s u e s o f d e b e n t u r e s a n d c o r p o r a t e b o n d s tr a d e in m a r k e t s c h a r a c t e r is e d b y lo w liq u id ity . H en ce , i f a b o r r o w e r w is h e s to r e v e r s e i t s c o m m it m e n t , it w ill fin d it d iffic u lt a n d / o r e x p e n s iv e to b u y b a c k i t s b o n d s . In c o n t r a s t , th e sw a p m a r k e t o f f e r s a h ig h le v e l o f liq u id ity . A s a r e s u lt , a b o r r o w e r c a n e a s ily r e v e r s e i t s c o m m it m e n t b y e n t e r in g in t o a sw a p . A f u r t h e r p o s s ib l e b e n e fit o f h a v in g a sw a p m a r k e t r e la te s to c r e d it a s s e s s m e n t . B e fo r e a b a n k m a k e s a lo a n , it a s s e s s e s th e c r e d it - w o r t h in e s s o f th e p o t e n tia l b o rr o w e r. If, s u b s e q u e n t ly , th e b o r r o w e r u s e s a n in t e r e s t r a te sw a p to c o n v e r t t h is lo a n fr o m (sa y ) a flo a tin g - r a te b a s i s to a fix e d - r a te b a s i s , th e in itia l f lo a tin g - r a te lo a n r e m a in s in fo rc e . T y p ically , th e o r ig in a l le n d e r is a b a n k . T h u s, in t e r e s t r a te s w a p s a llo w th e i m p o r t a n t t a s k o f c r e d it a s s e s s m e n t to re m a in la rg e ly in th e h a n d s o f th e b a n k s , w h ic h a r e u s u a lly s e e n a s h a v in g m o r e e x p e r ie n c e a n d b e t t e r a c c e ss to in f o r m a t io n th a n m a n y o t h e r p o t e n t i a l le n d e r s . It a ls o m e a n s t h a t b o r r o w e r s c a n o b t a in fix ed ra te fu n d in g w ith o u t in c u r r in g th e le g a l a n d a d m in is t r a t iv e c o s t s o f i s s u i n g d e b e n t u r e s o r c o r p o r a t e b o n d s . T h e se c o s t s c a n b e s u b s t a n t i a l . N o t all in t e r e s t r a te s w a p s a r e p la in v a n illa lik e th e o n e d e s c r ib e d a b o v e . T h ere a r e m a n y m o r e sp e c ia lis e d t y p e s o f i n t e r e s t r a t e s w a p s . F o r e x a m p le , o n e v a r ia t io n is th e f o r w a r d - s t a r t i n g s w a p , w h ic h is a s t a n d a r d sw a p w ith a d e f e r r e d s t a r t d a te . A n o t h e r is th e k n o c k o u t s w a p , in w h ic h th e sw a p t e r m in a t e s if a sp e c ifie d e v e n t o c c u r s, s u c h a s th e f lo a t in g r a te r i s i n g a b o v e a c e r ta in lev e l. In 2 0 0 9 , in r e s p o n s e t o th e g lo b a l fin a n c ia l c r is is , l e a d e r s o f th e G 2 0 c o u n t r ie s 39 c o m m it te d to th e p r o p o s a l t h a t t r a n s a c t i o n s in s t a n d a r d is e d o v e r - th e - c o u n te r d e r iv a t iv e s , in c lu d in g s w a p s , s h o u ld b e c e n tra lly c le a r e d th r o u g h c le a r in g h o u s e s , k n o w n a s c e n tr a l c o u n t e r p a r t ie s , o r C C P s, r a t h e r t h a n s e t t l e d b e tw e e n e a c h p a ir o f c o u n t e r p a r t ie s t o a c o n tr a c t. S u c h a p r o c e s s r e d u c e s c r e d it r is k a n d s im p lifie s th e t a s k o f c r e d it a s s e s s m e n t . T h e A u s tr a lia n G o v e r n m e n t h a s a u t h o r i s e d th e A S X a n d L C H .C le a r n e t to e s t a b lis h c le a r in g h o u s e s . L C H .C le a r n e t is a m u ltin a tio n a l c le a r in g h o u s e w h ic h is m a jo r it y o w n e d b y th e L o n d o n S to c k E x c h a n g e G r o u p .

17.13 Currency swaps m C u rre n c y s w a p s fa ll in to s e v e r a l c a t e g o r ie s . In th e in t e r b a n k m a r k e t, th e m o s t c o m m o n f o r m o f c u r r e n c y sw a p is a f lo a t in g - fo r - flo a t in g c u rre n c y sw a p , w h ic h is a ls o k n o w n a s a c r o s s - c u r r e n c y b a s i s s w a p . In th is ty p e o f s w a p , b o t h s e t s o f s w a p p a y m e n t s a r e c a lc u la te d u s in g flo a t in g i n t e r e s t r a t e s b u t th e sw a p p a y m e n ts a re in d iffe r e n t c u r r e n c ie s. U su a lly , th e r e is a ls o a n e x c h a n g e o f p r in c ip a ls a t th e s t a r t o f th e a g r e e m e n t a n d a re - e x c h a n g e o f p r in c ip a ls a t th e e n d o f th e a g r e e m e n t . H e n c e , u n lik e th e n o t io n a l a m o u n t o f a n i n t e r e s t r a te s w a p , th e c o r r e s p o n d in g a m o u n t s in a c u r r e n c y sw a p a r e n o t u s u a lly n o tio n a l: th e y a re p a id a t th e s t a r t a n d e n d o f th e sw a p .

LEARNING OBJECTIVE 10 Identify the characteristics and uses of interest rate swaps and currency swaps

38 The comparative advantage explanation has been criticised because it relies on the fixed- and floating-rate debt markets being segmented, so that fixed and floating interest rates are determined independently of each other. If these markets are unified, rather than segmented, then other explanations are required. While many of the swaps entered into in the early 1980s achieved large savings for both counterparties, as competition increased, this reason for using swaps lost much of its strength. For a detailed discussion, see Smith, Smithson and Wilford (1990, Chapter 10). 39 The G20 consists of 20 countries that together account for about 85 per cent of world gross domestic product. Members include the US, China, Japan, France, Germany, Italy, the UK and Australia.

4^^

A lth o u g h flo a tin g - fo r - flo a tin g c u rre n c y s w a p s a r e th e m o s t c o m m o n , th e m e c h a n ic s o f c u rre n c y sw a p s a re e a s ie r to e x p la in b y c o n s id e r in g a fix e d -fo r-fix e d c u rre n c y sw a p , in w h ic h a fix e d - ra te c o m m itm e n t in o n e c u rre n c y is e x c h a n g e d fo r a fix e d - ra te c o m m itm e n t in a n o th e r c u rre n c y .40 The s t r u c t u r e o f a fix ed -fo rfix e d c u rre n c y sw a p is illu s tr a te d in E x a m p le 1 7 .1 8 .

Example 17. Y a n k c o e n te rs in to a 3 -y e a r fix e d -fo r-fix e d c u rre n c y s w a p w ith B ritc o . T he lo a n p rin c ip a ls a r e £ 1 0 0 m illio n a n d U S $ 2 0 0 m illio n a n d th e c u rre n t s p o t e x c h a n g e ra te is U S $ 1 = £ 0 . 5 0 0 0 . T he s w a p re q u ire s Y a n k c o to m a k e a n n u a l s w a p p a y m e n ts o f 1 1 .8 p e r c e n t to B ritc o in US d o lla r s , w h ile B ritc o m a ke s a n n u a l s w a p p a y m e n ts o f 1 3 . 3 p e r c e n t to Y a n k c o in U K p o u n d s .41 T h e re is a n e x c h a n g e o f p r in c ip a ls a t the s ta rt o f th e s w a p a n d a re -e x c h a n g e o f p r in c ip a ls a t th e e n d o f th e s w a p . T he c a s h flo w s re q u ire d b y th e s w a p a r e set o u t in T a b le 1 7 . 1 7 .

TABLE 17.17 F》 ayments in a fixed-for-fixed currency swap E nd o f y e a r

S w a p p a y m e n ts m a d e B y B ritc o to Y a n k c o

B y Y a n k c o to B ritc o

0

£100m

$200m

1

$ 2 3 .6 m

£ 1 3 .3 m

2

$ 2 3 .6 m

£ 1 3 .3 m

3

$ 2 3 .6 m

£ 1 3 .3 m

3

$200m

£100m

A s s h o w n in T a b le 1 7 . 1 7 , th e s w a p c o m m its B ritc o to m a k e a se rie s o f c a s h p a y m e n ts in d o lla r s to Y a n k c o , a n d c o m m its Y a n k c o to m a k e a se rie s o f c a s h p a y m e n ts in p o u n d s to B ritc o . H e n c e , th e fu tu re s w a p p a y m e n ts re s e m b le a p a c k a g e o f f o r w a r d c o n tra c ts . F o r e x a m p le , a t th e e n d o f th e firs t a n d s e c o n d y e a rs , B ritc o w ill p a y $ 2 3 . 6 m illio n a n d r e c e iv e in re tu rn £ 1 3 . 3 m illio n , a n d a t th e e n d o f th e t h ir d y e a r, B ritc o w ill p a y $ 2 2 3 . 6 m illio n a n d re c e iv e in re tu rn £1 1 3 .3 m illio n . T h is set o f fu tu re c a s h flo w s is lik e h a v in g 1 -y e a r, 2 - y e a r a n d 3 -y e a r f o r w a r d c o n tra c ts to sell d o lla r s a n d b u y p o u n d s .42 Im p o rta n tly , h o w e v e r, e a c h im p lie d f o r w a r d e x c h a n g e ra te w ill not n e c e s s a rily e q u a l th e c o r r e s p o n d in g f o r w a r d e x c h a n g e ra te set in th e f o r w a r d e x c h a n g e m a rk e t.

A s w ith i n t e r e s t r a t e s w a p s , th e r e a r e th r e e m a in u s e s o f c u r r e n c y sw a p s : •

s p e c u la t in g

•

h e d g in g

•

r e d u c in g b o r r o w in g c o s t s . W e n o w d is c u s s b r ie fly e a c h o f t h e s e u s e s .

Speculating B r itc o m a y b e p r e d ic tin g t h a t in th e c o m in g y e a r s , th e d o lla r w ill w e a k e n a g a i n s t th e p o u n d (a n d th e r e fo r e th e p o u n d w ill s t r e n g th e n a g a i n s t th e d o lla r ). In t h a t c a s e , B r i t c o s fu t u r e d o lla r o u tflo w s w ill b e w o r th l e s s (in p o u n d t e r m s ) a n d i t s fu t u r e p o u n d in flo w s w ill b e w o r t h m o r e (in d o lla r t e r m s ) . T h a t is, th e f o r e c a s t c h a n g e in th e e x c h a n g e r a te w ill b e in B r i t c o s fa v o u r. 40 It is easy to show that combining an interest rate swap and a floating-for-floating currency swap creates the equivalent of a fixed-for-floating currency swap. Further, combining an interest rate swap and a fixed-for-floating currency swap creates the equivalent of a fixed-for-fixed currency swap. In this sense, therefore, markets for fixed-for-fixed and fixed-for-floating currency swaps are redundant. 41 Also referred to as pounds sterling'; standard nomenclature is GBP, indicating Great Britain pounds. Standard nomenclature for US dollars is USD. For ease of expression, in the remainder of this section we will refer to these two currencies as simply pounds and dollars. 42 In practice, currency forward contracts with terms longer than 1 year are relatively rare in the wholesale currency markets. Hence, the existence of currency swaps can be seen as a way of filling this gap.

C hapter seventeen F utures

c o n t r a c t s a n d swaps

S im ila rly , if Y an k co is u s i n g th e sw a p fo r s p e c u la t iv e p u r p o s e s , th e n Y a n k c o m u s t b e p r e d ic tin g th e o p p o s ite e x c h a n g e r a te c h a n g e : a s t r o n g e r d o lla r a n d a w e a k e r p o u n d . B e c a u s e th e sw a p c o m m it s Y a n k c o to fu tu r e p o u n d o u tflo w s , a n d fu t u r e d o lla r in flo w s , Y a n k c o b e n e f i t s fr o m a s t r o n g e r d o lla r a n d a w e a k e r pound. E x is tin g b o r r o w e r s c a n a ls o u s e i n t e r e s t r a t e s w a p s to s p e c u la t e o n e x c h a n g e r a te m o v e m e n ts . F o r e x a m p le , s u p p o s e Y a n k c o h a d a p r e - e x is t in g d e b t in d o lla r s b u t th e p o u n d in t e r e s t r a te is lo w e r th a n th e d o lla r in t e r e s t ra te . Y a n k c o c o u ld u s e a c u r r e n c y s w a p to c o n v e r t i t s h ig h - in t e r e s t d o lla r d e b t to low in t e r e s t p o u n d d e b t. In e ffe c t, t h is a c tio n is a s p e c u la t io n t h a t th e d o lla r w ill n o t d e p r e c ia t e a g a i n s t th e p o u n d , b e c a u s e i f i t d o e s s o , th e p o u n d i n t e r e s t c o s t w ill r is e in d o lla r t e r m s , p o t e n tia lly e lim in a t in g th e a p p a r e n t i n t e r e s t s a v in g s . A s e x p la in e d in th e fo llo w in g F in a n c e in A c tio n , it h a s b e e n c la im e d t h a t th e A u s tr a lia n G o v e r n m e n t e n te r e d in to c u r r e n c y s w a p s in t h is w ay.

TREASURY'S CURRENCY SWAPS CRASH_______________________

F in a n c e in

A c u r r e n c y s w a p c a n b e u s e d to c o n v e r t d e b t fr o m a h ig h in te re s t r a te d o m e s tic c u r r e n c y lo a n to a lo w in te re s t r a te f o r e ig n c u r r e n c y lo a n — w h ic h w ill s a v e th e b o r r o w e r m o n e y u n le s s , o f c o u rs e ,

A C T IO N

N ews

th e d o m e s tic c u r r e n c y d e p r e c ia te s . T h e n th e b o r r o w e r fa c e s th e p r o s p e c t o f th e b e n e fit o f th e lo w e r in te re s t r a te b e in g w ip e d o u t b y lo sse s o n th e e x c h a n g e ra te . W o u ld a n y o n e ta k e s u ch a ris k ? A c c o r d in g to th is e d it o r ia l in a M e lb o u r n e n e w s p a p e r in 2 0 0 2 s o m e o n e d id . T h e A u s t r a lia n G o v e rn m e n t n o less. F o r th e fir s t tim e s in c e th e 1 9 9 0 r e c e s s io n , A u s t r a lia n t a x p a y e r s a r e a t r is k o f f u n d in g h e a v y lo s s e s b y a g o v e r n m e n t f in a n c ia l a u t h o r ity . T h is tim e th e c u lp r it is th e F e d e r a l T re a s u ry , th r o u g h its c u r io u s p r a c t ic e o f t a k in g o u t u n h e d g e d c r o s s - c u r r e n c y s w a p s to r e d u c e th e in te r e s t b u r d e n o n th e p u b lic d e b t . C u r io u s , b e c a u s e th e T r e a s u r y h a s b e e n s o d is m is s iv e o f A s ia n c o u n tr ie s t h a t m a d e s im ila r m is ta k e s . Y e t a t n o s ta g e d i d it o r T r e a s u r e r P e te r C o s te llo w a r n us t h a t o u r m o n e y w a s a t r is k , u n til L a b o r s e n a to r s n o te d a s in g le - lin e e n t r y o n p a g e 8 0 o f a n a n n u a l r e p o r t r e v e a lin g t h a t in ju s t t w o y e a r s th e T r e a s u r y h a d ru n u p m o r e th a n $ 3 b illio n o f p r o s p e c tiv e f o r e ig n e x c h a n g e lo s s e s . B y J u n e 2 0 0 1 , its c u r r e n c y s w a p s h a d t u r n e d $ 8 b illio n o f d e b t in to a lm o s t $ 1 2 b i lli o n , r u n n in g u p u n r e a lis e d lo s s e s o f $ 3 . 8 b illio n . A t th is s ta g e th e s e a r e p r o s p e c tiv e lo s s e s ; w h e t h e r th e y o c c u r d e p e n d s o n w h e r e o u r d o lla r g o e s . B u t if th e d o lla r s ta y s r o u g h ly w h e r e it is, th e y a r e lo s s e s t h a t A u s t r a lia n f a m ilie s w i ll h a v e to p a y . W h y d i d th e T r e a s u r y r is k o u r m o n e y ? It b e g a n w it h a p la u s ib le r a t io n a le : in 1 9 8 7 a d e c a d e o f h ig h in f la t io n a n d c u r r e n c y p lu n g e s h a d le ft A u s t r a lia n b o n d r a te s u n c o m f o r t a b ly h ig h , s o th e T r e a s u r y t o o k a d v a n t a g e o f lo w e r U S r a te s b y s w a p p in g p a r t o f its A u s t r a lia n d o lla r d e b t f o r a U S d o lla r d e b t . T h is g a v e it lo w e r in te r e s t b ills a t th e r is k o f h ig h e r c o s ts if o u r d o lla r fe ll h e a v ily . F o r a d e c a d e th e s t r a t e g y w o r k e d ; th e T r e a s u r y c la im s t a x p a y e r s g a in e d m o r e th a n $ 2 b illio n fr o m lo w e r in te r e s t ra te s . B u t it w a s a h ig h - ris k s t r a t e g y t h a t w o u ld c o lla p s e if th e d o lla r c o lla p s e d . In a n a d m ir a b ly c a r e fu l r e p o r t in 1 9 9 9 , th e A u s t r a lia n N a t i o n a l A u d it O f f ic e p o in t e d o u t: 'T r e a s u r y h a s u s e d c r o s s - c u r r e n c y s w a p s , n o t to h e d g e e x is tin g e x p o s u r e s , b u t to c r e a te n e w e x p o s u r e s to U S d o lla r s . .. [T h is ] is in c o n t r a s t to th e p r a c tic e s o f o t h e r s o v e r e ig n d e b t m a n a g e r s , s ta te tr e a s u r y c o r p o r a t io n s a n d m o s t p r iv a t e s e c to r p r a c t ic e ’ . B y m id -1 9 9 9 th e T r e a s u r y h a d s w a p p e d $ 3 8 b illio n o f A u s t r a lia n d e b t in to U S d o lla r d e b t t h r o u g h 3 3 2 t r a n s a c t io n s . Y e t in 1 9 9 7 th e e n t ir e p o lic y r a t io n a le h a d d is a p p e a r e d . W it h in f la t io n a n d t h e b u d g e t b a la n c e u n d e r c o n t r o l, th e g a p b e t w e e n U S a n d A u s t r a lia n b o n d ra te s h a d v ir t u a lly v a n is h e d . A n d th e A u s t r a lia n d o lla r p lu n g e d in to t e r r it o r y t h a t m e a n t h e a v y lo s s e s f o r u n h e d g e d d e b t ; fr o m a lm o s t 8 0 U S c e n ts a t th e e n d o f 1 9 9 6 , it s a n k to 6 5 a t th e e n d o f 1 9 9 7 , 6 1 b y m id 1 9 9 8 a n d 5 1 b y m i d - 2 0 0 1 . T r e a s u r y r e v ie w e d th e p o lic y , b u t in s te a d o f g e t tin g o u t, g a m b le d o n th e d o lla r r e b o u n d in g . It w a s w r o n g , a n d t a x p a y e r s n o w s ta n d to lo s e h e a v ily . W e a r e o w e d a fu ll e x p la n a t io n , a fu ll d is c lo s u r e a n d a c k n o w le d g e m e n t o f r e s p o n s ib ilit y b y b o th T re a s u re r P e te r C o s te llo a n d T r e a s u r y s e c r e ta r y K e n H e n r y .

Source: 'Treasury's currency swaps crash', The Age, 6 March 2002, p. 14.

4 ^^

Hedging Suppose instead th a t Britco has a pre-existing contract which w ill generate future US dollar cash inflows fo r Britco. I f Britcos shareholders are British, the US dollar inflow s are an exchange-rate risk: the shareholders are concerned about the future pound values o f these US dollar inflows. In this case, entering in to the currency swap provides Britco w ith a hedge. When Britco receives the future dollar inflows, the swap ensures th a t they are effectively passed through to Yankco, so th a t B ritcos net cash flows consist only o f the pound inflow s from Yankco. Similarly, the currency swap would represent a hedge fo r Yankco i f it has a pre-existing contract which w ill generate future pound inflow s fo r Yankco. On a net basis, the swap converts Yankco from receiving pound inflow s to receiving dollar inflows. Many Australian companies— particularly banks— have borrowed foreign currencies in overseas markets and, almost immediately, have entered into currency swaps to elim inate the exchange-rate risk. Motives fo r seeking funding from overseas vary. The borrower may consider the interest rate to be attractive or the borrow er may fear th a t a large transaction in the domestic Australian m arket may force interest rates to rise, thus increasing the cost. Similarly, foreign issuers o f Australian dollar bonds in the Australian m arket (known as ‘kangaroo bonds’）have entered into currency swaps to elim inate exchangerate risk (Arsov et al. 2013).

Reducing borrow ing costs Like in te re st rate swaps, under some circumstances a currency swap may reduce the cost o f borrow ing fo r b o th parties. Using a fixed-for-fixed currency swap to reduce borro w in g costs is illu stra te d in Example 17.19.

Example 17.19 Y a n k c o w is h e s to b o r r o w £ 1 0 0 m illio n f o r 3 y e a rs a n d B ritc o w is h e s to b o r r o w $ 2 0 0 m illio n fo r 3 y e a rs . T he c u rre n t s p o t e x c h a n g e ra te is $1 = £ 0 . 5 0 0 0 . B o th c o m p a n ie s w is h to r e p a y u s in g th e s ta n d a r d b o n d c a s h f lo w p a t te r n — th a t is, in te re s t is p a id a t th e e n d o f e a c h y e a r a n d th e p r in c ip a l is r e p a id in fu ll a t th e e n d o f th e th ir d y e a r. T he in te re s t ra te s (in p e r c e n t p e r a n n u m ) a p p lic a b le to th e tw o b o r r o w e r s a r e s h o w n in T a b le 1 7 .1 8 .

TABLE 17.18 Interest rates payable by Britco and Yankco In te re st ra te s (% p .a .) O n $ b o r r o w in g s

O n £ b o r r o w in g s

Britco

12.0

14.5

Yankco

10.0

13.5

Com pany

L o o s e ly s p e a k in g , w h ile Y a n k c o c a n b o r r o w m o re c h e a p ly th a n B ritc o in b o th c u rre n c ie s , it h a s a 2 - p e r c e n ta g e p o in ts ( 2 0 0 b p s) a d v a n ta g e in d o lla r b o r r o w in g s b u t o n ly a

1- p e r c e n ta g e p o in t

( 1 0 0 b p s ) a d v a n ta g e in p o u n d b o r r o w in g s . T he s ta n d a r d fu n d in g c o s t a r g u m e n t f o r c u r r e n c y s w a p s is to s u g g e s t th a t Y a n k c o s h o u ld in it ia lly b o r r o w d o lla r s , w h ile B ritc o s h o u ld in it ia lly b o r r o w

p o u n d s , a n d th e t w o s h o u ld th e n s w a p lo a n

c o m m itm e n ts . T his is a c h ie v e d b y Y a n k c o a n d B ritc o e n te rin g in to a c u r r e n c y s w a p w h ic h re q u ire s e x c h a n g in g c a s h flo w s o n e a c h in te re s t p a y m e n t d a te a n d a t th e in it ia t io n a n d m a tu rity o f th e lo a n . A lth o u g h le g a lly th e o r ig in a l lo a n c o n tra c ts b e tw e e n Y a n k c o a n d th e d o lla r le n d e rs , a n d b e tw e e n B ritc o a n d th e p o u n d le n d e rs , re m a in u n d is tu rb e d , th e econom ic e ffe c t is th a t B ritc o a n d Y a n k c o h a v e s w a p p e d lo a n c o m m itm e n ts . H o w e v e r , a s tra ig h t s w a p o f lo a n c o m m itm e n ts is u n lik e ly . In th is e x a m p le , a s in m a n y s w a p s , o n e c o u n te r p a r ty is f in a n c ia lly s tro n g e r th a n th e o th e r: Y a n k c o is c le a r ly th e s tro n g e r c o u n te r p a r ty b e c a u s e it c a n b o r r o w a t lo w e r in te re s t ra te s th a n B ritc o in b o th c u rre n c ie s . In a s tra ig h t s w a p , Y a n k c o w ill s im p ly e n d u p p a y in g th e h ig h e r in te re s t ra te r e q u ire d o n a lo a n to B ritc o . T hus, Y a n k c o w ill n e e d a n in d u c e m e n t to e n te r in to th e s w a p . S u ch a n in d u c e m e n t m ig h t b e a c h ie v e d in a n u m b e r o f d iffe re n t w a y s . F o r e x a m p le , B ritc o c o u ld o ff e r Y a n k c o a fe e , p e rh a p s in th e fo rm o f a llo w in g Y a n k c o to re ta in

C hapter seventeen F utures

c o n t r a c t s a n d swaps

s o m e o f its lo a n p r in c ip a l, w h ile B ritc o tra n s fe rs th e w h o le o f its lo a n p r in c ip a l to Y a n k c o . A lte r n a tiv e ly , B ritc o c o u ld m a k e s w a p p a y m e n ts to Y a n k c o a t a n in te re s t ra te h ig h e r th a n th e 1 0 p e r c e n t re q u ire d b y Y a n k c o to r e p a y its US d o lla r c re d ito rs . A th ir d a p p r o a c h , w h ic h w e e x p la in b e lo w , in v o lv e s a n in te r m e d ia r y a n d tw o c u r r e n c y s w a p s . O n e s w a p is b e tw e e n B ritc o a n d th e in te r m e d ia r y , w h ile th e o th e r s w a p is b e tw e e n Y a n k c o a n d th e in te r m e d ia r y . T he d e ta ils a r e se t o u t in F ig u re 1 7 . 6 a n d T a b le 1 7 . 1 9 .

m

ure 17.6 Post-swap cash flows

▼ U S d o lla r lenders

Pou nd lenders

- US$ cash flow — £ cash flow The p re -s w a p a n d p o s t-s w a p n e t c a s h flo w s a r e s h o w n in T a b le 1 7 . 1 9 .

TABLE 17.19 Pre-swap and pos swap net cash flows 卜

End o f y e a r

P re -s w a p c a s h flo w s

「

P o s t-s w a p n e t ca sh flo w s

B ritc o

Yankco

B ritc o

Yankco

In te rm e d ia ry

0

+£100m

+US$200m

+US$200m

+£100m

—

1

-£14.5m

-US$20m

-US$23.6m

-£13.3m

+US$3.6m -£1.2m

2

-£14.5m

-US$20m

-US$23.6m

-£13.3m

+US$3.6m-£1.2m

3

-£14.5m

-US$20m

-US$23.6m

-£13.3m

+US$3.6m -£1.2m

3

-£100m

-US$200m

-US$200m

-£100m

—

A s s h o w n in F ig u re 1 7 . 6 , a fte r th e s w a p B ritc o h a s e x a c tly o ffs e ttin g in flo w s a n d o u tflo w s in p o u n d s a n d is p a y in g 1 1 .8 p e r c e n t fo r US d o lla r s . T h is is 0 . 2 p e r c e n t b e tte r th a n B ritc o c o u ld h a v e a c h ie v e d fo r its e lf d ire c tly . A fte r th e s w a p , Y a n k c o h a s e x a c tly o ffs e ttin g in flo w s a n d o u tflo w s in d o lla r s , a n d is p a y in g 1 3 . 3 p e r c e n t f o r p o u n d s . T h is is 0 . 2 p e r c e n t b e tte r th a n Y a n k c o c o u ld h a v e a c h ie v e d f o r its e lf d ire c tly . T h e fin a n c ia l in te r m e d ia r y c a r r ie s a n e x c h a n g e ris k in th a t o n e a c h in te re s t p a y m e n t d a te , it ha s a n e t d o lla r in flo w o f (0 .1 1 8 - 0 . 1 0 ) x $ 2 0 0 m illio n = $ 3 . 6 m illio n , a n d a n e t p o u n d o u tflo w o f ( 0 . 1 4 5 - 0 . 1 3 3 ) x £ 1 0 0 m illio n = £ 1 . 2 m illio n . T h e in te r m e d ia r y m ig h t s e e k to h e d g e th is ris k b y e n te rin g in to f o r w a r d c o n tra c ts , o r b y e n te rin g in to o th e r s w a p s . A lte r n a tiv e ly , if th e in te r m e d ia r y d o e s n o t h e d g e th is ris k , its n e t c a s h f lo w w ill b e n e g a tiv e o n ly in th e e v e n t th a t th e d o lla r d e p re c ia te s b y o n e -th ird in 3 y e a rs fro m a v a lu e o f £ 0 . 5 0 0 0 p e r d o lla r to less th a n £ 0 . 3 3 3 3

p e r d o lla r . T he

in te r m e d ia r y m a y r e g a r d th is v a lu e lo ss a s u n lik e ly a n d h e n c e a ris k w o r th c a r r y in g .

4^^

B usiness finance

As we discussed fo r interest rate swaps, an interm ediary would n o t norm ally lin k two particular currency swaps in the way th a t may be inferred from Figure 17.6. Like interest rate swaps, currency swaps are standardised and many m arket participants w ill m on itor th e ir total exposures by currency and tim ing, rather than seeking to hedge individually each currency swap. That is, like interest rate swaps, currency swaps are intermediated. A lth ou g h speculating, hedging and reducing borro w in g costs are the m ain reasons to use currency swaps, m arket p articip a nts have also found currency swaps a useful to o l in s tru c tu rin g contracts th a t exploit tax advantages, or th a t reduce the im pact o f governm ent regulations. For example, in the past, US companies have used currency swaps as p a rt o f a m ethod to e xploit some tax advantages o f b o rro w in g yen.43 One fin al issue is c re d it ris k . The credit risk o f a currency swap is usually considerably greater than the credit risk o f an interest rate swap. The m ain reason fo r the higher risk is th a t currency swaps usually require a re-exchange o f principals on the m a tu rity date, whereas in interest rate swaps there is no exchange o f principals. Obviously, loan principals involve sums th a t are much greater than the associated periodic interest flows. In practice, however, there have been relatively few defaults. Moreover, although the development o f centralised clearing is less advanced fo r currency swaps than fo r interest rate swaps, the trend towards centralisation and/or tig h te r regulation o f participating banks is expected to reduce credit risk.

CREDIT RISK

possibility of loss because a party fails to meet its obligations

43

H ld vHu M 3 I A 3 H JSI33HM3A3S pq

F o r d e t a ils , s e e S m it h , S m it h s o n a n d W ilfo r d ( 1 9 9 0 , p p . 2 2 0 - 4 ) .

SUMMARY T h is c h a p te r e x a m in e d fiv e m a in issues: •

•

First,

a

d is c u s s io n

p r o v id e d

o f w h a t fu tu re s

b a n k - a c c e p te d

b ill

fu tu re s

c o n tra c t,

th e

1 0 -y e a r

c o n tra c ts a r e a n d h o w fu tu re s m a rk e ts a r e o r g a n is e d .

T re a s u ry b o n d fu tu re s c o n tra c t, th e s h a re p r ic e in d e x

T his d is c u s s io n in c lu d e d a n e x p la n a tio n o f h o w th e

fu tu re s c o n tra c t, a n d th e 3 0 - d a y in te r b a n k c a s h ra te

c le a r in g

fu tu re s c o n tra c t.

house

in te rp o s e s

its e lf

b e tw e e n

tra d e rs ,

H a v in g

d e ta ile d

th e s p e c ific a tio n

a n d h o w th is p ro c e s s a llo w s tra d e rs to c lo s e o u t (o r

o f th e se c o n tra c ts , e x a m p le s w e r e p r o v id e d o f h o w

re ve rse ) th e ir c o n tra c ts b e fo re th e m a tu rity d a te . A n

th e s e c o n tra c ts m a y b e u se d fo r s p e c u la tio n a n d

e x p la n a tio n o f th e system o f d e p o s its , m a rg in s a n d

h e d g in g p u rp o s e s .

th e m a rk -to -m a rk e t ru le w a s a ls o p r o v id e d .

F o u rth , th e c h a p te r p r o v id e d a n a n a ly s is o f so m e

S e c o n d , th e c h a p te r d e a lt w ith s p e c u la tio n s tra te g ie s

o f th e d e te rm in a n ts o f fu tu re s p ric e s a n d s p e c ific a lly

th a t m a y b e e m p lo y e d u s in g fu tu re s m a rk e ts . F ive k in d s

e x a m in e d th e v a lu a tio n o f b a n k - a c c e p te d b ill fu tu re s

of

c o n tra c ts a n d s h a re p r ic e in d e x fu tu re s c o n tra c ts .

s p e c u la tio n

w e re

id e n tifie d — n a m e ly

s c a lp in g , lo n g -te rm

F o r w a r d - r a te a g re e m e n ts , w h ic h a r e o fte n u se d as

(o r o v e rn ig h t) p o s itio n ta k in g . T he p ro c e s s e s o f s h o rt

a n a lte r n a tiv e to in te re s t-ra te fu tu re s c o n tra c ts , w e r e

h e d g in g

a ls o d is c u s s e d .

s p r e a d in g ,

•

was

A u s tr a lia n S e c u ritie s E x c h a n g e , n a m e ly th e 9 0 - d a y

s tr a d d lin g ,

and

lo n g

day

h e d g in g

t r a d in g w e re

and

a ls o e x p la in e d .

Im p e rfe c t c o n v e rg e n c e , b a s is ris k a n d s p e c ific a tio n

F in a lly , th e c h a p te r d e s c rib e d th e m e c h a n ic s o f in te re s t

d iffe re n c e s w e r e d is c u s s e d a s re a s o n s w h y h e d g in g

ra te s w a p s a n d c u rre n c y s w a p s a n d illu s tra te d h o w

w ith fu tu re s c o n tra c ts m a y n o t b e p e rfe c t.

s w a p s m a y b e use d to s p e c u la te o n fu tu re c h a n g e s

T h ird , th e c h a p te r p r o v id e d d e ta ils o f th e s p e c ific a tio n

in in te re s t ra te s o r e x c h a n g e ra te s, to h e d g e in te re s t

o f fo u r f in a n c ia l

ra te

fu tu re s

c o n tra c ts

tra d e d

on

th e

risk a n d

exchange

b o r r o w in g costs.

ra te

ris k ,

and

to

re d u c e

C hapter seventeen F utures

c o n t r a c t s a n d swaps

b a sis

m a rg in c a ll

519

b a sis p o in t BBSW

c a ll o p tio n o n a fu tu re s c o n tra c t c a r r y in g co s t

s h o rt h e d g e r 544

fo r w a r d c o n tra c t fu tu re s c o n tra c t

509 508

1

s h o rt s e llin g s p o t p ric e

544

sw ap

513

517 511

s p e c u la to rs s p re a d

508

in te re s t ra te s w a p

t ) d

545

p u t o p tio n o n a fu tu re s c o n tra c t

556

lo n g h e d g e r

ra te s w a p

513

51 3

c u rre n c y s w a p

h e d g e rs

51 1

n o tio n a l p r in c ip a l (o r n o tio n a l a m o u n t) o f a n in te re s t

546

c re d it ris k

512

m a r k in g - to -m a r k e t

548

508 514

516 544

517

SELF-TEST PROBLEMS

S u p p o s e th a t, a t a p a r tic u la r tim e , th e J u n e fu tu re s p r ic e is $1 2 0 0 a n d th e S e p te m b e r fu tu re s p r ic e is $1 2 6 0 . You a r e c o n v in c e d th a t th e s p r e a d b e tw e e n th e J u n e a n d S e p te m b e r p ric e s w ill s o o n w id e n , b u t y o u h a v e n o b e lie f a s to w h e th e r b o th p ric e s w ill ris e , o r b o th p ric e s w ill fa ll. W h a t a c tio n (s ) s h o u ld y o u ta k e ? S h o w th a t as a re s u lt o f y o u r a c tio n (s ) y o u w ill m a k e a p r o fit, if, o n a s u b s e q u e n t d a te , th e J u n e fu tu re s p r ic e is $1 3 0 0 a n d

C H A P T E R S E V E N T E E N REVmv\^

KEY TERMS

th e S e p te m b e r fu tu re s p r ic e is $ 1 3 8 0 . 2

O n 2 S e p te m b e r th e q u o te d p r ic e o f th e 9 0 - d a y b a n k b ill fu tu re s c o n tra c t m a tu rin g o n 1 2 D e c e m b e r w a s 9 2 . 0 0 . O n 8 S e p te m b e r th e p r ic e w a s 9 2 . 5 0 . T h e fa c e v a lu e o f th e b a n k b ills u n d e r ly in g o n e c o n tra c t is $1 m illio n . S u p p o s e t h a t H a r o ld s o ld 1 5 su ch c o n tra c ts o n 2 S e p te m b e r a n d c lo s e d o u t h is p o s itio n o n 8 S e p te m b e r. Ig n o r in g tr a n s a c tio n co sts, h o w m u c h h a s H a r o ld m a d e (o r lo st)?

Solutions to self-test problem s are a v a ila b le in A p p e n d ix B.

QUESTIONS 1

[LO 1] W h a t a r e th e m a jo r d iffe re n c e s b e tw e e n a f o r w a r d c o n tra c t a n d a fu tu re s c o n tra c t?

2

[LO 1: D is tin g u is h b e tw e e n th e te rm s volume tra d e d a n d open positions.

3

[L O 1] D is tin g u is h b e tw e e n th e f o llo w in g , p r o v id in g in y o u r a n s w e r b r ie f e x a m p le s to illu s tra te th e p o in ts yo u m ake:

4

a)

d e liv e r a b le fu tu re s c o n tra c t a n d n o n -d e liv e ra b le fu tu re s c o n tra c t

b)

s p e c u la to r a n d h e d g e r

c)

s h o rt h e d g e r a n d lo n g h e d g e r.

[LO 1] G o to th e A u s tr a lia n S e c u ritie s E x c h a n g e w e b s ite

(w w w.asx.com .au) a n d fin d th e 'c o m m o d itie s ' o n

w h ic h fu tu re s c o n tra c ts a r e t r a d e d . W h y is th e re n o t a fu tu re s c o n tra c t o n w in e ? 5

[L O 2 ] E x p la in h o w th e A u s tr a lia n S e c u ritie s E x c h a n g e p ro te c ts its e lf a g a in s t th e ris k th a t b u y e rs a n d s e lle rs o f fu tu re s c o n tra c ts m ig h t d e fa u lt o n th e ir o b lig a tio n s .

6

[L O 3 ] D e fin e w h a t is m e a n t b y th e te rm ’ c a r r y in g c o s t’ w h e n d e a lin g w ith th e p r ic in g o f fu tu re s c o n tra c ts .

7

[LO 4 ] E x p la in w h a t is m e a n t b y a p e r fe c t h e d g e . D o e s a p e r fe c t h e d g e a lw a y s le a d to a b e tte r o u tc o m e

H o w m ig h t y o u e s tim a te th is c o s t w h e n d e a lin g w ith a fu tu re s c o n tr a c t o n a c o m m o d ity su ch a s w h e a t?

th a n a n im p e r fe c t h e d g e ? 8

[L O 4 】Futures markets are re a lly there fo r the benefit o f speculators, not hedgers. Very fe w contracts e n d in

delivery, so obviously the futures m arket traders a re n 't interested in the a ctu a l com m odities, a n d i f they're not interested in the a ctual com m odities, they c a n 't be hedgers. M a n y contracts a re n 't even deliverable. H o w could anyone hedge w ith contracts like that? C o n s id e r c a r e fu lly th e v a r io u s c la im s m a d e in th is s ta te m e n t.

.557

B usiness finance

9 10

11

[L O 5 ] W h a t is m e a n t b y b a s is risk? [L O 6 ] C o n s id e r th e e ffe c ts o f a n o v e r n ig h t s h a re p r ic e fa ll o f a r o u n d 2 5 p e r c e n t o n : a)

a s p e c u la to r w ith a lo n g p o s itio n in th e SPI 2 0 0 fu tu re s c o n tra c t

b)

a s u p e ra n n u a tio n fu n d w ith a s h o rt p o s itio n in th e SPI 2 0 0 fu tu re s c o n tra c t.

[LO 1 0 ] E x p la in h o w a n in te re s t ra te s w a p m a y b e u se d f o r s p e c u la tiv e o r h e d g in g p u rp o s e s , d e p e n d in g on th e c irc u m s ta n c e s o f th e s w a p p a r tic ip a n t .

12

[LO 1 0 ] W h y d o in te re s t ra te s w a p s a lm o s t n e v e r re q u ire a n e x c h a n g e o r r e -e x c h a n g e o f p r in c ip a ls b u t u s u a lly c u r r e n c y s w a p s re q u ire a n e x c h a n g e a n d a r e -e x c h a n g e o f p r in c ip a ls ?

13

[LO 1 0 ] E x p la in h o w a fix e d -fo r-fix e d c u r r e n c y s w a p m a y b e u se d f o r s p e c u la tiv e o r h e d g in g p u rp o s e s , d e p e n d in g o n th e c irc u m s ta n c e s o f th e s w a p p a r tic ip a n t.

PROBLEMS 1

Determinants of futures prices [LO 3] O n a p a r tic u la r d a y in th e X a n a d u Futures E x c h a n g e th e f o llo w in g g o ld fu tu re s p ric e s w e re o b s e rv e d : D e liv e ry d a te (m o n th s )

F utures p ric e p e r o u n c e ($ )

1

1379

2

1388

3

1410

6

1419

12

1439

In X a n a d u th e in te re s t ra te is 0 . 5 p e r c e n t p e r m o n th (c o m p o u n d ). It costs $ 2 p e r o u n c e p e r m o n th (p a y a b le fo r th e w h o le p e r io d , in a d v a n c e ) to s to re a n d in s u re g o ld . E ach fu tu re s c o n tra c t c o v e rs 8 o u n c e s o f g o ld . T he c u rre n t s p o t p r ic e o f g o ld is $ 1 3 7 3 p e r o u n c e . Id e n tity a n y a r b it r a g e o p p o rtu n itie s . E x p la in h o w such o p p o r tu n itie s c o u ld b e e x p lo ite d a n d c a lc u la te th e p r o fit p e r c o n tra c t. Ig n o re tra n s a c tio n costs, ta x e s a n d a n y in te re s t re c e iv e d o r fo r g o n e d u e to d e p o s its o r m a rg in s .

2

Speculation w ith 90-day bank bill futures contracts [LO 7] O n 3 0 S e p te m b e r 2 0 1 3 , th e q u o te d p ric e o n th e D e c e m b e r 2 0 1 3 9 0 - d a y b a n k b ill fu tu re s c o n tra c t w a s 9 7 . 5 1 . P e n n y b e lie v e d th a t in te re s t ra te s w o u ld fa ll o v e r th e n e x t m o n th . S u p p o s e th a t sh e b o u g h t fiv e c o n tra c ts o n 3 0 S e p te m b e r 2 0 1 3 a n d c lo s e d o u t h e r p o s itio n o n 31 O c to b e r 2 0 1 3 a t a p r ic e o f 9 7 . 4 2 . Ig n o rin g tra n s a c tio n costs, h o w m uch h a s P e n n y m a d e (o r lost)?

3

Speculation w ith 10-year bond futures contracts [LO 7 】 O n 3 0 S e p te m b e r 2 0 1 3 , th e D e c e m b e r 2 0 1 3 1 0 -y e a r b o n d fu tu re s c o n tra c t w a s p r ic e d a t 9 6 . 1 4 . S e a n , u n lik e P e n n y in P ro b le m 2, b e lie v e d th a t in te re s t ra te s w o u ld ris e o v e r th e n e x t m o n th . S u p p o s e th a t he s o ld s ix c o n tra c ts o n 3 0 S e p te m b e r a n d c lo s e d o u t h is p o s itio n o n 31 O c to b e r a t a p ric e o f 9 6 . 0 2 . Ig n o rin g tra n s a c tio n costs, h o w m uch h a s h e m a d e (o r lost)?

4

Speculation w ith SPI 200 futures contracts [LO 7] O n 3 0 S e p te m b e r 2 0 1 3 , th e D e c e m b e r 2 0 1 4 SPI 2 0 0 fu tu re s c o n tra c t w a s p ric e d a t 5 2 2 3 . 0 . M e g a n b e lie v e d th a t th e sh a re m a rk e t w a s lik e ly to fa ll o v e r th e n e x t m o n th . S u p p o s e th a t she s o ld se ve n c o n tra c ts on 3 0 S e p te m b e r a n d c lo s e d o u t h e r p o s itio n o n 31 O c to b e r a t a p ric e o f 5 4 1 6 . 0 . Ig n o r in g tra n s a c tio n costs, h o w m u ch h a s sh e m a d e (o r lost)?

5

Using 30-day interbank cash rate futures contracts [LO 7] O n 2 3 A p r il 2 0 1 3 , th e c lo s in g p r ic e o f th e M a y 2 0 1 3 3 0 - d a y in te rb a n k c a s h ra te c o n tra c t w a s 9 7 . 0 6 . The R eserve B a n k o f A u s tra lia (RBA) h a d a b o a r d m e e tin g s c h e d u le d fo r 7 M a y 2 0 1 3 a n d th e c u rre n t o v e rn ig h t c a s h ra te w a s 3 p e r c e n t p e r a n n u m . O n 2 3 A p r il, w h a t w a s th e p r o b a b ilit y im p lie d b y th e p r ic e o f th e M a y 2 0 1 3 3 0 - d a y in te r b a n k c a sh ra te c o n tra c t th a t th e R B A w o u ld d e c re a s e th e c a s h ra te to 2 . 7 5 p e r c e n t a t its M a y m e e tin g ?

558

f

C hapter seventeen F utures

Speculation with bank bill futures contracts [LO 7] The 9 O c to b e r 2 0 0 4 A u s tra lia n fe d e ra l e le c tio n w a s o n e in w h ic h th e p o s s ib le e ffe c t o f th e e le c tio n o u tc o m e o n in te re s t ra te s w a s a k e y p o in t o f d iffe re n tia tio n b e tw e e n th e p a rtie s . T h e th e n P rim e M in is te r J o h n H o w a r d a n d his L ib e ra l-N a tio n a l P a rty c o a litio n g o v e rn m e n t c a m p a ig n e d u n d e r th e s lo g a n th a t re -e le c tin g th e m w o u ld 'K e e p in te re s t ra te s lo w '. In a d d itio n , th e y ra n a d v e rtis e m e n ts s h o w in g th e d o u b le - d ig it in te re s t ra te s th a t p re v a ile d u n d e r L a b o r g o v e rn m e n ts in th e 1 9 8 0 s a n d e a r ly 1 9 9 0 s . T he A u s tra lia n L a b o r P a rty (ALP) c o u n te re d b y q u o tin g a Reuters s u rv e y o f 1 4 fin a n c ia l m a rk e t e c o n o m is ts , a ll o f w h o m s ta te d th a t th e p a r ty in g o v e rn m e n t w o u ld m a k e n o d iffe re n c e to th e le ve l o f in te re s t ra te s o v e r th e fo llo w in g th re e y e a rs . O n 8 O c to b e r 2 0 0 4 , th e q u o te d p ric e o n th e M a r c h 2 0 0 5 9 0 - d a y b a n k b ill fu tu re s c o n tra c t w a s 9 4 . 5 2 . M a r g a r e t b e lie v e d th a t in te re s t rates w o u ld fa ll f o llo w in g th e e le c tio n o n 9 O c to b e r. S u p p o s e th a t she b o u g h t e ig h t c o n tra c ts o n 8 O c to b e r a n d c lo s e d o u t h e r p o s itio n o n 11 O c to b e r a t a p ric e o f 9 4 . 5 7 . Ig n o rin g tra n s a c tio n costs, h o w m u ch h a s M a r g a r e t m a d e (or lost)?

7

Speculation with 10-year bond futures contracts [LO 7]

〇n

8 O c to b e r 2 0 0 4 , th e D e c e m b e r 2 0 0 4 1 0 -y e a r b o n d fu tu re s c o n tra c t w a s p r ic e d a t 9 4 . 4 3 5 . M ic h a e l,

u n lik e M a r g a r e t in P ro b le m 6 , b e lie v e d th a t in te re s t ra te s w o u ld rise fo llo w in g th e fe d e ra l e le c tio n o n 9 O c to b e r. S u p p o s e th a t h e s o ld tw o c o n tra c ts o n 8 O c to b e r a n d c lo s e d o u t his p o s itio n o n 1 1 O c to b e r a t a p ric e o f 9 4 . 5 2 5 . Ig n o rin g tra n s a c tio n costs, h o w m u ch ha s he m a d e (o r lost)?

8

Using 30-day interbank cash rate futures contracts [LO 7] O n 8 O c to b e r 2 0 0 4 , th e N o v e m b e r 2 0 0 4 3 0 - d a y in te rb a n k c a s h ra te fu tu re s c o n tra c t w a s p ric e d a t 9 4 . 7 4 a n d o n 11 O c to b e r 2 0 0 4 it w a s p ric e d a t 9 4 . 7 4 5 . T he R e serve B a n k o f A u s tr a lia (RBA) h a d a s c h e d u le d b o a r d m e e tin g o n 2 N o v e m b e r 2 0 0 4 . S u p p o s e w e a ssu m e th a t th e d e c is io n fa c e d b y th e R BA b o a r d w a s to e ith e r le a v e th e ta r g e t c a s h ra te u n c h a n g e d a t 5 . 2 5 p e r c e n t p e r a n n u m o r in c re a s e it to 5 . 5 p e r c e n t p e r a n n u m . W h a t w e re th e im p lie d p r o b a b ilitie s , o n 8 a n d 1 1 O c to b e r, o f th e R BA b o a r d le a v in g th e ta rg e t c a sh ra te u n c h a n g e d o n 2 N o v e m b e r?

9

Hedging with 90-day bank bill futures contracts [LO 7 】

CHAPTER SEVENTEEN REVIEW

6

c o n t r a c t s a n d swaps

You a re th e fin a n c e m a n a g e r o f P la y S a fe L t d . 〇n 2 8 A u g u s t, P la y S a fe ’s B o a rd o f D ire c to rs d e c id e s th a t, in 7 w e e k s ' tim e , P la y S a fe w ill issue n in e b a n k b ills , e a c h w ith a fa c e v a lu e o f $ 1 0 0 0 0 0 a n d a te rm o f 1 2 0 d a y s . In its p la n n in g , th e B o a rd h a s a s s u m e d th a t y ie ld s w ill n o t c h a n g e fro m th e ir c u rre n t le ve ls. O n 2 9 A u g u s t y o u a re to ld to a r r a n g e a h e d g e fo r P la y S a fe . O n th a t d a te , y o u a re g iv e n th e f o llo w in g d a ta :

Bank bill yields

90 days:

Bank bill futures

September:

120 days: December:

5.82% per annum 6.07% per annum 94.10 93.85

You a r r a n g e a n a p p r o p r ia te h e d g e . S e v e ra l m o n th s la te r y o u a r e a s k e d to w r ite a r e p o r t o n y o u r h e d g in g p e rfo rm a n c e , in c lu d in g re a s o n s fo r a n y n e t g a in o r loss m a d e . C o n s u ltin g th e re c o rd s , y o u d is c o v e r th a t th e b ills w e re issu ed o n tim e a t a ra te o f 7 . 3 7 p e r c e n t p e r a n n u m a n d th e fu tu re s c o n tra c t w a s re v e rs e d a t 9 2 . 6 5 . A t th a t tim e th e 9 0 - d a y b ill ra te w a s 7 .1 3 p e r c e n t p e r a n n u m . D e s c rib e h o w y o u w o u ld h a v e h e d g e d in this s itu a tio n . W h a t m a jo r p o in ts w o u ld y o u m a k e in th e re p o rt? In c lu d e re le v a n t c a lc u la tio n s .

10

Using 90-day bank bill futures contracts [LO 7] J a n e H e d g e s h a s t o d a y in v e s te d in a 1 8 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n , p r ic e d to y ie ld 6 . 3 0 p e r c e n t p e r a n n u m . S im u lta n e o u s ly she h a s s o ld a fu tu re s c o n tra c t o n a 9 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n . T he fu tu re s c o n tra c t w ill e x p ir e in 9 0 d a y s ' tim e fro m to d a y . T he fu tu re s p r ic e is 9 3 . 5 5 . J a n e in te n d s to settle th e fu tu re s c o n tra c t b y d e liv e ry . Ig n o rin g a n y e ffe cts fro m th e m a rk -to -m a rk e t rule, w h a t y ie ld (s im p le in te re st, in p e r c e n t p e r a n n u m ) w ill J a n e a c h ie v e o n h e r in ve stm e n t? W h a t , if a n y th in g , d o e s this im p ly a b o u t to d a y 's 9 0 - d a y b a n k b ill y ie ld ? W h y ?

11

Using 90-day bank bill futures contracts [LO 7] T oda y, H a n k Ltd issu e d a 1 2 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n a t a y ie ld o f 8 . 9 0 p e r c e n t p e r a n n u m . S im u lta n e o u s ly , H a n k b o u g h t a fu tu re s c o n tra c t o n a 9 0 - d a y b a n k b ill a t a p ric e o f 9 1 . 0 3 . The fu tu re s c o n tra c t m a tu re s in 3 0 d a y s 7 tim e a n d is b a s e d o n a fa c e v a lu e o f $1 m illio n . H a n k in te n d s to a llo w th e fu tu re s c o n tra c t to b e s e ttle d b y d e liv e ry . Ig n o rin g a n y e ffe c ts fro m th e m a rk -to -m a rk e t ru le , d e s c r ib e c a r e fu lly th e e c o n o m ic s u b s ta n c e o f H a n k 's tra n s a c tio n s . In c lu d e in y o u r a n s w e r d e ta ils o f a ll c a s h flo w s (a m o u n t, tim in g a n d w h e th e r th e y a re in flo w s o r o u tflo w s ). W h a t y ie ld (s im p le in te re st, in p e r c e n t p e r a n n u m ) w ill H a n k p a y ? W h a t , if a n y th in g , d o e s th is im p ly a b o u t to d a y 's in te re s t rates? W h y ?

559

12

Hedging with 10-year bond futures contracts [LO 7] T h u rb e r Ltd is a firm o f u n d e rw rite rs th a t t o d a y h a s h a d to ta k e u p a t fa c e v a lu e ( $ 7 .5 m illio n ) 8 -y e a r d e b e n tu re s issu e d b y B e e th a m P ro p e rtie s Ltd. T he B e e th a m d e b e n tu re s o ffe r a c o u p o n ra te o f 6 . 5 p e r c e n t p e r a n n u m , p a y a b le h a lf-y e a rly . T h u rb e r is th e re fo re a n 'u n w illin g le n d e r’ bu t, fo r v a rio u s re a s o n s , T h u rb e r in te n d s to h o ld th e B e e th a m d e b e n tu re s u n til th e firs t c o u p o n d a te , w h ic h is in 6 m o n th s 7 tim e , a n d th e n sell the d e b e n tu re s . T h u rb e r in te n d s to h e d g e b y u s in g th e A S X fu tu re s c o n tra c t o n 10 -y e a r g o v e rn m e n t b o n d s . The c u rre n t p ric e o f th is c o n tra c t is 9 5 . 0 0 .

13

a)

H o w m a n y A S X c o n tra c ts s h o u ld b e e n te re d in to ? S h o w y o u r c a lc u la tio n s a n d e x p la in b rie fly .

b)

W h a t risks (if a n y ) d o y o u th in k T h u rb e r m a y still fa c e , d e s p ite h a v in g h e d g e d ?

Speculation wirti SPI 200 futures contracts [LO 7] O n 1 8 F e b ru a ry y o u o b s e rv e th a t th e S & P /A S X 2 0 0 In d e x sta n d s a t 6 3 1 7 . 4 , w h ile th e M a r c h SPI 2 0 0 future s p ric e is 6 3 5 3 a n d th e Ju n e SPI 2 0 0 fu tu re s p r ic e is 6 3 9 0 . You b e lie v e th a t th e d iffe re n c e b e tw e e n th e M a r c h a n d Ju n e fu tu re s p ric e s is to o n a r r o w a n d w ill s o o n w id e n , b u t y o u h a v e n o v ie w s as to w h e th e r th e S & P / A S X 2 0 0 In d e x o r th e SPI 2 0 0 fu tu re s p ric e s w ill in c re a s e o r d e c re a s e . H o w c a n y o u r b e lie fs b e p u t to th e (fin a n c ia l) test? S h o w th a t, if y o u r p r e d ic tio n is rig h t, y o u w ill p r o fit fro m tr a d in g fu tu re s, re g a rd le s s o f w h e th e r s h a re p ric e s a s a w h o le in c re a s e o r d e c re a s e .

14

Hedging with SPI 200 futures contracts [LO 7] You a r e th e m a n a g e r o f th e D o rfm a n In ve stm e n t F u n d . O n 9 M a y y o u re c e iv e n o tic e th a t a s e g m e n t o f th e fu n d m ust b e s o ld o n o r a b o u t 3 0 M a y . T h is s e g m e n t c o m p ris e s a b r o a d ly b a s e d s e le c tio n o f lis te d A u s tra lia n sha res a n d is c u rre n tly v a lu e d a t $ 6 1 6 5 0 0 0 0 . T he ris k is h e d g e d u s in g J u n e SPI 2 0 0 fu tu re s. O n 2 8 M a y th e s h a re s a re s o ld a n d th e fu tu re s c o n tra c t is re v e rs e d . R e le v a n t d a ta a r e as fo llo w s :

r

O n 9 M ay

O n 28 M ay

Portfolio value

$61650000

$58400000

S&P/ASX 200

6322.6

6028.6

SPI 200 futures

6351

6041

|

B e a rin g in m in d th a t o n 9 M a y y o u d o n o t k n o w th e 2 8 M a y o u tc o m e s , r e p o r t o n h o w y o u w o u ld h a v e h e d g e d . In c lu d e in y o u r r e p o r t th e n u m b e r o f fu tu re s c o n tra c ts a n d w h e th e r th e y w e r e b o u g h t o r s o ld . Assess th e e ffe c tiv e n e s s o f th e h e d g e a n d e x p la in a n y im p e rfe c tio n s e x p e rie n c e d .

15

Valuation of SPI 200 futures contracts [LO 8] A s a t to d a y 's d a te , th e v a lu e o f sh a re s in th e M o n r o v ia n s h a re p ric e in d e x (SPI) is $ 1 2 6 0 0 0 . A 4 -m o n th fu tu re s c o n tra c t o n th o se sh a re s is p r ic e d a t $1 2 5 9 1 3 . In 4 m o n th s ’ tim e , d iv id e n d s to ta llin g $ 5 2 0 3 w ill b e p a id o n th e s h a re s. O f co u rs e , S, th e v a lu e o f sh a re s a t th a t tim e , is c u rre n tly n o t k n o w n . In M o n r o v ia th e in te re s t ra te fo r b o th b o r r o w in g a n d le n d in g is 1 p e r c e n t p e r m o n th (c o m p o u n d ). T h e re a re n o tra n s a c tio n costs o r ta x e s in M o n r o v ia . a)

S u p p o s e th a t to d a y y o u b u y th e sh a re s in th e in d e x a n d a ls o b o r r o w $ 5 0 0 0 . A fte r 4 m o n th s y o u c o lle c t th e d iv id e n d s , sell th e sh a re s a n d r e p a y th e lo a n . C a lc u la te th e re s u ltin g c a s h flo w s fo r to d a y a n d a fte r 4 m on th s.

b)

S u p p o s e in s te a d th a t t o d a y y o u b u y th e fu tu re s c o n tra c t a n d d e p o s it th e sum o f $ 1 2 1 0 0 0 in a n in te re s t-b e a rin g a c c o u n t. A fte r 4 m o n th s y o u settle o n th e fu tu re s c o n tra c t a n d w ith d r a w y o u r d e p o s it (w ith in te re st). C a lc u la te th e re s u ltin g c a s h flo w s fo r to d a y , a n d a fte r 4 m o n th s.

c)

E x p la in in d e ta il w h y th e a b o v e c a lc u la tio n s s h o w th a t th e fu tu re s c o n tra c t is c o rre c tly p ric e d to d a y .

d)

If t o d a y th e fu tu re s p ric e is $ 1 2 6 9 1 3 , c a lc u la te th e c u rre n t a n d fu tu re c a s h flo w s th a t re s u lt if to d a y th e fo llo w in g tra n s a c tio n s a re e n te re d in to s im u lta n e o u s ly : b o r r o w $ 1 2 6 0 0 0 , b u y sh a re s a n d sell th e future s c o n tra c t. C o m m e n t.

16

Forward-rate agreements [LO 9] C u rz o n Ltd n e e d s to b o r r o w $ 5 m illio n in 2 m o n th s , tim e . This a m o u n t w ill b e r e p a id (w ith interest) in a lu m p sum 9 0 d a y s la te r. R e p a y m e n t w ill th e re fo re o c c u r a p p r o x im a te ly 5 m o n th s fro m n o w . C u rz o n e n te rs in to a fo r w a r d - r a te a g re e m e n t w ith a b a n k , w ith th e c o n tra c t ra te set a t 7 . 5 0 p e r c e n t p e r a n n u m . W h a t ca sh p a y m e n t, if a n y , w ill th e b a n k b e re q u ire d to p a y C u rz o n Ltd?

C hapter seventeen F utures

Interest rate swap [LO 10] A s s u m e th a t t o d a y 's d a te is 1 M a r c h 2 0 1 5 . B u c k la n d B u ild in g Ltd (BBL) c a n b o r r o w f o r 3 y e a rs a t a fix e d in te re s t ra te o f 7 . 8 p e r c e n t p e r a n n u m , w ith in te re s t p a y a b le h a lf-y e a rly . T h e a n n u a l in te re s t ra te fo r th e c o r r e s p o n d in g f lo a t in g - r a t e lo a n is 6 -m o n th B B S W p lu s a m a r g in o f 6 0 b a s is p o in ts . T h e c u r r e n t 6 -m o n th B B S W is 6 . 1 5 p e r c e n t p e r a n n u m . F o r s im ila r lo a n s , A u b u r n B a n k Ltd (ABL) p a y s a fix e d r a te o f 7 .1 0

p e r c e n t p e r a n n u m a n d a flo a t in g r a te o f B B S W p lu s 5 b a s is p o in ts . BBL w is h e s to o b t a in fix e d - r a te

fu n d in g o f $ 2 5 m illio n a n d A B L w is h e s to o b t a in f lo a tin g - r a te fu n d in g f o r th e s a m e a m o u n t. A s s u m e th a t e v e r y d a y is a b u s in e s s d a y a n d th a t e v e r y p e r io d o f 6 c o n s e c u tiv e c a le n d a r m o n th s is e x a c tly e q u a l to h a lf a y e a r. a)

W h a t to ta l c o s t s a v in g (p e r h a lf-y e a r) is a v a ila b le if in it ia lly BBL b o r r o w s a t a flo a tin g ra te , A B L b o r r o w s a t a fix e d ra te a n d th e y th e n e n te r in to a n in te re s t ra te s w a p ?

b) A s s u m e th a t th e s w a p re q u ire s flo a tin g -ra te p a y m e n ts a t 6 -m o n th B B S W fla t (th a t is, w ith n o m a rg in a d d e d ) . D e s ig n a s w a p th a t a llo c a te s o n e -th ird o f th e to ta l c o s t s a v in g to BBL a n d tw o -th ird s to ABL. A fte r th e s w a p , w h a t fix e d ra te (p e r h a lf-y e a r) d o e s BBL p a y a n d w h a t flo a tin g ra te (p e r h a lf-y e a r) d o e s A B L p a y ? c)

O v e r th e n e x t th re e y e a rs , 6 -m o n th B B S W w a s : O n 1 S e p te m b e r 2 0 1 5 : 6 . 6 5 p e r c e n t p e r a n n u m O n 1 M a rc h 2 0 1 6 : 7 .3 5 p e r ce n t p e r a n nu m O n 1 S e p te m b e r 2 0 1 6 : 7 . 0 5 p e r c e n t p e r a n n u m O n 1 M a rc h 2 0 1 7 : 7 .5 5 p e r ce n t p e r a n nu m O n 1 S e p te m b e r 2 0 1 7 : 7 . 9 0 p e r c e n t p e r a n n u m O n 1 M a rc h 2 0 1 8: 7 .6 5 p e r cen t p e r annum C a lc u la te the n e t s w a p p a y m e n t m a d e o n e a c h d a te a n d state w h e th e r th e p a y m e n t w a s m a d e b y BBL o r ABL.

18

CHAPTER SEVENTEEN REVIEW

17

c o n t r a c t s a n d sw aps

Fixed-for-fixed currency swap [LO 10] P a n th e r is a S ou th A fr ic a n c o m p a n y a n d R e in d e e r is a S w e d is h c o m p a n y . T he fix e d in te re s t ra te s a t w h ic h th e y c a n b o r r o w m o n e y, r e p a y a b le a s a n in te re s t-o n ly lo a n o v e r 3 y e a rs (w ith a n n u a l p a y m e n ts ), a re :

S o u th A f r ic a n r a n d (Z A R )

B o r r o w in g

Panther

14.5% p.a.

4.5% p.a.

Reindeer

15.9% p.a.

4.8% p.a.

U ltim a te ly , P a n th e r w is h e s to b o r r o w S EK 2 0 0 m illio n , w h ile R e in d e e r w is h e s to b o r r o w Z A R 2 5 0 m illio n . In itia lly , P a n th e r w i ll b o r r o w r a n d w h ile R e in d e e r w ill b o r r o w k r o n o r . T h e c u r r e n t e x c h a n g e r a te is SEK 1 = Z A R 1 . 2 5 . A n in v e s tm e n t b a n k h a s o f f e r e d to e n te r in to s t a n d a r d f ix e d - fo r - fix e d c u r r e n c y s w a p s w ith b o th c o m p a n ie s . T h e b a n k w o u ld m a k e Z A R s w a p p a y m e n ts a t 1 4 . 5 p e r c e n t p e r a n n u m to P a n th e r, in re tu rn f o r S EK s w a p p a y m e n ts a t 4 . 3 p e r c e n t p e r a n n u m . T h e b a n k w o u ld m a k e SEK s w a p p a y m e n ts to R e in d e e r a t 4 . 8 p e r c e n t p e r a n n u m in re tu rn f o r Z A R s w a p p a y m e n ts a t 1 5 . 8 p e r c e n t p e r a n n u m . a)

C o m p le te th e f o llo w in g tw o ta b le s . U se p lu s s ig n s fo r c a s h in flo w s a n d m in u s s ig n s fo r c a sh o u tflo w s .

Panther’s cash flows (amounts) P re -s w a p c a s h flo w s

S w a p c a s h flo w s (SEK)

S w a p c a sh flo w s (ZA R )

Pos 卜 s w a p c a sh flo w s

Year 0 Year 1 Year 2 Year 3

561

B usiness finance

Reindeer’s cash flows (amounts) P re -s w a p c a sh flo w s

S w a p c a sh flo w s (SEK)

S w a p c a sh flo w s (ZA R )

P o s t-s w a p c a s h flo w s

YearO Year 1 Year 2 Year 3 b)

S h o u ld P a n th e r a n d R e in d e e r a c c e p t th e b a n k 's o ffe r? E x p la in .

c)

If P a n th e r a n d R e in d e e r a c c e p t th e b a n k ’s o ffe r, w h a t risk(s) d o e s th e b a n k in c u r? E x p la in .

REFERENCES Arsov, I., M oran, G ., Shanahan, B. & Stacey, K.; 'OTC derivative reform and the Australian cross-currency swap market', Bulletin, Reserve Bank of Australia, Sydney, June 20 1 3 , pp. 5 5 -6 3 . Australian Financial Markets Association, 2013 Australian Financial Markets Report, Sydney, 20 13 . Carew, E., Fast Forward: The History of the Sydney Futures Exchange, Allen & Unwin, Sydney, 1993.

------, How Australia's Forward-rote Agreement Markets Operate, Australian Financial Markets Association, Sydney, 1994. Chance, D.M. & Brooks, R., An Introduction to Derivatives and Risk Management, 8th edn, Thomson Learning, Mason, O hio, 20 10 . Cornell, B. & Reinganum, M ., 'Forward and futures prices: evidence from the foreign exchange markets7, Journal of Finance, December 19 81 , pp. 1 0 3 5 -4 5 . C o x , 丄 ， Ingersoll, J. & Ross, S., The relation between forw ard prices and futures prices', Journal of Financial Economics, December 1981, pp. 3 2 1 -4 6 . Cummings, J.R. & Frino, A., 'Tax effects on the pricing of Australian stock index futures7, Australian Journal of Management, December 2 0 0 8 , pp. 3 9 1 -4 0 6 . Easton, S.A. & Pinder, S.M., 'Predicting Reserve Bank of Australia interest rate announcements using the 30-day interbank cash rate futures contract: beware o f the target rate tracker', Australian Economic Review, M arch 20 0 7 , pp. 1 1 9 -2 2 . Figlewski, S. & Kon, S., 'Portfolio management with stock index futures', Financial Analysts Journal, January-February 1982, pp. 5 2 -9 .

562

French, K.R., 'A comparison of futures and forward prices',

Journal of Financial Economics, November 1983, pp. 31 1-42. Frino, A. & Jamecic, E., Introduction to Futures and Options Markets in Australia, Pearson Education Australia, Sydney, 20 0 5 . Heaney, R.A. & Layton, A.P., 'A test of the cost of carry relationship in Australia', Applied Financial Economics, April 1996, pp. 1 4 3 -5 4 . Howard, L. & Jameson, K., 'The futures markets', in R. Bruce et al. (eds), Handbook of Australian Corporate Finance, 5th edn, Butterworths, Sydney, 1997. Hunt, B. & Terry, C., Financial Institutions and Markets, 6th edn, Cengage, Australia, 201 1. Kolb, R.W. & O verdahl, J. A ., Understanding Futures Markets, 6th edn, John W ile y & Sons, Hoboken, N e w Jersey, 2 0 0 6 . Leeson, N . & W hitley, E., Rogue Trader: How I Brought Down Borings Bonk and Shook the Financial World, Little, Brown and Company, Boston, 19 96 . M arkovic, M ., yThe legal status of futures market participants in Australia7, Company and Securities Law Journal, April 1989, pp. 8 2 -1 0 0 . Sheedy, E. & McCracken, S., Derivatives: The Risks that Remain, Allen & Unwin, Sydney, 1997. Smith, C.W . Jr, Smithson, C.W . & W akem an, L.M., 'The evolving market for swaps', in J.M. Stern & D.H. Chew (eds), The Revolution in Corporate Finance, 2nd edn, Basil blackwell, O xford, 1992, pp. 3 5 5 -6 7 . -------, -------, & W ilfo rd , D.S.; Managing Financial Risk, Harper Business, N e w York, 1990.

CHAPTER CONTENTS 18.1

In tr o d u c t io n

564

O p t io n s o n f o r e ig n c u r r e n c y

588

18.2

O p t io n s a n d o p t io n m a r k e ts

564

O p t io n s , f o r w a r d s a n d fu tu re s

591

18.3

B in o m ia l o p t io n p r ic in g

577

O p t io n s o n fu tu re s

593

18.4

T h e B la c k - S c h o le s m o d e l o f c a ll

C o n t in g e n t c la im s

595

■

o p t io n p r ic in g

582

LEARNING OBJECTIVES A f te r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to : 1

u n d e r s ta n d th e m a jo r t y p e s a n d c h a r a c t e r is tic s o f o p t io n s a n d d is tin g u is h b e t w e e n o p t io n s a n d fu tu re s

2

id e n t if y a n d e x p la in th e f a c to r s t h a t a f f e c t o p t io n p r ic e s

3

u n d e r s ta n d a n d a p p l y b a s ic o p t io n p r ic in g th e o r e m s , in c lu d in g p u t - c a ll p a r it y

4

u n d e r s ta n d th e b in o m ia l m o d e l a n d th e B la c k - S c h o le s m o d e l o f o p t io n p r ic in g a n d c a lc u la t e o p t io n p r ic e s u s in g th e s e m o d e ls

5

e x p la in th e c h a r a c t e r is t ic s a n d u se s o f f o r e ig n c u r r e n c y o p t io n s a n d o p t io n s o n fu tu re s

6

d e f in e a c o n t in g e n t c la im a n d e x p la in th e o p t io n - lik e f e a tu r e s o f s e v e r a l c o n t in g e n t c la im s .

B usiness finance

Introduction CONTINGENT CLAIM

asset whose value depends on the value of some other asset

In this chapter we consider financial contracts known as options. M ost o f this chapter is concerned w ith options to buy or sell shares, b ut other types o f options are also considered. An option is a special case of a type o f contract called a co n tin g e n t claim . Stated simply, a contingent claim is an asset whose value depends on the value o f some other asset. A surprisingly large num ber o f financial arrangements fall into this category. Contingent claims are discussed in Section 18.8. First, however, we consider options and option markets.

18.2 Options and option markets

m LEARNING OBJECTIVE 1 Understand the major types and characteristics of options and distinguish between options and futures CALL OPTION

right to buy an underlying asset at a fixed price PUT OPTION

right to sell an underlying asset at a fixed price

EXERCISE (OR STRIKE) PRICE

fixed price at which an underlying asset can be traded, pursuant to the terms of an option contract

18.2.1 | W h a t is an option? An option is the rig h t (but n o t the obligation) to force a transaction to occur at some fu tu re tim e on terms and conditions agreed to now. For example, the buyer o f a call o p tio n on shares obtains the rig h t to buy shares in the future from the seller (also known as the writer*) o f the call at a price determ ined now.1 A t a future tim e, the buyer o f the call can exercise the rig h t to obtain the shares at the predeterm ined price, regardless o f what is then the current m arket price o f the shares. Similarly, the buyer o f a p u t o p tio n has the rig h t to sell the shares in the future to the w rite r o f the p ut at a predetermined price, regardless o f w hat is then the share s current m arket price. This rig h t to buy (in the case o f a call) or to sell (in the case o f a p ut) m ust be paid fo r by the option buyer at the tim e the option is purchased. The am ount paid is called the option price and is determ ined by m arket forces. The Australian Securities Exchange (ASX) provides facilities fo r the trading o f calls and puts on the shares o f more than 60 companies listed in Australia.2 The follow ing example, taken fro m th a t market, illustrates the nature o f a call option. On Friday 9 August 2013, the closing price o f the 'September 2013 36.00* series o f call options on the shares o f BHP B illito n (BHP) was $0.85. The closing price o f BHP shares on the same date was $35.29. Here, ^September* refers to the m onth in which the call expires. In this case, the date o f expiry is 27 September 2013.3 The figure *36.00* indicates an e x e rcise price (or str ik e p rice) o f $36, while the $0.85 is the price o f the call. Shares in BHP are the underlying shares* in this transaction and each option contract covers 100 shares. Therefore, the buyer o f one call contract paid 100 x $0.85 = $85 to obtain the rig h t to buy 100 BHP shares at any tim e between 9 August 2013 and 27 September 2013, at a predetermined price o f $36 per share. I f the buyer calls on the w rite r to ‘deliver’ （sell) the underlying shares, he or she is said to ‘exercise’ the option. If, as in this example, the call buyer is able to exercise at any tim e up to (and including) the expiry date, the option is said to be o f the
2

3

4^^

Shares are of course not the only assets that can be the subject of an option contract. For example, there are options on stock market indices, debt instruments, foreign currencies and futures contracts. The last two are discussed in Sections 18.5 and 18.7. Detailed discussion of all four can be found in standard specialised textbooks such as Hull (2013). In addition to standard put and call options, other option-style securities are also traded on the ASX. For example, ASX warrants are option-style securities that are issued by financial institutions and frequently have quite different payoff structures than standard exchange traded options. For example, a warrant may have a 'barrier1requirement that dictates that the warrant terminates once a certain price level, or barrier, is reached. The ASX website provides an up-to-date calendar of expiry dates at www.asx.com.au/documents/about/t24_trading_calendar .pdf.

C hapter eighteen O

p tio n s a n d c o n t in g e n t claim s

underlying shares, he or she is said to exercise* the option. As w ith calls, puts traded in this m arket are o f the American type.

Options on shares may be created by the company whose shares underlie the option contract, or by parties who have no association w ith the company. O ptions created by the company are nearly always call options and may be created fo r a num ber o f reasons, o f which two are the most common. First, these call options may be issued to investors as a means o f raising capital fo r the company. The sale o f the options raises capital and there w ill be a fu rth e r inflow o f capital i f the options are subsequently exercised. Options o f this kind may be listed on a stock exchange and appear in the share lists together w ith other securities issued by the company. Second, the company may issue call options to senior employees or directors o f the company. Typically, in the case o f listed companies, options o f this kind form p art o f the compensation package fo r managers and are n o t a significant source o f capital fo r the company. Options can also be created by parties who may have no association w ith the company. For example, two share m arket observers, A and B, may enter in to a private option contract on the shares o f BHP. This w ill not raise any capital for BHP and does n o t require any agreement or involvem ent on the p art o f BHP. Frequently, one or other o f the parties w ill be a shareholder in the company— fo r example, B may be a shareholder who buys a p ut on BHP shares to give protection against a fall in BHPs share price. However, it may be that neither p arty is a shareholder at the tim e o f entering into the option contract. O nly i f the option is subsequently exercised w ill it be necessary fo r shares to be delivered. Shares fo r this purpose can be purchased in the open m arket i f and when the o ption is exercised. Many o f the term s in private o ption contracts w ill be subject to negotiation between the parties. A fte r negotiation the contract w ill specify at least the following: • • • • • •

the type and number o f shares to be optioned the exercise price the expiry date the adjustment ( if any) to be made in the event o f a change in capital structure (due to any bonus or rights issues, fo r example) the adjustment (if any) to be made in the event o f a dividend payment and, o f course, the price o f the option.

On payment o f the option price the buyer and w rite r are bound contractually. While options created by private negotiation have the advantage th a t the features desired by the parties can be specified precisely, there are three m ajor disadvantages. First, since there is no organised system fo r bringing together potential parties to the contract, it w ill often be very d iffic u lt to fin d a party w ith whom to contract. Second, even i f such a party is found and a contract entered into, i t w ill not be possible to reverse out o f the contract before the agreed expiry date. Third, it w ill be necessary to investigate the credit-worthiness o f the other p arty every tim e an option is created. A solution to all three problems is to establish an organised market, called a listed option m arket, th a t provides a standardised form o f option contract, a list o f options in which trading can be undertaken and a procedure th a t avoids the need fo r repeated checking o f credit-worthiness. The Australian Securities Exchange provides a market o f this type.4 In a listed option market, traders select the desired underlying share, expiry date and exercise price from a lis t o f those available. Each contract covers a fixed num ber o f shares, and, although adjustments are made fo r new share issues during the life o f the option, they are n ot made fo r ordinary dividend payments.5 The only negotiable term is the option price, which is determ ined by m arket forces. An individual buyer in any option series is n ot bound contractually to an individual w riter, b ut rather the class o f buyers (as a whole) is bound contractually to the class o f w riters (as a whole), w ith exercise notices being distributed randomly between individual writers. However, exercise is not common because, instead o f exercising, the holder o f a call option can take his or her p ro fit by selling the call in the secondary m arket.6 I t is possible 4 5 6

Similar observations were made in Chapter 17 about the development of futures contracts from forward contracts. There are many similarities between the organisation of a listed option market and the organisation of a futures market. Adjustments are made in the case of special* and 'abnormal* dividends (see Australian Securities Exchange, 2013). Some reasons for preferring a sale to an exercise are explained in Section 18.2.8. As a consequence, in practice relatively few options are exercised.

B usiness finance

in this case th a t the buyer w ill be an existing w rite r who wishes to cancel out his or her position, in order to avoid being exercised against. The organisers o f the market check the credit-worthiness o f traders and, in a manner sim ilar to the role o f the futures m arket authorities, take the role o f counterparty in every transaction. A description o f this process in the futures m arket is provided in Section 17.2.2. There are numerous option markets around the w orld organised along these lines. The firs t such market to be established was the Chicago Board Options Exchange, which opened in 1973. In Australia, a market w ith a sim ilar structure was opened in 1976. M ost share options in Australia are traded through ASX Ltd, w ith the exchange also offering options on several futures contracts.

18 .2 .3 1O ption contracts and futures contracts It is im p o rta n t to distinguish between option contracts and futures contracts because it is often mistakenly thought th a t there are only m inor differences between them. O f course, there are some notable similarities. For example, both types o f contract may involve the delivery o f some underlying asset at a future date and at a predetermined price. However, there are very significant differences between them. M ost im portantly, a futures contract r e q u ir e s the delivery o f the underlying asset, whereas an option buyer c h o o s e s whether delivery w ill occur— th a t is, buyers in futures contracts have an obligation to buy the underlying asset, whereas buyers of, say, call options have the rig h t to buy i f they so choose. Therefore, if buyers in futures contracts take no action to cancel th e ir positions, they w ill be required to buy the underlying asset at the expiry o f the contract. I f buyers o f call or p u t options take no action to cancel th e ir positions, the options sim ply expire and there are no subsequent transactions. A related difference concerns payment. When a futures contract is made, the payment o f the futures price is not required u n til the expiry date, b ut when an o ption contract is made, the buyer m ust imm ediately pay the option price to the w rite r.7 I f the option is subsequently exercised, there is a fu rth e r transaction when the exercise price is paid.

18.2.41 Payoff structures for calls and puts PAYOFF STRUCTURE set o f fu tu re ca sh flo w s

I t is an axiom o f finance theory that, ultim ately, the prospect o f future cash flows is the only source o f value. An alternative term fo r the future cash flows o f a contract is its p a y o ff s tru c tu re . The easiest financial contract to value is one th a t promises (w ith certainty) a fixed am ount to be paid in cash on a fixed fu tu re date— th a t is, the payoff structure is a single cash flow w ith a probability o f 1.0. The payoff structures fo r options are more complicated because the payoff (cash flow) depends on the share price on the expiry date o f the option. Consider the BHP 36.00 call option discussed in Section 18.2.1. If, on the calls expiry date, the BHP share price is $36 or less, the call w ill be w o rth n othing on expiry. There w ill be no payoff at all. For example, there is no value in having a call th a t is about to expire and which gives the call holder the rig h t to pay $36 per share when the m arket price is only, say, $35 per share. If, however, the share price at the expiry o f the call is more than $36, then the payoff per share is the difference between the share price and the exercise price o f $36. For example, i f the share price at the expiry o f the call is $37, the payoff is $1. This is the payoff because the call holder could exercise the call and pay the exercise price o f $36 per share, and then imm ediately resell the share fo r its m arket price o f $37, producing a net cash inflow o f $1 per share. In summary, the payoff on a call option is: M a x [0 ,S * - A ] where S* = the share price on the calls expiry date8 X = the exercise price o f the call The payoff structure is shown in more detail in Table 18.1. The inform a tion in Table 18.1 is shown in graphical form in Figure 18.1. The payoff structure fo r a p u t option is illustrated using, as an example, the BHP 37.00 p ut option also discussed in Section 18.2.1. If, on the p u ts expiry date, the BHP share price is $37 or more, the p u t w ill be w o rth n othing on expiry. There w ill be no payoff at all. For example, there is no value in having a p ut that 7

8

Some options on futures contracts are an exception to this rule. Throughout this chapter, an asterisk is used to indicate the value of the variable on the options expiry date. Note also that in previous chapters we have used the symbol P for the share price. However, in the option pricing literature it is standard to use S for the share price.

(*)

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TABLE 18.1 Payoff structure for a bought call with an exercise price of $36.00 If th e s h a re p ric e ($) o n th e c a ll’s e x p ir y d a te is

T hen th e p a y o f f (ca sh flo w ) ($ ) to th e c a ll h o ld e r is

34.00

0

34.50

0

35.00

0

35.50

0

36.00

0

36.50

0.50

37.00

1.00

37.50

1.50

38.00

2.00

38.50

2.50

Figure 18.1 Payoff structure: call (bought)

is about to expire and which gives the p ut holder the rig h t to sell a share fo r $37 when the m arket price is already, say, $38 per share. However, if the share price on the expiry date o f the p u t is less than $37, then the payoff is the difference between the exercise price o f $37 and the share price. For example, i f the share price at the expiry o f the p u t is $35.50, the payoff is $1.50. In summary, the payoff on a p ut option is: M a x [0 ,X -S * ]

where S* = the share price on the p u ts expiry date X = the exercise price o f the p ut The payoff structure is shown in more detail in Table 18.2. The inform a tion in Table 18.2 is shown in graphical form in Figure 18.2.

1 8 .2 .5 1 Factors affecting call option prices The aim o f this section is to develop an in tu itiv e understanding o f the factors th a t w ill affect the price o f a call option.9 Discussion o f form al valuation models is undertaken in Sections 18.3 and 18.4. Table 18.3 shows the prices o f selected call options on BHP B illito n shares on 9 and 12 August 2013. 9

LEARNING OBJECTIVE 2 Identify and explain the factors that affect option prices

Similar factors are relevant to the determination of put prices. These are discussed in Section 18.2.6.

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TABLE 18.2 Payoff structure for a bought put with an exercise price of $37.00 If th e s h a re p ric e ($ ) o n th e p u t's e x p ir y d a te is

| T hen th e p a y o f f (cash flo w ) ($ ) to th e p u t h o ld e r is

34.50

2.50

35.00

2.00

35.50

1.50

36.00

1.00

36.50

0.50

37.00

0

37.50

0

38.00

0

38.50

0

Rgure 18.2 Payoff structure: put (bought)

gjp^od Table 18.3 provides the market prices o f nine call options on BHP. Panel A o f the table provides the prices o f these nine options at the close o f trading on Friday 9 August 2013. Panel B provides the prices of these options at the close o f business one trading day later. Panel C shows the percentage change in each call price between the tw o trading days. In the follow ing discussion we use the prices shown in Table 18.3 to illustrate the factors th a t affect call prices. Options have value because o ption buyers can exercise the option to th e ir advantage, should the o p p o rtu n ity to do so arise. A fundam ental advantage o f holding a call option is th a t i t may be possible to obtain the underlying shares more cheaply by exercising the option than by direct share purchase. Intuitively, the price paid fo r the rig h t to exercise should therefore reflect, among other factors, the probability th a t the share price w ill rise above the exercise price (or rise fu rth e r above it, i f it has already been exceeded). This probability should, in tu rn , be related to the follow ing factors.

The current share price The higher the current share price, the greater is the probability th a t the share price w ill increase above the exercise price, and therefore the higher the call price, other things being equal. Ignoring m arket imperfections, a call whose underlying share price is already above the exercise price m ust be w orth at least the difference between the two. This am ount is the cash flow th a t w ill occur i f the call is exercised

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TABLE 18.3 Closing prices of selected call options on BHP Billiton shares on Friday 9 August 2013 and Monday 12 August 2013 P an el A : C a ll p ric e s o n F r id a y 9 A u g u s t 2 0 1 3 (s h a re p r ic e = $ 3 5 . 2 9 ) E xe rcise p ric e s ($) $ 3 5 .0 0

$ 3 6 .0 0

$ 3 7 .0 0

27 September 2013

1.44

0.85

0.43

30 October 2013

1.67

1.10

0.67

28 November 2013

2.00

1.44

0.98

E x p iry d a te

P an el B: C a ll p ric e s o n M o n d a y 1 2 A u g u s t 2 0 1 3 (s h a re p ric e == $ 3 6 . 1 4 ) E xe rcise p ric e s ($ ) E x p iry d a te

$ 3 5 .0 0

$ 3 6 .0 0

$ 3 7 .0 0

27 September 2013

2.07

1.33

0.77

30 October 2013

2.25

1.57

1.03

28 November 2013

2.52

1.89

1.38

Panel C : P e rc e n ta g e c h a n g e in p ric e s fro m F rid a y 9 A u g u s t 2 0 1 3 to M o n d a y 1 2 A u g u s t 2 0 1 3 (s h a re p r ic e c h a n g e = 2 .4 % ) E xe rcise p ric e s ($ ) $ 3 5 .0 0

$ 3 6 .0 0

$ 3 7 .0 0

27 September 2013

44

56

79

30 October 2013

35

43

54

28 November 2013

26

31

41

E x p iry d a te

Source: Compiled from IRESS Financial Database.

immediately, and is referred to as the calls in trin sic value. However, even a call whose exercise price is above the current price o f the underlying share m ust be w orth something. I t has value as long as there is some chance, however small, th a t at some p o in t in the calls life the in trin s ic value may become positive. In Table 18.3, every call commands a price th a t is greater than its in trin s ic value. For example, on 9 August, the in trin sic value o f the September 35.00 call is 29 cents, and its price is $1.44. The dependence o f the call price on the current share price can be seen in the fact th a t all six calls increased in price when there was an increase in the price o f the underlying shares. Note also th a t the magnitude o f the percentage increases fo r the call prices far exceeds the percentage increase o f 2.4 per cent in the share price— th a t is, the leverage offered by call options is very high.

INTRINSIC VALUE

value of an option if exercised immediately

The exercise price Clearly, the higher the exercise price, the lower is the probability th a t the share price w ill increase above the exercise price, and, therefore, the lower the call price, other things being equal. This relationship can be seen in the prices given in Table 18.3. On both 9 August and 12 August, fo r any given expiry date, the call price falls when we consider higher exercise prices. For example, on 9 August, the price o f the options expiring in September is $1.44 when the exercise price is $35, falling to $0.85 when the exercise price is $36 and finally just $0.43 when the exercise price is $37.

The term to expiry The longer the term to expiry, the greater is the probability th a t the share price w ill increase above the exercise price. Therefore, the longer the term to expiry, the greater is the call price, other things being equal. To make the same p o in t in a slightly different way, consider tw o American calls th a t are equivalent

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B usiness finance

TIME VALUE

value of an option in excess of its intrinsic value

in every respect, except th a t one has a shorter term to expiry than the other. In the period before the expiry o f the shorter-term call, both calls provide the option buyer w ith the same rights. However, the rights conferred by the longer-term call continue fo r a fu rth e r period. Therefore, the longer-term call is more valuable. The am ount o f the call price over and above any in trin sic value is called the tim e value, since w ith all other factors constant it w ill be greater, the longer the term to expiry. Note, however, that term to expiry is only one factor determ ining the tim e value. I t should also be distinguished from the ‘tim e value o f money’，which is dealt w ith below. This effect o f term to expiry on call price can also be seen in the prices given in Table 18.3. On b oth 9 August and 12 August, fo r any given exercise price, the call price increases when we consider later expiry dates. For example, on 12 August, the price o f the options w ith an exercise price o f $35 is $2.07 fo r the options expiring in September, rising to $2.25 fo r the options expiring in October and then to $2.52 fo r the November series.

The volatility of the share VOLATILITY

variability of a share price; can be measured by the variance (or the standard deviation) of the distribution of returns on the share

The volatility o f a share is the va riab ility o f its price over tim e.10 The effect o f v o la tility on call price is illustrated in the follow ing simple example. Consider a high v o la tility share, H, whose current price is $5, and a low v o la tility share, L, whose current price is also $5. Consider call options on H and L at a mom ent before expiry. The exercise price o f both call options is $5. As explained previously, calls at expiry are w o rth a positive am ount i f the difference between the share price and the exercise price is positive. Otherwise they are w o rth zero. Suppose fu rth e r th a t the probabilities o f various share prices at expiry are known to be those shown in Table 18.4.

TABLE 18.4 Probability distributions for shares

H and L S h a re L

S h a re H S h a re p r ic e ($ )

P ro b a b ility

V a lu e o f c a ll ($)

S h a re p ric e ($)

P ro b a b ility

V a lu e o f c a ll ($ )

4.00

0.2

0.00

4.00

0.04

0.00

4.50

0.2

0.00

4.50

0.16

0.00

5.00

0.2

0.00

5.00

0.60

0.00

5.50

0.2

0.50

5.50

0.16

0.50

6.00

0.2

1.00

6.00

0.04

1.00

The expected values o f the calls on shares H and L are: E (call on H) = (0.2)($0.50) + (0.2)($1.00) = $0.30 E (call on L) = (0.16)($0.50) + (0.04)($1.00) = $0.12 The call on the lo w -vo la tility share is less valuable than the call on the h ig h -v o la tility share. This result is n o t peculiar to this p articular example and i t has been shown (M erton 1973a, p. 149) that, other things being equal, calls on h ig h -vo la tility shares are w o rth more than calls on lo w -v o la tility shares. The basic reason fo r this result is the asymmetric nature o f the payoffs on a call option. As shown in Table 18.4, when a call expires, the holder is ind iffe re nt between all the share prices th a t are less than or equal to the exercise price. A ll such share prices are equally disastrous fo r the call holder because in all such cases the value o f the call is zero. However, at expiry, fo r share prices th a t exceed the exercise price, the value o f the call increases by 1 cent fo r every 1-cent increase in the share price. A t times before expiry this asymmetry is n ot as sharp, b u t it remains true th a t the holder o f a call benefits more from , say, a 1-cent increase in share price than is lost from a 1-cent decrease in share price. W hile a higher share price v o la tility increases the chance o f both large increases and large decreases in the share price, the asymmetric features just described mean th a t the holder o f a call gains more from the increased chance o f a large increase in share price than is lost from the increased chance o f a large decrease in share price. Therefore, on balance, the call holder has a favourable view o f vo latility. Higher v o la tility increases the price o f a call, other things being equal. 10 Volatility can be measured in various ways. One frequently used measure is the variance of the returns on the share in a recent period.

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The risk-free interest rate The buyer o f a call option can defer paying fo r the shares. (O f course, the call also confers the rig h t n o t to buy the shares at all, b ut this is n ot the p o in t we are making.) Because interest rates are positive, money has a tim e value, so the rig h t to defer payment is valuable. The higher the interest rate, the more valuable is this right. Therefore, it is plausible to suggest th a t the higher the risk-free interest rate, the higher is the price o f a call, other things being equal.

Expected dividends I t was explained in Section 11.4.4 that when a company pays a dividend the share price w ill fall on the ex-dividend date. It has already been explained in this chapter th a t the price o f a call w ill decrease i f the price o f the underlying share decreases. It is to be expected, therefore, th a t a call on a share th a t w ill go ex-dividend before the expiry o f the call is w o rth less than i f the share either never pays dividends or, i f it does pay dividends, w ill n ot reach the next ex-dividend date u n til after the call has expired. In short, calls on shares th a t pay high dividends during the life o f the call are w o rth less than calls on shares th a t pay low dividends during the life o f the call, other things being equal. The effect o f dividends on call price may be reduced, though n ot eliminated, i f the option is o f the American type.11 As m entioned in Section 18.2.1, this type o f option may be exercised at any tim e before expiry. By exercising just before an ex-dividend date, the holder o f a call becomes a shareholder and is therefore entitled to the dividend. The cost o f this strategy is th a t the calls expiry date is, in effect, shifted to the ex-dividend date, thereby reducing its effective term to expiry. As explained earlier, a shorter term to expiry reduces the tim e value o f a call and hence reduces its price. Therefore, in deciding whether a call should be exercised before an ex-dividend date, the call holder needs to balance carefully the benefit of obtaining the dividend against the cost o f fo rfe itin g the options tim e value. To summarise, other things being equal, call prices should be higher (lower): a b c d e 1

the higher (lower) the current share price the lower (higher) the exercise price the longer (shorter) the te rm to expiry the more (less) volatile the underlying share the higher (lower) the risk-free interest rate the lower (higher) the expected dividend to be paid follow ing an ex-dividend date th a t occurs during the term o f the call.

The buyer o f a p ut option obtains the rig h t to sell shares at the exercise price. The higher the exercise price, the more the buyer o f the put stands to gain. For example, the rig h t to sell a share fo r $1 is more valuable than the rig h t to sell fo r only 90 cents, other things being equal. Therefore, fo r p u t options, the higher the exercise price, the higher is the price o f the option. For call options the opposite is true. Similarly, the rig h t to sell a share at a fixed price is less valuable the higher the current share price, other things being equal. For example, suppose th a t the holder o f a p ut exercised her rig h t to sell a share at the exercise price o f $1. I f the current share price is 90 cents, the holder o f the p ut gains 10 cents because she has been able to sell the share fo r 10 cents more than it is currently w orth. I f the share price had been higher— say, 95 cents— the gain would have been only 5 cents. Therefore, higher share prices im ply lower put prices, other things being equal. For call options, the opposite is true. The relationship between price and term to expiry is straightforw ard in the case o f American puts. Consider two American puts, equivalent in all respects except th a t one has a longer term to expiry. Both puts may be exercised at any tim e up to (and including) th e ir respective expiry dates. Therefore, the long­ term put perm its exercise at all times p erm itted by the short-term put, b u t in addition the long-term p ut

11 European-type options may contain a clause that adjusts the contract’s terms if there is a dividend. These ‘dividend protection clauses*, as they are known, also reduce, but do not eliminate, the effects of dividends on the calls price.

B usiness finance

perm its exercise after the expiry o f the short-term put. Therefore, fo r American puts, a longer term to expiry increases the value o f the put, other things being equal.12 This is also true o f call options. Table 18.5 shows the prices o f selected p u t options on BHP B illito n shares on Friday 9 August 2013 and Monday 12 August 2013.

TABLE 18.5 Closing prices of selected put options on BHP Billiton shares on Friday 9 August 2013 and Monday 12 August 2013 P an el A : Put p ric e s o n F r id a y 9 A u g u s t 2 0 1 3 (s h a re p r ic e = $ 3 5 . 2 9 ) E xe rc is e p ric e s ($ ) E x p ir y d a te

$ 3 5 .0 0

$ 3 6 .0 0

$ 3 7 .0 0

27 September 2013

0.86

1.34

2.02

30 October 2013

1.13

1.59

2.23

28 November 2013

1.43

1.83

2.42

P a n e l B: Put p ric e s o n M o n d a y 1 2 A u g u s t 2 0 1 3 (s h a re p r ic e = $ 3 6 . 1 4 ) E xe rcise p ric e s ($ ) $ 3 5 .0 0

$ 3 5 .0 0

$ 3 7 .0 0

27 September 2013

0.57

0.94

1.45

30 October 2013

0.84

1.19

1.71

28 November 2013

1.11

1.47

1.96

E x p ir y d a te

P an el C : P e rc e n ta g e c h a n g e in p ric e s fro m F r id a y 9 A u g u s t 2 0 1 3 to M o n d a y 1 2 A u g u s t 2 0 1 3 (s h a re p r ic e c h a n g e = 2 .4 % ) E xe rc is e p ric e s ($ ) $ 3 5 .0 0

$ 3 6 .0 0

$ 3 7 .0 0

27 September 2013

-34

-30

-28

30 October 2013

-26

-25

-23

28 November 2013

-22

-20

-19

E x p ir y d a te

Source: Compiled from IRESS Financial Database.

The influences o f exercise price and term to expiry can be seen in the p ut prices given in Table 18.5. On both trading dates, fo r any given expiry date, the p ut price is higher the higher is the exercise price. For example, on 9 August, the price o f the September 37.00 exceeds th a t o f the September 36.00, which in tu rn exceeds th a t o f the September 35.00. These prices illustrate that, other things being equal, a higher exercise price implies a higher p u t price. Comparing puts o f different terms, it is also clear th a t a longer term implies a higher p ut price, other things being equal. On b oth trading dates, fo r any given exercise price, the p ut price is higher the longer is the term to expiry. For example, on 9 August 2013, the price o f the September 35.00 p u t is $0.86, while the price o f the October 35.00 is $1.13. The effect o f the share price on the prices o f p u t options is also dearly evident in Table 18.5. On M onday 12 August the share price was higher than i t had been on the previous Friday and, as a result, all p ut prices had decreased on th a t day. As w ith calls, the percentage changes in the p ut prices exceed the percentage change in the share price. Unlike a call, a p ut has a m axim um possible value. For example, in the case o f the October 36.00 p u t in Table 18.5, even i f the price o f BHP shares should fall to zero, the

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12 For a European put, the relationship between price and the term to expiry is more complex. On the one hand, a short­ term European put can be exercised earlier than an otherwise equivalent long-term European put, therefore generating an earlier cash inflow for the holder of the put. This suggests that a short-term European put is m ore valuable than a long-term European put. On the other hand, a longer term to expiry increases the probability that the share price will fall below the exercise price, and this suggests that a short-term European put is le ss valuable than a long-term European put. For any given European put, both factors are relevant and either influence can dominate the other, depending on the put being considered.

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payoff to the holder o f the put cannot exceed $36. Because share prices can never fall below zero, a put can never be w orth more than its exercise price. The buyer o f a p ut option w ill gain i f share prices fall. Consequently, puts are especially attractive to shareholders who fear th a t the share price may decrease, b u t who nevertheless do n o t wish to sell th eir shares. Consider, fo r example, an investor who on 9 August 2013 bought a BHP share fo r $35.29 and a BHP September 35.00 p u t fo r $0.86, m aking a to ta l outlay o f $36.15. The p ut option ensures that, u n til it expires in September, the investor is guaranteed th a t he or she w ill n ot have to sell th e ir shares fo r less than $35 per share. Thus i f the share price decreased to, say, $31— which represents a loss o f $4.29 or 13.8 per cent o f the share price o f $35.29— this investor w ill be able to sell at $35 and thus w ill lose only $0.29 or 0.8 per cent o f the to ta l outlay o f $36.15. In effect, the purchase o f a p ut is like buying an insurance policy against the share price falling below a given level. As w ith call options, higher share v o la tility implies a higher option price. Higher v o la tility implies a greater chance o f large increases and large decreases in the share price. From the p u t holders view point, share price increases are bad news, while decreases are good news. But a p ut holder gains more from a share price decrease than is lost from an increase o f the same amount. So, on balance, a p ut holder has a favourable view o f share price vo latility. Because a p ut confers the rig h t to receive a future cash inflow, it is expected th a t p u t prices should be negatively related to interest rates. A higher interest rate reduces the present value o f whatever future cash inflow may be received. Finally, dividend payments reduce share prices, which benefits p ut holders, so higher expected dividend payments increase p ut prices. The effects fo r American calls and puts are summarised in Table 18.6. Positive (negative) means the option price responds in the same (opposite) direction to a change in the factor affecting prices.

TABLE 18.6 Factors affecting American option prices C a ll p ric e s

Put p ric e s

Current share price

Positive

Negative

Exercise price

Negative

Positive

Term to expiry

Positive

Positive

Volatility of the share

Positive

Positive

Risk-free interest rate

Positive

Negative

Expected dividends

Negative

Positive

F a cto r

18.2.7! Put-call parity For European options on shares th a t do n o t pay dividends there is an equilibrium relationship between the prices o f puts and calls th a t are w ritte n on the same underlying share, are traded simultaneously and have the same exercise price and term to expiry. This relationship, known as pu t-call parity, was derived by Stoll (1969) and subsequently analysed fu rth e r by M erton (1973b). We now derive and explain this relationship. It is assumed th a t options are traded in frictionless markets and th a t no security (or p o rtfo lio ) dominates any other security (or p ortfo lio ). The meaning o f ‘dominance’ in this context may be illustrated as follows. Suppose th a t on some future date there can be only three possible sets o f m arket conditions or States o f the world*, and the payoffs on securities (or portfolios) A and B in these states w ill be as shown in Table 18.7.

TABLE 18.7 Payoffs showing a dominant portfolio P o rtfo lio

P a y o ff ($ ) in : S ta te 1

S ta te 2

S ta te 3

A

5

7

11

B

5

7

10

LEARNING OBJECTIVE 3 Understand and apply basic option pricing theorems, including put-call parity

PUT-CALL PARITY

relationship that exists between the price of a call option and the price of the corresponding put option

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I f A and B sell fo r the same price today, then A dominates B because A pays the same as B in States 1 and 2, b u t pays more than B in State 3. Therefore, to prevent dominance, the price o f A today m ust be greater than the price o f B. Formally, A dominates B if, on some known date in the future, the payoff on A is greater than the payoff on B in one (or more) o f the possible states, and the payoff on A is at least as great as the payoff on B in all other possible states. A special case o f the no-dominance requirement arises i f A and B have the same payoff in all possible states. In th a t case A and B m ust command the same price today. I f the m arket is perfect, a no-dominance requirem ent is equivalent to a requirem ent th a t no arbitrage opportunities exist. Using these assumptions, i t can be shown th a t the follow ing relationship, known as p u t-c a ll parity, exists between p ut and call prices:

p= c- s+777

IliU

where p = the price o f the European put c = the price o f the corresponding European call S= the share price X = the exercise price 〆 = the risk-free interest rate fo r borrow ing or lending fo r a period equal to the term o f the p u t and the call Expressed in words, p u t-ca ll parity says that the p u t price equals the call price, less the share price, plus the present value (at the risk-free interest rate fo r the term o f the option) o f the exercise price.

TABLE 18.8 Payoffs showing put-call parity P o rtfo lio

V a lu e n o w

c+

A

X

P a y o ff in S ta te 2 (S " < X )

(S*-X)+X =S*

o +x =x

1+ 〆

p+ S

B

,

P a y o ff in S ta te 1 (S * rel="nofollow"> X )

o +s* =s*

(X- S*) + S* = X

To prove th a t Equation 18.1 holds, consider two portfolios, A and B. The com position and payoffs X o f these p ortfo lio s are shown in Table 18.8. Portfolio A consists o f the call, plus an investm ent o f ~ dollars invested at the risk-free rate, to mature on the expiry date o f the p u t and the call. Therefore, the X cash o utflo w required to set up Portfolio A is c 4- -------Portfolio B consists o f the p ut plus one share. The outflow required to set up Portfolio B is therefore p + S. As both options are European, they cannot be exercised before expiry, and the relevant 'states o f the world* are as follows: State 1 is a share price th a t is greater than or equal to the exercise price (S* > X ) and State 2 is a share price th a t is less than the exercise price (S* < X). I f State 1 occurs, then the call is w o rth S* - X and the p u t is w o rth zero. I f State 2 occurs, then the call is w o rth zero and the p u t is w o rth X- S*. In either state, the risk-free investm ent w ill mature w ith a value of: X

(1 + / ) = X

I f State 1 occurs, then both A and B have a payoff o f S*, b u t i f State 2 occurs, then b oth A and B have a payoff o f X Therefore, there is no reason to prefer A to B (or vice versa). Therefore, to prevent dominance, A and B m ust command the same price now — th a t is, the cost o f A and B m ust always be equal. This requires that:

X 1 +〆

p+ S

Rearranging this expression gives Equation 18.1. This theorem has three im p o rta n t implications. First, i f a form ula can be derived to price, say, a European call, then by using Equation 18.1, a form ula can be derived to price the equivalent put. Second,

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Equation 18.1 does n o t include the expected retu rn on the underlying share, im plying th a t the expected return is not directly relevant to pricing puts or calls. For example, suppose th a t an investor expects the price o f the underlying share to increase in the near future. Obviously such an investor is likely to buy a call, and sell a put. I t is tem pting— b ut incorrect— to suggest th a t this action w ill tend to increase the call price (because the demand fo r calls has increased) and decrease the p ut price (because the supply o f puts has increased). But i f this happened, Equation 18.1 would be violated and a profitable arbitrage would exist. Therefore, the expected return on the share is n ot directly relevant to option pricing. Third, i f the expected future v o la tility o f the share increases, w ith o u t a simultaneous change in the level o f today s share price, then the prices o f all puts and calls on the share should also increase (see Finance in Action). Put-call p arity should hold true both before and after a change in volatility. Investors1expectations o f the future direction o f a share price are relevant to the determ ination o f the share price itse lf — th a t is, the share price w ill reflect the influence o f these expectations. Therefore these expectations are relevant to o ption pricing b ut only via th e ir influence on the share price itself. They have no independent role to play. This conclusion has great significance fo r attem pts to construct formulae to price options because it implies th a t these form ulae do not need to include a measure o f expectations o f the future direction o f the share price. Such measurements are notoriously d iffic u lt to make.

VOLATILITY IS THE KEY TO PRICE MOVEMENTS________________

F in a n c e in

ACTION

If a c o m p a n y 's fu tu r e s u d d e n ly lo o k s m o r e u n c e r t a in , th e s h a re m a r k e t w i ll e x p e c t its fu tu r e s h a re p r ic e v o la t ilit y to b e h ig h e r. In p r in c ip le , th is s h o u ld m e a n t h a t b o th p u t a n d c a ll o p t io n s o n th e s h a re s s h o u ld in c re a s e in p r ic e . N ic e t h e o r y . . . b u t d o e s it r e a lly w o r k t h a t w a y in p r a c tic e ? Yes, it d o e s ! T h e ru m o u r la s t w e e k t h a t B r a m b le s w a s a t a k e o v e r t a r g e t c a u s e d its s h a r e s to ris e a n d B r a m b le s ' v o la t ilit y to ju m p in th e d e r iv a tiv e s m a r k e ts . M o s t B r a m b le s d e r iv a t iv e s e lle rs , o p t io n w r ite r s a n d w a r r a n t is s u e rs im m e d ia t e ly b e g a n a s k in g m o r e m o n e y f o r s h o r te r - d a te d o p t io n s a n d w a r r a n t s o v e r s h a re s in th e t r o u b le d c o m p a n y . T h is in c lu d e d b o t h p u ts a n d c a lls , a lth o u g h s h o r te r - d a te d c a lls ( O c t o b e r a n d D e c e m b e r e x p ir ie s ) w e r e th e h ig h e s t p r ic e d in te rm s o f im p lie d v o la t ility . T h e s e lle rs w e r e a s k in g m o r e o n th e lo g ic a l e x p e c t a t io n o f g r e a t e r u n c e r t a in t y in th e B ra m b le s s h a r e p r ic e w h ile th e r u m o u r p e rs is ts . T h e e x te n t o f th is u n c e r t a in t y c a n b e a s s e s s e d fro m a c lo s e e x a m in a t io n o f th e im p lie d v o l a t ili t y e x p e c t a t io n s o v e r B r a m b le s a t- o r c lo s e -to -th e m o n e y o p t io n s fr o m ju s t u n d e r 3 0 p o in ts to ju s t u n d e r 3 5 p o in ts o v e r th e w e e k .

Source.. 'Volatility is the key to price movements,, John Wasiliev, yAusfra//an F/nanc/a/ /?ev/evv, 24 September 2003.

The p u t-ca ll p arity theorem applies only to European options, whereas, in practice, most options are of the American type. W hile there is no simple equation lin k in g the values o f American puts and calls, upper and lower bounds have been established, as shown below: c —S +

X 1+〆 ，

< p < c -S

X

18.2

where p = the price o f the American put c = the price o f the corresponding American call S = the share price X = the exercise price r = the risk-free interest rate fo r borrow ing In effect, the lower bound in Equation 18.2 matches the result fo r European p u t-c a ll parity, while the upper bound exceeds this lower bound by the difference between the exercise price and the present value o f the exercise price. When the risk-free interest rate fo r borrow ing is low and/or the term o f the options is short, the present value effect w ill be small and hence the gap between the upper and lower bounds w ill also be small.13

13 For a detailed treatment of put-call parity under a range of conditions see Cox and Rubinstein (1985).

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Loudon (1988) studied approximately 1300 pairs o f prices fo r BHP puts and calls in 1985 and concluded th a t although violations o f p u t-c a ll p a rity were n o t uncommon, investors facing norm al transaction costs would be unable to p ro fit from the violations. More recently, Ofek, Richardson and W hitelaw (2004) tested fo r violations o f p u t-ca ll p a rity fo r approximately 80 000 matched pairs o f options trading on US exchanges between 1999 and 2001 and report th a t the p a rity relationship is frequently violated and that profitable strategies could be employed even after accounting fo r transaction costs.

1 8 .2 .8 1The minimum value of calls and puts Assuming frictionless markets and the same no-dominance fram ework used earlier to derive the p u t-ca ll p a rity theorem, the m inim um value o f a European call on a share that does n ot pay dividends is:

18.3

M in c = Max 0, S -

To prove this equation, consider two portfolios, A and Their composition and payoffs are shown in Table 18.9. As in the p ro of o f p u t-c a ll parity, Portfolio A consists o f the call and a risk-free investm ent X of | + dollars. Portfolio Br consists o f just one share. The two relevant states are again State 1 (S* > X ) and State 2 (S* < X ).

TABLE 18.9 Payoffs showing the minimum value of a call optio n Portfolio A

Value now c+

B,

X ------7 1+ 〆 S

Payoff in State 1 (S* > X) Payoff in State 2 (S* < X) (S *-X )+ X = S *

o +x = x

S*

s*

The explanation o f the entries in the table fo r Portfolio A is the same as in the proof o f p u t-c a ll parity. Portfolio Br, which consists o f only the share, pays o ff S* regardless o f the state th a t occurs. Therefore, if State 1 occurs, both A and B/ have a payoff o f S*, b ut i f State 2 occurs, then A pays o ff more than Br because in th a t state, X > S*. Invoking the no-dominance assumption, it follows th a t the value o f A m ust therefore be no less than the value o f Br at all times before the call expires— th a t is: > S which implies that: c > S-

X

The right-hand side o f this inequality can be negative but, because o f lim ite d liab ility, call prices can never be negative— th a t is, c > 0. Combining these tw o inequalities gives Equation 18.3. This result has an im p o rta n t im plication: in the absence o f dividends, American call options should n o t be exercised before expiry. Clearly the holder o f an American call would n o t even consider exercise unless the share price, S, exceeded the exercise price, X. Suppose th a t S > X and the holder o f an American call has decided to dispose o f the call. To do so a choice m ust be made between exercising the call and selling the call. However, this choice is easy. I f the call is exercised, the payoff (or, net cash flow) is X S - X b u t i f the call is sold, then, by Equation 18.3, the payoff is at least S----------which w ill exceed S - X 1+ 〆 provided only th a t the interest rate is positive. Given th a t interest rates are always positive, the payoff from selling the call m ust exceed the payoff from exercising the call. I t follows th a t an American call w ill never be exercised early and, accordingly, the rig h t to do so is valueless. The call m ig ht just as well be European. Under the conditions we have assumed, the d istin ction between European calls and American calls is irrelevant to th e ir valuation.

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A t first sight this conclusion may be surprising, b ut i t has an in tu itiv e explanation. I f a call is exercised early, the options life is cut short, so the call holder fo rfeits any tim e value the option had. One reason call options have a tim e value is th a t interest rates are positive, so later cash outflows are preferred to early cash outflows. By exercising early, the call holder m ust pay fo r the shares earlier than would otherwise have been necessary. Thus, i f a call holder has decided to dispose o f the option, he or she should always prefer to sell the call rather than exercise it. The rule against early exercise does n ot necessarily hold i f an ex-dividend date w ill occur during the life o f the call. As m entioned in Section 18.2.5, early exercise o f an American call can be rational in these circumstances. Traditionally it has been thought th a t early exercise o f a call would be rational only on the date imm ediately preceding the ex-dividend date; at all other times, selling the call w ill generate a greater cash flow fo r a call holder who wishes dispose o f the option. More recently however, A lp ert (2010) has demonstrated th a t tax effects can overturn this conclusion— th a t is, the after-tax cash flow from selling the call may be less than the after-tax cash flow from exercising the call. Using a sample o f UK options, A lp ert finds empirical evidence to suggest th a t many exercises th a t appear irra tion al in a no-tax framework may be rational i f tax effects are considered. Using sim ilar methodology, Phang and Brown (2011) study 454 instances o f the early exercise o f call options in the Australian m arket. They find that approximately tw o-thirds o f these instances occurred on the day im m ediately preceding the ex-dividend date. They also report th a t approximately 80 per cent o f the rem aining instances o f early exercise may be explained by option holders m aking th e ir exercise decision on the basis o f m axim ising th e ir after tax cash flows. The m inim um value o f a European p ut can be found by combining p u t-c a ll p a rity (Equation 18.1) and the m inim um value o f a European call (Equation 18.3). The result is: M in p = Max 〇,

X

18.4

However, unlike the case o f calls, the expression fo r the m inim um value o f a European p ut cannot be used to show that the d istin ction between American and European options is irrelevant fo r puts, even in the absence o f dividends. I t can be rational to exercise an American p ut before expiry, and therefore American puts are w o rth more than th e ir European counterparts. Again there is an in tu itiv e explanation. If a put is exercised, tw o things happen. First, as w ith calls, the o ptions tim e value is forfeited and this outcome is undesirable. Second, the p ut holder is paid fo r the shares earlier than would otherwise be the case. Because early cash inflow s are preferred to later cash inflows, this outcome is desirable. In some circumstances— fo r example, i f the current share price is very low and interest rates are very high— the second effect outweighs the first, and in these cases the rig h t to exercise early is valuable.

Binomial option pricing So far we have developed some logical bounds on option prices. For example, we have established that the price o f a long-term American option should exceed th a t o f its short-term counterpart. Similarly, we have established th a t a p ut option can never be w o rth more than the exercise price. W hile these sorts o f relationships are useful, they do n ot answer the fundam ental question we w ant to ask about any given option: how much (exactly) is i t worth? That is, w hat should be its price? Binomial option pricing is an im p o rta n t and widely used approach to answering this question. Binomial option pricing was firs t suggested by W illiam Sharpe, and developed in an article by Cox, Ross and Rubinstein (1979). In this section we present the m ain features o f th e ir m odel.14

L E A R N IN G O B JEC TIVE 4 U nde rstand the b inom ial m odel and the B la ck -S ch o le s m odel of option pricing a n d calculate option prices using these m odels

18.3.1 |T h e b asic idea: pricing a single-period call option using the binomial approach The distinguishing feature o f binom ial option pricing is its assumption that, after a given tim e period, the price o f the underlying asset can be one o f only tw o numbers— hence the use o f the term ‘binom ial’, 14 The ASX website provides a link to a calculator that will estimate option prices using the binomial model; see www.asx.com. au/prices/calculators.htm.

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which means *two numbers,. This assumption may sound unrealistic, b ut it turns out th a t the approach gives very realistic answers, provided th a t a large num ber o f short tim e periods are used in the analysis. However, in this section we restrict ourselves to the single-period case, which, although clearly unrealistic, perm its a clear illu stratio n o f basic principles. We explain these principles using Example 18.1.

E xample 18.1 Consider a 1-year call option with a $10.50 exercise price, on a share whose current price is $10. It is known that in 1 year’s time the share price will be either $1 1.50 or $9.50. No other share price outcome is possible: the share price will definitely be one of these two numbers. The 1-year risk-free interest rate is 8 per cent per annum. Using only this information, together with the standard assumption that arbitrage will not be possible, we can work out what today's call price should be. To do this, we first calculate the payoffs. If, at the expiry of the call in 1 year's time, the share price is $ 1 1.50, the call's payoff will be $ 1 1.50 - $ 1 0 .5 0 = $1. If the other share price ($9.50) occurs, the call's payoff will be zero. We now compare the payoffs on Portfolios A and B: Portfolio A: Buy two calls, each costing c dollars. Portfolio B: Buy one share ($10) and borrow $ 9 .5 0 /1 .0 8 = $8.80, which is the present value of $9.50. The payoffs on these portfolios are shown in Table 18.10.

6

TABLE 18.10 Payoffs for a single-period binomial model I Portfolio

Cash flow now

Payoff if P = $9.50

Payoff if P = $11.50

A: Buy 2 calls

-2c

0

$2.00

B: Buy 1 share

-$10.00

$9.50

$11.50

Borrow $9.50/1.08

+$8.80

-$9.50

Total (B)

-$1.20

0

丨

-$9.50 $2.00

The payoffs shown in Table 18.10 are identical. It does not matter whether an investor chooses Portfolio A or B: the outcome in both cases is a cash flow of zero if the expiry share price is $9.50, or a cash flow of $2 if the expiry share price is $1 1.50. Since A and B are, in effect, the same thing, they should be worth the same today. To prevent arbitrage, the cash flow required today to set up Portfolio A should equal the cash flow required today to set up Portfolio B—that is: -2 c = -$ 1 .2 0 which, of course, solves to give today's call price, c, of $0 .6 0 .15

Example 18.1 illustrates the fact th a t buying calls (Portfolio A) is like borrow ing to buy shares (Portfolio B). In Example 18.1, buying two calls was like borrow ing to buy one share. We could equally well describe this as 'buying one call is like borrow ing to buy h a lf a share*. O f course, the figure o f one-half is peculiar to this example. It is found by calculating the ratio o f the option spread and the share spread— in this case the calculation is: $ !-$0 $ 11.5 0 - $ 9.50 HEDGE RATIO (OR 一

1

一

2

DELTA)

ratio of the c h a n g e in an option price that results from a c h a n g e in the price of the underlying asset

In other cases, this ratio could be any number between zero and 1. This ratio is called the h edge ratio (o r d elta ). Estimates o f option deltas are provided in the M arket Wrap section o f the Australian Financial

Review.

15 We have rounded this answer. A more accurate answer i s : -

2

$

10 -

$9.50 、 =$0.601 851 85. 1.08 ,

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18.3.21 Risk neutrality as a solution method Perhaps the most remarkable feature o f Example 18.1 is n ot th a t we could w ork out the call price, b ut th a t we were able to do so w ith o u t m aking any assumption about risk. The call in Example 18.1 is w orth 60 cents, regardless o f the risk preferences o f traders in the m arket. If, fo r example, everyone in the m arket were risk averse, they would set the call price at 60 cents. I f everyone were risk neutral (or fo r th a t matter, risk seeking) they would s till set the call price at 60 cents.16 We can use this fact to provide an easy solution method. We pretend th a t all investors are risk neutral. This means th a t they ignore risk in th eir decision making. In a m arket comprising only riskneutral traders, all assets are priced so th a t they are expected to yield the risk-free return. In a risk-neutral world, pricing assets is thus very easy. It is sim ply a m atter o f finding out the expected value o f a future cash flow and then discounting this value at the risk-free interest rate. We reiterate th a t our answer does not depend on risk neutrality. We would get the same answer fo r the call price i f we assumed, say, risk aversion. We choose risk n eu tra lity only because it is easy. To illustrate how the m ethod works we show in Example 18.2 how the call o ption in Example 18.1 would be priced i f every trader were risk neutral.

Example

p ($ n .5 0 ) + (1-p)($9.50)

1.08 where p = the probability of State U occurring 1 - p = the probability of State D occurring Solving this equation gives p = 0.65 and 1 - p = 0 .3 5 .17 Turning our attention to the call option, its payoff is $1 in State U and $0 in State D. In a world of risk neutrality, the call price, c, will also equal its expected payoff, discounted at the risk-free interest rate: (0.65)($l) + (0.35)($0) c_

r 〇8

= $0,601 851 85 =$0.60 This, of course, is the same answer as we found in Example 18.1 when we did not pretend that all market participants were risk neutral.

18.3.31 Binomial option pricing with many time periods The single-period case is n ot realistic, b ut the basic principles can be extended to more than one period. In practice it is usual to use, say, 100 or 200 tim e periods. The calculations are readily made using a computer. To explain the procedures, we use three tim e periods. The solution to a m ulti-period binom ial option-pricing problem has three m ajor stages.

a Stage 1: Building up a lattice o f share prices. b Stage 2: Calculating the option payoffs at expiry from the expiry share prices, c

situation in which investors are indifferent to risk; assets are therefore priced such that they are expected to yield the risk-free interest rate

18.2

A share is worth $ 10 today and promises to pay off either $ 11.50 or $9.50 in 1 year's time. We will call the payoff of $1 1.50 'State U' (for 'up’）and the payoff of $9.50 'State D’ （ for 'down’). Given that this is a risk-neutral world, we can deduce the probabilities of States U and D occurring. This deduction is possible because, under risk neutrality, $10 must equal the expected payoff in 1 year, discounted for 1 year at the risk-free interest rate—that is: $1〇

RISK NEUTRALITY

Stage 3: Calculating option prices by calculating expected values and then discounting at the risk­ free interest rate.

16 How is this possible? Essentially, the reason is that we could redesign Portfolios A and B to give two risk-free outcomes. Regardless of individual differences in attitudes to risk, all market participants will agree that risk-free is indeed risk-free and will price the portfolios accordingly. 17 A warning: these probabilities do depend on risk neutrality. They are not the probability of any actual event occurring in the real world.

6

^

These stages are explained in Example 18.3.

E xample 18.3 We wish to value a three-month call option with an exercise price of $10.25. The current share price is $10 and the risk-free interest rate is 1.5 per cent per month. We use three time periods of 1 month each. It is assumed that at the end of each month the share price can move to only one of two values.

Stage 1: The lattice of share prices In Stage 1, our objective is to lay out all the future share prices that can arise, given our assumptions. In this example it is assumed that each month the share price can rise by 4 per cent or fall by 3.846 per cent. Our choice of 3.846 per cent is, of course, deliberate, and is equal to 1 - 1/ 1.04. The effect is that a rise (fall) in the share price in any given month will be exactly offset if there is a fall (rise) in the following month. For example, starting from $10; if the share price rises by 4 per cent in the first month, and then falls by 3.846 per cent in the second month, its price after 2 months is: $10.00(1.04)(1 -0 .0 3 8 4 6 ) = $ ,0 .0 0 (!.0 4 ) ( ^

)

= $ 10.00

The benefit of defining the 'up7 and 'down' states in this way is the dramatic reduction in the number of future possible share prices that need to be considered. In Figure 18.3, the possible future share prices are shown on a lattice diagram in bold type. We have labelled each node of the lattice with a capital letter. Today is represented by node A. Nodes 8 and C represent the two possible share prices at the end of the first month: •

If the share price increases in the first month: $ 10.00 x 1.04, then 8 = $ 10.40.

•

If the share price decreases in the first month: $ 1 0 .00/1 .04, then C = $9.6154.

Figure 18.3 Lattice of share prices and call prices r

$ 1 1 .2 4 8 6 $ 0 .9 9 8 6

$ 1 0 .4 0 0 0 $ 0 .1 5 0 0

$ 9 .6 1 5 4

$ 0.0

j

$ 8 .8 9 0 0

$0.0* •

Similarly, nodes D, E and F represent the three possible share prices at the end of the second month: •

If the share price increases in the first month and increases again in the second month: $10.00 x 1.04 x 1.04, then D = $10.8160.

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•

If the share price increases (decreases) in the first month and then decreases (increases) in the second month: $10.00 x 1 .0 4 /1 .0 4 , then E = $10.00.

•

If the share price decreases in the first month and decreases again in the second month: $ 1 0 .0 0 /1 .0 4 /1 .0 4 , then F = $9.2456.

Nodes G, H, I and J represent the four possible share prices at the expiry date of the call and are derived from nodes D, E and F by multiplying or dividing by 1.04 as appropriate.

Stage 2: Option payoffs at expiry As we know the expiry share prices from Stage 1, it is a simple matter to calculate the matching call option payoffs. Because the exercise price is $10.25, the call's payoffs are $0.9986 if the expiry share price is $1 1.2486 (node G); $0.15 if the expiry share price is $10.40 (node H]; and zero if the expiry share price is $9.6154 (node /) or $8.89 (node J). The call's payoffs are shown on Figure 18.3 in italic \ype.

Stage 3: Discounting Using the risk-neutral solution method, it is a simple matter to calculate the present value of the call's payoffs. As in the single-period example, we first need to find the probabilities of a rising and falling share price. The risk-neutral probabilities are the same at every node. Taking node 8 as an example, $10.40 must equal the discounted expected value, where the discounting is done at the risk-free interest rate of 1.5 per cent per month:

〇

(p )($ 1 0 .8 1 6 )^ (1 -p )($ 1 0 .0 0 ) 1 .0 1 5

where, as before, p is the probability of a rise in price and 1 - p is the probability of a fall. This equation solves to give p = 0.6814 and 1 - p = 0.31 86. We can now work back through the lattice from expiry to the present, at each node calculating the present value of the expected payoff. For example, at node D, the call's price is: ( 0 .6 8 1 4 ) ( $ 0 . 9 9 8 6 ) + ( 0 . 3 1 8 6 ) ( $ 0 . 15 ) 1 .0 1 5 = $ 0 .7 1 7 5

Similarly, at node E, the call's price is: ( 0 .6 8 1 4 ) ( $ 0 .1 5 ) + ( 0 .3 1 8 6 ) ( $ 0 ) 1 .0 1 5 ~ ~ = $ 0 .1 0 0 7

Working back through the lattice to today (node >A) gives the call's price as $0.3658 or about 37 cents.

Example 18.3 is a realistic treatm ent o f a binom ial option pricing problem in all b ut two respects. First, the number o f tim e periods was set at only three, whereas i t should be set at 30 or more to get an accurate answer. However, this accuracy is achieved sim ply by using a computer to perform the calculations. No new issue o f principle is involved. Second, we made no attem pt to ju s tify our choice o f ‘up’ and ‘down’ factors o f 4 per cent per m onth and 3.846 per cent per m onth, respectively. In practice, these factors are selected very carefully. Typically, the model user decides on w hat is thought to be an accurate estimate o f the standard deviation o f the d istrib u tio n o f share prices on the expiry date o f the option. In other words, it is necessary to forecast the vo la tility o f share returns during the life o f the option. A simple form ula then provides the and *down, factors th a t w ill produce a d istrib u tio n o f expiry share prices th a t has the desired standard deviation. For example, the up* factor is given by e(Ts^ t where a is the standard deviation and At the length o f each tim e period.18 18 Details are beyond the scope of this book. For an excellent treatment see Hull (2013).

4^^

So far we have discussed the binom ial approach fo r the case o f a call option on a share th a t does n o t pay dividends. Fortunately, i t is easy to use the binom ial approach to value put options and the binom ial model can also be m odified to incorporate dividends. Once the lattice o f future share prices is laid out, a p u t option can be priced as easily as a call option. The p ut option payoffs are calculated and then the same procedure o f discounting expected values is undertaken. Moreover, the American feature is easily incorporated sim ply by checking, at each node, whether the calculated option price is less than the payoff from immediate exercise. I f it is, then the payoff value is substituted fo r the calculated price. Similarly, the problem o f valuing options on dividend-paying shares is relatively easy to handle using the binom ial approach. A t the ex-dividend date, all possible share prices are reduced to reflect the payment o f the dividend. A practical d iffic u lty here is that the lattice no longer conveniently recombines, w ith the result th a t there is a very rapid increase in the num ber o f nodes (possible share prices) th a t need to be analysed. However, the power o f modern computers means th a t the m ethod is feasible.

The Black-Scholes model of call option pricing The binom ial model provides a numerical solution to the option pricing problem b u t i t does n o t provide an exact equation. In a very famous article, Black and Scholes (1973) presented a m odel th a t expresses the price o f a call as a function o f five variables:19 a the current price o f the underlying share b the exercise price o f the call C the calls term to expiry d the v o la tility o f the share (as measured by the variance o f the d istrib u tio n o f returns on the share) e the risk-free interest rate. This model stim ulated a great deal o f fu rth e r research in to options and, because o f its importance, is presented here in some detail.

The Black-Scholes model assumes the following: a b

c

There exists a constant risk-free interest rate at which investors can borrow and lend u nlim ited amounts. Share returns follow a random walk in continuous tim e w ith a variance (volatility) proportional to the square o f the share price. The variance is a know n constant. This assumption relates to the behaviour o f the share price over tim e. In particular, returns on this share are assumed to follow a random walk and the share is continuously traded in the m arket. The m odel is therefore cast in continuous tim e, as d istinct from discrete tim e, which considers a series o f tim e periods. The d istrib u tio n o f the rate o f return on the shares has a known, constant variance, which is a measure o f vo latility. It can also be shown th a t this assumption implies th a t the d istrib u tio n o f possible share prices on any given future date (such as on the options expiry date) is lognormal. Empirical studies suggest th a t share markets do n o t behave in exactly the way assumed in the model. W hile trading in many shares is frequent, it is n o t lite ra lly continuous. V o la tility is unlikely to be constant. The random-walk model and the lognorm al d istrib u tio n are n o t perfect descriptions o f th e ir real-world counterparts. There are no transaction costs, taxes or other sources o f frictio n .

19 The Australian Securities Exchange website provides a calculator that will estimate option prices using the Black-Scholes model; see www.asx.com.au/prices/calculators.htm.

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ptions a n d c o n tin g e n t claims

d

Short selling is allowed w ith no restrictions or penalties. This assumption means th a t any num ber o f securities can be sold, regardless o f the num ber actually held. For example, two calls can be w ritte n (sold) even i f only one share is held, and there is no need to deposit cash to secure such a position. These four assumptions define conditions in the share and option markets. In addition, Black and Scholes simplified the problem w ith tw o fu rth e r assumptions: e There are no dividends, rights issues or other complicating features. The call is o f the European type. Assumptions (e) and (f) are in fact alternatives, since it was shown in Section 18.2.8 th a t i f assumption (e) holds, then the d istin ction between American and European calls is irrelevant. Therefore, i f assumption (e) is made, the pricing form ula w ill be valid fo r both American and European calls. W ith these assumptions, the price, cf o f any given call is a function only o f the current share price, S, and time, t. The risk-free interest ra te ,〆，the vo latility, (J2, and the exercise price, X ， are know n constants in the problem.

1 8 .4 .2 1 The Black-Scholes equation Using these assumptions, Black and Scholes showed th a t the price o f the call option m ust be:

18.5

c = SN(dl )-X e ~ r，TN (d 2)

where

d\

£n{S/X)

+ ^ ct2)T c rV f

h i(S /X ) + ( / - ㈣

丁

rV T d\ - a V f N ( d ) indicates the cumulative standard norm al density function w ith upper integral lim it d. In other words, N (d) is the area under the standard norm al curve from -〇〇 to d. The definitions o f S, X and G 2 are as given previously and T is the term to expiry. N id ^ and N (d 2) are probabilities and are therefore numbers between zero and 1. Values o f the fu nctio n N can be found using Table 5 o f Appendix A, or the NORMSDIST function in M icrosoft Excel . In continuous tim e, e_r,T is the appropriate discount factor fo r T periods at rate / per period. Therefore Xe~r， T is the present value o f X. The application o f Equation 18.5 is illustrated in Example 18.4.

E xample 18.4 Suppose that we wish to find the Black-Scholes price for a call with the following characteristics: Current share price: S = $17.60 Exercise price: X = $16.00 Term to expiry: 7 = 3 months = 0.25 years Volatility (variance): a2 = 0.09 per annum Standard deviation: a = 0.3 per annum Risk-free interest ra te :〆 = 0.1 per annum, continuously compounding The first task is to calculate , 1

and c/2:

£n($ 17.60/$ 16.00) + [0.1+ (0.5)(0.09)]0.25 0 .3 V 0 2 5 = M i l ) + 0.03625 0.15 « 0.8771

d2 % 0 .8 7 7 -0 .1 5 « 0.7271

continued

B usiness finance

continued

Consulting the table of values for the standard normal distribution N [ .) , or by using the Microsoft Excel® NORMSDIST function, we find that: N(dJ = N(0.8771) = 0.8098 and N(d2) = N(0.7271) = 0.7664 The discounting factor e~r， T = e~0025 = 0.9753. Substituting into Equation 1 8.5: c= S N (d 1)-X e -/ r N(d2) =($ 17.60)(0.8098) - ($ 16.00)(0.9753)(0.7664) =$2,293

The Black-Scholes call price is therefore approximately $2.29. Table 18.11 shows fu rth e r examples o f the call prices that result from the Black-Scholes model if different values o f the variables are assumed. Also shown in the table is the greater o f (S - Xe~r， T) and zero, which is the m inim um theoretical price; equivalently, it is the call price under conditions o f perfect certainty.

TABLE 18.11 Examples of Black-Scholes call opti<〕n prices Example

Share price (S) 1Exercise price (X) Term to expiry Volatility (a) m

Risk-free interest rate (〆}

Model price (c) (cents)

Greater of zero and S - Xe_r"r (cents)

(a)

1.00

1.00

0.25

0.3

0.10

7.22

2.47

(b)

1.10

1.00

0.25

0.3

0.10

14.33

12.47

(c)

1.00

1.10

0.25

0.3

0.10

3.22

(d)

1.00

1.00

0.50

0.3

0.10

10.91

4.88

(e)

1.00

1.00

0.25

0.4

0.10

9.17

2.47

(f)

1.00

1.00

0.25

0.3

0.15

7.89

3.68

0

Each o f the examples (b) to (f) changes one o f the values used in Example (a). Therefore, the effect o f a higher share price— Example (b)— is shown to be a substantial rise in the call price, as discussed in Section 18.2.5. The direction o f influence o f the other variables is likewise in line w ith our comments in th a t section. These conclusions are quite general and do n ot depend on the particular numbers used in the examples. Similarly, the model price is never less than the m inim um theoretical price. The Black-Scholes model (Equation 18.5) is shown graphically in Figure 18.4. For some given vo latility, interest rate and exercise price, Figure 18.4 plots call price against share price fo r different values o f term to expiry. For a finite, positive value o f T, the curve approaches asym ptotically the broken line representing c = S - Xe~r， T as S increases. A t expiry, T = 0, the call is w o rth S* - X or zero, whichever is the greater, while a perpetual call (T 〇〇) commands a price equal to the share price. The Black-Scholes model is set in continuous tim e, rather than discrete tim e. Hence, the risk-free interest rate, r used in the model is an interest rate th a t assumes continuous compounding. In practice, interest rates are almost never quoted on a continuously compounding basis. Fortunately, to calculate Black-Scholes prices in practice we do n o t have to convert observed interest rates, which assume discrete compounding, to th e ir continuously compounding counterparts. The Black-Scholes equation (Equation 18.5) can be rew ritten as: c = SN(dx) - PVXN(d2) where

PVX = d\

X l+ R (n(S/PVX) + \c r2T

d2 = d \ - a V T

4^^

18.6

C hapter eighteen O

ptions a n d c o n tin g e n t claims

Figure 18.4 Graphical representation of the Black-Scholes equation

sSIJd IIDU

Xe_r i

C

S h a re price (S)

In Equation 18.6, R is the observed effective interest rate on a risk-free investm ent fo r a term equal to the term o f the option. The application o f Equation 18.6 is illustrated in Example 18.5.

E xample 18.5 Suppose that we wish to find the Black-Scholes price for a call option with the following characteristics:

6

^

Current share price: S = $9.95 Exercise price: X = $10.50 Term to expiry: 7 = 6 months = 0.5 years Volatility (variance): a2 = 0.16 per annum Standard deviation: 〇 = 0.4 per annum Risk-free interest rate: R = 5 per cent per half-year The first task is to calculate the present value of the exercise price: PVX:

$10.50 1.05 $ 10.00

The next task is to calculate ^ and d2 using Equation 18.6: ,

肋 ($9.95/$ 10.00) + (0.51(0.161(0.5)

M 〇-995) + 0.04 = 0.2828 = 0.1237 c/2 = 0.12 37 -0.2 82 8 = -0.1591

Consulting the table of values for the standard normal distribution N[.), or by using the Microsoft Excel® NORMSDIST function, we find that: ) = N(0.1237) = 0.5492 and N(d2) = N(-0.1591) = 0.4368

continued

4^^

B usiness finance

continued

Substituting into Equation 18.6: c = S N [d } ) - PVX N [d 2) =($9.951(0.5492 卜 ($ 10.001(0.4368) = $ 1.10

To verify that Equation 18.6 gives the same valuation as the original Black-Scholes equation (Equation 18.5), we first note that the continuously compounding interest rate that is equivalent to 5 per cent per half-year is 9.758 per cent per annum.20 Calculating the values to input into Equation 18.5 we find that: fn(S/X) + (〆 + 士a2) 7 d]

= oTf = ^n($9.95/$ 10.50) + (0.097 580 + 0.5 x 0.16) (0.5) 0 .4 \/ 〇3 ~ = M(0.947 619)+ 0.088 790 0.2828 = 0.1237 = d] - (Jy/T = 0 .12 37 -0.2 82 8 = -0.1591

As shown above, N ( ^ ) = N (0.1237) = 0.5492 and N [d 2 ) = N (-0 .1591) = 0.4368

Substituting into the original Black-Scholes equation (Equation 18.5): c= S N (d 1)-X e -r，T N(d2) = ($9.95)(0.5492)-($10.50)e-(〇09758)(°'5)(0.4368) =($9.95)10.5492) - ($10.50)(0.952 381 )(0.4368) = $ 1.10

Equations 18.5 and 1 8.6 provide the same valuation —$ 1 .1 0 —for the option. By invoking Equation 18.1, the p u t-c a ll p a rity equation, the Black-Scholes analysis also provides an equation to value European puts on shares th a t do n o t pay dividends.21 In a continuous tim e form ulation Equation 18.1 is: p = c - S + Xe~r， T

18.7

where p = the price o f the European put. S ubstituting Equation 18.5 in to Equation 18.7 and rearranging gives: p = S[N{d{) - 1 ] + Xe~rJT[ l - N ( d 2)] Equation 18.8 is the Black-Scholes European p u t pricing m odel.22 The application o f Equation 18.8 is illustrated in Example 18.6.

20 B e c a u s e ^ 7 = e_0 09758x 0-5 = e ^ 04879 = 0.952 381 = 1/1.05.~ 21 Note that it is necessary to assume a European-type put a n d no dividends because, even in the absence of dividends, it can sometimes pay to exercise prematurely an American-type put. This feature makes the pricing of American-type puts more complex than the pricing of American-type calls. 22 Because N ( d j) - 1 = - N(-rfj) and 1 - N (d 2) = N ( - d 2), Equation 18.8 can also be written as p = - S N ^ - d ^ + X e~ rTN { - d 2).

C hapter eighteen O

ptions a n d c o n tin g e n t claims

m

ure 18.4 Graphical representation of the Black-Scholes equation

Share price (S)

In Equation 18.6, R is the observed effective interest rate on a risk-free investm ent fo r a term equal to the term o f the option. The application o f Equation 18.6 is illustrated in Example 18.5.

E xample 18.5 Suppose that we wish to find the Black-Scholes price for a call option with the following characteristics: Current share price: S = $9.95 X = $10.50 Exercise price: Term to expiry: 7 = 6 months = 0.5 years Volatility (variance): a 2 = 0.16 per annum a = 0.4 per annum Standard deviation: Risk-free interest rate: R = 5 per cent per half-year The first task is to calculate the present value of the exercise price: PVX=㈣

1.05 = $ 10.00

The next task is to calculate ,

and d2 using Equation 18.6:

M $ 9 . 9 5 / $ 1 0 .0 0 ) + ( 0 . 5 ) ( 0 . 16 ) (0 .5 )

------------------ 0 ^ 3 = ^ n ( 0 .9 9 5 ) + 0 . 0 4 0 .2 8 2 8 = 0 .1 2 3 7

d2 = 0.12 37 -0.2 82 8 = -0.1591

Consulting the table of values for the standard normal distribution N[.), or by using the Microsoft Excel® NORMSDIST function, we find that: N(d} ) = N(0.1237) = 0.5492 and N[d2) = N (-0 .1591) = 0.4368

continued

4^^

B usiness finance

continued Substituting into Equation 18.6: c = S N [d ] ) - PVX N (d2) = ($9.95)(0.5492) - ($ 10.00)(0.4368)

=$1.10

To verify that Equation 18.6 gives the same valuation as the original Black-Scholes equation (Equation 18.5), we first note that the continuously compounding interest rate that is equivalent to 5 per cent per half-year is 9.758 per cent per annum.20 Calculating the values to input into Equation 18.5 we find that: en[S/X\+

d]

+ 〇

T

7r

= £n($9.95/$ 10.50) -f (0 .097580 + 0.5 x 0.16) (0.5) 0 .4 ^ 0 5 ~ = M Q -9 4 7 6 1 9 )+ 0.088 790 0.2828 = 0.1237 d2 = d ] - o V j = 0 .1 2 3 7 -0 .2 8 2 8 = -0.1591

As shown above, N (d !) = N (0 .1237) = 0.5492 and N [d 2 ) = N(-0.1591) = 0.4368

Substituting into the original Black-Scholes equation (Equation 18.5): c=SN (d1)-X e -/ r N(d2) = ($9.95)(0.5492)-($10.50)e-(a 〇9758H〇 -5)(〇 .4368) = ($9.95)(0.5492) - ($10.50)(0.952 381 )(0.4368)

= $ 1.10

Equations 18.5 and 18.6 provide the same valuation —$ 1 .1 0 —for the option. By invoking Equation 18.1, the p u t-c a ll p a rity equation, the Black-Scholes analysis also provides an equation to value European puts on shares th a t do n o t pay dividends.21 In a continuous tim e form ulation Equation 18.1 is: p = c - S + Xe~r， T

18.7

where p = the price o f the European put. S ubstituting Equation 18.5 in to Equation 18.7 and rearranging gives: p = S[N (dj) - 1 ] + Xe-r ，T[ l - N ( d 2)]

18.8

Equation 18.8 is the Black-Scholes European p u t pricing m odel.22 The application o f Equation 18.8 is illustrated in Example 18.6.

20 Because = e-0 09758^ 5 = e"004879 = 0.952 381 = 1/1.05.~ 21 Note that it is necessary to assume a European-type put a n d no dividends because, even in the absence of dividends, it can sometimes pay to exercise prematurely an American-type put. This feature makes the pricing of American-type puts more complex than the pricing of American-type calls. 22 Because N ( d ^ - 1 = - N (- ^ ) and 1 - N (d 2) = N ( - d 2), Equation 18.8 can also be vmtten as p = - S N i - d ^ + X e~ rTN ( - d 2).

4^^

C hapter eighteen O

ptions a n d c o n tin g e n t claims

Example 18.6 Suppose that we wish to find the Black-Scholes price for the put option that is the counterpart to the call option described in Example 18.4—that is: Current share price: Exercise price: Term to expiry: Volatility (variance): Standard deviation: Risk-free interest rate:

P = $17.60 X = $16.00 7 = 3 months = 0.25 years a 2 = 0.09 per annum o = 0.3 per annum 〆 = 0.1 per annum, continuously compounding

The calculations in Example 18.4 showed that with these values, NIc/]) = 0.8098, N ic y = 0.7664 and e_rT= 0.9753. Substituting into Equation 18.8, the Black-Scholes European put price is: p = S[N(d,) - 1] + XeVT[l - N(c/2)] = ( $ 1 7 . 6 0 ) ( 0 . 8 0 9 8 - 1 ) + |$ 1 6 .0 0 ) ( 0 .9 7 5 3 ) ( 1 - 0 . 7 6 6 4 )

=$0,298

The Black-Scholes European put price is therefore slightly less than 30 cents.

1 8 .4 .3 1A brief assessment of the Black-Scholes model An appealing feature o f the Black-Scholes m odel is th a t i t specifies a p articula r fu n ctio n a l fo rm lin k in g the variables, rather th an sim ply specifying the direction o f each variables influence. Slightly less obvious, b u t also a strength o f the model, is the num ber o f variables th a t i t does not include. As suggested earlier, the retu rn th a t investors expect on the underlying share has no place in the model. No assumption concerning the a ttitu d e o f investors towards risk is required or im plied. Conversely, the variables th a t are present in the m odel are fo r the m ost p a rt observable and have reliable data available. The share price, exercise price and term to expiry are directly observable, and good proxies exist fo r the risk-free interest rate. M easuring a share s v o la tility is subject to error; Black (1975, p. 36) described i t as *the big unknow n in the o ption formula*. However, i f a share s v o la tility (as measured by the variance o f the rate o f retu rn) is constant, as the m odel assumes, then the sequence o f past prices may be used to produce an accurate estimate o f the v o la tility . Therefore, although investors1 expectations o f the re tu rn on the share have no place in the equation, th is is n o t true o f v o la tility expectations. The model, in effect, sidesteps th is problem by assuming th a t the v o la tility is a know n constant. In practice, users o f the m odel may tr y a range o f values fo r th is variable. In o the r cases, users may take m arket prices o f options and then solve the Black-Scholes equation fo r the v o la tility ‘im p lie d ’ by the m arket price o f the option. Indeed, estimates o f ‘im plied v o la tility ’ are o f great interest to m arket participants as they are o fte n interpreted as pro vid ing current in fo rm a tio n about expectations o f future price vo la tility. Perhaps the m ost w idely cited im plied v o la tility measure is the Chicago Board Options Exchange V o la tility Index (VIX). This index is constructed by analysing the traded prices o f a series o f options w ritte n on the S&P 500 share price index— an index th a t reflects the price movements o f a p o rtfo lio o f shares in the very largest companies traded in the US— and estim ating the level o f v o la tility im plied by those o p tio n prices over the next 30 days. N ot only is th is in fo rm a tio n interesting in terms o f gauging current m arket sentim ent, b u t w ith the in tro d u c tio n o f futures contracts (in 2003) and options contracts (in 2006) w ritte n on the VIX , hedgers and speculators now have the a b ility to effectively trade in vo la tility. Follow ing its development by Professor Robert Whaley, the Chicago Board Options Exchange introduced V IX in 1993 w ith tw o m ain purposes. First, V IX was designed to provide m arket participants w ith a measure o f current expectations o f s h ort-term v o la tility , and second to then enable derivative contracts to be developed and traded on such a measure. Since its intro d u ctio n , VIX has often been cited as an aggregate measure o f the level o f apprehension fe lt by m arket traders about future price movements.

B usiness finance

Finance IN ACTION

H O W TO MEASURE FEAR WITH OPTIONS CONTRACTS! In endeavouring to understand the Market Volatility Index (VIX), it is essential to remember that it is not a backward-looking tool, as commentators sometimes suggest, measuring volatility that has already come to pass; instead, it is forward-looking, measuring volatility that investors expect to see. The VIX can be likened to a bond's yield to maturity—the discount rate that equates a bond's price to the present value of its promised payments. A bond’s yield is implied by its current price but it represents the expected future return of the bond over its remaining life. Similarly, VIX is implied by the current prices of S&P 5 0 0 index options but represents the expected future market volatility over the next 30 calendar days. Strictly speaking, volatility describes unexpected upward or downward movements; however, the S&P 5 0 0 index option market has become dominated by hedgers who buy index puts when they are concerned about the possibility of a drop in the stock market—essentially 'insuring' themselves—which explains why the VIX has been dubbed the ’ investor fear gauge ’！ Purchasing insurance is nothing new; we routinely purchase home and contents insurance as a means o f insuring our home value in the event of theft or natural disasters. If the chance of theft in your neighbourhood rises, your insurance company is likely to increase its premium. The same is true for portfolio insurance: the more investors demand, the higher the price. VIX is an indicator that reflects the price of portfolio insurance. Source: Information drawn from 'Understanding VIX', Robert Whaley, Journal of Portfolio Management, Spring 2009, pp. 9 8 -1 0 5 .

18.5 Options on foreign currency So far, we have confined our discussion almost entirely to options on shares. However, there are options on a wide variety o f underlying assets— even the weather! (See Finance in Action.) Fortunately, most o f the principles we have covered also apply to options on other underlying assets. In this section we consider options on foreign currency. O ptions on futures contracts are considered in Section 18.7.

Finance in

ACTION

HEDGING THE WEATHER______________________________________ Looked at one way, an option is an insurance contract. If a shareholder buys a put option, he or she has protection against the share price falling below the exercise price of the option. So, couldn't the idea of an option be extended to pretty much anything that someone might want to insure against? If, say, I’ m worried about cold weather, why can’t i buy an option that will pay off only if the weather gets too cold? Or, if Tm worried about wet weather, why can't I buy an option that pays off only if it rains? Well, you can, as shown in the following excerpt. In the summer of 2 0 0 1 , Dieter Worms could only sit and watch as rain kept golfers away from the fairways of his Gut Apeldor golf club in Hennstedt, about 100 kilometres north of the German city of Hamburg. The weather in 2001 was m iserable/ says 54-year-old Worms. ;W h a t I hate as the owner of a golf course is to get frustrated more and more every minute when you see the rain coming down in buckets —and not just for one day but for weeks and months/ In 2 0 0 2 Worms resolved to avoid a repeat of his frustration by buying a weather derivative from Societe Generale SA, France's third-largest bank by assets. He decided he could put up with 5 0 rainy days from M ay to September, the period when golf courses typically make about 80 per cent of their income. Once the number of days with more than a millimetre of rain passed 50, the derivatives contract started paying compensation for every wet day. Worms is one of thousands of business owners around the world who have sought to protect their balance sheets from the weather. The Weather Risk Management Association

C hapter eighteen O

ptions a n d c o n tin g e n t claims

(vsrww.wrma.org), a Washington-based trade group, shows that the number of weather riskmanagement contracts signed w orldw ide almost trebled to about 12 0 0 0 in the 12 months ended in March 200 3 from the year-earlier period. The contracts had an underlying value of $4.2 billion. In Europe, the number of contracts almost doubled to 1480 from 765. S o u rc e :

B a se d on 'H e d g in g the w e ather', M a r k G ilb e rt a n d A le ja n d ro B a rb a jo sa ,

B lo o m b e r g

M a rk e ts ,

vol. 1 3, no. 7,

July 2 0 0 4 , pp. 9 9 - 1 0 2 . "

18.5.1 | W h a t is an option on foreign currency? A call (put) option on foreign currency is a contract th a t confers the rig h t to buy (sell) an agreed quantity o f th a t foreign currency at a given exchange rate. O ptions on foreign currency are traded in organised markets such as the Philadelphia Exchange, as well as in ‘over-the-counter’ markets and by privately arranged contracts. A company selling, say, US dollars (in retu rn fo r Australian dollars) can equivalently be said to be purchasing Australian dollars (using US dollars). In the same way, a p u t option to sell US dollars (for Australian dollars) can equivalently be described as a call option to buy Australian dollars (using US dollars). Example 18.7 illustrates the nature o f options on foreign currency.23

L E A R N IN G O B JEC T IV E 5 E xp lain the characteristics a n d uses of foreign currency options a n d options on futures

E xample 18.7 On 24 August, Westpac Bank sold a 3-month US dollar put option (equivalently, a 3-month Australian dollar call option). The purchaser was an Australian exporter looking to insure the value of a future US dollar receipt against a possible depreciation in the value of the US dollar (equivalently, an appreciation in the value of the Australian dollar). The underlying currency amount was US$5 million and the exercise price was A$1 = US$0.71 18. At the time the option was purchased, the spot rate was also A$1 = US$0.7118. The price of this option was US$0.0199 per US$1; that is, the exporter paid US$(0.0199 x 50 0 0 0 0 0 ) = US$99500, which at the time was equivalent to A $ (9 9 5 0 0 /0 .7 1 18) = A$1 397 8 6 . On payment of this sum, the exporter obtained the right to sell US$5 million at the price of US71.18 cents per Australian dollar—that is, US$5 million could be sold for A $ (5 0 0 0 0 0 0 /0 .7 1 1 8) = A $ 7 0 2 4 4 4 5 . The cost of this right was US$99500. The payoff structure is shown in Table 18.12.

TABLE 18.12 Payoff structure for purchase of a put contract on US$5 million at an exercise price of A$1 = US$0.7118 If the spot rate per A $ 1 on the put’s expiry date is:

Then the payoff (cash flow) to the put holder is: In US$

In A$ equivalent

U S $ 0 .6 8 0 0

0

0

U S $ 0 .6 9 0 0

0

0

U S $ 0 .7 0 0 0

0

0

U S $ 0 .7 1 0 0

0

0

U S $ 0 .7 1 1 8

0

〇

U S $ 0 .7 2 0 0

0 .0 0 8 2 x 5 m / 0 .7 1 1 8 = 5 7 6 0 0

U S $ 0 .7 3 0 0

0 .0 1 8 2 x 5m /0 .7 1 1 8 = 1 2 7 8 4 5

1 2 7 8 4 5 / 0 .7 3 = 1 7 5 1 3 0

U S $ 0 .7 4 0 0

0 .0 2 8 2 x 5 m / 0 .7 1 1 8 = 1 9 8 0 8 9

1 9 8 0 8 9 / 0 .7 4 = 2 6 7 6 8 8

U S $ 0 .7 5 0 0

0 .0 3 8 2 x 5 m / 0 .7 1 1 8 = 2 6 8 3 3 4

2 6 8 3 3 4 / 0 .7 5 = 3 5 7 7 7 8

5 7 6 0 0 / 0 .7 2 = 8 0 0 0 1

continued 23 We are grateful to Westpac Banking Corporation for providing the information used in this example. We have rounded final calculations to the nearest dollar.

4 ^^

continued A s c an be seen from the p ayo ff structure in Table 1 8 .1 2 , the put provides protection a g a in st the effects of a dep reciating U S do llar (equivalently, an ap p re ciatin g Australian dollar). This protection be gin s to take effect w hen the value of an Australian do llar reaches the exercise price of U S 7 1 .1 8 cents. Ifr instead, protection w a s sou ght a g a in s t the effects of an ap p re ciatin g U S d o llar (equivalently, a dep reciating Australian dollar), a call option to buy U S dollars is required. The p ayo ff structure for a trader w h o buys a call option on U S $ 5 million at an exercise price of A $ 1 = U S $ 0 ,7 3 1 8 is show n in Table 1 8.13.

TABLE 18.13 Payoff structure for purchase of a call contract on US$5 million at an exercise price of A$1 = US$0.7318 If the spot rate per A$1 on the puts expiry date is:

Then the payoff (cash flow) to the put holder is: In US$

In A$ equivalent

US$0.7000

0.0318 x 5m/0.7318 = 217272

217272/0.70 = 310389

US$0.7100

0.0218 x 5m/0.7318 = 148948

148948/0.71 = 209 786

US$0.7200

0.0118 x 5m/0.7318 = 80623

80623/0.72 = 111977

US$0.7300

0.0018 x 5m/0.7318 = 12 298

12298/0.73 = 16847

US$0.7318

0

0

US$0.7400

〇

0

US$0.7500

0

0

US$0.7600

0

0

US$0.7700

0

0

1 8 .5 .2 1 Combinations of options on foreign currency Some o f the most frequent uses th a t have been made o f options on foreign currency involve combining two or more such options. For example, options can be combined to produce an arrangement sometimes know n as a ‘range forw ard’ or a ‘collar’. This arrangement is shown in Example 18.8.

Example 18.8 Conquest Investments Ltd expects to receive a cash inflow of A $30 million in the next month and plans to convert this sum to US dollars to invest in a US company. At current exchange rates, the US dollar value of this inflow is around US$17 million. Tim Johns, the manager of Conquest Investments, wants to be guaranteed to receive a minimum of US$25.68 million for delivery of the A $30 million. Should the Australian dollar appreciate in the next month, Johns is willing to accept a ceiling of receiving no more than US$26.28 million in return for delivery of the A$30 million. To lock in simultaneously the minimum of US$25.68 million and the maximum of US$26.28 million, Johns combines the purchase of a put to sell A $30 million (with an exercise price of US85.60 cents) with the sale of a call to purchase A$30 million (with an exercise price of US87.60 cents). The cash inflow from selling the call can then be used to help pay for the put.24 The payoff structure is shown in Table 18.14. Table 18.14 shows that, whatever the future exchange rate may be, Conquest Investments Ltd will receive no less than US$25.68 million but no more than US$26.28 million. If the future spot rate is between US85.60 and US87.60 cents per A $ l, the payoff on both options is zero and the arrangement requires only a spot transaction.

24 In practice it is common for the exercise prices to be selected carefully so that the put price equals the call price. Therefore the inflow from one exactly offsets the cost of the other, making the deal appear 'free*.

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TABLE 18.14 Payoff structure for Example 18.8, Conquest Investments Ltd If the spot rate per A 〇>1 on the expiry date is:

Then the US$ cash flows are: 〇n

〇n

the pu㈣

the call⑹

Purchase of US$ (spot)(c)

Total

US$0.8200

+1080000

0

+24600000

+25680000

US$0.8300

+780000

0

+24900000

+25 680000

US$0.8400

+480000

0

+25 200000

+25680000

US$0.8500

+180000

0

+25500000

+25 680000

US$0.8560

0

0

+25 680000

+25 680000

US$0.8600

0

0

+25800000

+25800000

US$0.8700

0

0

+26100000

+26100000

US$0.8760

0

0

+26280000

+26280000

US$0.8800

0

-120000

+26400000

+26280000

US$0.8900

0

-420000

+26700000

+26280000

US$0.9000

0

-720000

+27000000

+26280000

US$0.9100

0

-1020000

+27300000

+26280000

(°l

For e x p iry spot rates less than the exercise price of U S $ 0 . 8 5 6 0 , e a ch calculation is + ( U S $ 0 . 8 5 6 0 - e x p iry spot rate) x 3 0 million.

(b)

For e x p iry spot rates greater than the exe rcise price o f U S $ 0 . 8 7 6 0 , e a ch calculation is -(e x p ir y spot

(cl

Each calculation is e x p iry sp ot rate x 3 0 million.

rate - U S $ 0 . 8 7 6 0 ) x 3 0 million.

18.6 Options, forwards and futures There is a simple relationship between prices o f European options and forw ard prices. As forw ard contracts are most frequently encountered in foreign currency dealings, we w ill explain the relationship using options on foreign currency and forw ard contracts on foreign currency. However, in principle it holds fo r a much wider range o f underlying assets.

E xample 18.9 Suppose that, in Example 18.8, the exercise price of the call had, like that of the put, been US85.60 cents. In that case, the payoffs are as shown in Table 18.15.

TABLE 18.15 Payoffs for put bought and call sold, both with an (exercise price of US85.60 cents If the spot rate per Aq> 1 on the expiry date is:

Then the US$ cash flows are: 〇n

the puH。）

〇n

the call⑹

Purchase of US$ (spot” c)

Total

US$0.8200

+1080000

0

+24600000

+25 680000

US$0.8300

+780000

0

+24900000

+25680000

US$0.8400

+480000

0

+25 200000

+25 680000

continued

B usiness finance

Table 18.15 continued If the spot rate per A$1 on the expiry date is:

Then the US$ cash flows are: On the puH°^

〇n

the cal 1(6)

Purchase of US$ (spot)㈦

Total

US$0.8500

+180000

0

+25 500000

+25 680000

US$0.8560

0

0

+25 680000

+25 680000

US$0.8600

0

-120000

+25800000

+25 680000

US$0.8700

0

-420000

+26100000

+25 680000

US$0.8800

0

-720000

+26400000

+25 680000

US$0.8900

0

-1020000

+26700000

+25 680000

问 For

e x p iry spot rates less than the exercise price of U S $ 0 . 8 5 6 0 , e a ch calculation is + ( U S $ 0 . 8 5 6 0 - e xp iry spot rate) x 3 0 million.

^ For e x p iry spot rates greater than the exercise price o f U S $ 0 . 8 5 6 0 , e a ch calculation is (e xpiry spot rate - U S $ 0 . 8 5 6 0 ) x 3 0 million. (CJ

C a lcu la te d usin g 3 0 million x spot rate.

The final column of Table 18.15 shows that this combination of transactions is equivalent to a guarantee that A$30 million can be sold for US$16.68 million. In effect, therefore, this combination is equivalent to having a forward contract to sell A $30 million at a forward price of US55.60 cents per A$ 1. It is a simple matter to provide an algebraic proof. Given that: Total cash flow = cash flow from put + cash flow from call + cash flow from spot transaction then if S < X, the total cash flow is: (X -S * ) + 0 + S* = X

but if S > X, the total cash flow is: 〇 _ (S* - X) + S* = X

Therefore, the future total cash flow is always X. Suppose that the price of the put was equal to the price of the call, and both the put and the call have the same exercise price, term to expiry, and so on. In this case, the arrangement illustrated in Table 18.15 requires no net initial cash inflow or outflow and it therefore replicates a forward contract at both initiation and expiry. To prevent arbitrage, the forward price (exchange rate) should therefore equal the exercise price of the options. In summary, if the prices of a put and its counterpart call are equal, the forward price for the underlying asset should equal the exercise price of the options.

As we discussed in Section 18.2.1, forw ard contracts are very sim ilar to futures contracts. Therefore, i f the prices o f a p ut and its counterpart call are equal, the futures price fo r the underlying asset should approximately equal the exercise price o f the options. A fu rth e r connection between option contracts and futures contracts is through a security know n as a ‘low exercise price o ptio n ’ (LEPO). Such contracts are listed on the ASX. Consider a 1-m onth call option w ith an exercise price o f 1 cent, on a share whose current m arket price is $10. Clearly, there is v irtu a lly no chance th a t the share price w ill be anywhere near 1 cent during the coming m onth. Accordingly, the o ption is almost certain to be exercised ( if n o t sold to someone else before expiry). The true option element is thus exceedingly small and, in effect, a LEPO is v irtu a lly a com m itm ent to purchase. Who would n o t expect to exercise an option to buy a share fo r 1 cent when the current share price is around $10? Furtherm ore— unlike the rules applying to norm al share options— the ASX rules on LEPOs do not require th a t LEPO buyers pay the option price at the in itia tio n o f the contract. Instead, the ASX merely

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requires th a t LEPO buyers pay a m argin call i f the share price falls, and th a t LEPO sellers pay a m argin call i f the share price rises. The result, therefore, is th a t a LEPO requires no payment at in itia tio n b u t produces cash inflows or outflows as the share price changes, and ( if n o t earlier reversed) is v irtu a lly certain to result in a purchase o f the share. This description is almost identical to th a t o f a futures contract on a share. In other words, financially speaking, a LEPO is almost identical to a futures contract on a share.

Options on futures

A number o f futures exchanges, including the ASX, have introduced options on th e ir more heavily traded futures contracts.25 A call o ption on futures confers on the buyer o f the call the rig h t to enter into a futures contract as a buyer. Similarly, a p u t option on futures confers on the buyer o f the p u t the rig h t to enter into a futures contract as a seller. O ften the expiry date o f the option is sh ortly before the expiry date o f the futures contract. For example, suppose th a t on 15 February the price o f a futures contract on gold, m aturing on 20 May, is $1500. On 15 February it may also be possible to buy a call option on this futures contract w ith an exercise price of, say, $1540 and an expiry date o f 13 May. This call confers the rig h t to assume the role o f buyer in the futures contract at a futures price o f $1540. On 15 February this o ption may be w orth, say, $30. Suppose th a t the futures price o f gold increases and th a t by 10 May the futures price has reached $1630 and the call buyer wishes to take the p ro fit. I f the call is an American type the call buyer could exercise the call on 10 May, thereby becoming registered from th a t date as a futures buyer at a price o f $1540. Through operation o f the m ark-to-m arket rule, the sum o f $90 w ill be credited to the buyer. Alternatively, instead o f exercising the call, i t could sim ply be sold in the options m arket. In principle the price obtained should be $90 o r more.

Options on futures have proved to be popular w ith traders, particularly in the case o f options on financial futures. Although there are many possible reasons fo r this popularity, options on futures have three attributes th a t may have prom pted m arket participants to trade in the option rather than in the underlying futures contract:

a Open futures positions entail very high risks fo r a speculator, p articularly i f those positions are held fo r a long time. For example, i f a m arket participant believed th a t the share price index (SPI) was likely to rise substantially in the next 2 months, then w ith o u t options, and apart from buying the shares themselves, the only way to speculate on this belief is to buy SPI futures. M any speculators would n ot w ant to take th is risk, sim ply because they could incur large losses i f the SPI should fall. A call o ption on futures allows the speculator to pay a given sum (the option price) in retu rn fo r avoiding the p ossibility o f large losses. The a b ility to p ro fit i f the belief proves correct is unimpaired. In short, options on futures can preserve the basic speculative uses o f futures, b u t w ith o u t the open-ended com m itm ent th a t futures themselves require, b Hedgers may n o t be certain enough o f th e ir own circumstances to ju s tify accepting the obligations o f a futures contract. Consider the follow ing situation. A small m anufacturer has tendered fo r a particular job and the manager believes th a t although there is a fa ir chance o f success, i t is n ot certain. I f the tender is accepted, there w ill be an immediate need fo r short-term funding o f approximately $1 m illio n to buy the necessary raw materials. O f course, i f the tender is n o t accepted, there is no such need. The manager believes th a t there is a need to hedge, because the financial via b ility o f the project w ill be threatened i f interest rates increase between now and the date on 25 In this section it is assumed that the reader is familiar with futures contracts. Futures contracts are explained in detail in Chapter 17.

A

B usiness finance

i which the name o f the successful tenderer w ill be announced. This risk cannot be hedged using futures contracts because a futures contract is a com m itm ent, b u t the m anufacturer cannot be com m itted to the project unless and u n til the tender is accepted. A t present the m anufacturers need to hedge is contingent on the future outcome o f the tender process. The m anufacturer could set up a contingent hedge by buying a p u t option on a bank b ill futures contract. The am ount paid fo r the put is like an insurance premium. I f interest rates rise, bank b ill futures prices w ill fa ll and the p u t w ill be more valuable. The p u ts increased value w ill protect the manufacturer, should protection be needed. O f course, i f interest rates fall, so w ill the p ut price. Indeed, the p ut price may even fa ll to zero and the m anufacturer w ill then have lost the to ta l price paid fo r the put. This is like buying fire insurance and n o t having a fire. No claim is made on the insurance policy and the prem ium is lost. The deposit/m argin system is simpler fo r option buyers than fo r futures traders. (O ption sellers s till face u nlim ited risks so there are s till complications applicable to them.) Once option buyers have paid the option price they can make no fu rth e r losses. Consequentiy, there is little or no reason to subject option buyers to a stringent deposit/margin system. For this reason, smaller futures traders may prefer to buy a call instead o f buying futures. Similarly, they may prefer to buy a p ut instead o f selling futures.

C

1 8 .7 .3 1 Pricing options on futures The valuation o f options w ritte n on futures contracts, such as those traded on the Australian Securities Exchange,26 has been derived by Asay (1982) and Lieu (1990) and is provided by the follow ing formulae: c = FN{d3) - X N ( d 4) p = X N (-d 4) - F N ( - d 3) where

^ 刚

18.9 n s iP !

^ a y/T

d^- crVT where c = price o f the call p = price o f the p ut F = futures price X = exercise price T = term to expiry o f the option O2 = v o la tility o f the futures price Note th a t the form ulae above look very sim ilar to the standard Black-Scholes equations (Equations 18.5 and 18.8) w ith the only notable differences being th a t the share price has been replaced by the price o f a futures contract w ritte n on the share and the omission o f the interest rate from the form ula. The in tu itio n behind the interest rate omission is straightforw ard, because in the standard Black-Scholes equations the interest rate represents compensation to the trader fo r having funds tie d up in the share. As a futures contract requires no in itia l investm ent, there is no need to include an interest rate when estim ating the value o f futures options.

1 8 .7 .4 1 Specification of the SPI 200 futures options contract The SPI 200 futures options contract has the follow ing m ajor features: a

b

Option style. American. Contract unit. The contract u n it is the value o f the SPI 200 futures contract, w hich its e lf is valued by reference to the S&P/ASX 200 Index m ultiplie d by $25.

26 Black (1976) derived the pricing formula for futures options traded in markets where the option premium is payable up-front. However, the premium on futures options traded on the ASX is not paid immediately but is instead marked to market in a similar way as is any position in a futures contract. Asay (1982) and Lieu (1990) adjust Blacks model to account for this difference in market structure.

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Settlement. The contract is deliverable and may be exercised on any business day up to and including the last trading day. Upon exercise the holder w ill receive (deliver) the underlying SPI 200 futures contract position at the exercise price. d Quotations. The contract is quoted as the value o f the SPI 200 futures contract to 0.5 index points, e Exercise prices. Set at intervals o f 25 basis points. New o ption exercise prices are created automatically as the underlying futures contract price fluctuates, f Termination o f contract. A ll trading ceases at 12 noon on the th ird Thursday o f the contract m onth, w ith settlem ent occurring the day follow ing the close o f trading.

C

Example 18.10 illustrates the use o f options contracts w ritte n on the SPI 200 futures contract.

Example 18.10 Diacono Fidelity is a superannuation fund that collects contributions from its members on a quarterly basis and invests those funds in a diversified portfolio of Australian equities. It is 5 July 2013 and the management of the fund is concerned that the general level of share prices will rise prior to 3 October 2013, when it is next going to invest the funds. It has approximately $ 1 500 00 in contributions that will be invested. W hile Diacono Fidelity could hedge the risk of prices rising by taking a long position in a futures contract, they wish to still benefit from any possible decline in market prices that might occur prior to the funds being invested, and hence determine that it would be optimal to take a position in a futures option contract instead. On 5 July 2013, the S&P/ASX 200 Index closed at 4841.7 and the December 2013 S&P/ASX SPI 200 Index futures contract closed at 4790 or at a contract price of 4790 x $25 = $119 750. Diacono Fidelity decides to buy a December 2013 call option written on the SPI 200 Index futures contract and with an exercise price of 5150 points (or at a contract price of 5150 x $25 = $128 750). The closing price of the December 2013 SPI 200 call options with an exercise price of 5150 points on 5 July was 39.5 points, which equates to a contract price of 39.5 x $25 = $987.50. So on 5 July 201 3, Diacono Fidelity agreed to pay $987.50 for the right to enter into the SPI 200 futures contract at any time before 12 noon on 19 December 2013 at a notional price of $128750. On 3 October 2013 the S&P/ASX 200 Index closed at 5234.9 and the December 2013 S&P/ ASX SPI 200 Index futures contract closed at 5230 or at a notional contract price of 5230 x $25 = $130750. Diacono Fidelity could have exercised the futures option to enter into the futures contract as a buyer at a notional price of $ 1 2 8 7 5 0 and reversed out as a seller at $1 30750 , resulting in a gain of $2000. After deducting the price of the call option of $987.50, the net gain would have been $ 1012.50, which could then be used to offset the generally higher level of equity prices that Diacono Fidelity now faces in the market.

18.8 Contingent claims

im L E A R N IN G

18.8.1 | W h a t is a contingent claim? A t the most basic level, an option on shares is sim ply an agreement th a t allows a choice about buying or selling shares to be made at a later date. The choice w ill be exercised i f i t is in the interests o f the option holder to do so. The decision w ill depend on the future value o f the shares. A contingent claim, is an asset whose value depends on the given value o f some other asset. A call option is perhaps the simplest type o f contingent claim. A large number o f financial contracts are contingent claims and this raises the possibility th a t such contracts m ig ht be valued using an option pricing (tha t is, contingent-claims) approach. In the follow ing six sections we provide examples o f financial contracts th a t can be interpreted as options. However, detailed discussion o f the pricing form ulae is beyond the scope o f the book.

18 .8 .2 | Rights issues One o f the simplest contingent claims arises when a company raises new share capital by way o f a renounceable rights issue. In this case a shareholder is given the rig h t to purchase new shares in the

O B JEC T IV E 6 Define a contingent claim a n d exp lain the option-like features of several contingent claim s

B usiness finance

company at an issue price set by the company. The rights m ust be sold or taken up by a specified date. In fact, a rig h t is sim ply a call option issued by the company. Unlike listed call options, exercise o f this rig h t does affect the company s capital structure because new capital is raised. Furtherm ore, in practice the life o f a rig h t is usually much shorter than the life o f m ost listed call options. Nevertheless, a rig h t is a call option and therefore can be valued using option pricing principles.27

18 .8.3 |C o n ve rtib le bonds A convertible bond is a type o f debt security that, in addition to paying interest, gives the investor the rig h t to convert the security in to shares o f the company. For example, on the m a tu rity o f the convertible bond, the investor can accept a cash payment in the usual way, or can take a predeterm ined number o f shares instead o f the cash payment. The choice is up to the investor. A convertible bond is therefore equivalent to ordinary debt plus a call o ption on the shares o f the company.28

1 8 .8 .4 1 Valuation of levered shares and risky zero-coupon debt One o f the firs t contracts to be identified as a contingent claim is a share in a company th a t has debt outstanding. Such a share is know n as a levered share1. Because companies cannot offer government guarantees, there is some risk o f default. Consider, fo r example, the shareholders in a company th a t has issued zero-coupon debt.29 W hen the debt matures, the shareholders m ust make a choice th a t resembles the choice facing the holder o f a call option th a t has reached its expiry date. The shareholders can direct the company to repay the debt o r they can allow the company to default. Choosing to repay is equivalent to the shareholders exercising a call option to reclaim the company s assets from the debtholders. Choosing to default is equivalent to the shareholders allowing the call to expire unexercised. I t is as i f the shareholders have transferred the company s assets to the debtholders b u t have a call o ption to buy back the assets by repaying the debt on the m a tu rity date. The m ajor variables involved in p ricing a call option are reinterpreted as shown in Table 18.16.

TABLE 18.16 Interpreting a levered share as a call option on a company's assets Call option on shares

Levered share interpretation

The current (market) value o f the share

The current (market) value of the company s assets

The exercise price

The amount due at the debts m aturity (the face value o f the debt)

The term to expiry of the option

The term to m aturity o f the debt

The volatility o f the share

The volatility o f the company’s assets

The risk-free interest rate

The risk-free interest rate

In principle, therefore, we could value the shares using an option pricing approach. Given th a t the m arket value o f the company is equal to the sum o f the m arket value o f the shares and the m arket value o f the debt, once we know the value o f the shares we can calculate the value o f the debt as well.

1 8 .8 .5 1 Valuation of levered shares and risky coupon-paying debt The contingent-claims approach can also be applied to the problems o f valuing risky coupon-paying debt and valuing the shares o f a company th a t has issued this type o f debt. A lthough this is a more d iffic u lt application, it is relatively simple to explain the insight th a t enables the problem to be solved. In this 27 For a detailed discussion, see Smith (1977). 28 For a detailed discussion, see Ingersoll (1977). A shorter and more accessible discussion can be found in Courtadon and Merrick (1992, pp. 271-2). 29 The most important distinguishing feature of zero-coupon debt is that it is repaid by a single lump sum paid on the maturity date. No intermediate (or coupon) interest payments are required. It is also known as pure discount1debt.

4 ^^

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ptions a n d c o n tin g e n t claims

case shares can be regarded as a sequence o f call options. On the debts m a tu rity date, a payment w ill be due and w ill consist o f the face value plus the last coupon. Consider a date after the second-last coupon payment, but before the m a tu rity date. Looking ahead to the m a tu rity date, the lum p-sum payment due at m a tu rity is the exercise price o f a simple call option. This is the case discussed in the previous section. But to have reached this far, the shareholders m ust have paid the second-last coupon. That is, the shareholders m ust have decided to pay the second-last coupon, rather than default at th a t time. Therefore, the second-last coupon is also an option. I t is like a call option, where the underlying asset is the simple call o ption represented by the fin al repayment. In other words, paying the second-last coupon gives shareholders the option o f proceeding on to the m a tu rity date, where they face th e ir final option o f repaying o r defaulting on the debt. The second-last coupon is therefore an option on an option, or, as i t is sometimes called, a compound option (Geske 1979,1977). W orking backwards in this way, we can value the shares. The value o f the risky debt is given by the value o f the assets, less the value o f the shares.

The net present value (NPV) approach to project evaluation, which we explained in detail in Chapters 5 and 6, is based on an analogy between a proposed investm ent project and a bond. Like a bond, a project produces a set o f future cash flows. The NPV approach proposes that, like the cash flows o f a bond, the cash flows o f a project should be discounted to a present value and summed to find the to ta l value o f the project. W hile the NPV approach has proved to be an extrem ely valuable to o l in project evaluation, this does n o t mean i t is always the best to o l to use. There are tw o flaws in the bond analogy. First, in the bond m arket an investor can purchase a bond today a n d /o r an identical bond at some fu tu re date. But in real investm ent projects, th is is frequently n o t the case. For example, co nstructio n o f an office block on a p articula r site could be started now, or at th is tim e next year. C onstruction cannot be started on both dates. Second, once a bond is purchased, the cash flows to the investor are fixed. N othing the investor does can change the cash flows produced by the bond. But in real investm ent projects managers can intervene in the project a fte r i t has begun and thus influence the cash flows generated by the project. For example, a project can be abandoned. Consider, fo r example, a gold m ine th at, given the cu rren t price o f gold, has a negative NPV (see Brennan & Schwartz 1992).30 Does th is im p ly th a t the m ine is worthless? No. Ownership o f the m ine confers a num ber o f rig h ts th a t are valuable, including the rig h t to close the m ine and the rig h t to reopen i t at a la te r date. W hether and when these rights w ill be exercised w ill depend on the cost o f exercising the rig hts and the fu tu re price o f gold. In short, these rig hts attached to m ine ownership are like options: the option to abandon and the option to reopen. Mine ownership is, o f course, ju st one example, and many projects involve Veal* options.31 In this paragraph we describe several im p o rta n t categories o f real options. M any investm ent proposals im p lic itly include an option to defer. For example, a b uilding m ig ht be constructed today, or next year, or the year after that. The option to defer can be valuable because during the period o f deferral new in fo rm a tio n may emerge and may affect the investm ent decision. A related option is the option to study. For example, instead o f sim ply accepting o r rejecting an investm ent proposal, there is often an option to undertake a p ilo t project to collect more in fo rm a tio n about the likely outcomes o f the proposed project. O ther investment projects are likely to lead to fu rth e r investm ent opportunities. For example, a project may include an option to expand at a later date the o utp ut o f a given product or to expand the range o f products th a t the company produces. A ll options are valuable: by definition, an option cannot have a negative value. Estim ating the value o f a real option is often a significant challenge to managers, b u t is w orthw hile given the many insights provided by option pricing theory. For example, the o ption to abandon a project and sell o ff the assets previously com m itted is an example o f an Am erican-style p ut option held by the firm . Whereas the valuation o f a p u t option on a share is relatively straightforw ard, it is more d iffic u lt to id e n tify and measure those variables th a t are inputs in to the valuation o f real options. Table 18.17 illustrates the lin k

30 The original academic work is Brennan and Schwartz (1985). 31 For a detailed treatment of real options, see Trigeorgis (1996). For more accessible discussions, see Leslie and Michaels (1997), Copeland and Keenan (1998) and Dixit and Pindyck (1995).

C O M P O U N D OPTION

option on an option (e.g. an option to buy an option)

O PTION TO A B A N D O N

right to discontinue an investment project O PTIO N TO REOPEN

right to restart a shut-down investment project OPTIO N TO DEFER

right to b e g in an investment project at a later date OPTION TO STUDY

right to gath er more inform ation on an investment project OPTION TO EXPAND

right to incre ase the scale of a n investment project

B usiness finance

between those variables th a t are inputs in to the valuation o f puts w ritte n on ordinary shares and those th a t are necessary fo r valuing the option to abandon a project.

TABLE 18.17 Variables that have； an impact on the value of the option to abandon a project Put option on shares

Option to abandon a project

The current (market) value o f the share

The present value o f the expected cash flows from the project

The exercise price

The salvage value of the assets committed to the project

The term to expiry o f the option

The remaining life o f the project

The vo la tility of the share

The volatility of the expected cash flows from the project

The risk-free interest rate

The risk-free interest rate

W hen m ig h t management choose to exercise its option to abandon operations and sell o ff the projects assets? To begin w ith , standard option pricing theory tells us th a t it is n o t optim al to exercise a p u t option early sim ply because the exercise price exceeds the current value o f the asset, and hence the company should n o t autom atically abandon operations as soon as the present value o f the expected cash flows from the project is less than the salvage value o f the projects assets. The in tu itio n behind this decision when considering puts w ritte n on shares is th a t p rio r to expiry there is s till a chance th a t the share price may again be greater than the exercise price, in which case the option holder may regret having made the decision to sell at the exercise price. In term s o f the real option, the logic is very sim ilar in th a t a decision to sell o ff the assets fo r th e ir salvage value precludes the company from p articipating in any wealth that m ight be created i f the expected cash flows from the project are subsequently greater than the salvage value o f the assets. O ption pricing theory also demonstrates th a t i t m ig ht be optim al to exercise a p ut option early i f the value o f the asset is very low relative to the o ptions exercise price. This suggests that, in terms o f our option to abandon, the decision to sell o ff the project s assets w ill only be made when the present value o f the expected cash flows from the project are so far below the salvage value o f the assets th a t the company would be better o ff accessing the cash from the asset sale rather than w aitin g to see how the u ncertainty associated w ith the project is resolved. Some managers fear th a t allowing th e ir project analysts to include option values w ill lead to unjustifiable increases in capital expenditure. However, this is n o t necessarily the result. For example, recognising th a t a project has an option to defer can lead to lower capital expenditure. I f the project is n o t deferred, the option value is lost. Moreover, while it is true th a t all options have value, it is also true th a t many options are more valuable i f le ft unexercised. Thus, fo r example, the optim al decision may be to retain the option to expand by n o t investing in a new p la nt today, rather than to exercise the option by investing in a larger plant.

C hapter eighteen O

ptions a n d c o n t in g e n t claims

•

•

•

An equilibrium relationship between put and call prices, known as put-call parity, shows that a European put on a share that does not pay dividends can be replicated by a combination of the share, a risk-free deposit and the counterpart call. Binomial option pricing is a practical way to price many options. It provides a numerical solution method rather than a valuation equation. An option pricing equation, developed by Black and Scholes, is an important milestone in finance theory and has performed well in empirical tests, both in Australia and overseas, if a dividend-adjusted version of the model is used. The model can also be adapted to price options on assets other than shares, including options on foreign currency and options on futures. A large number of financial contracts are contingent claims and an option pricing approach has often proved useful in analysing and pricing these contracts. Examples include rights issues, convertible bonds, shares in a levered company and the default risk structure of interest rates. Real options, such as options to abandon or expand a project, are important in project evaluation.

An option is the right to force a transaction to occur at some future time on terms and conditions decided upon now. For example, the buyer of a call (put) option on shares obtains the right to buy (sell) the shares at a fixed price, known as the exercise price. Options that can be exercised at any time up to expiry are known as 'American options', while those that can be exercised only on the expiry date, and not before, are known as 'European options’ . The buyer of an option obtains a right, whereas the buyer in a futures contract takes on an obligation. A contingent claim is an asset whose value depends on the given value of some other asset. An option is one kind of contingent claim. The cash flows at expiry of an option depend only on the expiry share price and the exercise price. Before expiry, call option prices are influenced by a number of factors, including the current share price (a positive influence), the exercise price (negative), the term to expiry (positive), share volatility (positive), the risk-free interest rate (positive) and expected dividends (negative). Put option prices are affected by the same influences, but some of the signs are reversed.

CHAPTER S G H T E E N REVIEW

SUMMARY

KEY TERMS call option 564 compound option 597 contingent claim 564 exercise (or strike) price 564 hedge ratio (or delta) 578 intrinsic value 569 option to abandon 597 option to defer 597 option to expand 597

option to reopen 597 option to study 597 payoff structure 566 put option 564 put-call parity 573 risk neutrality 579 time value 570 volatility 570

SELF-TEST PROBLEMS A European call option is currently priced at $1.70 and has an exercise price of $15 and a term to expiry of 8 months. The current price of the underlying share is $14.90. The share does not pay dividends. The risk-free interest rate is 0.75 per cent per month (compound). The price of the equivalent put option is $0.83. Show that: a) the price of the call option exceeds its minimum theoretical price b) an arbitrage profit would be earned by simultaneously buying the put, selling the call, buying the share and borrowing the present value of the exercise price c) explain the result in (b).

599

B usiness finance

2

Use the binomial model to price a call option with the following features: exercise price $6, term to expiry 2 months, current share price $6.50, 'up7 factor 1.05 per month, /down, factor 1 /1 .0 5 per month and risk-free interest rate 1 per cent per month. Use two time periods, each of 1 month.

3

Use the Black-Scholes model to calculate the price of a European call option with the following features: exercise price $12, term to expiry 3 months, current share price $12.15, volatility (standard deviation) 20 per cent per annum and risk-free interest rate 10 per cent per annum (continuously compounding). The underlying share does not pay dividends.

Solutions to self-test problems are available in Appendix B.

QUESTIONS 1

[LO 1] Distinguish between the following: a) put option and call option b) American option and European option c) option contract and futures contract d) time value of an option and time value of money.

2

[LO 1】 Selling a share is the opposite o f buying a share. Therefore, an option to sell a share must be the opposite o f an option to buy a share. Is this statement true? Explain.

3

[LO 2] List and explain the factors likely to influence the value of a call option.

4

[LO 2] Options ore so risky that trading in them is really just another form o f gam bling. Discuss.

5

[LO 2] In 2002 a former executive with Macquarie Bank, Simon Hannes, was jailed for insider trading. The offence related to Mr Hannes trading on the basis of information he had received indicating the likely takeover of the transport company TNT by the Dutch firm KPN. Specifically, having learnt of the impending takeover, and at a time when TNT was trading at approximately $1.56 per share, Mr Hannes purchased almost $ 9 0 0 0 0 worth of short-dated call options with an exercise price of $2. Following the public announcement of the takeover bid, the share price for TNT increased to approximately $2.40 per share. Mr Hannes attempted to sell his options but the trades were questioned by his broker. Had the sale been successful he would have generated a profit in excess of $2.3 million. a) Why do you think Mr Hannes employed options rather than shares to exploit the price-sensitive information he had in his possession? Specifically, why do you think he used short-dated out-of-the-money call options? b) Could Mr Hannes have used put options to exploit the same information?

6

[LO 3 】 W hat is the value of a call option on its expiry date? Why? W hat is the value of a put option on its expiry date? Why?

7

[LO 3] W hat is the minimum value of a call option on a share that does not pay dividends? Why?

8

[LO 3] Explain briefly why it is generally not rational to exercise a call option before its expiry date. Under what circumstances can it be rational? In these cases, what do option holders obtain, and what do they forgo?

9

[LO 3] A call option has no maximum possible value; a put option does. Why?

10 [L〇 5] Diacono Shoes Ltd is an Australian manufacturer of upmarket shoes that utilises high-qualityleather imported from Italy. The firm's CEO, Mr Lyle Diacono, is concerned about the possible increase in the price of the Italian leather that the firm uses due to an appreciation in the euro relative to the Australian dollar, and is considering alternative hedging strategies to mitigate this risk. He has been in contact with his friendly investment banker, who has pointed out that the firm might benefit by locking in an exchange rate using currency futures contracts or alternatively might consider buying options written on currency futures contracts. Assuming that he wants to mitigate the risk associated with adverse currency movements, what are the factors that Mr Diacono should consider when choosing between currency futures contracts and options written on currency futures contracts? 11

600

[L〇 5] Ozzie Glassworks Ltd of Adelaide has been awarded the contract to supply glass for a giant aquarium to be built in Lancaster, England. However, the contract is conditional on the promoter of the

C hapter eighteen O

ptions a n d c o n t in g e n t claims

12

[L0 6] Parklands Ltd has issued debentures. Explain how Parklands shares are similar to options.

13

[LO 6] Hi Gear Toys Ltd is facing severe financial difficulties; its cash flows are barely enough to cover its fixed-interest commitments. Hi Gear's share price is very low. Alf Hawke, Hi Gear's managing director, decides that the company should begin manufacturing a new toy that just might prove to be a runaway success (but probably will not). Alf announces the decision at a press conference. Do you think Hi Gear's share price would rise, fall or stay about the same? Why?

PROBLEMS 1

Option pricing [LO 3] The following is an extract from the Xanadu Financial Review of 2 November 2014. Call Option Trading Company: Jempip Industries Ltd Last sale price: $3.27 Expiry month

Exercise price ($)

Last sale ($)

December 2014

2.75

0.51

December 2014

3.00

0.32

December 2014

3.25

0.09

December 2014

3.50

0.04

December 2014

4.00

0.04

March 2015

2.75

0.64

March 2015

3.00

0.44

March 2015

3.25

0.18

March 2015

3.50

0.06

March 2015

4.00

0.04

CHAPTER EIGHTEEN REVIEW

project obtaining a construction approval from the Lancaster City Council. Ozzie Glassworks has quoted a fixed price of U K£2000000. W hat advice would you give Ozzie Glassworks? Explain.

The risk-free interest rate in Xanadu is 1 per cent per month. Jempip options cover 1000 shares per contract, may be exercised at any time, expire at the end of their expiry month and are not protected against dividend payments. Jempip pays dividends of 10 cents per share in April and October each year. Which prices appear to violate option pricing theory? Give brief reasons. 2

PuH:all parity [LO 3] You observe the following prices in a situation in which European put-call parity ought to apply: Put price

$1.95

Call price

$1.10

Share price

$20.00

Exercise price

$22.00

Term to expiry

4 months

Risk-free interest rate

1% per month (compound)

601

a) Show that put-call parity is breached in this case. b) Calculate the payoffs to show that the following strategy is an arbitrage: sell the call, buy the put, buy the share and borrow the present value of the exercise price for 4 months. Option pricing [LO 3]

You observe the following prices in a situation in which call options should sell for at least their minimum theoretical price of M ax [0, current share price - present value of the exercise price]: Call price

$0.33

Share price

$17.50

Exercise price

$18.00

Term to expiry

6 months

Risk-free interest rate

10% p.a. (simple, i.e. 5% for a 6-month period)

W hat should the minimum call price be? Calculate the payoffs to show that the following strategy is an arbitrage: buy the call, short sell the share and lend $17.17 at the risk-free interest rate for 6 months. Put^all parity [LO 3]

Put and call options are available on the shares of Christopher Toms Ltd (CTL). The options are of the European type. CTL is due to pay its next dividend of 10 cents per share in January 2015. The risk-free interest rate is 1 per cent per month. On 31 August 2014 you observe the following market prices for CTL call options: Company: CTL Last sale price: $2.00

Exercise price ($)

Option price ($)

30 November 2014

2.25

0.10

30 November 2014

5.00

0.005

Expiry date

Use put-call parity to estimate market prices for the November 2.25 and November 5.00 put options. If these put options had been of the American type, what would their minimum values have been? Does this suggest that, unlike call options, some American put options should be exercised prematurely? Why, or why not? Binomial option pricing [LO 4 】

Use binomial option pricing to price a 3-month European call option with an exercise price of $15 on a share whose current price is also $15. Use three time periods of 1 month each, a monthly 'up factor7of 1.02 and a monthly 'down factor7 of 1/1.02. The risk-free interest rate is 0.5 per cent per month. Binomial option pricing [LO 4]

Use binomial option pricing to calculate the price of the European put option that matches the call option in the previous problem. Does put-call parity hold? Black-Scholes pricing [LO 4]

a) Calculate the Black-Scholes price for a call option with the following features: share price $3, exercise price of $2.75, term to expiry 3 months, risk-free interest rate 10 per cent per annum (continuously compounded) and volatility (variance) 0.16 per annum. Calculate the Black-Scholes price of a put option with the same features. b) Calculate the Black-Scholes price for the same call option if the share price increases by 1 cent to $3.01. By how much does the call price change? How could you use this information to hedge against share price changes? c) Compare the percentage change in the call price with the percentage change in the share price if the share price increases from $3 to $3.01. Why might this comparison be useful to someone with inside information on the company that issued the shares? Black-Scholes pricing [LO 4]

Calculate the Black-Scholes price for a call option with the following features: share price $25, exercise price $24.50, term to expiry 1 year, risk-free interest rate 6 per cent per annum (compounding annually) and volatility (variance) 0.0625 per annum.

C hapter eighteen O

Black-Scholes pricing [LO 4]

Calculate the Black-Scholes price for a call option with the following features: share price $1 2.32, exercise price $1 2.50, term to expiry 180 days, risk-free 180-day bill rate 7.5 per cent per annum and volatility (variance) 0.0225 per annum. 10

Currency option [LO 5]

Today is 8 August 2015. The Red Claret Hotel Group is selling a travel business that it has been operating in Kyoto, Japan. As a result, it expects to receive approximately 800 million yen in November 2015. The current exchange rate is about 63 yen to one Australian dollar. Because of its other financial commitments, Red Claret needs to be sure that it will receive at least A $12.3 million from the sale, regardless of any movements in the exchange rate. If the exchange rate moves in the company’s favour during the next few months, the company is willing to forgo any gain accruing above an inflow of A$1 3.0 million. Foreign currency options on yen are available in contracts covering 100 million yen each, with exercise prices in half-yen steps, expiring on the second Thursday in August, September, October, November and December. What option contract(s) should Red Claret enter into? Explain. 11

Futures options pricing [LO 5 】

Use the futures call option pricing model (Equation 18.9) to value the following call option on the SPI 200 futures contract:

12

•

current futures price is 6170 points

•

exercise price (X) is 6000 points

•

term (T) of the option is 3 months

•

volatility (a2) of the futures contract is 20 per annum

•

risk-free interest rate (/) is 6.75 per cent per annum (continuously compounding).

CHAPTER EIGHTEEN H E V H W

9

ptions a n d c o n t in g e n t claims

Real options [LO 6]

Duff Ltd is a brewing company that was established 3 years ago. When it commenced operations, management purchased a bottling machine for $1.2 million. This machine has the ability to be converted so that it also inserts corks into wine bottles. The conversion costs $250000. An equivalent machine, without the ability to be converted so that it also seals wine bottles, would have cost $800000. a) Define the option described above (i.e. name it and label it as either a put or a call option). b) In addition to the risk-free rate of return and the term to expiry, the following four characteristics have been shown to affect the value of an option: i) current value of asset ii) exercise price of option iii) volatility of asset returns over the life of the option iv) dividends paid during life of option. Describe these characteristics in relation to the option possessed by Duff Ltd. c) The /premium, for a financial option is the price paid to acquire it. Is there any premium associated with the real option described above? d) Are there any circumstances in which Duff Ltd may exercise its option early? Explain the advantages and disadvantages associated with early exercise. 13

Options in loan contracts [LO 6]

The loan contract described as follows is a simplified version of an actual security: RA Best Constructions International Ltd seeks to borrow from Multi Bank the sum of US$10 million, repayable by a single payment to be made in 1 year's time. However, this payment is made up of two components: •

Component 1 is a payment of US$2 million, which for convenience may be called 'interest7at the rate of 20 per cent per annum.

•

Component 2 is the payment of an amount that depends on the exchange rate between yen and US dollars on the maturity date of the loan. We may call this a repayment, R, in full satisfaction of the principal, X, which is owed. If the future exchange rate, S, is 169 (or more) yen per US dollar, then the full principal of

603

B usiness finance

US$10 million must be repaid. If the future exchange rate is 84.5 (or fewer) yen per US dollar, then none of the principal needs to be repaid; Best is 'forgiven7 all the debt. If the future exchange rate falls between 84.5 and 169 yen per US dollar, the repayment required is related to the principal according to the following formula:

甲

)

When Multi Bank investigated this proposal, the exchange rate was 185 yen per US dollar. At the same date the interest rate that Best would have paid for a standard 1-year fixed rate US dollar loan was 11 per cent per annum. a) Taking Multi Bank's viewpoint, analyse the loan in terms of its options characteristics. b) Again taking Multi Bank's viewpoint, and assuming that you have a model that can be used to value any opltion you may define, explain how you would investigate this proposal.

REFERENCES Alpert, K., 'Taxation and the early exercise of call options', Journal of Business Finance and Accounting, June/July 2010, pp. 7 1 5 - 3 6 .

Asay, M.R., yA note on the design of commodity options con\rac\s , Journal of Futures Markets, 1982, pp. 1-8. Australian Securities Exchange, Explanatory Note for ASX Option Adjustments, 2013. Available at www.asx.com .au/documents/products/Explanatory_Note_for_Option_ Adjustments_andTerminations.pdf. Black, F., Tact and fantasy in the use of options', Financial Analysts Journal, July/August 1975, pp. 3 6 -4 1 ,6 1 -7 2 . ____, 'The pricing of commodity contracts’ ，Jouma/ of Financial Economics, January/t^arch 1976, pp. ] 67-79. ____, & Scholes, M., 'The pricing of options and corporate liabilities', Journal of Political Economy, May/June 1 9 7 3 , p p .6 3 7 -5 4 .

Brennan, MJ. & Schwartz, E.S., 'Evaluating natural resource investments', Journo/of Bus/ness, 1985, pp. 135-58. ____, 'A new approach to evaluating natural resource investments', in J.M. Stern & D.H. Chew (eds), The Revolution in Corporate Finance, 2nd edn, Basil Blackwell, Oxford, 1 9 9 2 , pp. 1 0 7 - 1 6 .

Brenner, M., Courtadon, G. & Subrahmanyam, M., 'Options on the spot and options on futures', Journal of Finance, December 1985, pp. 1303-17. Copeland, T.E. & Keenan, P.T., 'How much is flexibility worth?', The McKinsey Quarterly, no. 2, 1998, pp. 39-49. Courtadon, G.R. & Merrick, The option pricing model and the valuation of corporate securities’，in 丄M. Stern & D.H. Chew (eds), The Revolution in Corporate Finance, 2nd edn, Basil Blackwell, Oxford, 1992, pp. 265-78. Cox, J.C., Ross, S.A. & Rubinstein, M., 'Option pricing: a simplified approach,/ Journal of Financial Economics, 1979, pp. 229-63. Cox, J.C. & Rubinstein, M., Option Markets, 1st edn, Prentice-Hall, Englewood Cliffs, New Jersey, 1985. Dixit, A.K. & Pindyck, R.S., 'The options approach to capital investment7, Harvard Business Review, May/June 1995, pp. 105-15.

604

Geske, R., 'The valuation of corporate liabilities as compound options7, Journal of Financial and Quantitative Analysis, November 1977, pp. 541-52. ____, ;The valuation of compound options', Journal of Financial Economics, March 1979, pp. 63-81. Hull, J., Fundamentals of Futures and Options Markets, 8th edn, Prentice-Hall, Englewood Cliffs, New Jersey, 2013. Ingersoll, J., yA contingent-claims valuation of convertible securities,/ Journal of Financial Economics, May 1977, pp. 289-322. Leslie, K.J. & Michaels, M.P., 'The real power of real options', The McKinsey Quarterly, no. 3, 1997, pp. 4-22. Lieu, D. 'Option pricing with futures-style margining', Journal of Futures Markets, 1990, pp. 327-38. Loudon, G.F., 'Put-call parity theory: evidence from the big Australian', Australian Journal of Management, June 19887 pp. 53-67. Merton, R.C., 'Theory of rational option pricing', Bell Journal of Economics and Management Science, Spring 1973a, pp. 141-83. ____,'The relationship between put and call prices: comment', Journal of Finance, March 1973b, pp. 183-4. Ofek, E.; Richardson, M. & Whitelaw, R.F., limited arbitrage and short sales restrictions: evidence from the options markets', Journal of Financial Economics, November 2004, pp. 305-42. Phang, G. & Brown, R., 'Rational early exercise of call options: Australian evidence7, Accounting and Finance, 2011, pp. 732-44. Smith, C.W. Jr〆Alternative methods for raising capital: rights versus underwritten offerings', Journal of Financial Economics, December 19 7 7 , pp. 273-307. Stoll, H.R., 'The relationship between put and call option prices, Journal of Finance, December 1969, pp. 802-24. Trigeorgis, L., Real Options: Managerial Flexibility and Strateqy in Resource Allocation. MIT Press. Cambridqe (Mass.), 1996. Whaley, R., 'Understanding V\Xf, Journal o f Portfolio Management, Spring 2009, pp. 98-105.

CHAPTER CONTENTS ic t i

Introduction

606

19.2

Reasons for takeovers

608

19.3

Economic evaluation of takeovers

614

19.4

Alternative valuation approaches

618

ICTE! Regulation and tax effects of takeovers 19.6

Takeover defences Corporate restructuring

19.8

Empirical evidence on takeovers

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

evaluate suggested reasons for takeovers

2

explain how to estimate the gains and costs of a takeover

3

explain the main differences between cash and share-exchange takeovers

4

outline the regulation and tax effects of takeovers in Australia

5

outline defence strategies that can be used by target companies

6

identify the various types of corporate restructuring transactions

7

outline the main findings of empirical research on the effects of takeovers on shareholders7 wealth.

TAKEOVER

acquisition of control o f one company by another TARGET COMPANY

object of a takeover bid

Takeovers are im p o rta n t transactions in the m arket fo r corporate control. A takeover typically involves one company purchasing another company by acquiring a controlling interest in its vo ting shares. Such an investm ent is variously described as a ‘takeover’, an ‘acquisition’ o r a ‘merger’. I t is possible to distinguish between mergers and takeovers, b u t in this chapter the term ta k e o v e r w ill generally be used to refer to all instances where an acquiring company1 achieves control o f another company, referred to as the ta rg e t com pany.

The m arket fo r corporate control is a m arket in which alternative teams o f managers compete fo r the rig h t to control corporate assets and make top-level management decisions (Jensen & Ruback 1983). Essentially, by changes in control, corporate assets can be quickly redeployed in ways expected to bring economic benefits and add value fo r shareholders. O ther transactions in this m arket include divestitures, spin-offs and buyouts, all o f which are defined and discussed in Section 19.7. The m ain topic o f this chapter is takeovers, because they are the m ost im p o rta n t o f these transactions in the Australian m arket fo r corporate control. A fte r a takeover, the acquiring company obtains control o f the target company s assets, so a takeover is an indirect investm ent in assets. The fact th a t the investm ent is made indirectly does n ot change the basic principle th a t an investm ent should proceed if, and only if, it has a positive net present value (NPV). Despite this basic sim ila rity between takeovers and other investm ents, there are several reasons why takeovers should be treated as a separate topic. These reasons include:

b

takeovers are controversial and at times there has been rather heated public debate about whether takeover a ctivity is beneficial to shareholders and the economy the NPV o f a takeover can be very d iffic u lt to estimate, b u t correct analysis w ill be easier i f i t is based on an understanding o f why takeovers occur and on knowledge o f the evidence on th e ir effects on returns to investors

C

a t a k e o v e r m a y g iv e r is e t o c o m p le x le g a l, a c c o u n t in g a n d t a x q u e s t io n s

d

the acquiring company s plans may be frustrated by defensive tactics employed by the management o f the target company, or by the interven tion o f other potential acquirers.

a

Takeover activity fluctuates widely over tim e. These fluctuations are reflected in Figure 19.1, which shows th a t between 1974 and 2013 the num ber o f bids fo r Australian listed companies varied between a high of 289 in 1988 and a low o f 38 in 1994 and 2002. These fluctuations are o fte n described as takeover ‘waves’. In the US, takeover waves have occurred at the tu rn o f the tw e n tie th century, in the 1920s, the 1960s, the 1980s and a fu rth e r wave o f takeover a c tiv ity began in 1993 (Gaughan 1994; Andrade, M itc h e ll & Stafford 2001). The phenom enon o f takeover waves is n o t fu lly understood, b u t there is evidence th a t takeover a c tiv ity in A ustralia is p o sitive ly related to the behaviour o f share prices. For example, Bishop, Dodd and O fficer (1987) reported a close relationship between changes in share prices and the num ber o f takeovers in the period 1972 to 1984. The explanation preferred by Bishop, Dodd and O fficer fo r th is relatio n ship is th a t periods when the prices o f shares are increasing rapidly are also periods o f o ptim ism fo r investm ent. The increase in share prices w ill reflect increased demand fo r real goods, which w ill require companies to increase th e ir productive capacity. W hile companies w ill increase th e ir capacity by investing in new p la n t and equipm ent (in te rn a l investm ent), managers w ill also be loo king fo r o p p o rtu n itie s to take co n tro l o f existing assets, p a rtic u la rly assets th a t are n o t being used efficiently. W hen such o p p o rtu n itie s are found there w ill be an increase in takeover a c tiv ity (external investm ent). In short, b o th in te rn a l and external inve stm en t w ill respond to th e same economic forces. Therefore, a relationship between the state o f the economy and the level o f takeover a c tiv ity 1

When a takeover bid is first announced, the eventual outcome is unknown. Therefore we also use the terms bidder* or offeror1when a takeover is still in progress.

C hapter nineteen A

nalysis o f takeovers

Figure 19.1 Number of takeover bids for Australian listed companies 1974-2013

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Sources: S. Bishop, P. Dodd & R.R. O fficer, 'Australian takeovers: the evidence 1 9 7 2 -1 9 8 5 ', Policy Monograph, 12, Centre for Independent Studies, St Leonards, 19 8 0, 1 9 8 7; 1 985 to 1990, Corporate Adviser; 1995 to 2 0 1 3 , SDC Platinum.

is to be expected. In the m ost recent A ustralian study o f the relationship between takeover a ctivity, share prices and economic conditions, Finn and Hodgson (2005) examined 1665 successful takeovers th a t occurred between 1972 and 1996. They conclude th a t share prices and takeover a c tiv ity share a common lon g-te rm trend, w hich is co ntrary to previous studies th a t have suggested th a t each responds to the o the r over a sh orter tim efram e. F urther, they fin d th a t aggregate takeover a c tiv ity is influenced by fundam ental economic factors such as in d u s tria l production, capital expenditure and interest rate levels, rather th an by speculative a ctivity. Researchers in the US have noted th a t at any given tim e, takeover a ctivity exhibits ind ustry clustering and each wave o f takeovers is different in terms o f in d u stry composition. These observations suggest that a significant p o rtio n o f takeover a ctivity m ig ht be due to economic shocks at the in d u s try level. For example, an industry m ight be affected by m ajor technological changes, supply shocks such as changes in commodity prices, and deregulation (Andrade, M itche ll & Stafford 2001). These shocks can lead to excess capacity and stim ulate an increase in takeovers th a t lead to liqu id atio n o f m arginal assets. Im portantly, research by H arford (2005) shows th a t in order fo r an economic shock to induce a wave o f merger activity, there also needs to be sufficient capital available to acquirers to fund the acquisitions. Andrade and Stafford (2004) demonstrate th a t in addition to takeovers providing an o p p o rtu n ity fo r companies operating in growth industries to expand productive capacity, they also provide the mechanism by which companies operating in industries th a t are contracting and have low grow th prospects exit the industry and allow invested capital to be redeployed elsewhere. As Jensen (1988) points out, i f an in d u stry has suffered slowing growth, i t is preferable th a t excess capacity is reduced in this orderly way rather than the more costly and disorderly process o f bankruptcy.

1 9 .1 .2 1 Types of takeover

HORIZO NTAL TAKEOVER

Takeovers are usually classified as follows: •

A h o rizo n ta l tak eov er is the takeover o f a target company operating in the same line o f business as the acquiring company. An example o f this fo rm o f takeover is the takeover by Westpac Bank o f St George bank in 2008.

takeover of a target company operating in the same line of business as the acquiring company

B usiness finance

A v e rtica l ta k eo v er is the takeover o f a target company th a t is either a supplier o f goods to, or a consumer o f goods produced by, the acquiring company. An example is the 2012 acquisition o f the ta xi company Yellow Cabs by Cabcharge Australia, a provider o f payment services fo r the taxi industry. A co n g lo m era te ta k eo v er is the takeover o f a target company in an unrelated type o f business. There have been a num ber o f high-profile acquisitions o f this type. For example, over the last 30 years Wesfarmers has acquired companies operating in industries as diverse as retail, m ining, liquefied petroleum gas d istrib u tio n and insurance.

VERTICAL TAKEOVER

takeover of a target company that is either a supplier of goods to, or a consumer of goods produced by, the acquiring company CONGLOMERATE TAKEOVER

takeover of a target company in an unrelated type of business

Reasons for takeovers

LEARNING OBJECTIVE 1

Evaluate suggested reasons for takeovers

SYNERGY

in takeovers, the situation where the performance and therefore the value of a combined entity exceeds the sum of the previously separate components

Just as there are different types o f takeovers, so there are many different reasons w hy takeovers occur. We begin by presenting a fram ework fo r the evaluation o f these reasons and then discuss some o f the suggested reasons individually. As noted above, takeovers are p a rt o f the m arket fo r corporate control in which alternative management teams compete fo r the rig h t to manage corporate assets. C om petition in th is m arket should ensure th a t asset control is acquired by those teams th a t are expected to be the m ost efficient in u tilising those assets. It should also ensure th a t the interests o f management cannot diverge too far fro m those o f shareholders. For example, suppose th a t a company is poorly managed, resulting in low profits and a low share price. An o pp o rtu n ity then exists fo r a more efficient management team to take over this company, replace the inefficient managers and reverse the poor performance o f the company. However, the m arket fo r corporate control should n ot be viewed only as providing a severe disciplinary measure against incom petent management. Increased p ro fita b ility through a change o f management does n ot necessarily im ply th a t the previous management was incompetent, only th a t a more efficient team was available (Dodd & Officer 1986). Wealth (or value) can be created by combining tw o companies i f the takeover transfers control o f assets to managers who can recognise more valuable uses fo r those assets, either w ith in the combined company or by redeployment o f the assets elsewhere. The term sy n erg y is often used to describe the value gains th a t can be associated w ith com bining tw o entities. In other words, i f there are synergistic benefits associated w ith combining tw o companies A and T, then the combined company w ill be w orth more than the sum o f th e ir values as independent entities: yAT> K A+ y T where VAT = the value o f the assets o f the combined company VA = the value o f Company A operating independently VT = the value o f Company T operating independently In th is chapter the subscripts A and T are used to denote the acquiring and target companies, respectively. To summarise, the m ain im plications o f this approach are th a t takeovers are value-increasing transactions and th a t the m arket fo r corporate control is influenced largely by the existence o f synergies. I t follows that, in evaluating the suggested reasons fo r takeovers, we need to consider whether the particular reason suggested is consistent w ith the existence o f an economic gain from combining two companies. The suggested reasons fo r takeovers th a t we w ill evaluate are as follows: • • • • « • • • •

the target company is managed inefficiently the acquiring and target companies have assets th a t are complementary the target company is undervalued cost reductions result from the takeover incireased m arket power results from the takeover diversification benefits result from the takeover the target company or the acquiring company has excess liq u id ity or free cash flow tax benefits result from the takeover there are increased earnings per share and price-earnings ratio effects.

C hapter nineteen A

nalysis o f takeovers

1 9 .2 .1 1 Evaluation of the reasons for takeovers The target com pany is managed inefficiently In this case, the acquiring company s managers may see an o p p o rtu n ity to use the target company s assets more efficiently. The more efficient use o f assets may result in an increase in the value o f the target company. However, the acquiring company s aspiration to improve the efficiency o f the target company s operations may n o t always be realised. Even i f an acquiring company is managed efficiently, this does not necessarily mean th a t its managers w ill be able to improve the performance o f another company. This is particularly so where the two companies operate in different industries. This suggests th a t improvements in efficiency are less likely to be achieved w ith a conglomerate takeover. As a corollary, improvements in efficiency are most likely to be achieved w ith a h orizontal takeover, as the acquiring company s managers are likely to have the expertise needed to manage the target company s operations more efficiently. However, the m arket value o f a company may be low, n ot because its managers are inefficient, b ut because they make decisions in th e ir own interests rather than in those o f the company s shareholders. The discussion o f agency costs in Chapter 1 suggests th a t managers may attem pt to transfer wealth from shareholders to themselves. I f the value reduction is large, it is likely th a t the company w ill eventually be identified as a takeover target, since an acquiring company w ill be able to eliminate, or at least reduce, the agency costs, thereby providing benefits fo r its own shareholders.

Complementary assets A takeover can be attractive i f either or b oth o f the companies can provide the other w ith needed assets at relatively low cost. For example, this can occur when the target company s managers are considered to have valuable skills. The m otive fo r the takeover is to acquire expertise. I t may be cheaper to acquire this expertise via a takeover than to hire and tra in new staff. This is often an argum ent fo r taking over small, often unlisted, companies th a t have failed to realise th e ir fu ll p otential because th e ir managers do not have skills in all areas o f management. For example, a group o f engineers may establish a computer hardware company th a t does n o t earn a satisfactory p ro fit because the engineers lack m arketing skills. A large company w ith a strong m arketing team may take it over because it is seen as a relatively cheap means o f acquiring the technical skills o f the target company s staff. Similarly, the complementary skills o f the acquiring company s sta ff may be used to improve the targets profitability.

The target com pany is undervalued Describing a target company as sim ply ‘undervalued’ is n o t very meaningful, since a takeover always implies th a t the target is w o rth more to the acquiring company than i t was w o rth to its previous shareholders. Managers o f acquiring companies often refer to th e ir targets as ^presenting w onderful opportunities’ or ‘too good to pass up’，suggesting th a t they believe in th e ir a b ility to id e n tify ‘bargains’. Chapter 16 presents empirical evidence on m arket efficiency which suggests th a t m ost managers w ill find i t very d ifficu lt to id e n tify such opportunities. However, even i f managers are able to id e n tify undervalued shares, i t is n ot necessary to buy whole companies, paying premiums fo r control, to p ro fit from th e ir a b ility to ide ntify ‘bargains’. Instead, they could buy a parcel o f the shares at the m arket price, w ait u n til the m arket recognises the shares* value, and then sell. I t has never been seriously suggested th a t share markets are fu lly efficient in the strong-form sense. I t is therefore possible th a t a company s managers may have private inform a tion n o t yet reflected in the price o f another company s shares. Share acquisition follows, and may extend to acquiring a controlling interest in the target company. A takeover may also occur when the m arket value o f the target company is less than the sum o f the m arket values o f its assets. This does n o t necessarily mean th a t the share m arket is inefficient, as the company s share price may accurately reflect the value o f its assets in th e ir current use. However, such a company can become a takeover target because other managers recognise the existence o f alternative, better uses fo r the assets. Investors who focus on searching fo r takeover opportunities o f this type are often referred to as co rp o ra te raiders or asset strippers. Their activities can be regarded as involving a form o f synergy because a crucial factor is the skill o f the acquiring company s managers in identifyin g opportunities to create value by redeploying assets to alternative uses.

CORPORATE RAIDERS

aggressive corporate or individual investors w ho purchase a com pany’s shares w ith the intention of achieving a controlling interest and replacing the existing management

Cost reductions A nother reason fo r takeovers is th a t the to ta l cost o f operating the combined company is expected to be less than the cost o f operating the tw o companies separately. These cost savings may be due to various economies o f scale, and are therefore more likely to be achieved in the case o f a h orizontal takeover. For example, tw o fu rn itu re manufacturers, by combining, may be able to reduce th e ir production costs because production runs w ill be longer, resulting in the fixed costs o f a production run being incurred less frequently. Cost savings may also be achieved in a vertical takeover. For example, combining companies where one is a supplier to the other may result in more efficient coordination o f the activities o f the tw o companies. One reason is th a t the costs o f comm unication and various form s o f bargaining can be reduced by a vertical takeover.

Increased market pow er Taking over a company in the same in d u stry may increase the m arket power o f the combined company. The increase in m arket power may enable the acquiring company to earn m onopoly profits i f there are significant barriers to e n try in to the industry. Governments frequently legislate to prevent takeovers th a t are considered likely to result in an excessive level o f concentration in an industry. Section 50 o f the Competition and Consumer A ct 2010 prohibits a company from acquiring the shares or assets o f another company where the acquisition is likely to result in a substantial lessening o f com petition in a market. The Australian C om petition and Consumer Commission (ACCC, www.accc.gov.au) has issued Merger Guidelines th a t explain the procedures and policies th a t it w ill follow in determ ining w hether i t w ill oppose a particular takeover on the grounds th a t the takeover is anticom petitive. An example o f such opposition occurred in October 2012 when the ACCC announced th a t i t would oppose the acquisition o f a small chain o f three hardware stores around Ballarat in country V ictoria by the jo in t venture partners behind the Masters chain o f hardware stores. The m ain reason given fo r the decision was th a t the ACCC believed th a t the acquisition would result in a substantial lessening in com petition in the hardware m arket in the Ballarat region.

Diversification benefits Portfolio theory shows th a t investors can reduce th e ir risk by holding a diversified p o rtfo lio o f assets.2 A sim ilar reason has been advanced to ju s tify a takeover. The takeover, i t is suggested, enables a company to reduce risk via diversification. Assume th a t a steel m anufacturer diversifies its interests by taking over an o il exploration company. The question is: Does the reduced risk brought about by the takeover benefit the steel m anufacturers shareholders? The somewhat surprising answer is generally no. The steel m anufacturers shareholders already had the o p p o rtu n ity to hold shares in o il exploration companies so the takeover does n o t provide any investm ent o p p o rtu n ity th a t did n o t previously exist. Therefore, when shareholders themselves hold diversified p ortfolios, diversification by a company is a neutral factor th a t w ill neither alter its m arket value n o r benefit its shareholders. Takeovers m otivated by diversification can be beneficial to managers. Therefore, the occurrence o f such takeovers can indicate the existence o f agency problems.3 A related argum ent is th a t com bining tw o companies whose earnings streams are less than perfectly correlated w ill lower the risk o f default on debt, so th a t the debt capacity o f the com bination is greater than the sum o f the debt capacities o f the tw o companies operating separately. This is the result o f the co-insurance effect, which means th a t lenders to one company can now be paid o ut o f the combined assets o f both companies. W hile the co-insurance argum ent is essentially correct, the problem is th a t shareholders w ill n ot necessarily benefit from the reduction in default risk and interest cost o f debt.

2 3

See Section 7.5. However, there may be cases where company diversification is of value to investors. Shareholdings in a private family company may represent a high proportion of the family's wealth and the family members may wish to reduce their risk by diversifying. To obtain the funds to invest elsewhere, they might have to sell part of their interest in the company, but this would mean diluting their control, and might also cause a large capital gains tax bill. Because of these barriers, diversification by the company will almost certainly be more attractive than diversification by the individual shareholders. Such cases are the exception rather than the rule, and for public companies whose shareholders can diversify cheaply, company diversification will not add value for shareholders.

C hapter nineteen A

Suppose th a t two companies, each w ith debt securities outstanding, merge. The default risk o f each company s debt w ill fall and the value o f the debt securities w ill increase. This effect is called the co-insurance, effect because each company reduces the default risk o f the other. This gain to debtholders is at the expense o f shareholders, who now have to guarantee the debt o f b oth companies, and the loss to shareholders exactly offsets the gain to debtholders. I f tw o companies combine and then borrow, the shareholders w ill benefit from a lower interest rate, b ut they are providing the lenders w ith lower risk, so there is s till no net gain. However, shareholders can benefit from the co-insurance effect to the extent that expected bankruptcy costs are reduced, or there are net tax savings. Therefore, while combining companies can yield genuine financing benefits, i t is d oubtful th a t th e ir magnitude is sufficient to ju s tify many takeovers.

Excess liquidity or free cash flow A company w ith excess liq u id ity may be identified as a takeover target by companies seeking access to funds. However, i t seems d iffic u lt to ju s tify paying a prem ium to obtain control o f a company fo r this reason alone, because the capital m arket can provide funds at lower transaction costs. On the other hand, companies w ith excess liq u id ity may tu rn to the acquisition o f other companies rather than retu rn more cash to th e ir shareholders. Such takeovers may result from managers pursuing th e ir own interests, rather than m axim ising the wealth o f shareholders. Managers may pursue greater m arket share in existing lines o f business or diversification in to additional industries because larger companies are often associated w ith higher salaries and benefits, and more prom otion opportunities. Jensen argued that this conflict o f interest can be severe in companies th a t generate substantial free cash flow and can lead to such companies engaging in takeovers th a t generate very small benefits, or even value reductions.4 For example, diversification programs achieved through takeovers are likely to benefit managers b ut may reduce shareholders* wealth. Where managers persist in this type o f activity, th e ir own company is likely eventually to become a takeover target. Therefore, the free cash flow hypothesis shows how some takeovers are evidence o f the conflicts o f interest between shareholders and managers, while others are a response to the problem.

Tax benefits Taking over a company w ith accumulated tax losses may reduce the to ta l tax payable by the combined company. In Australia, the Commissioner o f Taxation restricts the use o f past accumulated tax losses to situations where i t can be shown th a t either the continuity-of-ownership-and-control test or the samebusiness test is satisfied.5 To pass the continuity-of-ow nership-and-control test requires th a t owners o f at least 51 per cent o f the company s shares when it incurred losses remain as owners when those accumulated losses are offset against taxable income and the effective control o f the company has n ot changed between the generation and u tilisa tio n o f the tax losses. The same-business test provides that where the continuity-of-ow nership-and-control test is n o t satisfied, the past accumulated losses can s till be offset against taxable income where the acquired company continues in the same business after the takeover. For companies w ith resident shareholders, the incentive to reduce company tax payments in this way is much smaller under the im putation tax system than it was under the classical tax system. This follows from the fact that, as discussed in Chapter 11, company tax is essentially a w ithholding tax against the personal tax liabilities o f shareholders. Hence, other things being equal, a reduction o f company tax w ill mean th a t shareholders have to pay more personal tax on dividends. Therefore, any advantage associated w ith low ering company tax payments w ill be only a tim in g advantage. In an international setting there are p otentially substantial gains to be made by acquirers operating in high-tax jurisdictions ta king over target companies which are located in countries w ith lower tax rates. For example, in 2013 the US pharmaceutical company Perrigo launched a successful bid fo r Irish drug company Elan Corporation. Following the acquisition, Perrigo shifted its headquarters to Ireland so as to take advantage o f the significantly lower corporate tax rate in Ireland (12.5 per cent) than in the US (40 per cent).

4 5

Free cash flow is defined as operating cash flow in excess of that required to fund all projects that have positive net present values. See Jensen (1986 and 1998). See Subdivision 165-A of the Incom e T a x A ss e s s m e n t A c t 1 9 9 7 .

nalysis o f takeovers

Increased earnings per share and price-earnings ratio effects Corporate financial objectives are sometimes expressed in term s o f grow th in earnings per share (EPS), and this may lead an acquiring company to evaluate the effect o f a proposed takeover on its EPS. U nfortunately, this approach is unreliable. W hile a takeover th a t is economically viable should lead to increased EPS fo r the acquiring company, i t is easy to design a takeover th a t produces no economic benefits, b u t which nevertheless produces an immediate increase in EPS. Example 19.1 illustrates this situation.

E xample 19.1 T h is e x a m p le re fe rs to th e d a ta in T a b le 1 9 .1 .

TABLE 19.1 Effect of takeover on earnings per share and market value of Company A Item

Com pany A

C om pany T

No. of shares

200000

100000

250000

Earnings ($/year)

200000

100000

300000

1.00

1.00

1.20

Share price ($)

10.00

5.00

10.00

P-E ratio

10.00

5.00

8.33

2.00

0.50

2.50

EPS ($)

C o m b in e d c o m p a n y A

+T

：

Market value o f equity ($m)

S u p p o s e th a t th e re a r e n o e c o n o m ic b e n e fits a s s o c ia te d w ith c o m b in in g c o m p a n ie s A a n d T. If A a c q u ir e s T b y is s u in g o n e o f its s h a re s , w o r th $ 1 0 , f o r e v e r y t w o T s h a re s , a ls o w o r th a to ta l o f $ 1 0 , w h a t is th e e ffe c t o f th e ta k e o v e r o n th e EPS a n d v a lu e o f C o m p a n y A ?

SOLUTION A s th e re a r e n o e c o n o m ic b e n e fits , th e e a r n in g s o f th e c o m b in e d c o m p a n y w ill s im p ly b e th e sum o f th e in d iv id u a l c o m p a n ie s 7 e a r n in g s , $ 3 0 0 0 0 0

p e r a n n u m . T h e ta k e o v e r w ill m e a n

is s u in g a

fu rth e r 5 0 0 0 0 A s h a re s , m a k in g 2 5 0 0 0 0 o n issu e, a n d th e EPS f o r th e c o m b in e d c o m p a n y w ill b e $ 3 0 0 0 0 0 / 2 5 0 0 0 0 = $ 1 . 2 0 , a n im m e d ia te in c re a s e o f 2 0 p e r c e n t. A lth o u g h th e ta k e o v e r looks a ttr a c tiv e , it cannot b e a ttr a c tiv e b e c a u s e th e ta k e o v e r g e n e ra te s n o e c o n o m ic b e n e fits . T h e fa c t th a t it h a s n o e c o n o m ic b e n e fits is se e n in th e fin a l r o w o f T a b le 1 9 . 1 : th e c o m b in e d c o m p a n y is w o r th o n ly th e sum o f th e v a lu e s o f th e t w o in d iv id u a l c o m p a n ie s .

The reason th a t EPS increases in Example 19.1 is sim ply th a t A was able to acquire a company w ith earnings o f $100000 per annum by issuing only 50000 o f its shares. This, in tu rn , was possible because As price-earnings ratio o f 10 was greater than T s ratio o f 5. The effect we have illustrated here is called bootstrapping and i t occurs in share-exchange takeovers whenever the acquiring company s priceearnings ratio exceeds the target company s price-earnings ratio. Therefore, i f EPS is used in takeover evaluation it is im p o rta n t to distinguish between the effects o f true grow th and the bootstrap effect. To avoid confusion, i t m ig ht be better sim ply to ignore EPS in the context o f takeovers. We do n o t expect everyone to heed our last piece o f advice so we w ill go one step fu rth e r to h ig hligh t another way in which analysis* based on EPS can be misleading. An analyst, impressed by the 20 per cent increase in EPS resulting from As acquisition o f T, m ig ht be tempted to value the combined company by applying As price-earnings ratio o f 10 to the new EPS o f $1.20, giving a share price o f $12 and an equity value o f $12 250 000 = $3 m illion. But this m ust be wrong, because, w ith no economic benefits, the value o f the combined company can only be $2.5 m illion , so the share price is $10 and the price-earnings ratio is 8.33 rather than 10. We have more to say about the use o f price-earnings ratios later in the chapter, b ut the p o in t we wish to emphasise now is th a t there is no basis fo r assuming th a t an acquiring company s pre-takeover price-earnings ratio w ill continue to apply to a combined company.

C hapter nineteen A

1 9 .2 .2 1 Survey evidence of the motives for takeovers Having evaluated possible reasons fo r one company acquiring another, i t is useful at th is p o in t to consider w hat the managers o f acquiring companies have to say about th e ir rationale fo r takeovers. Mukherjee, Kiym az and Baker (2004) surveyed the chief financial officers o f US bidder companies th a t had been involved in the 100 largest takeovers in each year between 1990 and 2001, and asked them to id e n tify the relative im portance o f a lternative reasons fo r the acquisition. Results are provided in Table 19.2.

TABLE 19.2 Motives for takeovers M o tiv e

P e rc e n ta g e o f re s p o n d e n ts th a t ra n k e d th is m o tiv e as m o st im p o r ta n t

Take advantage o f synergy

37.3

Diversify

29.3

Achieve a specific organisational form as part o f an ongoing restructuring program

10.7

Acquire a company below its replacement cost

8.0

Use excess free cash

5.3

Reduce tax on the combined company due to tax losses of the acquired company

2.7

Other

6.7

Source: T.K. Mukherjee, H. Kiym az «& H. Baker, 'M erger motives and target valuation: a survey of evidence from CFOs7, Journal o f Applied Finance, W inter 2 0 0 4 , p. 15. © The Financial M anagem ent Association International, University of South Florida, CO BA 4 2 0 2 East Fowler Avenue, BSN 3331 Tampa FL 3 3 6 2 0 -5 5 0 0 , w w w .fm a .o rg

The relative importance o f realising synergistic benefits is n o t unexpected given th a t these benefits are perhaps the easiest to id e n tify — and hence communicate to shareholders o f b oth the bidder and target companies. O f interest, given the discussion in Section 19.2.1, is the relatively high ranking given to diversification as a justifica tion fo r takeover activity. W hen quizzed fu rth e r on the sources o f the diversification benefits, the m ost popular response was th a t diversification Results in much less devastating effects on the firm during economic downturns. W hile this response is consistent w ith the n otio n that shareholders may benefit through the company diversifying by the consequent reduction in expected bankruptcy costs_ due to a lower probability o f bankruptcy— it is also consistent w ith management attem pting to protect the value o f th e ir own capital (both financial and human), which is largely tied up in the company. This second effect is an example o f an agency problem th a t m ight adversely affect the value o f the company, especially i f managers are w illin g to overpay fo r targets in order to realise these diversification benefits.

1 9 .2 .3 1 The roles of takeovers The valid reasons fo r takeovers can be classified in to tw o groups, w hich suggests tw o m ain roles fo r takeovers. F irst, the th re at o r p o te n tia l fo r takeover can discipline management o f target companies. To be effective, threats m ust sometimes be carried out, and in cases where significant inefficiencies or agency problems rem ain despite the th re at, the managers o f target companies can be replaced via takeovers. Evidence th a t the tu rn ove r rate fo r the to p executive o f target companies increases dram atically fo llo w in g a takeover is provided by M a rtin and M cConnell (1991). They also found th a t in cases where the top executive was replaced a fte r a takeover, target companies had been p erfo rm in g poorly relative to o th e r companies in th e ir ind ustry. These results indicate th a t the takeover m arket is im p o rta n t in c o n tro llin g the behaviour o f managers. H arfo rd (2003) w ent even fu rth e r by exam ining the fu tu re em ploym ent prospects o f target directors fo llo w in g successful takeover bids. He reports th a t n o t only are directors o f poorly p e rfo rm in g acquired companies lik e ly to lose th e ir board seat,

nalysis o f takeovers

B usiness finance

b u t they are also less lik e ly to acquire another d irectorship in the fu tu re relative to a co ntrol group o f other directors. Second, takeovers can take advantage o f synergies such as economies o f scale or complem entarity between assets. A basic difference between these tw o roles is th a t in the firs t case the gains are associated w ith changes o f control, whereas in the second case, the gains are associated w ith combining previously separate assets or companies. A nother difference is th a t takeovers designed to replace management are more likely to be hostile than those driven by synergies. In b o th cases there are usually other ways in which sim ilar benefits can be achieved. Poor management could be replaced by a company s own Board o f Directors and synergies associated w ith combining assets can be achieved through jo in t ventures. Therefore, takeovers are one way in which management can be improved or synergies exploited, b u t the prevalence o f takeovers suggests th a t they are often the most effective way.

ik

LEARNING

OBJECTIVE 2

Explain how to estimate the gains and costs of a takeover

19.3 Economic evaluation of takeovers For an acquiring company, takeovers are investments th a t should proceed i f th e ir net present value (NPV) is positive. This may sound simple, b u t takeovers are typically complex; the benefits involved may not be obvious, and there are several ways in which NPV analysis could be applied to them . Some o f these ways are best avoided because they are p articularly prone to the effects o f forecast errors. Therefore, i t is desirable to use a fram ework th a t directs atte ntio n to the key issues o f id e n tifp n g and quantifying the benefits o f a proposed takeover and comparing benefits w ith costs. Assume th a t you are an investm ent analyst employed by Company A to evaluate the takeover o f Company T. The gain from the takeover can be defined as the difference between the value o f the combined company and the sum o f th e ir values as independent entities: Gain = V^AT- ( K A + y T) The logic o f Equation 19.1 is th a t i t should prom pt the follow ing question: W hat characteristics o f this takeover mean th a t the tw o companies should be w o rth more when combined than when separate? However, the fact th a t there is a gain from the takeover does n o t necessarily mean th a t i t should proceed. Management also has to consider the cost o f obtaining control o f the target. Assuming fo r the present th a t cash is used to buy Company T, the net cost is defined as: Net cost = cash - VT

19.2

The term net cost is used to emphasise th a t we are considering cost in terms o f the premium paid over T s value as an independent entity. The takeover w ill have a positive NPV fo r Company As shareholders only i f the gain exceeds the net cost: NPVa = gain - net cost = gain - cash + yT > 0

19.3

I f NPVa is equal to zero, then Equation 19.3 can be used to find the value o f Company T to Company A, V ^ ) , which is the maximum price A should pay fo r the target: 1/聊

= cash = gain + V"T

19.4

Therefore, the valuation o f Company T can be broken in to tw o steps: the firs t is to estimate VT and the second is to estimate the gain from the takeover. I f the target is a listed company, the evidence on m arket efficiency shows th a t the m arket capitalisation o f the company s securities should be an unbiased estimate o f VT , so the main emphasis should be on estim ating the gain. In other words, i t is necessary to focus on the incremental cash flow effects o f the takeover. There are likely to be effects on both cash inflows and outflows, which can be categorised as in the follow ing checklist: Increm ental inflows a sales revenue b proceeds from disposal o f surplus assets.

C hapter nineteen A

Incremental outflows operating costs b taxes paid C capital investm ent to upgrade existing assets or acquire new assets.

a

Valuation o f a target company based on increm ental cash flows is illustrated in Example 19.2.

Example

19.2

You a re a n a n a ly s t f o r M a y f a ir Ltd, w h ic h is c o n s id e r in g th e a c q u is itio n o f B o a r d Ltd. Y ou h a v e id e n tifie d th e f o llo w in g e ffe c ts o f th e ta k e o v e r: •

in v e s tm e n t o f $ 4 0 0 0 0 0 w ill b e r e q u ire d im m e d ia te ly to u p g r a d e s o m e o f B o a r d 's o ld e r assets

•

a s s e t u p g r a d in g , e c o n o m ie s o f s c a le a n d im p r o v e d e ffic ie n c y w ill in c re a s e n e t o p e r a tin g c a s h flo w s b y $ 2 9 0 0 0 0 p e r a n n u m in p e r p e tu ity

•

s o m e o f BoarcTs asse ts th a t h a v e b e e n p r o d u c in g a c a s h in flo w o f $ 7 0 0 0 0 p e r a n n u m w ill b e s o ld . T he n e w o w n e rs o f th e s e asse ts s h o u ld b e a b le to use th e m m o re p r o fita b ly a n d s a le p r o c e e d s a re e x p e c te d to b e $ 8 0 0 0 0 0

•

n e w p la n t c o s tin g $1 m illio n w ill b e p u rc h a s e d a n d is e x p e c te d to g e n e r a te n e t o p e r a tin g c a sh flo w s o f $ 2 3 0 0 0 0 p e r a n n u m in p e rp e tu ity . B o a r d ’s a c tiv itie s a r e a ll o f th e s a m e ris k a n d th e r e q u ire d ra te o f re tu rn is 1 5 p e r c e n t p e r a n n u m .

Y o u r c h ie f e x e c u tiv e h a s a s k e d y o u to e s tim a te : a)

th e g a in fro m th e ta k e o v e r

b)

th e m a x im u m p r ic e th a t M a y f a ir s h o u ld b e p r e p a r e d to p a y f o r B o a r d 's s h a re s .

SOLUTION a)

B a s e d o n y o u r e s tim a te s , th e o v e r a ll c h a n g e in n e t o p e r a tin g c a s h flo w s w ill b e $ 2 9 0 0 0 0 - $ 7 0 0 0 0 + $ 2 3 0 0 0 0 = $ 4 5 0 0 0 0 p e r a n n u m . T h is h a s a p re s e n t v a lu e o f $ 4 5 0 0 0 0 / 0 . 1 5 = $ 3 m illio n . T h e g a in w ill b e : G a in = $ 3 0 0 0 0 0 0 - $ 4 0 0 0 0 0 + $ 8 0 0 0 0 0 - $1 0 0 0 0 0 0 =$2400000

b) T h e m a x im u m p r ic e M a y f a ir s h o u ld b e p r e p a r e d to p a y is th e v a lu e o f B o a rd Ltd a s a n in d e p e n d e n t e n tity , p lu s th e g a in o f $ 2 . 4 m illio n . B o a rd h a s 5 m illio n s h a re s o n issu e , w h ic h h a v e a m a rk e t p r ic e o f $ 2 e a c h . A s s u m in g th a t m a rk e t p r ic e e q u a ls v a lu e a s a n in d e p e n d e n t e n tity :

Vj = 5 0 0 0 0 0 0 x $ 2 = $ 1 0 0 0 0 0 0 0 and:

VJ[A] = $ 2 4 0 0 0 0 0 + $ 1 0 0 0 0 0 0 0 = $ 1 2 4 0 0 0 0 0 so th e m a x im u m p r ic e M a y f a ir s h o u ld b e p r e p a r e d to p a y is: $ 1 2 4 0 0 0 0 0 / 5 0 0 0 0 0 0 = $ 2 . 4 8 p e r s h a re

19.3.1 I Comments on estimation of takeover gains The cash flow effects in Example 19.2 were deliberately kept very simple so th a t complex discounted cash flow calculations would n o t cloud the central issue o f the incremental effects o f a takeover. In doing so, the impression may have been given that, apart from assessing any immediate cash flow effects associated w ith sale or purchase o f assets, estim ating the gain from a takeover only involves estimating the incremental operating cash flows and discounting these cash flows at the target company s required rate o f return. In some cases this may be so, b ut in other cases there w ill be a need to divide the increm ental cash flows into different risk classes and apply a different discount rate to each class, and there may be cases where discounted cash flow analysis is n o t the best approach at all. For example, a takeover may open up new

nalysis o f takeovers

grow th opportunities, which result in intangible strategic benefits whose values are very uncertain. The imm ediate cash flow effect o f investing in such opportunities is generally negative, b u t these outlays may be necessary in order to have the o pp o rtu n ity o f entering a new development. The outlays can therefore be viewed as the purchase price o f an option, and the option-pricing principles discussed in Chapter 18 are likely to be more applicable than discounted cash flow analysis.6

1 9 .3 .2 1 Comparing gains and costs LEARNING OBJECTIVE 3 Explain the main differences between cash and shareexchange takeovers

In Example 19.2, the gain from M ayfair Ltd acquiring Board Ltd was estimated to be $2.4 m illion. Before m aking an offer, M ayfair s management also has to consider the net cost o f the takeover. The m ethod used to estimate the net cost differs, depending on w hether the acquiring company pays cash fo r the target or issues shares in exchange fo r the shares o f the target company. Estim ation o f the net cost o f a cash takeover is illustrated in Example 19.3.

Example

19.3

S u p p o s e th a t M a y f a ir p a y s $ 2 . 3 0 p e r s h a re fo r B o a rd , g iv in g a to ta l o u t la y o f $ 1 1 .5 m illio n . W h a t is: a)

th e n e t c o s t o f th e ta k e o v e r?

b)

th e g a in to M a y f a ir 's s h a re h o ld e rs ?

SOLUTION a )

丨 n E q u a tio n

1 9 . 2 , th e n e t c o s t o f a c a s h ta k e o v e r w a s d e fin e d a s th e a m o u n t o f c a s h p a id , m in u s

th e v a lu e o f th e ta r g e t a s a n in d e p e n d e n t e n tity . T h e n e t c o s t is: N e t cost = cash - V j = $11 5 0 0 0 0 0 - $ 1 0 0 0 0 0 0 0 =$1500000 T his resu lt s h o w s th a t $ 1 . 5 m illio n o f th e to ta l g a in a s s o c ia te d w ith th e ta k e o v e r g o e s to B o a rd ’s s h a re h o ld e rs . T his is th e c o s t to M a y f a ir o f g a in in g c o n tro l o f B o a rd . b)

T h e N P V f o r M a y f a ir 's s h a re h o ld e rs (E q u a tio n 1 9 .3 ) is:

NPV a = g a in - n e t c o s t = $ 2 4 0 0 0 0 0 -$ 1 5 0 0 0 0 0 =$900000

Example 19.3 illustrates a fundam ental point: the am ount o f the cash consideration determines how the to ta l gain is divided between the tw o sets o f shareholders: every additional dollar paid to Boards shareholders means a dollar less fo r M ayfair s shareholders. For a cash takeover, comparing gains and costs is straightforward when, as we have assumed so far, the value o f the target as an independent e ntity is equal to its m arket value. Suppose, however, that Board Ltd has been regarded by m arket participants as a likely takeover target and this speculation has increased its share price from $1.70 to $2. In other words, part o f the possible gains from a takeover are already impounded in Boards m arket price and VT is only $8.5 m illion, rather than the m arket value o f $10 m illion. The true value o f Board to M ayfair is $8.5 m illio n + $2.4 m illio n = $10.9 m illion , which means th a t paying $11.5 m illio n w ill harm, rather than benefit, M ayfa irs shareholders. In terms o f our previous calculations, the gain is s till $2.4 m illion , b u t the true net cost is: Net cost = cash - VT = $ 1 1 5 0 0 0 0 0 - $8 5 00 000 = $3000000

and: NPVa = gain - net cost = $ 2 4 0 0 0 0 0 - $ 3 0 0 0 000 = -$ 6 0 0 0 0 0

6

For a detailed discussion o f valuation methods, see Roller, Goedhart and Wessels (2010).

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nalysis o f takeovers

This problem highlights tw o im p o rta n t lessons fo r the management o f acquiring companies. First, management should check th a t the share price o f a proposed target has n o t already been increased by takeover rumours. Second, management should keep its takeover intentions completely confidential u n til form ally announcing the bid. Finally, in m aking a d istin ction between value and m arket price, we are n o t suggesting th a t there is any m arket inefficiency, or th a t there is anything w rong w ith the m arket price. In fact the m arket would be inefficient i f it did not respond to rum ours o f a possible takeover. The problem is th a t i f there are rumours th a t have increased the targets share price, the m arket price no longer gives a measure o f the targets value as an independent entity.

1 9 .3 .3 1 Estimating cost for a share-exchange takeover Estimating the net cost o f a cash takeover offer is straightforw ard.7 In the case o f the proposed takeover o f Board by M ayfair, the net cost was: Cash -

= $11500 000 - $ 10 000 000 = $1500000

Calculation o f the cost is more complex when the acquiring company issues shares in exchange fo r the targets shares. The cost in this case depends on the post-takeover price o f the acquiring company s shares. Calculation o f the net cost o f a share-exchange takeover is illustrated in Example 19.4.

E xample

19.4

M a y f a ir h a s 2 0 m illio n s h a re s o n issu e w ith a m a rk e t p r ic e o f $ 4 . 6 0 e a c h b e fo r e th e ta k e o v e r b id fo r B o a rd is a n n o u n c e d . M a y f a ir o ffe rs o n e o f its s h a re s f o r e v e r y t w o s h a re s in B o a rd . W h a t is th e n e t c o s t o f th e ta k e o v e r?

SOLUTION B a s e d o n th e s e te rm s , M a y f a ir a p p e a r s to b e p a y in g $ 2 . 3 0 p e r s h a re fo r B o a rd so it m ig h t see m th a t th e n e t c o s t w o u ld re m a in a t $ 1 . 5 m illio n . H o w e v e r, th e n e t c o s t d e p e n d s o n th e v a lu e o f th e M a y f a ir s h a re s is s u e d to B o a rd 's s h a re h o ld e rs a n d th is d e p e n d s o n M a y f a ir 's s h a re p r ic e after th e ta k e o v e r o ffe r is a n n o u n c e d . T he v a lu e o f th e c o m b in e d c o m p a n y c a n b e fo u n d b y r e a r r a n g in g E q u a tio n 1 9 . 1 : Vat = W + VT + g a in = 2 0 0 0 0 0 0 0 x $ 4 .6 0 + $ 1 0 0 0 0 0 0 0 + $ 2 4 0 0 0 0 0 =$104400000 A fte r th e ta k e o v e r, th e n u m b e r o f M a y f a ir s h a re s o n issu e w ill b e 2 0 m illio n + 2 . 5 m illio n a n d th e v a lu e o f th e s h a re s is s u e d to a c q u ir e B o a rd is: 2 ^

5 x$1 0 4 400 000 = $ l l

600 000

If B o a rd is w o r th $ 1 0 m illio n a s a n in d e p e n d e n t e n tity , th e n e t c o s t o f a c q u ir in g B o a rd is: $ 1 1 6 0 0 0 0 0 - $ 1 0 0 0 0 0 0 0 = $1 6 0 0 0 0 0

In general the estimated cost o f a share-exchange takeover is: Net cost = b x V ^ j- VT where b = the fraction o f the combined company th a t w ill be owned by the form er shareholders o f the target company. The NPV fo r M ayfair’s shareholders (Equation 19.3) is now:

7

Fortunately, cash-only offers are the most common in practice although over the years they have fallen in popularity. To illustrate, Da Silva Rosa et al. (2000) reports that in 1988 approximately 81 per cent of the bids were cash bids. In contrast, in 2009 only 54 per cent of the bids for Australian listed firms were cash bids, 31 per cent were share-only bids and the remaining 10 per cent offered a mix of cash and/or shares.

6

i

B usiness finance

NPV^ = gain - net cost = $ 2 400 00 0 -$ 1 600 000 =$ 80 0 000 These calculations show th a t fo r the share-exchange offer the true net cost is expected to be $100 000 more than i t would have been i f M ayfair had paid cash fo r Board. Similarly, the NPV to M ayfair s shareholders is $100 000 less than i t would have been under the cash offer. This difference arises because M ayfair s shares are w o rth more after the takeover than they were w o rth previously. I f the m arket agrees w ith M ayfair s valuations, then once the takeover bid is announced, M ayfair s share price w ill be $104.4 m illion /2 2.5 m illio n = $4.64 or 4 cents more than its pre-bid price. Therefore, since Boards shareholders w ill receive M ayfair shares, rather than cash, they w ill receive p art o f the takeover gain. I t should now be clear th a t there is a basic d istin ction between cash offers and share-exchange offers: fo r a cash offer, the net cost is independent o f the takeover gain; fo r a share-exchange offer, the cost depends on the takeover gain, because the cost is a fu nctio n o f the acquiring company s share price after the bid is announced. Consequently, the cost o f a share-exchange takeover can only be estimated when the bid is at the planning stage. Equation 19.5 can be used to make the estimate. A nother im p o rta n t d istin ction between cash and share-exchange offers is th a t a share exchange mitigates the effect o f valuation errors. For example, suppose th a t after acquiring Board Ltd, M ayfair s management finds th a t Boards assets are w o rth only $5 m illion. I f M ayfair paid $11.5 m illio n cash to Boards form er shareholders, then the cash is gone forever and M ayfair s shareholders w ill bear the fu ll loss o f $6.5 m illion. However, i f M ayfair acquired Board by issuing shares, p a rt o f the loss w ill be borne by Board's form er shareholders.

Alternative valuation approaches The takeover analysis in Section 19.3 is based on m arket values and estimates o f the present value of increm ental cash flows. In some cases, m arket values may n ot be available because the target company is unlisted, or they may be considered unreliable, perhaps because the shares are rarely traded. In such cases, there w ill be a need to use other valuation approaches, the m ost popular o f w hich are based on earnings and assets.8

In this approach, the bidder values the target by firs t estim ating the future earnings per share (EPS) o f the target. The EPS figure is then m ultiplie d by an appropriate1price-earnings (P-E) ratio to obtain an im plied price (valuation) o f the target. This approach can be given a theoretical u nderpinning by lin k in g i t to the present value o f a perpetuity. I f the appropriate P-E ratio is regarded as 1 /r, the inverse o f the discount rate, then, using the p erpetuity form ula the present value is:

PV= EPS/r = EPSx l/ r = EPS x P-E =P Im p o rta n t assumptions underlying this approach include: • •

the company s future earnings stream can be represented by a single number, typically referred to as ‘future m aintainable earnings’ risk differences between companies can be fu lly captured in the discount rate, r.

As Penman (2013, p. 181) points out, when these conditions are n o t met, the P-E ratio should not be accorded any theoretical significance and is best regarded as a summary indicator o f a company s perceived capacity to generate earnings. Even where these assumptions hold, capitalising earnings using a P-E m ultiple should not be regarded as discounting future earnings. The cash flows to investors in shares are dividends, n o t earnings, part o f 8

For a discussion o f the valuation methods that are most commonly used, see Mukherjee, Kiymaz and Baker (2004).

C hapter nineteen A

nalysis o f takeovers

which are reinvested each year. Therefore, we can regard the value o f a share as the present value o f a stream o f dividends, or equivalently, as the present value o f a stream o f earnings minus the present value o f the reinvested (retained) earnings stream. Discounting earnings rather than dividends amounts to including all the returns from an investm ent w ith o u t allowing fo r the outlay needed to generate those returns.

1 9 .4 .2 1 Valuation based on assets A company s equity can be valued by deducting its to ta l liabilities from the sum o f the m arket values o f its assets. This approach may be appropriate where the bidder intends to sell many o f the targets assets or where the company has been operating at a loss. Criticisms o f this approach include the following: • • •

figures in the balance sheet based on historical cost are u nlikely to provide a reliable guide to m arket values intangible assets may n o t be included in the balance sheet there may be com plem entarity between assets so th a t the to ta l m arket value o f the assets may be greater than the sum o f th e ir individual m arket values.

Even where reliable m arket values can be found fo r all identifiable assets, the resultant valuation w ill rarely coincide exactly w ith the m arket value o f the company s equity.

19.5 Regulation and tax effects of takeovers m Takeover activity and procedures are regulated by Commonwealth legislation. The m ost im p o rta n t legislation is Chapter 6 o f the Corporations A ct 2001.9 The Australian Securities and Investments Commission (ASIC, www.asic.gov.au) has a significant role in adm inistering activities covered by the legislation. For example, ASIC can obtain inform a tion on the beneficial ownership o f shares, and can allow exemptions from compliance w ith the legislation. Also ASIC can apply to the Takeovers Panel (www.takeovers.gov.au) fo r an acquisition o f shares to be declared unacceptable or fo r a declaration o f unacceptable circumstances. The panel can make such a declaration even i f the legislation has n ot been contravened. Furthermore, s. 659B o f the Corporations A ct dictates th a t parties to a takeover do n o t have the rig h t to commence civil litig a tio n in relation to a takeover while i t is current. Instead, the power to resolve disputes during this period resides w ith the Takeovers Panel, which also has the power to review certain decisions made by ASIC where those decisions are made w ith respect to parties to a takeover. The objectives o f the takeovers legislation are set o ut in s. 602. The legislation seeks to ensure that: • •

• •

the acquisition o f control over vo ting shares in a listed company or an unlisted company w ith more than 50 members takes place in an efficient, com petitive and inform ed m arket the shareholders and directors o f a target company - know the id e n tity o f the bidder - have a reasonable tim e to consider the proposal - are given enough info rm a tio n to enable them to assess the m erits o f the proposal as far as practicable, all shareholders have a reasonable and equal o p p o rtu n ity to participate in any benefits offered by the bidder an appropriate procedure is followed in the case o f the compulsory acquisition o f vo ting shares or interests or any other kin d o f securities.

The takeovers legislation provides that, unless the procedures laid down in Chapter 6 o f the Corporations A ct are followed, the acquisition o f additional shares in a company is virtu a lly prohibited if this would:

b

result in a shareholder being e ntitled to more than 20 per cent o f the voting shares; or increase the voting shares held by a party th a t already holds between 20 per cent and 90 per cent o f the voting shares o f the company.

9

For a detailed discussion, see Levy and Pathak (2012).

a

LEARNING OBJECTIVE 4 Outline the regulation and tax effects of takeovers in Australia

[ww^|

B usiness finance

|w w ^ J

Any investor is p erm itted to purchase up to 20 per cent o f a company s shares at any tim e, subject to the requirem ent th a t once the holding exceeds 5 per cent, a substantial shareholding notice m ust be issued w ith in tw o business days, or by 9:30 am on the next business day i f a takeover bid is currently underway. Furtherm ore, when a substantial shareholder s interest in a company increases or decreases by 1 per cent or more the m arket m ust be inform ed o f this change. The takeover threshold has been set at 20 per cent because anyone who owns less than 20 per cent o f a company s shares is u nlikely to be able to exercise control. I f an investor wishes to exceed the 20 per cent threshold and obtain control o f a target company, this can generally be done only by follow ing one o f the tw o procedures th a t the legislation permits: an off-m arket bid o r a m arket bid. An off-m arket bid can be used to acquire shares th a t are listed on a stock exchange or shares in an unlisted company. A m arket bid is applicable only where the target is listed on a stock exchange. Creeping takeovers*, which are discussed in Section 19.5.4, are also allowed. ASIC provides news and policy statements on takeovers on its website w w w.asic.gov.au/asic/ASIC.

N SF/byHeadline/Takeovers.

19.5.1 | Off-m arket bids An acquiring company can make an off-m arket bid (whether by way o f a cash offer, a share exchange or a com bination o f these) to acquire shares in the target company. This offer m ust remain open fo r between 1 and 12 m onths and may be fo r 100 per cent or a specified p roportion o f each holders shares. A broad outline o f the steps involved in an off-m arket bid is provided in s. 632 o f the Corporations A ct and shown in Figure 19.2.

Figure 19.2 Outline of steps in an off-market bid Com pany Step 1

bidder's statement (together with offer document)

Step 2

notice that step 1 has been done

Step 3

bidder's statement and offers

Step 4

notice that step 3 has been done

w W

— -------►

• ASIC • target • market^0)

• ASIC

• holders o f bid class securities

------ >

• ASIC • target • market ㈣

Target Step 5

• bidder

target's statement ---------- >

• holders o f bid class securities • ASIC • market(〇 l

^ This means that a copy of the document should be sent to any exchange on which a target company's shares are listed for publication to the wider market. Source: Corporations Act 2001.

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Once an off-m arket bid has been made fo r a listed company, the offeror is allowed to purchase target company shares on the stock exchange. An offeror can increase its offer price b u t has to pay this increased amount to all shareholders who accept the offer, including any who have previously accepted a lower price.

19.5.2|M arket bids A m arket bid is possible only where the shares o f the target company are listed on a stock exchange. Im portantly, the buyer m ust pay cash fo r the shares and the offer cannot be conditional. Like an off-m arket bid, the offer m ust be open fo r a period o f 1 to 12 m onths. Figure 19.3 from s. 634 o f the Corporations A ct gives a broad outline o f the steps involved in a m arket bid. In this case, i f the offer price is increased, there is no need to pay the higher price to target shareholders who sold p rio r to the increase.

Figure 19.3 Outline of steps in a market bid Com pany Step 1

announcement of bid to the market

Step 2

bidder's statement

Step 3

bidder's statement and any other documents sent with it to the market

Step 4

copy o f documents sent to holders

'W

w

• market • target • ASIC

• holders of bid class securities

• market • ASIC

Target Step 5

target's statement

• • • •

market target ASIC holders o f bid class securities

Bidder Step 6

makes offers on the market

Source: Corporations Act 2001.

19.5.31 Disclosure requirements The Corporations A ct includes im p o rta n t provisions fo r the disclosure o f inform a tion by bidders and targets. The aim is to make im p o rta n t inform a tion related to the takeover more accessible through the provision o f a bidder’s statement and a target’s statement. The info rm a tio n th a t should be contained in a bidders statement is the same w hether the bid is an off-m arket or m arket bid. The inform a tion to be contained in a bidders statement includes: • •

the id e n tity o f the bidder details o f the bidders intentions regarding the continuation o f the targets business and any m ajor changes to be made to the business

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• • • • •

details o f how cash consideration w ill be obtained where securities are offered as consideration, inform a tion fo r a prospectus fo r an offer o f those securities the price(s) paid by the bidder to acquire the targets securities during the previous 4 m onths fo r an off-m arket bid, the bidders voting power in the target any other m aterial info rm a tio n th a t may assist the target company s shareholders in deciding w hether to accept the offer.

The target m ust respond to the takeover bid by issuing a targets statement, which is the same fo r b oth off-m arket and m arket bids. In general, the targets statement m ust include all info rm a tio n that target shareholders would reasonably require to make an inform ed decision on whether to accept the bid. I t m ust also contain a statement by each director o f the target recommending whether or n ot the bid should be accepted and giving reasons fo r the recommendation. Alternatively, each director m ust provide a statement giving reasons why a recommendation is n o t made. The targets statement m ust be accompanied by an experts report i f the bidder is connected w ith the target. Specifically an experts report is required i f the bidder s voting power in the target is 30 per cent or more, or i f a director o f the bidder is a director o f the target. The expert m ust have a professional reputation* and is required to state, w ith reasons, whether the offer is considered to be fa ir and reasonable.

This approach is p erm itted by s. 611 o f the C o rp o ra tio n s A c t. It allows the acquisition o f no more than 3 per cent o f the target company s shares every 6 m onths, provided th a t the threshold level o f 19 per cent has been m aintained fo r at least 6 months. No public statement is necessary. Because o f the tim e required to achieve control, the creeping takeover approach is o f little commercial significance.

PARTIAL TAKEOVER

takeover in which a bidder seeks to acquire no more than part o f a com pany’s issued shares

PROPORTIONAL BID

partial takeover bid to acquire a specified proportion o f the shares held by each shareholder

P a rtia l ta k e o v e rs, where a bidder seeks to gain control by acquiring only 51 per cent, or perhaps less, o f the target company s shares, have been the subject o f particular regulatory attention. The reasons are, first, th a t the prem ium fo r control may be paid to only a favoured group o f shareholders, and second, th a t there is p otential fo r target shareholders to be coerced into accepting an offer th a t is n o t in th e ir best interests. Suppose th a t an offer is made fo r 40 per cent o f the shares in a company, and the holders o f 80 per cent o f the shares accept. Under a pro-rata offer, the bidder would then accept h a lf o f the shares offered by each o f these holders, who would be the only ones to share in the control prem ium . Pro-rata bids have been prohibited in Australia since 1986. The bidder in a p artial takeover m ust specify a t th e o u ts e t the pro po rtio n o f each holders shares th a t the bidder w ill offer to buy. This m ethod is referred to as a p ro p o rtio n a l bid. An example is the August 2013 bid by Loyal Strategic Investm ent Ltd fo r 75 per cent o f each shareholder s shareholding in the exploration company Coalbank Ltd. A disadvantage o f propo rtio na l bids is greater uncertainty about th e ir outcome from the view point o f the bidder, because the bidder m ust estimate the likely response rate o f target shareholders. A company s constitution may provide th a t a p roportional takeover bid fo r the company can proceed only i f shareholders vote to approve the bid. The C o rp o ra tio n s A c t allows this restriction on proportional takeovers b u t also specifies th a t any shareholder approval requirements generally cease to apply after 3 years. Some companies have adopted these requirements, which, while restricted in duration, can be renewed in the same way as they were originally adopted. Partial takeover bids have become extremely rare in Australia.

Two companies th a t are contem plating a frie n d ly m erging o f th e ir operations may consider entering in to a sc hem e o f a r ra n g e m e n t rather than proceed w ith a takeover bid. Such schemes are court-approved unions th a t are governed by Chapter 5 o f the C o rp o ra tio n s A c t 2 0 0 1 . Before a court grants its approval fo r a scheme o f arrangement, i t w ill require a w ritte n statem ent by ASIC th a t i t has no objection to

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the scheme and w ill then need to be satisfied th a t the scheme is n o t designed to avoid the takeover provisions o f Chapter 6. The a ttra ctio n o f a scheme o f arrangem ent to frie n d ly parties may be th a t it provides greater ce rta inty w ith regards to the tim in g o f the acquisition events. The proposed scheme o f arrangement is sent to all shareholders by the target company and a vote is conducted. Provided th a t more than 50 per cent o f shareholders holding at least 75 per cent o f shares in the company vote in favour o f the scheme, the scheme w ill be passed, subject to the c o u rts approval, allow ing all shares in the target company to be transferred to the bidder. In contrast, a bidder engaged in an off-m arket bid needs to acquire the approval o f at least 75 per cent o f shareholders h olding at least 90 per cent o f the shares in the target company before i t can com pulsorily acquire the rem aining shares. There has been some suggestion th a t the so-called ‘headcount’ requirem ent th a t more than 50 per cent o f the shareholders need to agree before a scheme is approved by the courts is unnecessarily restrictive. In recent years there have been a num ber o f high-profile mergers th a t have taken place via a scheme o f arrangement. These mergers include the merger between Adelaide Bank and Bendigo Bank th a t resulted in the subsequent d elisting o f Adelaide Bank shares and the renam ing o f Bendigo Bank as Bendigo and Adelaide Bank Ltd. A nother such merger occurred in the $14.6 b illio n merger between the large wealth management company AM P Ltd and the smaller financial services company AXA Asia Pacific Holdings Ltd.

Other legislation th a t may influence a bidders decision to make a takeover offer includes: • •

•

the C o m p e titio n a n d C o n s u m e r A c t 2 0 1 0 , which was referred to in Section 19.2.1 the F o re ig n A c q u is itio n s a n d T a k e o v e rs A c t 1 9 7 5 1which provides the Commonwealth Treasurer w ith the power to p ro h ib it takeovers follow ing advice received from the Foreign Investm ent Review Board (w w w.firb.gov.au). An example o f the Treasurer exercising this power occurred in November 2013. Archer Daniels M idland Company, a US-based global grain group, launched a $3.4 b illio n takeover bid fo r GrainCorp, one o f Australia’s largest agricultural companies. The Treasurer prohibited the takeover on the grounds th a t GrainCorp controlled the p o rt netw ork th a t handled in excess o f 85 per cent o f to ta l grain exports from the country and th a t to allow the acquisition was against the national interest other Commonwealth legislation th a t may in h ib it takeovers in specific industries, such as the banking and media industries.

In addition to this legislation, some o f the listin g rules o f the ASX also affect takeovers. These include a requirement th a t directors m aintain secrecy during discussions bearing on a p otential takeover offer and a requirement restricting directors o f a target company from m aking an allotm ent o f shares fo r a period o f 3 m onths after receiving a takeover offer.

In September 1999, the Com m onwealth G overnm ent released the re p o rt o f the Ralph Review o f Business Taxation (Ralph Review) th a t included recomm endations on capital gains tax re lie f where the consideration in a takeover was an exchange o f shares. This recom m endation was im plem ented in the N e w B u s in e s s T a x S y s te m (C a p ita l G a in s T a x ) A c t 1 9 9 9 1w hich to ok effect from 10 December 1999. The legislation allows the target company to apply to the A ustralian Taxation Office (ATO), on behalf o f its shareholders, fo r re lie f fro m capital gains tax where the consideration fo r a takeover is in the form o f an exchange o f shares. The effect o f the legislation is th a t shareholders in the target company are able to defer a p o te n tia l capital gains tax lia b ility u n til the shares in the acquiring company they accepted as consideration are sold. It was claimed in evidence to the Ralph Review th a t acquiring companies were often forced to pay a capital gains tax prem ium , to induce the target shareholders w ith p otential capital gains tax liabilities to accept the offer. This meant th a t takeover bids included a cash component so th a t target shareholders had the cash necessary to pay any resulting capital gains tax liability. I t was claimed th a t offer prices were forced up and there was a bias against those bids th a t solely involved a share exchange. An example cited in this context is the 1997 takeover o f the Bank o f Melbourne by Westpac. Westpacs offer o f $1,435 b illio n

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included a cash component to enable Bank o f Melbourne shareholders to meet th e ir potential capital gains tax liability. The importance o f capital gains tax relief to the success o f a proposed acquisition is readily illustrated by reference to the failed acquisition by private hospital operator Healthscope o f the diagnostics division o f Symbion Health follow ing the refusal by the ATO to grant relief fro m capital gains tax to Symbion Health’s shareholders.

As management is obliged to act in the best interests o f shareholders, the way in which it deals w ith a potential takeover bid raises many corporate governance issues. As a takeover bid implies a potential change in the ownership and control o f the company, which in tu rn may threaten the tenure o f the existing management team, i t is no surprise th a t the Takeovers Panel has provided considerable direction about how management should conduct its e lf during the b id process. The panels directions cover the increasingly im p o rta n t issue o f break fee agreements entered into by companies in takeover negotiations. A break fee agreement is an arrangement entered in to by two companies where one promises to pay the other a sum o f money i f certain events occur th a t have the effect o f causing the proposed merger to fail. In 2000, less than 4 per cent o f Australian takeover bids involved break fee agreements, while by 2006 the p roportion had increased to more th an 43 per cent o f bids. For example, in 2004 WMC Resources entered into a $92 m illio n break fee agreement w ith BHP B illito n th a t would be triggered by a number o f events, including the w ithdraw al o f the Boards support fo r the bid or the eventual success o f a competing bid. A t the tim e o f BHP B illito n s bid, W MC was subject to a hostile bid (at a lower price) by another m ining company, Xstrata. U ltim ately, BHP was successful in its acquisition and the break fee was never paid. The im p o rta n t question raised in the financial press at the tim e o f the BHP B illito n bid was whether break fees were detrim ental to target shareholders. There are many competing theories about the impact o f break fees on shareholder wealth.10 One argument suggests th a t break fees are an example o f an agency cost imposed on target company shareholders by entrenched management teams seeking to maximise th e ir personal u tility by diverting control o f the company to a specific favoured acquirer. The cost to shareholders is in the fo rm o f a reduction in the prem ium th a t they may have received were alternative bidders n o t dissuaded from bidding by the presence o f the break fee agreement (see Bates & Lemmon 2003; Officer 2003; and Rosenkranz & Weitzel 2007). Given this interpretatio n o f break fees i t is no surprise th a t the Takeovers Panel has provided some direction on when a break fee agreement would be acceptable. The panels position, as stated in Guidance Note 7: Lock-up Devices, involves a
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19.6 Takeover defences m W hile most takeover bids th a t are announced succeed, there are also many cases where management o f the target company is successful in preventing a change in control. The Takeovers Panel has issued a guidance note relating to takeover defences in which i t states th a t a decision about the ownership and control o f a company should ultim ately be made by shareholders and n o t by management.11 Nevertheless, the guidance note concedes th a t where a targets management believes resistance is in the best interests o f the company s shareholders, such action would be consistent w ith the objectives o f Chapter 6 o f the Corporations Act. Defence measures are o f tw o basic types: those th a t pre-empt or discourage bids and those implemented after a bid is received. The more common categories o f strategy include the follow ing (Casey & Eddey 1986).

LEARNING OBJECTIVE 5

O utline defence strategies that can be used by target companies

19.6.1 | Poison pills Poison p ills are a pre-emptive measure employed so as to make the target company less attractive to

PO ISON PILL

a potential bidder in the event th a t i t is successful in its takeover attem pt. An example o f a poison p ill defence relates to Liberty M edia Corporation s announcement on 3 November 2004 th a t it had reached an agreement w ith a th ird p arty allowing it to increase its holding in News Corporation by 8 per cent to 17.1 per cent. In response, News Corporation announced the establishment o f a ‘Shareholder Rights Plan’ that would be triggered i f any p arty acquired more than 15 per cent (or i f currently holding more than 15 per cent, increased its holding by more than 1 per cent). The plan would enable shareholders, other than the party who had triggered the event, to purchase one additional share fo r each share owned at h alf the prevailing m arket price, resulting in a significant d ilu tio n in the value and size o f Liberty s stake in News Corporation. In defence o f the adoption o f the poison p ill scheme, News Corporation chairman Rupert Murdoch claimed th a t i t was fo r the good o f small shareholders as i t prevented an acquirer from gaining control o f News Corporation shares at depressed prices. The poison p ill defence proved successful when in December 2006 News Corporation agreed to swap its controlling stake in satellite broadcaster DirecTV in retu rn fo r L ib erty’s stake in News Corporation.

strategic move by a com pany that may become a takeover target to make its shares less attractive to an acquirer by increasing the cost of a takeover (e.g. an issue of securities that w ill convert to shares if a takeover bid occurs)

1 9 .6 .2 1 Acquisition by friendly parties The management o f a target company seeks the assistance o f a *white knight*, who generally purchases the targets shares on the open m arket w ith the aim o f either d riving up the share price, or preventing the bidder from achieving its m in im u m acceptance level. An example from the mid-1980s occurred when Bond Corporation was believed to be preparing fo r a takeover bid o f biscuit m anufacturer A rn o tts . US company Campbell Soup Company purchased shares as a frien dly party and acquired a strategic parcel (or ‘blocking stake’）o f A rn o tt’s shares th a t effectively stymied Bond C orporation’s takeover ambitions. Interestingly, the *w hite knight* in th is case its e lf turned in to a predator in 1992. A fte r having acquired 33 per cent o f A rn o tt s shares, Campbell Soup announced its own bid fo r A rn o tts , which was successfully finalised in 1997. More recently, lu xu ry car-maker Porsche acquired a strategic stake in Volkswagen in order to prevent a hostile bid from other car manufacturers and/or private equity groups. Volkswagen manufactured key components fo r Porsche and hence an acquisition by a hostile th ird party w ould have exposed Porsche to significant business risk. Subsequently, Porsche launched a failed bid fo r control o f Volkswagen. This was followed by a successful bid by Volkswagen fo r a significant pro po rtio n o f the Porsche business.

1 9 .6 .3 1 Disclosure of favourable information Management o f a target company may release in fo rm a tio n th a t w ill, i t hopes, convince shareholders th a t the bid undervalues the company. Such in fo rm a tio n includes p re lim ina ry earnings results, new contracts and statements o f asset m arket values and p ro fit forecasts. The release o f such in fo rm a tio n 11

G u id an ce N o te 1 2 : F r u str a tin g A ction is a v a ila b le a t th e T a k e o v e r s P a n e l s w e b s ite ,

www.takeovers.gov.au.

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is designed to make the takeover p ro h ib itiv e ly expensive fo r the bidder a nd /o r deliver a dditional value to shareholders in the fo rm o f an increased offer price. In recent years the regulatory authorities have emphasised th a t any in fo rm a tio n released by target management durin g the course o f a takeover attem pt m ust be accurate. This p o in t was w ell illu stra te d in Ju ly 2001 when ASIC launched civil proceedings against three form er directors o f GIO Insurance L td in relation to p ro fit forecasts issued by GIO d u rin g a takeover a tte m p t by AM P Ltd. Forecasts issued by GIO durin g this period predicted profits o f $80 m illio n from its reinsurance business fo r the financial year ending June 1999. Following the successful acquisition by AMP, GIO declared a before-tax loss o f $759 m illio n fo r the same period and ASIC alleged th a t the directors prosecuted w ithh eld in fo rm a tio n concerning the m agnitude o f the losses. A n othe r im pedim ent to listed target companies selectively releasing favourable in fo rm a tio n is the continuous disclosure obligations as set o ut in Australian Securities Exchange L isting Rule 3.1, which states: 'Once an e n tity is or becomes aware o f any in fo rm a tio n concerning i t th a t a reasonable person w ould expect to have a m aterial effect on the price or value o f the entity's securities, the e n tity m ust im m ediately te ll ASX th a t in fo rm a tio n ’. Consequently, a company th a t fu lfils its continuous disclosure requirements w ill fin d i t more d iffic u lt to keep good news from the m arket in an e ffo rt to defend against possible takeover bids.

The management o f a target company often claims th a t the bid is inadequate and may also appeal to regulatory authorities such as the Foreign Investment Review Board, the Australian C om petition and Consumer Commission and/or the Takeovers Panel. They may also criticise the bidding company, as occurred repeatedly during the hostile takeover b id fo r Patrick Corporation by the Toll Holdings group. Chris Corrigan, the chief executive o f Patrick Corporation, fiercely defended his company from acquisition in w hat has been one o f the m ost v itrio lic takeover contests witnessed in Australia. For example, Corrigan placed advertisements in newspapers stating th a t ‘Patrick needs Toll like a fish needs a bicycle’ and when Patricks corporate strategy was criticised by Paul L ittle, the chief executive o f Toll, he responded by saying th a t was *like being called stupid by the village idiot* (Chessel 2005).

The significance o f the target directors* attitude to a takeover bid places the onus on directors to ensure that th e ir recommendation is consistent w ith their responsibilities to shareholders. Directors o f a target company may be faced w ith a conflict o f interest, because a takeover bid th a t they believe to be in the best interests o f shareholders may leave them unemployed i f it is successful. Therefore, directors o f a target company may oppose a bid because they place th eir own interest above th eir responsibilities to shareholders. On the other hand, resistance to a takeover bid can benefit shareholders i f i t forces the bidder to increase the offer, or attracts a higher offer from another bidder. The impact o f the defence by a target company s management against a takeover offer has been the subject o f research in Australia and overseas. Maheswaran and Pinder (2005) examined 133 bids fo r companies listed on the ASX. They found that resistance by a target company s Board reduced the probability th a t a b id w ould be successful and increased the likelihood th a t the offer price would be increased by the bidder, b u t had no im pact on the chances that a competing bidder would launch an alternative bid fo r the target company s shares. Interestingly, they fin d th a t there is no evidence o f a relationship between the m agnitude o f the control prem ium offered and the incidence o f bid resistance. In a sim ilar study, Schwert (2000) analysed 2346 takeover contests th a t had occurred in the US. He found th a t he could n o t differentiate on economic grounds between bids th a t had been rejected by target management and those th a t had been accepted. The contention th a t managerial resistance to takeovers may n o t be in the best interests o f shareholders is o f concern since the ‘m arket fo r corporate control’ concept sees takeovers as a mechanism fo r resolving shareholder-manager conflicts by replacing inefficient managers. The effectiveness o f th is m arket w ill be reduced i f such managers use defensive tactics to entrench th e ir positions. O f course, it is poorly perform ing managers who are likely to have the greatest d iffic u lty in m aintaining employment o r obtaining other jobs after a takeover. Empirical evidence supports this contention in th a t companies whose management resisted takeover are characterised by poorer performance p rio r to the takeover bid (Morck, Shleifer & Vishny 1988; Maheswaran & Pinder 2005). The problem o f managers giving predominance to th e ir own interests may be overcome by structuring the compensation o f top-level managers so th a t th e ir own

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interests w ill be better aligned w ith those o f shareholders. Some companies approach this problem by offering top-level managers large term ination payments (golden parachutes*) i f they lose th e ir jobs due to a takeover. Such payments may be effective in preventing managers from resisting a takeover bid th a t is in the best interests o f shareholders. However, i f the payments are too generous, they may cause managers to recommend th a t shareholders accept an inadequate bid.

19.7 Corporate restructuring While mergers and takeovers remain the m ost frequent transactions in the m arket fo r corporate control, in recent years there has been an upsurge in transactions where companies or groups were reduced in size by asset disposals, divided in to separate entities or transferred to private ownership. We begin by defining the m ost frequent o f these restructuring transactions: •

Divestitures. Assets (often in the form o f a whole subsidiary, branch or division) are sold to another company. Spin-offs. The operations o f a subsidiary are separated from those o f its parent by establishing the subsidiary as a separate listed company. However, there is no change in ownership because shares in the form er subsidiary are distributed to the shareholders o f the parent company. Leveraged buyouts. A company or division is purchased by a small group o f (usually in stitu tio n a l) investors using a high p roportion o f debt finance. Where the investors are headed by the company s senior managers, the buyout is often referred to as a m an a g em e n t bu yout. A fte r a buyout the company is privately owned and the shares are n o t norm ally listed on a stock exchange.

•

•

The follow ing subsections briefly summarise the evidence on the wealth effects o f restructuring transactions and discuss possible explanations.12

19.7.1 | Divestitures A d iv estitu re (or sell-off] involves assets, which may be a whole subsidiary, being sold fo r cash, and is therefore essentially a reverse takeover from the view point o f the seller. An example o f such a sell-off occurred in February 2014 when Royal Dutch Shell sold o ff its Australian-based oil refinery and 870 petrol stations to the Swiss-based m ultina tio na l energy company V ito l fo r $2.9 billion. The frequency o f divestitures, and the value o f the assets involved, has increased over the last 20 years, w ith Eckbo and Thorburn (2008) reporting th a t in 2006 approximately $320 billion o f assets across 3500 divestitures were sold in the US. W hile takeovers increase the wealth o f target (seller) shareholders, it has also been found that divestitures create value fo r the shareholders o f selling companies. Eckbo and Thorburn (2008) survey the evidence provided by a num ber o f studies in the topic area and report th a t shareholders in selling companies earn— on average— a return o f 1.2 per cent upon the announcement o f the divestiture. Furthermore, shareholders in the companies on the buy-side o f the divestiture transaction also enjoy an increase in wealth as the average share price reaction to the announcement th a t th e ir company has bought the divested assets is 0.5 per cent. Possible reasons as to why the market perceives divestitures as good news are: an increase in corporate focus fo r the selling company, the elim ination o f negative synergies that arise through the cross-subsidisation o f poorly perform ing segments o f the company, and the fact th a t the buying company is able to derive greater value o ut o f the divested assets than the selling company.

LEARNING OBJECTIVE 6

Identify the various types o f corporate restructuring transactions

LEVERAGED BUYOUT

company takeover that is largely financed using borrowed funds; the remaining equity is privately held by a small group of investors M AN AG EM EN T BUYOUT

purchase o f all o f a com pany’s issued shares by a group led by the com pany’s management DIVESTITURE (OR s ell- o f f )

sale o f a subsidiary, division or collection of related assets, usually to another company

1 9 .7 .2 1 Spin-offs SPIN-OFF

In this type o f transaction, a single organisational structure is replaced by tw o separate units under essentially the same ownership. Eckbo and Thorburn (2008) review the results o f 19 studies into the valuation effects o f sp in -o ff a ctivity and, sim ilar to the findings relating to divestitures, report th a t the average share price reaction to the announcement o f a spin-off was 3.3 per cent. In terms o f explaining this positive result fo r shareholders there are a num ber o f additional factors— in addition to those relating to the benefits also relating to divestitures— th a t p rio r studies have highlighted. For example, the positive share price reaction m ig ht reflect the transfer o f wealth from bondholders to shareholders, as valuable 12

T h e fo llo w in g d is c u s s io n r e lie s s u b s t a n t ia l ly o n E c k b o a n d T h o r b u r n ( 2 0 0 8 ).

the separation of certain assets (or a division) from a company upon which are issued new shares that are allocated to the com pany’s existing shareholders

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assets are removed from the reach o f creditors. Alternatively, the spin-off m ig ht reflect the increased expectation o f the receipt o f a control prem ium as the transaction has increased the probability o f a takeover o f the newly listed subsidiary and/or the parent company. The positive wealth effect m ight also reflect the reduction in in fo rm a tio n asymm etry between management s valuation o f the company and the m arkets valuation. Specifically, i t has been suggested th a t a spin-off reduces the problem associated w ith aggregating financial inform a tion across the company and faced by anyone attem pting to value the company, such as security analysts. An example o f a significant spin-off occurred in 2007, when Toll Holdings, at the tim e Australias largest tran spo rt and logistics company, spun o ff its p o rt and rail assets in to a new company, Asciano, while continuing to operate its sizeable logistics business. As p art o f the spin-off process, m ost o f the debt held by the combined group was assigned to Asciano, because its p o rtfo lio o f quality tangible assets provided superior debt capacity. As a consequence, Toll was then able to raise additional debt to fund future corporate acquisitions such as the $191 m illio n takeover o f Singapore-based logistics group Sembawang Kim trans Ltd.

1 9 .7 .3 ! Buyouts BUYOUT (OR GOING-PRIVATE) TRANSACTION

transfer from public ownership to private ownership o f a company through purchase of its shares by a small group of investors that sometimes includes the existing management

A b u y o u t o r g o in g -p riv a te tra n sa ctio n can take one o f a num ber o f forms, each o f which involves a rearrangement o f financial and ownership structures o f a single operating entity. Consequently, there is no scope fo r operating synergies such as economies o f scale. Figure 19.4 indicates the rise and fall o f buyout a ctivity in the US in recent years.

:igure 19.4 US leveraged buyout activity 45<

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C hapter nineteen A

nalysis o f takeovers

Buyouts may be in itia te d by vendors and th e ir advisers or by management. Management presumably expects to gain from the transaction and there is evidence th a t the form er public shareholders also gain through receiving a substantial prem ium over the previous share price.13 I t follows th a t some real gain must be expected to follow fro m the transfer from public to private ownership. One source o f gain is the avoidance o f listin g fees and shareholder servicing costs, which can be quite substantial fo r small public companies. Another is the effect on managerial incentives. Managers who also own th e ir company stand to benefit more than salaried employees from th e ir efforts. In addition to pure* going-private transactions, where managers use th e ir own resources, possibly supplemented by personal borrow ing, to buy out the previous shareholders, there are leveraged buyouts, which involve significant corporate borrowing. These buyouts are almost always arranged by a buyout specialist who invests equity capital in the company, arranges the necessary debt finance and takes an active part in overseeing its performance. Figure 19.4 indicates the great increase in leveraged buyout activity in the early to mid-2000s and then the subsequent fall in this type o f a ctivity during the global financial crisis and the near-collapse o f worldwide debt markets. The v ia b ility o f a leveraged buyout transaction is heavily dependent upon the availability o f large amounts o f relatively cheap debt. The subsequently high deb t-e q uity ratios o f buyout companies do n ot necessarily mean th a t private companies have an inherently greater debt capacity than th e ir public counterparts. In m ost leveraged buyouts, early repayment o f p art o f the debt is a high p rio rity and the in itia l high level o f debt is feasible because most such buyouts involve low -risk businesses w ith stable cash flows. The debt finance has an im portant positive role by giving the new owners an even greater incentive to improve efficiency. Because of the severe penalties associated w ith default, it is im p o rta n t to elim inate waste and generate cash flows that are sufficient to service the debt. The gains associated w ith transferring some companies to private ownership prom pt the follow ing question: Should all companies be privately owned? The answer is no. Public companies have the advantage o f access to equity capital on term s th a t reflect the diversification benefits available to investors in the capital market. The value o f such access depends on the grow th opportunities available to the company. Therefore, public ownership has im p o rta n t advantages fo r large-scale enterprises th a t involve significant risks and have an ongoing need to raise capital; in other cases, however, private ownership can be advantageous.14

SWAGGERS G ONE OUT OF THE BUYOUT FUNDS_____________

F in a n c e in

The following excerpts were taken from an article in the Australian Financial /?ev/ew examining the decline in the level of buyout activity. The article notes that buyout funds rely heavily upon access to debt and the consequences of a contraction in debt markets such as that which occurred with the sub-prime mortgage crisis in 2007. Heilman & Friedm an’s C ap ita l Partners IV Fund has generated a 3 6 per cent return for investors since 2 0 0 0 . Kohlberg Kravis Roberts7 M illennium Fund has done even better, notching a 41 per cent take since 2 0 0 2 . But investors in private equity funds w hoV e enjoyed large returns like these during the buyout boom should brace themselves for a fall. Buyout firms relied on cheap debt in the past 2 years to finance the biggest deals of all time, often paying premiums o f more than 3 0 per cent. But as the sub-prime m ortgage meltdown rattles credit markets, firms w ill have to sell their companies to buyers w ho no longer have access to low-cost loans. That w ill cut the sale prices of the companies and slash the buyout funds7 returns, says b illio n a ire financier W ilb u r Ross. "W hen it comes time to resell these investments, w e ll likely be in a very different rate environm ent/ says Ross, whose N e w York-based W L Ross & Co focuses on distressed assets such as vehicle spare-parts makers. 'The im plications for returns could be substantial/ continued

13 For example, in a sample of 57 going-private proposals that involved a cash consideration, the premium averaged 56.31 per cent over the market price 2 months before the announcement. See De Angelo, De Angelo and Rice (1984). 14 Recent evidence on the performance of buyouts is provided by Cohns, Mills and Towery (2014).

A C T IO N

B usiness finance

continued In 2 0 0 5 , b u y - o u t fir m s b e g a n t o s h o w a s w a g g e r r a r e ly s e e n in th e in d u s tr y 's 3 0 - y e a r h is to r y . In th e U S in th e fir s t h a lf o f th is y e a r , m e g a d e a ls f o r T X U C o r p , F irs t D a ta C o r p a n d E q u it y O f f ic e P r o p e r tie s T ru s t— a ll t o p p in g U S $ 2 0 b i lli o n ( $ 2 4 . 5 b i l l i o n ) — w e r e p a r t o f a r e c o r d U S $ 6 1 6 b illio n in a n n o u n c e d p u r c h a s e s . T h a t ’s ju s t s h y o f 2 0 0 6 ’s r e c o r d to ta l o f U S $ 7 0 1 . 5 b i lli o n , B lo o m b e r g d a t a s h o w s . C h e a p c r e d it fu e lle d th e fr e n z y . T h e e x t r a in te r e s t in v e s to r s d e m a n d e d t o o w n h ig h - y ie ld h ig h - r is k d e b t r a t h e r th a n U S T re a s u r ie s fe ll to 2 .4 1

p e r c e n t a g e p o in ts in J u n e , th e lo w e s t o n r e c o r d . T h e r a te s e n a b le d b u y o u t f ir m s , w h ic h

u s e c r e d it to f in a n c e a b o u t t w o - t h ir d s o f a c o m p a n y ’s p u r c h a s e p r ic e , to r a t c h e t u p t h e ir b id s . P re m iu m s f o r U S c o m p a n ie s , o r th e p e r c e n t a g e o f f e r e d a b o v e th e t a r g e t 's s to c k p r ic e , s o a r e d to 3 9 p e r c e n t in J u n e c o m p a r e d w it h 2 3 p e r c e n t a y e a r e a r lie r . G a v in M a c D o n a ld , M o r g a n S ta n le y 's h e a d o f E u r o p e a n m e r g e r s a n d a c q u is it io n s , s a id in A p r i l a U S $ 1 0 0 b illio n le v e r a g e d b u y o u t w a s p o s s ib le . B u t b y J u ly th e a p p e t it e f o r d e a ls , e s p e c ia lly r e c o r d - b r e a k in g o n e s , h a d e v a p o r a t e d . In v e s to rs , s u r p r is e d b y t h e ir le v e l o f e x p o s u r e to th e s u b - p r im e d e b a c le , s a w g r e a t e r r is k in th e a b o u t U S $ 3 3 0 b illio n o f lo a n s a n d b o n d s t h a t b a n k s h a d s la te d to fu n d le v e r a g e d b u y o u ts . In v e s to rs b a lk e d a t c r e d it te rm s t h a t a l lo w e d c o m p a n ie s to r e p a y d e b t b y is s u in g m o r e b o n d s . L e n d e rs h a d to r e w o r k o r c a n c e l a t le a s t 4 5 lo a n a n d b o n d o f f e r in g s s in c e th e b e g in n in g o f Ju ly , in c lu d in g d e b t to p a y f o r C e r b e r u s C a p it a l M a n a g e m e n t ’s a c q u is it io n o f C h r y s le r . B u y o u t fir m s a n d s e lle rs a r e a ls o r e n e g o t ia t in g d e a ls to g e t f in a n c in g a n d k e e p th e m a l i v e . 〇n A u g u s t 2 6 , H o m e D e p o t, th e w o r ld 's b ig g e s t h o m e - im p r o v e m e n t r e ta ile r , a g r e e d t o s e ll its c o n s t r u c t io n s u p p ly u n it B a in C a p it a l, C la y t o n D u b ilie r & R ic e a n d C a r ly le G r o u p f o r U S $ 8 . 5 b illio n . T h a t's 1 8 p e r c e n t le ss th a n th e p r ic e n e g o t ia t e d in J u n e , H o m e D e p o t s a id th is w e e k . M a n y o t h e r d e a ls a r e n 't g e t t in g d o n e . T h e v a lu e o f a n n o u n c e d b u y o u ts d r o p p e d to U S $ 1 8 b i lli o n f r o m A u g u s t 1 t o 2 6 . T h a t c o m p a r e s w it h U S $ 8 7 . 4 b illio n la s t m o n th a n d U S $ 1 3 1 . 1

b i lli o n in J u n e , B lo o m b e r g

d a ta s h o w s . P r iv a te e q u it y fir m s w i ll a ls o s t r u g g le to s e ll t h e ir h o ld in g s to c o r p o r a t io n s a n d o t h e r fu n d m a n a g e r s a t h ig h p r ic e s . In 2 0 0 5 , H e ilm a n & F r ie d m a n p a id U S $ 1 .1 b i lli o n f o r in te r n e t a d v e r t is in g c o m p a n y D o u b le c l ic k a n d , le ss th a n 2 y e a r s la te r, a g r e e d to s e ll it t o G o o g le f o r U S $ 3 .1 b illio n . T h e s e la r g e p a y - o ffs w i l l b e m u c h h a r d e r to g e t in c o m in g y e a r s a s th e c o s t o f c r e d it ris e s , s a y s S c o tt S p e r lin g , c o - p r e s id e n t o f b u y o u t f ir m T h o m a s H L e e P a rtn e rs in B o s to n .

Source: 'Swagger's gone out o f the buy-out funds', Jason Kelly, Australian Financial Review, 31 August 2 0 0 7 , p. 40.

19.8 Empirical evidence on takeovers LEARNING OBJECTIVE 7

Outline the main findings of empirical research on the effects of takeovers on shareholders, wealth

There has been considerable empirical research in to takeovers. For example, many studies have evaluated the wealth effects o f takeovers on shareholders o f the acquiring and target companies. These studies use share price changes around the tim e o f the firs t public announcement o f a takeover to measure these wealth effects. Abnorm al returns on shares in both acquiring and target companies around the tim e o f the takeover announcement are measured by the difference between actual and expected returns. The expected returns take account o f the influence o f m arket-wide events on the returns fro m an individual company s shares. A p art from market-wide events, the only factor assumed to be common to all companies in the studies is th e ir involvem ent in takeover negotiations. Therefore, the abnormal returns are a measure o f the wealth effects o f the takeover.15 In discussing the evidence, we make substantial use o f a paper by Andrade, M itche ll and Stafford (2001), w hich examined US mergers from 1973 to 1998, and a paper by Brown and da Silva Rosa (1997), who evaluated takeovers in Australia during the period January 1974 to November 1995.

15 This event study* methodology is commonly employed in tests of the efficient market hypothesis and is outlined in Chapter 16.

C hapter nineteen A

One result th a t stands out in all market-based studies is th a t target company shareholders earn significant positive abnormal returns. For example, Brown and Da Silva Rosa (1997) found an average abnormal return o f 25.5 per cent over the 7-m onth period around the takeover announcement. For the 1528 target companies in th e ir sample, the to ta l increase in shareholders1 wealth was approximately $15 billion. These results probably understate the to ta l wealth effects o f takeovers fo r target shareholders. Casey, Dodd and Dolan (1987) reported substantial abnormal returns on target company shares around the tim e th a t significant shareholding notices were filed. For th e ir sample, this occurred on average 127 days before the announcement o f a takeover bid. Significant gains to target shareholders are to be expected because the acquiring company m ust offer more than the previous m arket price o f the shares. The current shareholders are, by defin itio n, parties who prefer to hold rather than sell the shares at the previous m arket price. Several studies report th at, on average, the shares in target companies perform ed poorly before the takeover bid. Brown and Da Silva Rosa found evidence o f very poor pre-bid performance by target companies. For th e ir sample o f 1371 targets, the average abnormal retu rn over the period from m onths -3 6 to - 6 relative to the bid was -23 .3 per cent. This is consistent w ith the concept th a t takeovers transfer control o f assets to companies w ith more efficient managers or more profitable uses fo r those assets. The in itia l increase in wealth o f the target company s shareholders appears to be m aintained, even where the takeover bid is unsuccessful. This could be because the bid prom pted a change in the target company s investm ent strategy, which is expected to improve performance, or because inform a tion released during the b id caused the m arket to revalue the shares. A nother explanation is th a t the m arket may expect a fu rth e r bid fo r the target company. Research by Bradley, Desai and Kim (1983) is consistent w ith the last explanation. They found th a t many companies th a t were the subject o f an in itia l unsuccessful takeover bid received a subsequent successful bid w ith in 5 years o f the first. These subsequent bids resulted in fu rth e r positive abnormal returns fo r target shareholders. Where no subsequent bid eventuated, the shares o f the unsuccessful targets declined, on average, to th e ir (market-adjusted) pre-bid level. Based on this evidence, i t appears th a t the gains associated w ith takeover bids are perm anent only where a change in control occurs— th a t is, the results do n o t support the suggestion th a t gains to target shareholders result from the m arkets reassessment o f previously undervalued shares. W hile it seems obvious th a t the higher the price offered by an acquirer the more likely i t is th a t the target shareholders w ill accept the bid, a more recent paper has considered the importance o f the price offered relative to the recent h isto ry o f the share price o f the target company. Baker, Pan and W urgler (2012) analysed over 7000 takeover bids in the US and demonstrated th a t an inordinate num ber o f bid prices are set at a recent peak in the share price. For example, they show th a t the m ost common offer price set by acquirers exactly matched the highest price th a t the target company s shares had reached over the 52 weeks before the announcement o f the takeover b id.16 Furtherm ore, they show th a t the likelihood o f the bid being accepted jumps abnorm ally when the offer price exceeds a peak price. The authors interpret these results as being consistent w ith the psychological phenomenon know n as anchoring1, in th a t target shareholders anchor th e ir required compensation at recent share price peaks.

On average, the shareholders o f acquiring companies earn positive abnormal returns in the years before the takeover b id is made. Brown and Da Silva Rosa (1997) found th a t average abnormal returns accumulated to almost 32 per cent over the period from -3 6 to -6 m onths before the bid. This suggests that takeover bids are typically made by companies th a t have been doing well, and have demonstrated an a bility to manage assets and growth. In the 7-m onth period around the announcement o f the bid, the average abnormal return fo r successful bidders was 5.0 per cent. W hile Australian studies fin d positive abnormal returns to bidders over a 7-m onth period, other studies th a t have measured returns over shorter periods surrounding the announcement o f takeover bids have found th a t the average abnormal retu rn to shareholders o f bidding companies is close to zero, and negative in some cases. Moreover, announcement 16 To ensure that their sample of prices is not affected by the bid itself, Baker, Pan and Wurgler (2012) measure the 52-week high over the 52 weeks ending 30 days prior to the announcement of the bid.

nalysis o f takeovers

B usiness finance

o f a takeover bid is associated w ith a share price decline in a significant p ro po rtio n o f individual cases.17 Jarrell and Poulsen (1989) identified three general explanations th a t have been offered fo r the negligible wealth effects fo r acquiring company shareholders. These explanations are: a

takeovers are profitable, b u t the wealth effects are disguised com petition depresses returns to acquirer C takeovers are neutral or poor investments. b

The rationale fo r each o f these explanations is now discussed.

The wealth effects of takeovers are disguised Essentially, this explanation suggests th a t takeovers are profitable b u t the announcement o f an individual takeover has little effect on the acquiring company s share price. One reason is th a t acquiring companies are typically much larger than th e ir targets, so w hile there may be a w orthw hile dollar gain to shareholders, the gain is small relative to the to ta l value o f the acquiring company. A second reason is th a t many companies have a known strategy o f grow th by acquisition. Therefore, the expected gains from th is strategy may already be reflected in the companies’ share prices, and the announcement o f a particular bid conveys little new inform a tion to the m arket.18 Third, announcement effects th a t are small o r negative may also reflect m arket reaction to the financing o f the takeover. In particular, a shareexchange offer may signal th a t the management o f the acquiring company considers th a t its shares are overvalued. Therefore, the takeover its e lf may have a positive announcement effect, b u t this can be offset by the effects o f the inform a tion related to the financing o f the takeover.19

Com petition depresses returns to acquirers The returns to successful bidders are likely to be lower if a takeover is resisted by target management or contested by m ultiple bidders. There is evidence th a t abnormal returns to target shareholders are higher when there are m ultiple bidders, in which case gains to acquiring company shareholders are insignificantly different from zero. However, when there is only one bidder, acquiring company shareholders earn significant positive returns. The degree o f com petition in takeovers could be influenced by changes in government regulation, development o f innovative financing techniques and the use o f defensive strategies by target companies. Therefore, the returns to acquirers may have changed over time.

Takeovers are neutral or poor investments This explanation is th a t many takeovers are bad investments and the small or negative returns to acquiring company shareholders correctly reflect this situation. One advocate o f th is explanation is Roll (1986), who argued th a t many managers o f acquiring companies are affected by hubris*. In other words, they are supremely confident th a t th e ir a bility to value other companies is better than th a t o f the market. Consequently, they are likely to pay more fo r target company shares than they are w orth, and Roll argued th a t the large returns to target company shareholders represent wealth transfers from the shareholders o f acquiring companies. A recent study by Levi, Li and Zhang (in press) considered the issue o f overconfidence and how the gender m ix on a company s board o f directors may have an impact on shareholder wealth. They report th a t companies w ith female directors are less likely to undertake acquisitions and, where they do, they tend to pay lower control premiums. The authors interpret this result as indicating th a t female directors are inherently less overconfident than th e ir male counterparts and th a t this can help create shareholder value. There is also evidence th a t m any acquired companies are later divested, which may indicate th a t the original takeover turned o ut to be a failure.20 To assess the va lid ity o f these explanations, Jarrell and Poulsen (1989) examined the returns to acquiring company shareholders in a large sample o f successful tender offers over the period 1963 to 1986. They found th a t returns to acquirers were positively related to the size o f the target relative to the 17 For example, Dodd (1992, p. 515) notes that results reported in two US studies show that in more than 40 per cent of cases, the bidding company s share price fell when a takeover bid was announced. 18 For evidence on the prior capitalisation of takeover gains, see Schipper and Thompson (1983). 19 For Australian evidence on the effects of the method of payment in takeovers see Da Silva Rosa et al. (2000), while Bugeja and Da Silva Rosa (2008) demonstrate how the tax position of the target shareholder affects the method of payment decision. 20 However, it has been reported that divestiture of previously acquired companies often yields profits for the selling company. Therefore, subsequent divestiture does not necessarily mean that the original acquisition was a failure. See Kaplan and Weisbach (1992).

4^^

C hapter nineteen A

bidder, which is consistent w ith the explanation th a t returns to acquirers can be disguised when target companies are small. They also found th a t returns to acquirers were smaller when the bid was opposed by target management, and were lower after changes in regulation th a t favoured competing bidders. In summary, th e ir results support the firs t two explanations, b u t they also note th a t some other studies have found evidence th a t supports the argument th a t takeovers are poor investm ents.21

1 9 .8 .3 1 Are takeovers poor investments? While there is conclusive evidence th a t target company shareholders gain significantly from takeovers, the evidence on returns to acquiring company shareholders is much less conclusive. Consequently, whether takeovers generate net gains fo r shareholders has been a contentious issue. Bradley, Desai and Kim (1988) studied this issue by examining the returns to shareholders o f matched pairs o f target and acquiring companies in successful tender offers over the period 1963 to 1984. They found an average gain o f $117 m illio n , or 7.4 per cent, in the combined wealth o f shareholders. The total percentage gain remained remarkably constant over tim e and by far the larger share o f the gain w ent to the target shareholders, although the division o f the gain shifted against the acquiring company shareholders over time. In general, th e ir results support the hypothesis th a t takeovers yield real, synergistic gains and do n ot support Rolls wealth transfer* hypothesis. Announcement period abnormal returns fo r a much larger sample o f US mergers and takeovers are shown in Table 19.3.

TABLE 19.3 Announcement period abnormal returns US mergers P e rio d

1 9 7 3 -7 9

(%) by decade for

1 9 8 0 -8 9

1 9 9 0 -9 8

1 9 7 3 -9 8

Target [-1 ，+1]

16.0(a)

16.0(a)

15.9

16.0(fl)

[-20, Close]

24.8(°)

23.9(a)

23.3(fl)

23.8

[-1, + i]

-0.3

-0.4

-1.0

-0.7

[-20, Close]

-4.5

-3.1

-3.9

-3.8

Acquirer

Combined [-1, +1]

1.5

2.6(fl)

1.4(fl)

1.8(fl)

[-20, Close]

0.1

3.2

1.6

1.9

598.0

1226.0

1864.0

3688.0

Number of observations Statistically significant at the 5 per cent level.

Source: G. Andrade, M . M itchell and E. Stafford, 'N e w evidence and perspectives on mergers', Journal of Economic Perspectives, Spring 2001; p. 110.

Table 19.3 shows announcement period abnormal returns over tw o event windows— the 3 days immediately surrounding the takeover announcement, and a longer window beginning 20 days before the announcement and ending at the close o f the takeover. As usual, these results show th a t target company shareholders are clear winners in takeovers, w ith abnormal returns over the 3-day event w indow being remarkably consistent at 16 per cent over the whole period. The abnormal returns over the 3-day event window, fo r the target and acquirer combined, average 1.8 per cent fo r the whole sample. This result is statistically significant and suggests that, on average, takeovers do increase shareholders* wealth. The results fo r acquirers suggest that, on average, 21 For example, there is evidence that some types of takeover harm the shareholders of acquiring companies. See Mitchell and Lehn (1990). This evidence is discussed in Section 19.8.4.

nalysis o f takeovers

A

B usiness finance

takeovers may well be poor investments fo r shareholders o f the acquiring company. However, while all the estimates are negative, none is statistically significant. Therefore, while i t is clear th a t acquiring company shareholders are n o t big winners, i t is also d iffic u lt to claim th a t they are generally losers. More info rm a tio n on the wealth effects o f takeovers can be obtained by also considering the m ethod o f paym ent— or the financing o f the transaction. Table 19.4 shows average announcement period returns when the sample studied by Andrade, M itche ll and Stafford (2001) is s p lit in to subsamples on the basis o f w hether any shares were used to finance the takeover. The results in Table 19.4 show th a t announcement period abnormal returns fo r acquirers are negative only when the acquirer uses shares to finance the transaction. When the payment to target shareholders includes at least a share component, the 3-day average abnormal retu rn to acquirers is a statistically significant -1.5 per cent.

TABLE 19.4 Announcement period abnormal returns (%) for subsamples 1973-98 F o rm o f p a y m e n t

S h a re s

N o sh a re s

Target [-1, + i]

13.0(fl)

20.1(«)

[-20, Close]

20.8(fl)

27.8(〇)

[-1, + i]

-1.5(a)

0.4

[-20, Close]

-6.3

Acquirer

-0.2

Combined [-1, +1] [-20, Close] Number o f observations

0.6

3.6(a)

-0.6

5.3

2194.0

1494.0

Statistically significant at the 5 per cent level.

Source: G . Andrade, M . M itchell and E. Stafford, 'N e w evidence and perspectives on mergers7, Journal o f Economic Perspectives, Spring 2 0 0 1 , p. 112.

W hen the payment does n o t include any shares, the average abnormal retu rn is an insignificant 0.4 per cent. For the acquiring company a share-exchange takeover can be regarded as tw o simultaneous transactions: acquisition o f another company and a share issue. As discussed in Chapter 13 there is evidence that, on average, share issues are associated w ith negative abnormal returns o f about -1.5 to - 3 per cent around the tim e o f the announcement. Explanations fo r this fin d in g focus on differences between the inform a tion available to managers and outside investors. I f managers are more likely to issue equity when they believe the company s shares are overpriced, investors w ill respond to an issue announcement by m arking down the share price. Even i f this explanation is n o t accepted, the evidence suggests th a t when assessing the wealth effects o f takeovers fo r shareholders i t is im p o rta n t to distinguish between share and non-share takeovers. The results in Table 19.4 show th a t target shareholders also receive higher returns when payment fo r the takeover does n ot include shares. Therefore, it is n o t surprising th a t differences in financing are also related to differences in the overall wealth effects o f takeovers. As shown in Table 19.4, the combined average abnorm al returns fo r share-financed takeovers are indistinguishable from zero, b u t fo r non-share takeovers the corresponding result is 3.6 per cent. In summary, the evidence on announcement-period share m arket returns suggests that, in general, takeovers create value fo r the shareholders o f the combined companies. However, in cases where target shareholders are paid w ith the acquirers shares, the gains to target shareholders are offset by losses fo r

C hapter nineteen A

the acquirer and the combined wealth effects are negligible. In Australia, by way o f contrast, there is only weak support fo r the view th a t differences in the financing o f takeovers are related to the overall wealth effects o f takeovers. In a study o f 240 takeover bids between 1988 and 1996, Da Silva Rosa et al. (2000) found th a t abnormal returns earned by bidders and targets over the bid announcement period were n ot significantly associated w ith the proposed m ethod o f financing the takeover. More recently, in the US Betton, Eckbo and Thorburn (2010) report evidence th a t suggests th a t rather than the m ethod o f payment being the key driver o f bidding shareholder returns, it may instead be the size o f the bidder and the status o f the target company th a t is im p orta nt. Specifically, they report th a t bidding company returns tend to be negative when the bidding company is very large and when the bid is fo r a publicly listed target rather than one th a t is privately owned, irrespective o f the m ethod o f payment. In contrast, they report th a t shareholders o f bidding companies th a t are small and th a t are bidding fo r non-listed targets tend to earn significantly positive returns and th a t these returns are actually higher when it is a share-financed bid. Sim ilar results have also recentiy been reported fo r the Australian m arket by Shams, Gunasekarage and Colombage (2013).

Long-term abnorm al returns In an efficient m arket, announcement-period share price reactions should be unbiased responses to all the inform ation contained in the announcement o f a takeover. However, several studies th a t measure long­ term share returns over periods o f up to 5 years after com pletion o f a takeover cast doubt on whether announcement-period returns do provide adequate measures o f the wealth effects o f takeovers. For example, Loughran and V ijh (1997) examined 947 acquisitions over the period 1970 to 1989 and tracked the returns on the shares o f the acquiring company fo r 5 years after completion o f the acquisition. They found th a t these 5-year abnormal returns differed significantly w ith the fo rm o f payment. Acquirers that issued shares as payment had average abnormal returns o f -24 .2 per cent, whereas those th a t paid cash recorded abnormal returns o f 18.5 per cent. In some subsamples where they also distinguished between takeovers and tender offers, the retu rn differences were even greater. I f the long-term post­ takeover abnormal returns to acquirers are negative, these returns could outweigh the gains earned by shareholders in the announcement period and the net wealth effect o f takeovers could be negative. For example, Loughran and V ijh found th a t target shareholders who held on to the acquirer s shares received as payment in share-exchange takeovers did n o t earn significant abnormal returns. It is n o t d ifficu lt to find possible reasons fo r a relationship between the fo rm o f payment and the p ro fita b ility o f acquisitions. Shares are usually issued as payment in mergers th a t are friendly deals supported by managers o f the target. Cash is usually paid in tender offers th a t are more likely to be hostile and are followed by high turnover o f target management as the acquirer seeks to realise efficiency gains. W hile there may be large differences in the gains associated w ith different types o f acquisitions, i f the m arket is efficient it should n o t take years fo r the effects to be reflected in share prices. However, m arket inefficiency is n o t the only possible explanation fo r the inconsistency between long-term abnormal returns and the announcement-period returns. A nother explanation lies in the accuracy o f the models used to estimate expected returns. Over a 3-day event w indow the expected re tu rn is close to zero, so it is easy to determ ine th a t announcement-period returns o f about 2 per cent or even less are abnormal. However, as the retu rn w indow becomes longer, the model o f expected returns becomes much more im portant, and measures o f long-term performance can also be sensitive to bias inherent in some research designs. Brown and Da Silva Rosa assessed the long-run performance o f acquiring companies in the Australian m arket and found th a t i t is im p o rta n t to control fo r factors such as company size and survival. Survival is im p o rta n t because the average returns to companies th a t survive over a given period differ from those recorded by newly listed companies and by companies th a t delist due to takeover, merger or bankruptcy. Brown and Da Silva Rosa (1998, p. 36) found th a t when appropriate controls were used, the post-bid performance o f acquiring companies did n ot differ significantly from the performance o f control companies. They concluded:
nalysis o f takeovers

B usiness finance

Several studies provide evidence on the characteristics o f takeovers th a t are likely to harm rather than benefit the shareholders o f acquiring companies. There are at least three reasons w hy the managers o f acquiring companies m ig ht pay more than targets are w orth. a b

C

Rolls hubris hypothesis suggests th a t managers pay too much fo r target companies because they overestimate th e ir a b ility to run them. Managers may pursue th e ir own objectives rather than those o f th e ir companies, shareholders. In particular, as discussed in Section 19.2.1, Jensen (1986) argued th a t value-reducing takeovers w ill be common when the acquiring company has significant free cash flow th a t gives management the a b ility to finance unprofitable investments. He also argues th a t m any takeovers are designed to reverse previous unprofitable takeovers. In other words, many companies th a t have made unprofitable takeovers w ill, themselves, become targets in takeovers designed to reverse the original value reduction. Therefore, while takeovers can be a ‘problem ’, they can also provide a ‘solution’. Some managers may make unprofitable takeovers sim ply because they are poor managers, possibly seeking other fields in which they hope to p erform better. Some o f the many US studies th a t provide relevant empirical evidence are now outlined.

Lang, Stulz and W alkling (1989) studied successful tender offers and classified the acquiring and target companies using Tobins Q ratio, which is the ratio o f a company s market value to the replacement cost o f its assets. The Q ratio was used as a measure o f managerial performance on the basis th a t well-managed companies th a t make profitable investments should have Q ratios greater than 1, w hile poorly managed companies are likely to have Q ratios less than 1. The authors found significant relationships between Q ratios and the p ro fita b ility o f takeovers to acquiring company shareholders. Takeovers th a t involved a high-Q acquirer and a low -Q target produced gains o f approximately 10 per cent fo r shareholders, b ut when a low -Q acquirer announced a bid fo r a high-Q target, acquiring company shareholders lost approximately 4 per cent on average.22 M itche ll and Lehn (1990) tested whether some takeovers are designed to change the control o f companies th a t had previously made value-reducing acquisitions. Two groups o f companies th a t had made takeover bids were identified: (a) those subject to a later takeover bid w ith in the study period (‘targets’), and (b) those n o t subject to a bid w ith in th a t period (non-targets*). Takeover announcements by the ‘targets’ were associated w ith significant losses fo r shareholders, while those by the ‘non-targets’ were associated w ith significant gains. Many o f the o riginal acquisitions were later reversed, either by voluntary divestiture or by a hostile
The evidence seems clear th a t a ctivity in the m arket fo r corporate control has a positive effect on wealth. For example, Brown and Da Silva Rosa estimated th a t the bids fo r 1528 targets covered by th e ir study created value o f $15 b illio n fo r the shareholders o f target companies. 22 The results reported by Lang, Stulz and Walkling (1989) for tender offers have also been supported for takeovers, and are not an artefact of the characteristics of the bid itself, such as the method of payment. See Servaes (1991).

■ R NINETEEN A NALYSIS OF TAKEOVERS

The evidence discussed above was obtained from market-based studies— th a t is, studies th a t used share prices to measure the effects o f takeovers. Some researchers have preferred to use accounting data to assess the effects o f takeovers on company perform ance by exam ining measures o f p ro fita b ility, risk and growth. For example, McDougall and Round (1986) used th is approach to study Australian takeovers. In common w ith other sim ilar studies, they were unable to fin d any evidence o f benefits such as improved p ro fita b ility or reduction o f risk. In fact, they concluded th a t a strategy o f corporate acquisition resulted in a deterioration in the performance o f the m erging firm s relative b oth to th e ir pre-takeover experience, and also compared w ith the experience o f the m atching non-m erging firm s, measured in accounting terms* (p. 182). Australian studies o f takeover a c tivity in the petroleum ind ustry (Hyde 2002), the banking sector (Avkiran 1999) and between credit unions (Ralston, W rig h t & Garden 2001) reaffirm the fin d in g th a t there is little evidence th a t performance o f the merged entity, measured using accounting data, improves in the post-acquisition period. The accounting-based results are clearly inconsistent w ith those o f the more popular market-based studies. This suggests th a t at least one o f the tw o approaches is unreliable. Bishop, Dodd and O fficer (1987, pp. 3 3 -4) argued th a t there are serious problems in using accounting data to assess the effects o f takeovers. For example, the benefits o f a takeover may take years to be fu lly reflected in earnings and are likely to show up at d ifferent times fo r different companies. Therefore, the effects may be d iffic u lt to detect. Further, p ro fita b ility ratios are likely to be biased, owing to revaluation o f the target company s assets and w rite -o ff o f takeover-related goodwill. Market-based studies are also subject to p otential measurement problems. Share price changes around the tim e a takeover is announced w ill show how investors expected the takeover to w ork out, but the expected effects may n o t eventuate. These studies m ust also rely on some model o f the norm al returns on shares to estimate the abnormal returns related to takeovers. Simmonds (2004) demonstrates that returns to the shares o f bidding companies may be biased downwards when a risk-adjusted model o f expected returns is used. To overcome this, Simmonds suggests th a t substituting the actual retu rn from the m arket as a proxy fo r expected retu rn fo r the bidding company's shares w ill yield more reliable results. In summary, while the market-based approach is generally preferred, i t is n o t infallible and i t would be desirable to show th a t the results o f market-based studies can be supported by other independent evidence. This approach was adopted by Healy, Palepu and Ruback (1992), who used b o th accounting data and share price data to examine the effects o f the 50 largest mergers in the US between 1979 and m id-1984. To m inim ise the problem s involved in using accounting data, they focused on estimates o f operating cash flows before interest and tax, rath er th an on accounting p ro fit, w hich could be influenced b o th by the m ethod o f accounting fo r the takeover and by the financing o f the takeover. Healy, Palepu and Ruback fo un d th a t a fte r the takeovers, perform ance d id im prove significantly, on average, relative to the perform ance o f o th e r companies in the same industries. The im provem ent was greatest in takeovers th a t involved overlapping businesses. Also, they found a strong positive relationship between th e ir estimates o f takeover-related changes in operating cash flows and share price changes o f the companies involved in the takeover at the tim e th a t takeovers were announced. In summary, they provided fu rth e r evidence th a t takeovers do result in im proved perform ance and they showed th a t, when im plem ented carefully, the accounting-based and market-based approaches can yield consistent results.

Market-based studies are useful in documenting the magnitude o f takeover-related wealth changes fo r shareholders, b u t they provide no inform a tion about the source o f the wealth changes. Some critics have suggested th a t the wealth increases received by shareholders do n ot represent real economic gains but instead are the result o f various redistributive effects. One such hypothesis is based on alleged m arket myopia. According to this hypothesis, investors are said to be preoccupied w ith short-term earnings performance and w ill undervalue companies th a t undertake long-term developments, m aking them prim e targets fo r takeover. O ther redistributive hypotheses are based on suggestions th a t takeovers transfer wealth from debtholders to shareholders, or impose losses on employees o f the target company. In addition, there are those hypotheses discussed earlier in the chapter: target undervaluation due to m arket inefficiency, tax benefits and m onopoly power.

Em pirical evidence soundly rejects the ‘undervaluation’ hypothesis and the ‘m arket myopia’ hypothesis. Tax benefits do appear to have at least a m in o r role in m otivating takeover activity, b ut the evidence is inconsistent w ith shareholder gains being transferred from debtholders or employees (Jarrell, Brickley & N etter 1988, p. 58). This is n o t to suggest th a t there are no losers in the m arket fo r corporate control: managers o f target companies are obvious losers in some, possibly many, cases, b ut there is no evidence o f systematic losses th a t could offset the large gains to shareholders. Having firs t identified improvements in post-merger cash flow performance, Healy, Palepu and Ruback (1992) proceeded to explore the sources o f the changes in cash flow. The changes could have arisen from a variety o f sources, including higher operating margins, greater asset pro du ctivity or lower labour costs. The changes m ig ht also have been achieved by cu tting outiays on capital investm ent and research and development (R & D). They found th a t the higher post-merger cash flows were due p rim a rily to increased asset p ro d u ctivity and there was some evidence o f lower labour costs. They found no significant changes in capital outlays or in R & D expenditures. Therefore, the improved cash flows were n o t due to focusing on short-term performance at the expense o f long-term viability. Fee and Thomas (2004) go fu rth e r by exam ining the financial statements n o t only o f the acquiring company b u t also o f the suppliers and customers o f the company. They fin d little evidence to suggest th a t the gains to acquiring companies are due to th e ir being able to exert m onopolistic power and charge customers more. Instead, they report th a t the gains to acquiring companies are largely linked to increased buying power th a t results in getting better deals from suppliers. A fte r surveying the vast body o f Australian evidence, Da Silva Rosa and W alter (2004) drew the follow ing conclusions: a

Takeovers are in itia te d by companies th a t are high perform ers and are seeking to continue to perform well. b Target shareholders enjoy significant gains when th e ir company is subject to a takeover bid, b ut these gains tend to dissipate where the b id is unsuccessful and no follow -up b id is launched. C Shares in acquiring companies tend to underperform in the m arket follow ing acquisition. This is at least p a rtly due to the relatively high costs incurred by acquirers as a consequence o f the Australian regulatory environm ent in the m arket fo r corporate control.23 d Following acquisition, the analysis o f the long-run performance o f combined entities indicates th a t the anticipated benefits from the acquisition often fa il to materialise. However, Da Silva Rosa and W alter note th a t the methodological problems associated w ith studies o f this type mean th a t it is very d iffic u lt to reach any strong conclusions about the long-run performance o f successful bidding companies.

23

F o r e x a m p le , D a S ilv a R o s a a n d W a lte r ( 2 0 0 4 ) a r g u e t h a t th e b i d d e r s m a r k e t v a lu e is r e d u c e d b y th e r e q u ir e m e n t t h a t th e y s t a n d in th e m a r k e t fo r a 1 - m o n th p e r io d c o m m e n c in g 1 4 d a y s a f t e r th e ta k e o v e r a n n o u n c e m e n t b e c a u s e th e y a r e g iv in g a w a y a p o t e n t ia lly v e r y v a lu a b le p u t o p t io n t o t a r g e t s h a r e h o ld e r s .

C hapter nineteen A

nalysis o f takeovers

•

Takeovers are an important part of the market for corporate control in which alternative management teams compete for the right to manage corporate assets. The takeover of one company by another is an indirect investment in real assets and, like any other investment, should proceed only if it has a positive NPV. • Takeovers occur frequently in Australia, and the level of takeover activity varies considerably over time. The reasons for this variation are not fully understood, but there is evidence that industry shocks, such as deregulation, play an important role. • There are three main types of takeover (horizontal, vertical and conglomerate) and many different reasons why takeovers occur. • Combining two companies can create value by transferring control of assets to managers who can use or deploy those assets more efficiently. • Other sources of value gains (synergistic benefits) from takeovers include replacing inefficient management, economies of scale, cost savings through vertical integration, and complementarity between the skills and expertise of the two entities. • Suggested reasons for takeovers that are of dubious validity include diversification benefits and effects on earnings per share. • Economic evaluation of proposed takeovers should focus on identifying and quantifying the benefits of the takeover and comparing those benefits with the associated costs. This leads to valuing the target company using an incremental approach—that is, a listed target would be valued by taking the market price as a starting point and adding to it the present value of the incremental net cash flows expected to result from the takeover. This present value represents the gain from the takeover. The NPV to the acquiring company is the gain minus the net cost of acquiring the target, where the net cost is the premium paid over and above the target's value as an independent entity • There is a fundamental difference between cash and share-exchange takeover offers. In a cash offer, the net cost is simply the difference between the cash

paid and the value of the target as an independent entity. However, in the case of a share-exchange offer, the net cost depends on the share price of the acquiring company after the takeover offer has been announced. • Takeovers are regulated by legislation thatemphasises equity between shareholders of the target company and requires disclosure of information by bidders. • With very limited exceptions, an investor may not acquire more than 20 per cent of a company’s shares unless the investor makes a takeover bid for the company by way of either an off-market bid or a market bid. • In the case of a partial takeover, the bidder must specify, at the outset, the proportion of each holder’s shares that the bidder will offer to buy. • The market for corporate control also includes transactions in which companies or groups are reduced in size by asset disposals ('divestitures’), divided into separate entities (/spin-offs,) or transferred to private ownership ('buyouts'). These corporate restructuring transactions are associated with increases in value that can be significant. In some cases, the explanations for the gain may be similar to those for takeover gains. In other cases, the explanation rests on factors such as lower agency costs and effects on managerial incentives. • There is ample empirical evidence that takeovers provide substantial benefits for the shareholders of target companies. The evidence on benefits to the shareholders of acquiring companies is less conclusive. Abnormal returns on acquiring company shares around the time of takeover bids are much smaller in percentage terms than those on target company shares. • W hile takeovers generate net benefits for shareholders on average, there is evidence that some types of takeover consistently harm the shareholders of acquiring companies. Such takeovers may serve the objectives of managers and are a /problem, for investors, but the market for corporate control can also provide a 'solution7 in that many unprofitable takeovers are later reversed.

KEY TERMS buyout (or going-private) transaction conglomerate takeover 608 corporate raiders 609 divestiture (or sell-off) 627 horizontal takeover 607 leveraged buyout 627 management buyout 627 partial takeover 622

628

poison pill 625 proportional bid 622 spin-off 627 synergy 608 takeover 606 target company 606 vertical takeover 608

CHAPTER NINETEEN REVIEW

SUMMARY

SELF-TEST PROBLEMS 1 Alpha Ltd is considering the acquisition of Beta Ltd. Both companies are wholly equity financed and each has 2 million shares on issue. The annual net cash flows of Alpha and Beta are $1 million and $500000, respectively, and these cash flows are expected to remain constant in perpetuity. Alpha shareholders require a rate of return of 20 per cent per annum, but Beta's operations are of higher risk and its shareholders require a 25 per cent per annum rate of return. After the takeover, Beta's net cash flow is expected to increase to $7 5 0 0 0 0 per annum in perpetuity with no change in risk. a) Calculate the price per share at which Beta represents a zero net present value investment to Alpha. b) Calculate the value of Beta as an independent entity. c) Alpha offers $2.6 million cash for 100 per cent of Beta. Calculate the effect of the takeover on the wealth of each company's shareholders. 2

Bako Ltd (B) has completed an exhaustive evaluation preparatory to the proposed acquisition of 50 per cent of the shares of Cullen Ltd (C). On the basis of this evaluation, B7s management has estimated that the value of B's equity will increase from $320 million to $380 million as a result of the partial takeover. The pre-takeover number of shares in the two companies is 80 million in B and 20 million in C. Bys management is now considering whether to proceed with the takeover by making one of the following bids: a) a cash offer for C’s shares of $5 per share (C's shares are currently selling for $4) b) a share offer of 3 shares in B for every 2 shares in C. Should B proceed with the takeover in either case?

Solutions to self-test problems ore available in Appendix B.

QUESTIONS 1

[LO 1] Explain the following terms:

a) market for corporate control b) synergy c) disciplinary takeover d) takeover waves e) coinsurance effect f)

free cash flow

g) bootstrapping h) off-market bid i)

market bid

j)

proportional bid

k) white knight l)

golden parachute

m) spin-off n) leveraged buyout o) hubris p) corporate raider. 2

[LO 1] Duck Ltd, a conglomerate, has a market capitalisation of $400 million. The management of Drake Ltd believes that it can acquire Duck for $500 million and sell its divisions separately for a total of about $800 million. Outline possible reasons for the difference between these values.

3

[ID ]] Takeovers are important because they provide the only w ay to exploit synergies and ensure that managers o f corporations act in the interests o f shareholders. Comment on this statement.

C hapter nineteen A

nalysis o f takeovers

[LO 1] Takeover activity tends to vary significantly over time. Outline the factors that may explain this variation.

5

[ L O l] There are three types of takeover: horizontal, vertical and conglomerate. Give recent Australian

examples of each type of takeover. 6

[LO 1】 /A company ccrn reduce /7s r/s/c by tat/ngf over crnof/ier company. Do you agree with this statement? Is it a justifiable reason for a takeover?

7

[LO 1] A company with accumulated tax losses is necessarily a valuable takeover proposition. Discuss this statement.

8

[LO 2] Budget Computers specialises in buying second-hand computers and renting them out. Owing to

rapid technological changes and intense competition, Budget has recorded losses in recent years and is now threatened with liquidation. Its major asset is a stock of largely obsolete computers. Fleeting Electrics Ltd is a newly listed company with interests in consumer electrical goods. The Chairman of Fleeting suggests that it should acquire Budget for two reasons. First, it provides diversification, and second, he argues that by injecting fresh capital, Budget can be 'rescued' and should appreciate markedly in value. Critically evaluate the Chairman's arguments. 9

[LO 2] The value of Minnow Ltd to W hale Ltd can be determined by:

a) discounting Minnow's net cash flows to a present value b) the present value of Minnow's expected future dividends c) estimating the present value of the incremental net cash flows directly attributable to the takeover, and add­ ing this to the current market value of Minnow. Critically evaluate each of these approaches. Which one would you advise the management of Whale to use? Give reasons. 10

CHAPTER NINETEEN REVIEW

4

[L0 2]

a) In an efficient market, the price of a company's shares is an unbiased estimate of their 'true' value. How might the 'true7value of a takeover target differ from its value to a potential bidder? What relationship exists between this latter value and the actual offer price? b) Asset backing is irrelevant os a measure o f the worth o f a company subject to o takeover bid. Comment on this statement. 11

[L〇 2] Carrion Ltd has announced a takeover bid for Elephant Ltd, one of Australia’s largest companies.

The Chairman of Carrion argues that the takeover will be economically viable because it will lead to more efficient management of Elephant’s assets, there are tax advantages involved, and value can be created by dividing Elephant into three or four separate entities, each based on a single line of business. a) Critically evaluate each of the three reasons for takeover viability suggested by the Chairman. b) Assuming that Carrion already holds 15 per cent of Elephant's shares, briefly outline the legislative require­ ments that must be met in any bid for control of the target. c) Elephant's shares had a market price of $7.90 prior to any purchases by Carrion. Analysts employed by Carrion have valued the shares at $1 1.50, based on the present value of future net cash flows. Outline the relationship you would expect between these values and Carrion's bid price. 12

[L0 3] There is no reason for on acquiring company to prefer a cosh b id to a shore exchange or vice verso.

13

[L0 4] W hat are the benefits and costs of an unregulated market for takeovers? In view of the Australian

Discuss this statement. legislation regulating takeovers, evaluate the benefits and costs. 14

[LO 4] The Takeovers Panel is just another form o f government bureaucracy that is a waste o f resources that

could easily be 'token over' itself by the Australian Securities and Investment Commission without any effect on the market for corporate control. Evaluate this statement. (Hint: access the website www.takeovers.gov.au

to review the make-up and powers of the panel as well as some of the decisions reached.) 15

[L0 4] W hat are the benefits and costs associated with having the Australian Competition and Consumer Commission (ACCC) involved with the market for corporate control? Give an example of where the ACCC has not permitted an acquisition to proceed and outline its reasons for doing so. (Hint: www.accc.gov.au provides access to the news releases issued by the ACCC explaining the reasons for their decisions.)

16 [L 0 4 ] Outline the factors that the management of a bidding company should take into account when deciding whether to make an off-market or an on-market offer for a target.

641

B usiness finance

17

[LO 5] As management knows more about the doy-to-day running o f the company than shareholders, shareholders should always follow monogement's lead in rejecting a takeover b id that management soys is against the best interests o f shareholders. Comment on this statement.

18

\X〇 6] Investing private equity in a buyout is less risky than investing in an initial public offering. Discuss

this statement. 19

[LO 6] Leveraged buyout activity increased dramatically between 2000 and 2006. Suggest reasons for this increase.

20

[LO 6] Taking a company private often results in significant pressure being placed on the management team to cut costs and moke operations more efficient. Discuss this statement.

21

[L0 7] The evidence is clear that takeovers in aggregate in Australia have resulted in substantial increases in the value of the corporate economy (Bishop, Dodd & Officer 1987, p. 6). Outline the major points that support this conclusion.

22

[L0 7] Maureen Carroll examines the share prices of companies that are the targets of takeover bids. She finds that their share prices rise substantially when the bid is announced and, over the next 12 months, do not drop back to the pre-bid level, even if the takeover is unsuccessful. Advise Maureen of possible explanations for this observation.

23

[L0 7] Claire McDonald is concerned that market-based evidence on the effects of takeovers may be misleading. She agrees that target company shareholders gain substantially, but argues that these gains could be the result of wealth transfers from employees, and from the shareholders of acquiring companies. Claire says, 1 won't be convinced that takeovers are beneficial until someone can show exactly where the gains come from,. Outline evidence that should convince Claire that takeovers provide real benefits.

cA 1

PROBLEMS

Evaluating takeovers and N P V [LO 2]

Yam Ltd (Y) has been evaluating the acquisition of Xavier Ltd (X). The annual expected cash flows of Y and X are, respectively, $1.16 million per annum in perpetuity and $640000 per annum in perpetuity. These cash flows are expected to be unaffected by the takeover. The systematic risk (beta) of Y is 0.75 and of X is 1.0. The risk-free interest rate is 10 per cent and the expected excess return on the market portfolio is 6 per cent. Calculate the price at which X represents a zero net present value investment. Is it likely that Y's shareholders will benefit from the takeover? 2

Evaluating takeovers [LO 2]

Assume the information in Problem 1, except that the post-takeover cash flow of the two companies is expected to be $1.95 million per annum in perpetuity. Is the acquisition likely to be of benefit to Y's shareholders? 3

Alternative approaches to target valuation [LO 2]

Farrout Ltd is planning to acquire a small boat builder, Winged Keel Pty Ltd. Three opinions have been obtained on the value of the target. These are as follows: a) Based on the latest earnings of Winged Keel, and applying Farrout's price-earnings ratio, the company is worth $1.2 million. b) Based on total tangible assets, a value of $2 million is indicated. c) Based on the present value of Winged Keel's expected future dividends, it is worth $1.5 million. Evaluate each of these approaches and indicate any inherent problems. Which would you select as the most appropriate? 4

Evaluating takeovers [LO 2]

Squire Clothing is considering the acquisition of the Skintight Jeans Company. Squire will pay $2 million to buy Skintight’s assets and will also assume its liabilities of $900000. It has been estimated that Skintight's existing assets will generate pre-tax cash flows of $500000 per annum for 25 years. The assets can be depreciated for tax purposes at 20 per cent per annum straight-line, with no salvage value. The company tax rate is 33 per cent and Squire estimates that an investment of this level of risk should yield 12 per cent per annum after tax. Evaluate the proposed takeover. 642

C hapter nineteen A

Evaluating cash versus share offers [LO 2, 3 】

Crocodile Ltd is considering the acquisition of Shark Finance. The values of the two companies as separate entities are $10 million and $5 million, respectively. Crocodile estimates that by combining the two companies it will reduce selling and administrative costs by $250000 per annum in perpetuity. Crocodile can either pay $7 million cash for Shark or offer Shark a 50 per cent holding in Crocodile. If the opportunity cost of capital is 10 per cent per annum: a) What is the gain, in present value terms, from the merger? b) What is the net cost of the cash offer? c) What is the net cost of the share alternative? d) What is the NPV of the acquisition under: i) the cash offer ii) the share offer? 6

,

EPS bootstrapping [LO 2 3]

Progressive Ltd is determined to increase its earnings per share from $1 to $1.33, so it acquires Lo-Gear. The following facts are provided: I Item

Progressive

Lo-Gear

Merged company

1.00

1.25

1.33

Price per share ($)

20.00

12.50

?

Price-earnings ratio

20.00

10.00

?

Number of shares

100000

200000

?

Total earnings ($)

100000

250000

?

2 000000

2500000

?

Earnings per share ($)

Total market value ($)

1

C H A P T E R MNETEElSf S V I E W

5

nalysis o f takeovers

There are no economic benefits from combining the two companies. In exchange for Lo-Gear's shares, Progressive issues just enough of its own shares to ensure its $1.33 earnings-per-share objective. w

Complete the table for the merged company. How many shares of Progressive are exchanged for each share of Lo-Gear? What is the net cost of the takeover to Progressive? W hat is the change in the total market value of the Progressive shares that were on issue before the takeover? Based on these results, comment on the use of earnings-per-share comparisons in assessing the viability of takeovers.

REFERENCES Andrade, G., Mitchell, M. & Stafford, E.,'New evidence and perspectives on mergers', Journal of Economic Perspectives, Spring 2001, pp. 103-20. ------, & Stafford, E., Investigating the economic role of mergers', Journal of Corporate Finance, January 2004, pp. 1- 36. Avkiran, N.K., The evidence on efficiency gains: the role of mergers and the benefits to the public', Journal of Banking and Finance, July 1999, pp. 137-49. Baker, M., Pan, X. & Wurgler,丄 ，'The effect of reference point prices on mergers and acquisitions', Journal of Financial Economics, October 2012, pp. 49-71.

Bates, T. & Lemmon, M., 'Breaking up is hard to do? An analysis of termination fee provisions and merger outcomes7, Journal of Financial Economics, September 2003, pp. 469-504. Beerworth, W.J., 'Mergers, acquisitions and takeovers’，in R. Bruce, B. McKern, I. Pollard & M. Skully (eds), Handbook of Australian Corporate Finance, 5th edn, Butterworths, Sydney, 1997, pp. 164-204. Betton, S., Eckbo, B. & Thorburn, K., 'Corporate takeovers' in B.E. Eckbo (ed.), Takeover Activity, Valuation Estimates and Sources of Merger Gains, vol. 1, Elsevier North Holland, Amsterdam, 2010, pp. 3-137.

643

Bishop, S., Dodd, P. & Officer, R.R., 'Australian takeovers: the evidence 1972-1985#, Policy Monograph, 12, Centre for Independent Studies, Sydney, 1987. Bradley, M., Desai, A. & Kim, E., ’The rationale behind interfirm tender offers: information or synergy?', Journal of Financial Economics, April 1983, pp. 183-206. ------, ------• ------, 'Synergistic gains from corporate acquisitions and their division between the shareholders of target and acquiring firms', Journal of Financial Economics, May 1988, pp. 3-40. Brown, P. & Da Silva Rosa, R., 'Takeovers: who wins?', JASSA, Summer, 1997, pp. 2-5. ------• ------, 'Research method and the long-run performance of acquiring firms', >Au5fra//cm Jouma/ of yVianagemenf, June 1 9 9 8 , pp. 2 3 - 3 8 .

Bugeja, M. & Da Silva Rosa, R., Taxation of shareholder capital gains and the choice of payment method in takeovers7, Accounting and Business Research, September 2008, pp. 331-50. Casey, R., Dodd, P. & Dolan, P., 'Takeovers and corporate raiders: empirical evidence from extended event studies', Australian Journal of Management, December 1987, pp. 2 0 1 - 2 0 .

------,& Eddey, P., 'Defence strategies of listed companies under the takeover code', Australian Journal of Management, December 1986, pp. 153-71. Chappie, L., Christensen, B. & Clarkson, P., 'Termination fees in a ''bright line,/ jurisdiction,/ Accounting and Finance, December 2007, pp. 643-65, Chessel, J., 'The big takeovers of 2005', Sydney Morning Herald, 24 December 2005; p. 41. Cohn, J.B., Mills, L.F., & Towery, E.M., 'The evolution of capital structure and operating performance after leveraged buyouts: evidence from US corporate tax returns', Journal of Financial Economics, February 2014, pp. 469-94. Curtis, J. & Pinder, S., 'Break-fee restrictions: where's the harm?7, Agenda: A Journal of Policy Analysis and Reform, June 2007, pp. 111-22. Da Silva Rosa, R., Izan, H., Steinbeck, A. & Walter, T., ’The method of payment decision in Australian takeovers: an investigation of causes and effects', Australian Journal of Management, June 2000; pp. 67-97. ------, & Walter, T., 'Australian mergers and acquisitions since the 1980s: what do we know and what remains to be done’， Australian Journal of Management, Special issue 2004, pp. i-xiv. De Angelo, H., De Angelo, L. & Rice, E.M., 'Going private: minority freezeouts and stockholder wealth', Journal of Low and Economics, October 1984, pp. 367-401. Dodd, P. The market for corporate control: a review of the evidence7, in J. Stem and D. Chew (eds), The Revolution in Corporate Finance, 2nd edn, Blackwell, Oxford, 1992. ------,& Officer, R.R., 'Corporate control, economic efficiency and shareholder justice7, Policy Monograph, 9, Centre for Independent Studies, Sydney, 1986. Eckbo, B. & Thorburn, K., 'Corporate restructuring: breakups and LBOs7, in B.E. Eckbo (ed.), Handbook of Corporate Finance: Empirical Corporate Finance, vol. 2, Elsevier North Holland, Amsterdam, 2008, pp. 135-202.

Eddey, P. & Casey, R., 'Directors' recommendations in response to takeover bids: do they act in their own interests?’, Australian Journal of Management, June 1989, pp. 1-28. Ernst & Young Australia, Australian Management Buyouts— The Story Continues, Sydney, 2000. Fee, C. & Thomas, S., 'Sources of gains in horizontal mergers: evidence from customer, supplier, and rival firms’， Journal of Financial Economics, August 2004, pp. 423-60. Finn, F. & Hodgson, A., 'Takeover activity in Australia: endogenous and exogenous influences', Accounting and Finance, November 2005, pp. 375-94. Gaughan, P.A., Introduction: the fourth merger wave and beyond,/ in P.A. Gaughan (ed.), Readings in Mergers and Acquisitions, Blackwell, Oxford, 1994. Harford,丄，’Takeover bids and target directors’ incentives: the impact of a bid on directors' wealth and board seats’， Journal of Financial Economics, July 2003, pp. 51-83. ------, 7What drives merger waves?7, Journal of Financial Economics, September 2005, pp. 529-60. Healy, P.7 Palepu, K. & Ruback, R., 'Does corporate performance improve after mergers?', Journal of Financial Economics, April 1992, pp. 135-75. Hite, G. & Owers,丄〆The restructuring of corporate America: an overview', in J. Stern and D. Chew (eds), The Revolution in Corporate Finance, 2nd edn, Blackwell, Oxford, 1992. Hyde, C.E., 'Evaluating mergers in the Australian petroleum industry7, The Economic Record, September 2002, pp. 299-311. Jarrell, G., Brickley, J. & Netter, J.; The market for corporate control: the empirical evidence since 1980', Journal of Economic Perspectives, Winter 1988, pp. 49-68. ------, & Poulsen, A., The returns to acquiring firms in tender offers: evidence from three decades', Financial Management, Autumn 1989, pp. 12-19. Jensen, M., 'Agency costs of free cash flow, corporate finance and takeovers', American Economic Review, May 1986, pp. 323-9. ------, Takeovers: their causes and consequences,, Journal of Economic Perspectives, Winter 1988, pp. 21-48. ------, The takeover controversy: analysis and evidence', in J. Stem and D. Chew (eds), The Revolution in Corporate Finance, 3rd edn, Blackwell, Oxford, 1998, pp. 351-77. ------, & Ruback, R.; The market for corporate control: the scientific evidence', Journal of Financial Economics, April 1983, pp. 5-50. Kaplan, S. & Weisbach, M., The success of acquisitions: evidence from divestitures^ Journal of Finance, March 1992; pp. 107-38. Koller, J., Goedhart, M. & Wessels, D., Valuation: Measuring and Managing the Value of Companies, 5th edn, John Wiley & Sons, Hoboken, New Jersey, 2010. Lang, L., Stulz, R. & Walkling, R., 'Managerial performance, Tobin’s Q and the gains from successful tender offers’， Journal of Financial Economics, September 1989, pp. 137-54. Levi, M., Li, K. & Zhang, F., 'Director gender and mergers and acquisitions', Journal of Corporate Finance, in press. Levy, R., Takeovers Law and Strategy, LBC Information Services, Sydney, 1996.

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Penman, S.H., Financial Statement Analysis and Security Valuation, 5th edn, McGraw-Hill Irwin, New York, 2013. Ralston, D., Wright, A. & Garden, K., 'Can mergers ensure the survival of credit unions in the third millennium?,/ Journal of Bonking and Finance, December 2001, pp. 2277-304. Reserve Bank of Australia, Financial Stability Review, March 2007. Roll, R., The hubris hypothesis of corporate takeovers', Journal of Business, April 1986, pp. 197-216. Rosenkranz, S. & Weitzel, U. 'Bargaining in mergers: the role of outside options and termination provisions', Working Paper 07-06, 2007, Utrecht School of Economics. Schipper, K. & Thompson, R., 'Evidence on the capitalised value of merger activity of acquiring firms', Journal of Financial Economics, April 1983, pp. 85-119. Schwert, G., 'Hostility in takeovers: in the eyes of the beholder?7, Journal of Finance, December 2000, pp. 2599-640. Servaes, H., 'Tobin’s Q and the gains from takeovers’， Journal of Finance, March 1991, pp. 409-19. Shams, S., Gunasekarage, A. & Colombage, S. 'Does the organisational form of the target influence market reaction to acquisition announcements? Australian evidence', Pacific-Basin Finance Journal, September 2013, pp. 89-108. Simmonds, D.P., 'The impact of takeover offer timing on the measurement of Australian bidder gains: 1976 to 1995 ’， Australian Journal of Management, Special issue 2004, pp. 1-60. Standard and Poors, Cross-Market Commentary: The Value of Announced LBOs in 2013 Dropped Compared with 2012 Levels, New York, 2014. Walkling, R. & Long, M., 'Agency theory, managerial welfare and takeover bid resistance7, Rond Journal of Economics, Spring 1984, pp. 54-68.

CHAPTER NINETEEN REVIEW

------, & Pathak, N., Takeovers Law and Strategy, 4th edn, Thomson Reuters, Sydney, 2012. Loughran, T. & Vijh, A., 'Do long-term shareholders benefit from corporate acquisitions?', Journal of Finance, December 1997, pp. 1765-90. McDougall, F. & Round, Dw The Effects of Mergers and Takeovers in Australia, Australian Institute of ManagementVictoria and National Companies and Securities Commission, 1986. Maheswaran, K. & Pinder, S., 'Australian evidence on the determinants and impact of takeover resistance', Accounting and Finance, vol. 45, no. 4, 2005, pp. 613-33. Martin, K. & McConnell, J., 'Corporate performance, corporate takeovers and management turnover', Journal of F/nonce, June 1991, pp. 671-87. Mayanya, J., 'Reforming Australia’s takeover defence laws: what role for target directors? A reply and extension’， Australian Journal of Corporate Law, vol. 10, 1999, pp. 162-91. Mitchell, M. & Lehn, K., 'Do bad bidders become good targets?', Journal of Political Economy, April 1990, pp. 372-98. Morck, R., Shleifer, A. & Vishny, R.; 'Characteristics of targets of hostile and friendly takeovers’，in AJ. Auerbach (ed.), Corporate Takeovers: Causes and Consequences, National Bureau of Economic Research, Chicago, 1988, pp. 101-29. ----- , ------■------, 'Do managerial objectives drive bad acquisitions?', Journo/of Finance, March 1990, pp. 31-48. Mukherjee, T.K., Kiymaz, H. & Baker, Hw 'Merger motives and target valuation: a survey of evidence from CFOs’， Journal of Applied Finance, Winter 2004, pp. 7-24. Officer, M., 'Termination fees in mergers and acquisitions', Journal of Financial Economics, September 2003, pp. 431-67.

nalysis o f takeovers

645

CHAPTER TWENTY Management of short-term assets: inventory

CHAPTER CONTENTS 20.1

Introduction

6 47

20.2

The im portance o f short-term financial decisions

6 47

20.3

Types o f short-term asset

648

20.4

The need for short-term asset managem ent

648

20.5

Short-term assets and short-term liabilities

649

20.6

O ve rvie w of inventory m anagem ent

6 50

20.7 I Inventory costs: retailing and w holesaling

650

20.8

Inventory costs: m anufacturing

651

20.9

Inventory m anagem ent under certainty

652

20.10 Inventory m anagem ent under uncertainty 20.11

658

Inventory m anagem ent and the 'just-in-time’ system 661

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

understand the im portance o f short-term assets in the Australian econom y

2

identify the three m ajor types o f short-term assets

3 4 5

evaluate the need fo r short-term asset m anagem ent

6

understand the nature o f acquisition costs, ca rrying costs and stockout costs

7

understand and a p p ly the econom ic order quantity model

8

understand and a p p ly models o f inventory m anagem ent under uncertainty

9

understand the difference between specifying an acceptable p ro b a b ility o f stockout and specifying an acceptable expected customer service level.

understand the relationship between short-term assets and short-term liabilities identify the benefits and costs o f holding inventory

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20.1

a n a g e m e n t o f short -term assets : in v en t o r y

Introduction

M ost o f the financial decisions considered in previous chapters were long term , involving such decisions as the choice o f capital structure and the selection o f investments in property, plant and equipment. These assets are regarded as long term because norm ally they do n ot need to be replaced fo r several years. However, most companies also hold short-term assets such as in v en to ry , liquid a ssets and accounts receivable (o r d e b to r s). These are short 1 6 ^ * because any individual item o f inventory, or any particular liqu id asset, or any single account receivable w ill generally be replaced or burned over* in a m atter o f days, weeks or m onths. Both short-term assets and long-term assets require a com m itm ent of resources by the company, and thus both form s o f investm ent deserve careful analysis by the financial manager. Similarly, both short-term and long-term liabilities deserve the financial managers attention. In a company s statement o f financial position (often called its 'balance sheet,), short-term assets are referred to as cu rren t a sse ts and short-term liabilities are referred to as cu rren t lia b ilitie s. The distinction between ‘current’ and ‘non-current’ is the tim e period involved. A current asset w ill norm ally be converted into cash in less than one year, while a current lia b ility is due fo r payment in less than one year. A ll other assets and liabilities are classified as non-current. In this chapter, we use the terms ‘current， and ‘short-term ’ interchangeably. In Sections 20.2 to 20.5 we consider the general area o f investm ent in short-term assets and the incurrence o f short-term liabilities, while in Sections 20.6 to 20.11 we consider the management o f inventory. In the next chapter we w ill consider the management o f liquid assets and accounts receivable.

INVENTORY

comprises raw materials, work in progress, supplies used in operations and finished goods LIQUID ASSETS

comprise cash and assets that are readily convertible into cash, such as bills of exchange ACCOUNTS RECEIVABLE (o r

debtors)

sum of money owed to a seller as a result of having sold goods or services on credit

20.2 The importance of short-term financial decisions Compared w ith m u ltim illio n dollar investments in, say, m ining ventures, automated factories or space technology, the issues involved in investm ent in short-term assets may appear trivia l. Although such a view is understandable, it is nevertheless incorrect from both theoretical and empirical viewpoints. It was made clear in the chapters dealing w ith long-term investments th a t funds are invested to earn a competitive return. Short-term investments use resources in exactly the same way as long-term investments: a dollar invested in a short-term asset is a dollar n ot invested in some other asset. As a result, the wealth-m axim ising company w ill w ant to ensure th a t all its investments are selected and managed efficiently. It is true th a t short-term financial decisions are usually less complex than long-term financial decisions. For example, a decision to build an automated factory may be based on forecasts o f cash flows fo r perhaps 15 years, as well as an analysis o f the risks involved. In contrast, a decision to invest surplus cash in, say, 90-day bank bills can be based on cash flow forecasts fo r a few m onths and a comparison o f current interest rates on other short-term investments. However, the fact th a t short-term financial decisions are generally less complex does n o t necessarily mean th a t they are less im p o rta n t than long-term decisions. A company may have invested in projects w ith large positive net present values and adopted an ideal debt-equity ratio, but may get into severe d ifficu lty because it overlooked the need to have sufficient cash available to meet this year s fixed commitments. Regardless o f how im p o rta n t an issue may appear to be in principle, its practical economic significance w ill generally be lim ite d i f there is very little money involved. However, there can be no doubt th a t a great deal o f money is involved in short-term asset holdings. In Australia, the typical company holds about oneth ird o f its to ta l assets in short-term assets. However, this varies considerably between industries and even between companies operating in the same industry. For example, at the end o f the 2013 financial year, the proportion o f to ta l assets held as short-term assets was 29 per cent fo r Boral, a building and construction materials company, 31 per cent fo r Heemskirk Consolidated, a small m ining company, but only 14 per cent fo r BHP B illiton, a diversified m ining company, 86 per cent fo r Paperlinx, a paper manufacturer and wholesaler and 28 per cent fo r W oolworths, a large retailer.

LEARNING OBJECTIVE 1 Understand the importance of short­ term assets in the Australian economy CURRENT ASSETS

cash, inventory, accounts receivable and other assets that will normally be converted into cash within a year CURRENT LIABILITIES

debt or other obligations due for payment within a year

V LEARNING OBJECTIVE 2 Identify the three major types of short­ term assets

20.3 Types of short-term asset The short-term assets held by businesses are o f three m ajor types as follows.

20.3.1 | Inventory For a manufacturer, inventory includes raw materials, w ork in progress and finished goods n ot yet sold. For a wholesaler or retailer, inventory consists m ostly o f merchandise in the warehouse or on the shelves.

2 0 .3 .2 1 Liquid assets (cash and short-term investments) V irtu a lly all companies need to have at least some cash on hand in order to carry on business. For many purposes short-term investments such as bills o f exchange, overnight deposits and very short-term bank deposits are a good substitute fo r cash and have the added advantage th a t they generate interest revenue.

2 0 .3 .3 1 Accounts receivable (debtors) Companies often extend short-term credit to th e ir customers. For example, a supplier o f goods may not require payment o f the am ount owed u n til a period o f 30, 60 or even 90 days has passed. D uring the period from the date o f purchase to the date o f payment, the supplier has the short-term asset, account receivable’.

V LEARNING OBJECTIVE 3 Evaluate the need for short-term asset management

20.4 The need for short-term asset management In a simple w orld o f frictionless, perfect markets there would be no need fo r a company to hold short­ term assets and consequently issues concerning th e ir management would not arise. For example, i f a company required more raw materials it would be able to obtain them instantaneously at the current m arket price. Under these conditions there would clearly be no need to hold an inventory o f raw materials. The same is true o f other forms o f inventory. Cash holdings are in the same position because any shortage could be instantaneously m et at the current m arket price (interest rate). Similarly, in the case o f accounts receivable there would be no need fo r the company to w ait fo r the custom ers paym ent because, as we explain in Chapter 21, the asset could be sold fo r its present value. The p o in t is that, unlike most o f the topics studied in finance, the model o f the frictionless, perfectly competitive m arket is usually not a useful starting p o in t fo r the analysis o f short-term asset management. This is n o t because markets in short-term assets are n ot competitive; indeed, they are often highly competitive. The problem lies more in the assumption that markets are
F a c t o r in g a n d d is c o u n t in g a re d is c u s s e d in C h a p t e r 1 0 .

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a n a g e m e n t o f short -term assets : in v en t o r y

than sell an account receivable. Again, therefore, a source o f fric tio n has proved to be significant. In this case the frictio n is the cost o f obtaining inform ation. Because we do n ot assume frictionless, perfect markets, the analysis o f short-term asset management tends to have a different ‘feel’ from many other topics in finance. Indeed, many o f the issues involved are often discussed n ot only in finance b ut also in related disciplines such as management accounting and operations research. Nevertheless, the management o f short-term assets should be o f v ita l concern to the financial manager. As noted previously, short-term assets involve a com m itm ent o f the company s resources. Good decisions w ill mean efficient use o f those resources and w ill result in increased wealth fo r the shareholders; poor decisions w ill have the opposite effect. In principle, decisions about investments in short-term assets can be approached using the net present value model in the same way as decisions about long-term assets. For example, an account receivable should be held if its net present value is positive, but should not be held i f its net present value is negative. As usual, the appropriate discount rate to apply is the o p p o rtu n ity cost o f capital, which in this case is the rate o f retu rn required on an asset th a t has the same risk as the account(s) receivable. To estimate the opp ortu nity cost, the capital asset pricing model could be applied, given an estimate o f the beta o f accounts receivable.2 Unfortunately, such estimates are d ifficult, i f n ot impossible, to obtain. In most cases, pursuing this approach does n ot provide practical solutions in this area, despite the v a lid ity o f the principles involved. Although wealth m axim isation is s till the ultim ate objective, different techniques are often needed to estimate and optim ise the costs and benefits.

20.5 Short-term assets and short-term liabilities Although the focus o f Chapters 20 and 21 is the management o f short-term assets, it should also be remembered that managers m ust also make decisions about short-term liabilities. Managers are likely to try to m aintain a fa irly stable relationship between the m a tu rity structure o f the company s assets and the m a tu rity structure o f its liabilities. For example, life insurance companies tend to hold a relatively large proportion o f th e ir assets in the fo rm o f long-term investments because the average life insurance policy is not expected to mature u n til a relatively long tim e has elapsed. This ‘m atching policy’ also applies to shorter m aturities, so a company whose current assets comprise a relatively large pro po rtio n o f its total assets w ill often make greater use o f short-term debt than other companies. The basic ideas underlying the m atching policy are easily explained. Assume th a t a company has only one non-current asset. By borrow ing fo r a period equal to the assets life, management expects th a t the asset w ill generate cash flows sufficient to meet the payments required by the loan. A short-term asset and its matching lia b ility may each involve only one cash flow. The m atching policy is seen very clearly in the case o f trade bills, which usually require the drawer to pay the face value o f the b ill on a future date that coincides w ith the date on which the drawer expects to receive payment fo r the goods that have been sold.3 I f the m a tu rity o f the lia b ility is shorter than the life o f the asset, then there is a risk th a t the company either w ill not have sufficient cash to repay the debt or w ill n ot be able to renew the debt. I f the m a tu rity o f the debt is longer than the life o f the asset, then there is a risk th a t the company w ill not have sufficient alternative sources o f cash at the end o f the assets life to continue meeting the interest payments on the debt. To illustrate the m atching policy, we considered matching a p articular asset w ith a particular lia b ility but, in practice, the matching policy usually does n o t need to be carried to such an extreme. Instead, managers w ill often focus on broad aggregates relating to different classes o f assets and liabilities. For example, managers may classify assets and liabilities into fo ur m a tu rity classes: very short term , short term, medium term and long term . W ith in each class, managers w ill seek to m aintain a balance between assets and liabilities. Alternatively, the managers may seek to balance the average m a tu rity o f assets and liabilities. A more sophisticated approach is to calculate the ‘duration’ o f the company’s assets and select a matching lia b ility structure. As discussed in Appendix 4.1, duration is the appropriate measure o f m atu rity where i t is sought to immunise a p o rtfo lio against changes in interest rates. 2

S e e S e c tio n 7 .6 .2 fo r a d is c u s s io n o f th e c a p it a l a s s e t p r ic in g m o d e l.

3

S e e S e c tio n 1 0 .5 .3 fo r a m o re d e t a ile d d e s c r ip tio n o f b ills o f e x c h a n g e .

LEARNING OBJECTIVE 4 Understand the relationship between short-term assets and short-term liabilities

20.6 Overview of inventory management There are three m ain types o f inventory. LEARNING OBJECTIVE 5 Identify the benefits and costs of holding inventory

Raw materials inventory comprises inventory th a t w ill fo rm p art o f the completed product o f a

a

b c

m anufacturer, but which has yet to enter the production process. For example, iro n ore is an im p o rta n t raw m aterial th a t would be held in inventory by a steel producer, Work in progress inventory comprises p a rtia lly completed products th a t require additional processing before they become finished goods. Finished goods inventory fo r a m anufacturer is completed products n o t yet sold; fo r a retailer or wholesaler i t is merchandise on hand.

Inventories form a substantial p art o f a typical company s investm ent in short-term assets. For example, at the end o f the 2013 financial year, Boral held 37 per cent o f its short-term assets in the form o f inventories, while the corresponding percentages fo r Heemskirk, BHP B illiton , Paperlinx and W oolworths were 24, 29, 30 and 68 per cent respectively. The size o f the investm ent suggests that inve ntory management is needed in every business. Before considering in detail the costs and benefits o f holding inventory, the m ajor issues involved in inve ntory management are illustrated by a simple example. Suppose th a t the manager o f a retail store is considering the level o f inventory the store should hold. I f too little inventory is held there w ill frequently be occasions when customers w ill arrive at the store, ready and w illin g to buy a product, only to fin d that it is unavailable. Sales w ill be lost and customer goodwill w ill suffer. Also, i f the inve ntory level is too low, the store w ill need to reorder the products it sells at more frequent intervals, thus incu rring the costs o f ordering more often than would otherwise be the case. I f too much inventory is held these problems w ill be avoided, b ut a different set o f problems w ill arise. H igh inve ntory levels tie up large amounts o f capital and lead to high storage and insurance costs. The choice o f inventory level therefore involves a balancing o f costs and benefits. However, it is convenient to th in k o f the benefits as costs avoided*. For example, the benefit o f a retailer always having inve ntory on hand can be thought o f as avoiding the costs* o f lost sales and lost customer goodwill. Viewed in this way, inventory management becomes a problem o f cost m inim isation. The costs o f holding inventory are generally classified in to three groups: acquisition costs, carrying costs and stockout costs.

V LEARNING OBJECTIVE 6 Understand the nature of acquisition costs, carrying costs and stockout costs

20.7 Inventory costs: retailing and wholesaling 20.7.1 I Acquisition costs The m ost obvious cost o f acquiring inventory is the price paid fo r each u n it o f inventory. However, unless there are qua ntity discounts available (as discussed in Section 20.9.4), the u n it price is the same, regardless o f inventory policy, and is therefore n ot relevant to the choice o f policy. Relevant acquisition costs are those th a t vary w ith the inventory policy adopted. These costs include:

b

ordering costs: clerical and adm inistrative costs are incurred every tim e an order is placed freight and handling costs: every order placed w ill result in freight costs and, when the goods are

c

quantity discounts forgone: larger orders w ill often attract a discount in price. I f smaller orders are

a

received, handling costs placed, these discounts w ill n ot be obtained and consequently an o p p o rtu n ity cost is incurred. Per u n it o f inventory, each o f these costs w ill be lower, the larger the order placed. Large orders im ply relatively infrequent ordering and high inventory levels.

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a n a g e m e n t o f short -term assets : in v en to r y

2 0 .7 .2 1 Carrying costs A fter inventory has been acquired, it m ust be held (or carried*). The higher the inve ntory level, the higher w ill be the to ta l carrying costs. Carrying costs include:

Opportunity cost of investment. Inventory ties up capital th a t could have been invested elsewhere in the company s activities. For example, i f the o pp o rtu n ity cost o f capital is 10 per cent per annum, then holding $100 o f inventory involves an annual cost o f $10. b Storage costs. A fte r inventory is received, it m ust be stored. This w ill involve the payment o f rent or, i f the company owns its storage facilities, the forgoing o f rental revenue th a t could otherwise have been earned. Storage costs can be high fo r goods th a t are bulky and also fo r those th a t require special handling, such as refrigeration. c Insurance premiums. I f the inventory is insured, the premiums w ill probably vary directly w ith the value o f the inventory held. d Deterioration and obsolescence. Losses attributable to these factors are likely to be higher fo r higher levels o f inventory. For a spectacular case, see Finance in Action, e Price movements. I f there is a decrease in the price o f merchandise held in inventory, a loss is incurred. I f there is an increase in price, a gain is made, and this element o f the carrying cost is negative.

a

WINE MYSTERY DOESN'T HOLD WATER_______________________

Finance in

In 2013, the Australian company Treasury W ine Estates discovered that its US branch held in its inventory millions of dollars7 worth of wine that it thought had been sold. In addition to the resulting embarrassment, the costs were expected to be huge, as revealed in the following excerpts from an article by Elizabeth Knight in the Melbourne newspaper The Age. We now have the great Treasury W ine Estates mystery—millions of litres of wine thought to have been sold to US consumers have miraculously appeared in warehouses and supermarket shelves. The real mystery is not how they came to be there or even why $35 million (yes, that's $35 million) of wine w ill be flushed down the toilet or buried in landfill, it's why we only heard about it this week. How do you misplace that much wine without management knowing? The stock [that is, the share price] got beaten around on M onday following the astounding announcement that excess inventory would cost the company $1 6 0 million in provisions and wipe $30 million from earnings in the 2 0 1 4 year. Source: 'W ine mystery doesn't hold water7, Elizabeth Knight, The Age, 17 July 201 3.

2 0 .7 .3 1 Stockout costs Avoidance o f stockout costs is the m ajor benefit o f holding inventory. I f a company s inventory o f a particular item is completely exhausted, customers may purchase elsewhere in order to obtain immediate delivery. Sales are lost. M any customers soon lose patience in this situation and may switch all th e ir business to a competitor, thus causing fu rth e r sales to be lost.

20.8 Inventory costs: manufacturing 20.8.1 | Inventories of raw materials The costs th a t apply to a m anufacturer faced w ith the problem o f choosing an inventory level fo r raw materials are sim ilar to those that apply to retailers and wholesalers. The m ajor difference relates to stockout costs. For a manufacturer, a shortage o f raw materials inventory w ill disrupt the production process and impose costs because equipm ent and labour w ill be underutilised.

ACTION

N ews

B usiness finance

2 0 .8 .2 1 Inventories of finished good! As well as holding an inventory o f raw materials, m ost manufacturers hold an inventory o f th e ir finished products. In this case, carrying costs and stockout costs are sim ilar to those faced by a retailer or a wholesaler, b u t the acquisition costs d iffer in th a t the set-up costs fo r a production run may also have to be included. Set-up costs are the costs incurred each tim e a new production run is started. H igh set-up costs call fo r larger production runs to spread the costs over a greater num ber o f units produced in each run. In tu rn , this implies th a t a high level o f finished products inve ntory w ill be carried. A rigorous way o f determ ining the inventory level th a t m inimises the costs o f holding inventory is to use a quantitative model. One such model is the economic order q ua n tity model, w hich is discussed in the next section.

20.9 Inventory management under certainty LEARNING OBJECTIVE 7

The economic order q ua ntity model is designed to help a manager determ ine the inve ntory level that m inimises the to ta l costs associated w ith inventory.

Understand and apply the economic order quantity model

20.9.1 I The economic order quantity (EOQ) model The EOQ model assumes th a t demand fo r the product is constant (per u n it o f tim e) and know n w ith certainty.4 I t is also assumed th a t no q ua ntity discounts are available and th a t orders o f new inventory are filled in sta n tly— th a t is, the lead tim e between ordering and receiving items to be held in inventory is assumed to be zero. There is, therefore, no need to order inventory u n til the current inventory level reaches zero. This situation is illustrated in Figure 20.1.

Figure 20.1 Inventory cycles

c D 〇■ _g

6

Cycle (time)

The company places an order fo r Q units at tim e zero. Since demand is constant, th is inventory level w ill then fa ll steadily over tim e. A t Time 1, inve ntory has reached zero, so a new order fo r Q units is placed and in sta n tly filled, restoring the inventory level to Q. The second cycle then begins and the process is repeated. This process continues throughout the year.

4

In S e c t io n 2 0 .1 0 t h is a s s u m p t io n i s r e m o v e d a n d th e p r o b le m is e x a m in e d a llo w in g f o r u n c e r t a in d e m a n d .

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a n a g e m e n t o f short -term assets : in v en t o r y

The problem is to choose an order q ua ntity Q th a t w ill m inim ise the to ta l cost o f the inve ntory policy. The value o f Q th a t achieves th is goal is called the econom ic o rd e r q u a n tity (EOQ) and is denoted here by Q*. A fte r Q* has been calculated, the optim al tim e period between the placement o f each order is found by dividing demand per period, D, by the economic order quantity, Q*. For example, i f demand is 12 000 units per year, and the economic order q ua ntity is found to be 1000, orders need to be placed 12 times per year— th a t is, m onthly. In calculating EOQ, the n ota tion we use is: D = demand (in physical u nits) per period (e.g. demand per year) a = acquisition costs ($) per order placed c = carrying cost ($) per period per u n it o f inventory, including the o p p o rtu n ity cost o f capital invested in inventory Q = q uantity (in physical units) per order p = price ($) per u n it o f inventory Inventory policy w ill affect the acquisition costs and carrying costs. These costs are defined as follows: Acquisition costs per year = acquisition costs per order x num ber o f orders per year D = a—

Q

Carrying costs per year = annual carrying cost per u n it o f inventory x average inventory In each cycle the in itia l inventory is Q units, and over the cycle the inve ntory declines steadily to zero. Therefore, the average inve ntory level is —. Therefore: Carrying costs per year :

2

The annual to ta l cost, TC, o f the inventory policy is the sum o f the acquisition and carrying costs and is given by:

tc=

— + c-2^

B9SVI

Q

The relationship between acquisition and carrying costs and the to ta l cost o f the inventory policy is illustrated in Figure 20.2.

Figure 20.2 Determining economic order quantity

s ! J Oc a > 6u!XJJ CO

puoUOUDbuaos 如 s o u

a)

.E

Order size (units)

5

N o te t h a t n o s t o c k o u t c o s t h a s b e e n s p e c ifie d . U n d e r c o n d it io n s o f c e r ta in ty , s t o c k o u t s n e e d n e v e r o c c u r. S im ila r ly , s t o c k o u t s n e e d n e v e r o c c u r if o r d e r s a re fille d in sta n tly .

ECONOMIC ORDER QUANTITY (E O O )

optimal quantity of inventory ordered that minimises the cost of purchasing and holding the inventory

aD

Note th a t acquisition costs,— — , decrease as the order quantity, Q, increases because w ith a larger order Q q ua ntity there w ill be fewer orders. However, carrying costs, increase as the order q ua ntity increases because w ith larger orders, the average inve ntory level w ill be higher. The economic order quantity, Q*, is the value o f Q, which m inimises to ta l cost. This qua ntity may be found using the follow ing equation:6 Q*

l2aD

The application o f this model is illustrated in the follow ing three Examples.

E xample 20.1 Retailing Clarke's Photography Store sells 12 0 0 0 packets of photographic paper per year. The wholesale price is $3 per packet. The cost of processing each order to be placed with the wholesaler is $1 2.50 and carrying costs are 30 cents per packet per year. W hat is the economic order quantity and the optimal time period between orders?

SOLUTION In this example D = 12000, a = $1 2.50 and c = $0.30. Using Equation 20.2: Q*

l2aD

2 x $12.50 x 12000 ~ V

$0.30

=1000 packets The number of orders per ye a r:

12 000 1000

12 Therefore, orders are placed monthly.

E xample 20.2 Manufacturing (raw materials inventory) Cranfield Manufacturing Ltd uses 4500 metres of wire each year in its production process. Acquisition costs are $250 per order and the wire costs $1 per metre per year to store. W hat is the economic order quantity and the optimal time period between orders?

SOLUTION In this example D = 4500, a = $250 and c = $1. Using Equation 20.2: Q*

2oD

2 x $250x4500 = V $1 = 1 50 0 metres The number of orders per years :

4500 1500

Therefore, orders are placed three times per year—that is, once every 4 months. 6

Equation 20.2 may be derived by differentiating Equation 20.1 w ith respect to Q and setting the derivative equal to zero.

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a n a g e m e n t o f short -term assets : in v en t o r y

Example 20.3 6

Manufacturing (finished goods inventory) Dunbar Fabricating Ltd produces a specialised type of metal sheeting. Demand is 5000 sheets per year. Each production run costs $1750 to set up and storage costs are $25 per sheet per year. What is the optimal size of a production run and the optimal number of runs per year?

^

SOLUTION In this example D = 5000, a = $1750 and c = $25. Using Equation 20.2: !2aD

Q* =

2 x $1750x5000 $25 8 3 7 sheets

The number of production runs per year is

5000 83 7

or approximately six per year. Therefore, a

production run should be scheduled every 2 months.

2 0 .9 .2 | Cost estimation The relevant costs in the EOQ model are increm ental costs and may be d iffic u lt to estimate in practice. Accounting systems may not be designed to separate inventory costs from other operating costs and, even i f they are, they w ill generally provide average rather than m arginal costs. Fortunately, both the optim al order q uantity and, more im portantly, to ta l inventory costs are likely to be fa irly insensitive to errors in estimates o f u n it costs. Two factors contribute to this property o f the model. First, suppose the acquisition cost, at is doubled, or the carrying cost, c, is halved. The optim al order quantity, Q*, w ill then increase by a factor o f only i f all other factors remain unchanged. Second, the to ta l cost, TC, in Equation 20.1 is generally n o t very sensitive to changes in the order quantity. As may be seen from Figure 20.2, this is p articularly so in the region o f Q*. Example 20.4 illustrates the effects o f a large error in estimating the acquisition cost.

Example 20.4 6

Cost estimation In Example 20.1, D = 12 000, a = $ 12.50, c = $0.30 and it was found that Q *= 1000. Suppose that the true value of the acquisition cost a is $25 per order, but management believes it is only $1 2.50. What is the effect of this estimation error on the company's total cost?

SOLUTION The effect of this estimation error can be assessed by comparing: a) the cost of the optimal inventory policy that management would adopt if it had the correct information, with b) the cost of the inventory policy that management believes to be optimal, based on its incorrect estimates. Using the true value of a and Equation 20.2, the economic order quantity would be: l2aD

Q* =

12 x $25 x 12000

V

$0.30

1414 packets

continued

^

continued

The annual total cost of the optimal inventory policy using Equation 20.1 would be: 了广

$25 x 12 000 1414 =$ 4 2 4

$0.30 x 1414 2

But management, believing that a is $12.50, will choose an order quantity of 1000 packets. The annual cost of this policy is: 了广

$25 x 12000 1000 =$ 45 0

$ 0 .3 0 x 1 0 0 0 2

The annual cost of adopting management's estimate of a is only $26 or 6.1 per cent more than the annual cost under the 'true7optimal policy. Therefore, the EOQ model is fairly robust, and should work well in practice, despite difficulties in making accurate estimates of the input data.

2 0 .9 .3 |T h e EOQ model with positive lead time In the previous discussion, lead tim e was assumed to be zero— th a t is, it was assumed th a t when an order was placed i t was filled instantly. In m ost cases such an assumption is unrealistic, because after an order has been placed it w ill almost always take tim e fo r the goods to be delivered and placed in inventory. W ith a positive lead tim e, a new order m ust be placed before the current inventory level reaches zero. To m inim ise carrying costs, the reorder p o in t is chosen so th a t goods from the new order are placed in inve ntory just as the inventory level reaches zero. This process is illustrated in Example 20.5.

Example 20.5 Referring to Example 20.2, suppose that it takes 1 month for Cranfield’s wire orders to be delivered and placed in inventory. W hat is the effect of this lead time on Cranfield's inventory policy?

SOLUTION Under these circumstances, Cranfield simply reorders wire when the current inventory level is equal to 1 month's usage. The amount used each month is 1^22 = 375. This is illustrated in Figure 20.3.

Figure 20.3 Choosing a reorder point

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a n a g e m e n t o f short -term assets : in v en to r y

2 0 .9 .4 1 The EOQ model with quantity discounts I f discounts are available on larger qua ntity orders, then the price o f the inventory is relevant to determ ining the economic order quantity. As the order q ua ntity increases, the purchase o f the inventory benefits from the lower price paid fo r each u n it o f inventory, and from spreading the other acquisition costs over a larger order quantity. However, carrying costs increase as the inventory level increases. The procedures fo r dealing w ith q ua ntity discounts are shown in Example 20.6.

Example 20.6 Consider again the case of Clarke's Photography Store, discussed in Example 20.1. In that example, annual demand, D, was 12000 packets of paper; the price, p, was $3 per packet; acquisition costs, a, were $1 2.50 per order; and carrying costs, c, were 30 cents per packet per year. Suppose, however, that the wholesaler offers Clarke’s Photography Store quantity discounts as shown in Table 20.1. What is the optimal inventory policy with the quantity discounts?

TABLE 20.1 Photographic paper prices with quantity discounts Purchase quantity, Q

Price per packet, p ($)

1-500

3.00

501-1499

2.98

1500-2499

2.96

2500-4999

2.94

5000 and over

2.92

SOLUTION The annual total cost, TC, to Clarke's Photography Store is given by: TC = inventory costs + acquisition costs + carrying costs aD cQ = pD+— + —

Q

= 12000p+

2

1 5 〇 Q〇Q + 〇 , i 5 Q

In the absence of quantity discounts, the economic order quantity, Q * , was found to be 1000 packets. It can be shown that with quantity discounts the optimal price-quantity combination must be one of the following combinations (Goetz 1965): a) b) c) d) e)

p= p= p= p= p=

$3.00 $2.98 $2.96 $2.94 $2.92

and and and and and

Q = 500 Q = 1000 Q = 1500 Q = 2500 Q = 5000

These combinations are found by the following procedure. First, locate the optimal quantity in the absence of quantity discounts, and the price that would be payable for that quantity if there were quantity discounts. In this case Q = 1000 and p = $2.98. This is Combination (b). Next, in each of the quantity ranges provided in Table 20.1, select the quantity nearest to the optimal quantity in the absence of discounts (in this case 1000). For example, in the quantity range 2500-49 99, the quantity nearest to 1000 is 2500. The price payable in that case is $2.94 per packet. This is Combination (d). continued

B usiness finance

continued

The final step is to calculate the total cost for each of the combinations of price and quantity, and to select the combination that achieves the lowest total cost. These calculations are as follows: $150000

12 000 x $3.00

500

12 000 x $2.98 + 12 000 x $2.96 + 12 000 x $2.94 + 12 000 x $2.92 +

$150000 1000 $150000 1500 $150000 2500 $150000 5000

$0.15 x 500 = $36375 + $0.15

x

1000 = $36060

+ $0.15 x 1500 = $35 845 + $0.15 x 2 5 0 0 = $35715 + $0.15 x 5000= $35 820

The lowest cost combination is (d), and the economic order quantity is therefore 2500 packets.

20.10 Inventory management under uncertainty LEARNING OBJECTIVE 8 Understand and apply models of inventory management under uncertainty

SAFETY STOCK

additional inventory held when demand is uncertain, to reduce the probability of a stockout

In Section 20.9 i t is assumed th a t management is certain about the value o f each relevant variable. In particular, it is assumed th a t retailers and wholesalers know, w ith certainty, the level o f demand, while manufacturers are assumed to know, w ith certainty, the rate at which the raw m aterials inventory would be used in production. Suppose, however, th a t demand (or usage as the case may be) is uncertain. I f the lead tim e between placement o f an order and its delivery is zero, the presence o f uncertainty is n ot a problem. I f demand or usage should suddenly increase, management can respond by sim ply placing an order th a t is filled instan tly and therefore no stockout need occur. However, as explained previously, the lead tim e fo r fillin g orders is usually positive, and therefore stockouts may occur during this time. Inventory management requires tw o im p o rta n t decisions. First, management m ust choose the quantity to be ordered. Second, management m ust choose the reorder point— th a t is, the level o f inventory that w ill trigger the placement o f a new order. M ost o f the discussion o f inventory decisions under certainty related to the qua ntity decision. The reorder p o in t decision was solved sim ply by reordering when the current inve ntory level would just equal demand (or usage) during the lead tim e. In Example 20.5, Cranfields reorder p o in t is 375 metres o f wire, because this level is exactly equal to 1 m onth s usage and the lead tim e is 1 m onth. The new order would arrive at Cranfields factory at precisely the m om ent when the inve ntory reached zero. In contrast, under uncertainty, w hile the q ua ntity decision w ill be the same as th a t made when certainty is assumed, the reorder p o in t decision requires a more sophisticated analysis. A standard approach to inventory management under uncertainty is as follows. First, the q ua ntity decision is made by applying the certainty-based EOQ model, using the best estimate o f demand (or usage). Second, the reorder p o in t decision is made by adding a 'safety stock* to the reorder p o in t th a t would have been chosen under conditions o f certainty— th a t is, management deliberately chooses to reorder at a tim e when the current inve ntory level exceeds the qua ntity likely to be required during the lead tim e. The am ount o f this excess is called the s a fe ty sto ck. For example, i f the rate at which Cranfield uses w ire is uncertain, its management may decide on a safety stock o f 250 metres o f wire. In th a t case the reorder p o in t is (375 + 250) = 625 metres instead o f 375 metres. An order is placed when 625 metres o f wire is s till in inventory, even though i t is expected th a t when the new order arrives in 1 m on ths time, only 375 metres w ill have been used so there w ill s till be 250 metres o f wire in inventory. Figure 20.4 shows the expected inventory level through time. So fa r we have illustrated the notion o f safety stock b ut have n o t provided any insig ht in to the factors th a t determine its size. There are two approaches to determ ining safety stock size: the firs t specifies an acceptable p robability o f a stockout occurring during the lead tim e and the second specifies an acceptable expected level o f customer service.

C hapter tw enty M

a n a g e m e n t o f short -term assets : in v en to r y

\l Ch

〇

Figure 20.4 Choosing a reorder point with safety stock

Rec)rder Dint I

Metre of wire

\

\

ro Oi O

o hO Cm

\

i 0

1

i 2

\

A \

i

3

4

5

6

Recjrder Dint

>rder Dint

7

Safety stock , 8

, 9

, 10

i

11

1 12

.

Month

Both approaches are explained by using the example o f Q uintro Electronics Ltd, a wholesale supplier o f electronic components. Q uintro is open fo r business fo r 50 weeks each year. The annual demand fo r one o f Q uintro s components is 50 000 units. The lead tim e fo r new orders is exactly 1 week. On a weekly basis, demand has an expected value, £(D), o f 1000 and the probability d is trib u tio n shown in Table 20.2.

TABLE 20.2 Probability distribution of weekly demand Probability

Quantity demanded

0.02

665

0.05

700

0.10

800

0.18

900

0.30

1000

0.18

1100

0.10

1200

0.05

1300

0.02

1335

Acquisition costs are $200 per order, and carrying costs are 20 cents per component per year. Regardless o f the approach taken to calculate the safety stock, using Equation 20.2 the economic order quantity, Q*, is found to be: * 一 / 2 x $200 x 50 000 一

V

$0.20

= 1 0 000 units The next problem is to determ ine the reorder point. To what level should inve ntory be allowed to fall before a new order is placed? The tw o approaches to answering this question are explained in Sections 20.10.1 and 20.10.2.

20.10.1 | Specifying an acceptable probability of stockout The firs t approach requires th a t Q u in tro s management m ust determ ine an acceptable probability o f a stockout during the lead tim e o f 1 week. Suppose Q u in tro s management decides th a t it is prepared to accept a 2 per cent probability o f a stockout. From Table 20.2 it can be seen th a t there is a 2 per cent chance th a t demand during the lead tim e w ill be more than 1300 units. The safety stock is therefore 300 units and the reorder p o in t is 1300 units. I f a safety stock level o f 300 units is held, the customers’ needs w ill be less than fu lly satisfied in 2 per cent o f all lead times.

20.10.2 I Specifying an acceptable expected customer service level

LEARNING OBJECTIVE 9

Understand the difference between specifying an acceptable probability of stockout and specifying an acceptable expected customer service level

The approach based on stockout probability is often unsatisfactory because fo r m ost suppliers it focuses on the w rong measure. Suppose, fo r example, th a t during a particular lead tim e, demand exceeds 1300 units. In this case Q uintro cannot meet the demand fo r electronic components and this is therefore one o f those lead tim es during which a stockout occurs. However, this does not indicate anything about the magnitude o f the stockout problem. Knowing th a t a stockout has occurred does n o t provide any inform a tion on how many sales were lost. Given th a t the cost o f a stockout depends directly on the num ber o f lost sales, sim ply know ing th a t a stockout has occurred provides very little info rm a tio n about the costs incurred. Likewise, know ing the probability o f a stockout provides very little in fo rm a tio n about the likely costs. For example, suppose demand during a particular lead tim e is 1335 units. In this case only 35 units o f sales have been lost, and the stockout cost is quite low. The same p o in t can be made by referring to the customer service leveF, which can be quantified by calculating the ratio o f sales to the level o f orders and expressing this ratio as a percentage. I f demand is 1335 units, the customer service level is 1300/1335 or 97.38 per cent. This indicates th a t a high service level, and therefore a low level o f stockout costs, has been m aintained, notw ith stan d in g the fact th a t a stockout has occurred. Presumably, most managers are more concerned about the im pact o f a stockout on the customer service level than they are about the probability o f a stockout. This suggests th a t inventory policy should be based on an expected (target) level o f customer service, rather than on a target level o f stockout probability. The procedures needed to calculate the inve ntory level required fo r this policy are set out in Example 20.7.

E xample 20.7 Suppose that Quintro's management decides that it will accept, on average, a 98 per cent expected customer service level during the lead time—that is, it is Quintro's policy that there should be a probability of 0.02 that any particular customer's demand during the lead time will not be met. What is the required level of safety stock and the corresponding reorder point?

SOLUTION For each possible quantity demanded, the customer service level will be 100 per cent if the safety stock is sufficient to meet the level of demand. If the safety stock is insufficient to meet the level of demand, the customer service level will be the sum of the expected demand during the lead time (in this case 1000 units) and the safety stock divided by the quantity demanded. For example, if the safety stock is 50 units, the customer service level in those cases where demand is 1 100 will be 1000 + 50 〇「 95 45 per cent. The expected customer service level may then be found by summinq 1100

across the customer service levels for each possible quantity demanded. For example, if the safety stock is 50 units, then the expected customer service level given the possible levels of demand shown in Table 20.2 is: 0 .0 2 x 1

+ 0 .0 5 x 1 + 0 . 1 0 x 1 + 0 . 1 8 x 1 + 0 . 3 0 x 1 + 0 . 1 8 x

+ 0 .1 0 x

1050

1200 9 6 .5 4 %

+ 0.05

x

1050 1300

+ 0 .0 2 x

1050 1335

1050 1100

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a n a g e m e n t o f short -term assets : in v en t o r y

Similarly, if the safety stock is 300 units, then the expected customer service level is: 0.02 x 1 +0.05 x 1 + 0 .1 0 x 1 +0.18 x 1 + 0 .3 0 x 1 +0.18 x 1 + 0 .1 0 x 1 + 0.05 x 1 + 0.02 x

1300 1335

=99.95%

The target customer service level of 98 per cent may then be found by trial and error. The safety stock level must be increased if it provides an expected customer service level of less than 98 per cent, and it has to be decreased if it provides an expected customer service level of more than 98 per cent. In this example, if the safety stock level is 99 units, then the expected customer service level is: 0.02 x 1 + 0.05 x 1 + 0.10 x 1 + 0.18 x 1 + 0.30 x 1 + 0.18 x

1099 1100

1099 1099 1099 + 0.10 x - ^ - + 0 . 0 5 x + 0.02 x 1200 1300 1100 = 98%

which is equal to the specified target. Therefore, the required safety stock is 99 units, and, since the expected demand during the lead time is 1000 units, the reorder point is 1099 units.

The result in Example 20.7 may be compared w ith a reorder p o in t o f 1300 units, which is the solution calculated in Section 20.10.1 when the stockout p ro b a b ility was set at 2 per cent. I f a new order is placed when the in ve n to ry level falls to 1300 u nits, there is a 2 per cent chance th a t, at the end o f the lead tim e, no in ve n to ry w ill remain. O f course, at any p o in t during the lead tim e th is p ro b a b ility is much smaller. For example, a customer who arrives ju s t after the s ta rt o f the lead tim e is almost guaranteed th a t his or her order w ill be met. However, th is is n o t given any w eight in the decision to set the inve ntory level at 1300. Instead, the focus is on conditions at the end o f the lead tim e. As shown earlier, the expected custom er service level associated w ith a reorder p o in t o f 1300 is 99.95 per cent. This is an extrem ely high level. In contrast, the customer service level approach takes account o f conditions throughout the lead time. W ith the reorder p o in t set at 1099 units, the probability o f a stockout is 0.35. Therefore, customers who arrive at the end o f the lead tim e face a 35 per cent chance th a t th e ir orders w ill n ot be met. However, customers who arrive at the sta rt o f the lead tim e face an almost 0 per cent chance th a t th e ir orders w ill n ot be met. Overall, the average chance o f unm et orders during the lead tim e is 2 per cent and the expected customer service level is therefore 98 per cent. In general, there is no reason w hy suppliers should focus only on the end o f the lead tim e, since customers at th a t p o in t are neither more nor less valuable than customers at any other time. The expected customer service level approach is therefore preferred.

Inventory management and the 'just-in-time' system The <just-in-tim e , system is a way o f organising high volume repetitive m anufacturing o f goods such as m otor vehicles, engines and power tools.7 I t is based on the concept, firs t introduced by the Toyota M otor Corporation, th a t raw materials, equipment and labour are each supplied only in the amounts required, and at the times required, to perform the m anufacturing task. Therefore, a basic element o f the system is the coordination o f production processes so th a t raw materials and components are delivered to the location where they are needed at precisely the times they are required. Compared w ith a traditional system, this synchronisation o f delivery w ith demand reduces inventory levels, lead times and

7

F o r a m o re d e t a ile d d is c u s s io n o f th e ju s t- in - tim e s y s t e m , s e e L a n g fie ld - S m it h , T h o rn e a n d H ilto n ( 2 0 1 2 , C h a p t e r 1 5 ).

delivery quantities. For example, items th a t are bulky, expensive and obtained from local suppliers may be delivered once per day or even once per shift. In industries where both customers and suppliers adopt the just-in-tim e approach, inventories o f raw materials, w ork in progress and finished goods can be reduced substantially. However, the just-in-tim e system is n o t sim ply an inventory management system. Its adoption w ill reduce inventory, b ut th a t is n ot its m ajor function; rather, i t is a system th a t focuses on the elim ination o f waste in all forms, and improvements flow from reducing the need to hold inventories. For example, a machine th a t form s part o f a production line may break down several times per day. The trad ition al solution m ight be to hold large safety stocks o f this machines inputs and outputs. This ties up capital and requires storage facilities. Under the just-in-tim e system the machine would be redesigned so th a t i t operated more reliably, thereby e lim inating the need fo r safety stocks. The result is an im provem ent in overall efficiency, as well as a reduction in inventory costs. W hile many m anufacturing operations may be able to reduce w ork in progress by this approach, complete adoption o f the just-in-tim e system involves radical changes in relationships between manufacturers and suppliers, and in handling facilities. For example, the requirements fo r effective just-in-tim e operation include reliable quality o f supplies and transportation, short distances between suppliers and buyers, and frequent delivery o f small quantities o f goods. Where these requirements cannot be met, an im p o rta n t role remains fo r inventory management.

MS A a A l N 3 M l a 3 1 d v H u

SUMMARY •

pq

•

•

•

662

Assets such as inventory, liquid assets and accounts receivable are described as 'short term, because they are turned over rapidly. The resources committed to such assets are large, and if shareholders' wealth is to be maximised, the company's short-term assets need to be selected carefully and managed efficiently. Unlike most topics in finance, the model of a perfectly competitive, frictionless market is often not a useful starting point for analysing short-term asset management. This is because there would be no need to hold short-term assets, such as inventory, in a world of perfectly competitive, frictionless markets. While the relevant markets are generally competitive, it is the frictions in these markets that give rise to the need to hold short-term assets. Managers must make decisions concerning short­ term liabilities as well as short-term assets. An approach that is employed by many companies involves matching maturity structures of assets and liabilities. This approach minimises the risk that a company will have insufficient cash to meet liabilities as they fall due. There are three main types of inventory: raw materials, work in progress and finished goods. • If a retailer or wholesaler holds too little inventory, there will be lost sales due to stockouts and goods will have to be ordered frequently. • If too much inventory is held, extra capital will be tied up and the costs of storage and insurance will increase.

•

•

•

Determining an optimal inventory level involves minimising the total of the relevant costs. These are costs that vary with the inventory policy adopted. For retailers and wholesalers, the costs of holding inventory can be classified into three groups: acquisition costs, carrying costs and stockout costs. In turn, acquisition costs include ordering costs, freight and handling costs and, in some cases, quantity discounts forgone. Each of these costs will be lower per unit of inventory, the larger the order placed. Carrying costs include the opportunity cost of capital invested in inventory, storage costs and insurance costs. When demand is known with certainty, inventory management can be based on the economic order quantity (EOQ) model. The EOQ model estimates an optimal order quantity such that the total of acquisition costs and carrying costs is minimised. Inputs to the model include marginal costs, which may be di 仟icult to estimate. However, the model is robust in that total costs are relatively insensitive to estimation errors. When demand is uncertain, the order quantity decision may be the same as that under certainty, but the reorder point is changed by adding a safety stock to the reorder point, which would be chosen under certainty. The size of the safety stock may be determined on the basis of the probability of a stockout or, preferably, on the basis of specifying an acceptable level of customer service. Customer service is defined as the ratio of sales to orders and reflects the magnitude of any loss of sales due to stockouts.

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a n a g e m e n t o f short -term assets : in v e n t o r y

accounts receivable (or debtors) current assets 647 current liabilities 647 economic order quantity (EOQ)

th

647

inventory 647 liquid assets 647 safety stock 658

653

SELF-TEST PROBLEMS

1 Each year, Palmer Engineering Ltd produces 500 high-quality jet sprockets used in aircraft engines. A production run costs $3000 to set up and storage costs are $48 per sprocket per annum. Calculate the optimal size of a production run and the number of runs per annum.

2

Ron Harper operates a large sports store specialising in cricket equipment. Harper buys cricket balls from Mackintosh Sports Ltd. It takes Mackintosh 1 month to process and deliver an order. Harper estimates that during the cricket season the monthly demand for cricket balls follows the probability distribution overleaf. j

Probability

Q u antity dem anded

0.10

1600

0.20

1800

0.50

2000

0.15

2200

0.03

2400

0.02

2600

1

nHAPTER T W E N T Y REVIEW

KEY TERMS

What reorder point will ensure that there is only a 5 per cent chance that a stockout will occur during the lead time? What reorder point will ensure that the expected customer service level during the lead time is 95 per cent? Solutions to self-test problems are available in Appendix B.

QUESTIONS 1

[LO 1] Relative to total assets, businesses in the retail and wholesale sectors invest substantially more in short-term assets than do businesses in the service sector. Suggest reasons for this difference.

2

[L O l] For the average company, cash represents a much smaller percentage of its total short-term assets than accounts receivable. Suggest reasons for this difference.

3

[ID ]] Uncertainty makes it difficult for a financial manager to forecast a company's requirement for shortterm funds. Discuss. W hat steps can a financial manager take to minimise the resulting risks to the company?

4

[LO 1] Explain why the proportion of a company's total assets tied up in inventory varies widely from company to company. Give examples.

5

[LO 2] Distinguish between the major types of short-term asset.

6

[LO 3] Should the decision to invest in short-term assets be approached differently from the decision to invest in long-term assets? Why?

7

[LO 4] Explain the 'maturity matching7 concept. W hy do many companies pursue policies based on this idea?

663

B usiness finance

8

[LO 5】For a retailer, what are the major costs and benefits of holding inventory? What different benefits and costs apply to raw materials inventory held by a manufacturer?

9

[LO 6] Distinguish between acquisition costs and carrying costs.

10

[LO 7] The Economic O rder Quantify model is essentially a w ay to find the optim al mix o f acquisition costs and carrying costs. Do you agree? Why?

n

[LO 8] W hat is 'safety stock'? Explain how it is possible that safety stock might be negative.

12 [LO 8] Because it is impossible to obtain precise measures o f the necessary data, theoretical inventory management models are virtually useless. Comment on this statement. 13

[LO 9] Explain briefly why the expected customer service level approach to inventory management is preferable to the acceptable probability of stockout approach.

CA

PROBLEMS

1

Inventory management under certainty [LO 5 】 The Leichhardt Pharmacy sells 5000 bottles of vitamin C tablets each year. The clerical and related costs of placing and processing an order amount to $25 and the carrying costs are 16 cents per bottle per annum. Calculate the economic order quantify (EOQ) and the time period between placement of orders.

2

Inventory management under certainty [LO 7] Drummond Garden Tools Ltd specialises in the manufacture of lawn rakes. Every 6 months, Drummond buys 1500 rake handles from Kilmarnock Timber Mills at a cost of $1.50 per handle. The clerical and processing cost is $75 per order, and each handle costs $1.80 per annum to store. Calculate Drummond's economic order quantity (EOQ) and the annual cost saving that would be achieved using the EOQ.

3

Inventory management with quantity discounts [LO 7] The vitamin C tablet manufacturer who supplies the Leichhardt Pharmacy (see Problem 1) has begun offering quantity discounts to its customers as follows: 1

Q u antity ordered

Price per bottle ($)

1 -9 9 9

2.00

1 0 0 0 -1 9 9 9

1.99

2 0 0 0 -2 9 9 9

1.98

3 0 0 0 -3 9 9 9

1.97

4000+

1.96

|

Calculate the new economic order quantity (EOQ). 4

Inventory management under uncertainty [LO 9] Driscoll Magazines Ltd places orders for new stock every month. The new stock arrives 1 week after placement of the order. Driscoll has estimated that weekly demand follows the probability distribution below. 丨

664

Probability

Q u antity dem anded

0.060

100

0.150

120

0.460

140

0.166

160

0.144

180

0.020

200

f

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a n a g e m e n t o f short -term assets : in v e n t o r y

Inventory management under uncertainty [LO 9 】 Using the data on Cranfield Manufacturing Ltd in Example 20.2: a) calculate the total annual cost of the optimal inventory policy b) show that any order quantity between 1095 and 2055 metres results in an annual cost within 5 per cent of the minimum. Comment on the implications of this result.

REFERENCES Goetz, B.x Quantitative Methods: A Survey and Guide for Managers, M cG raw-H ill, N e w York, 1965. Hill, N.C. & Sartoris, W.L., Short-term Financial Management: Text and Cases, 3rd edn, M acm illan, N ew York, 1995. Kallberg, J.G. & Parkinson, K.L.; Current Asset Management, John W ile y & Sons, N ew York, 1984. Langfield-Smith, K., Thorne, H. & Hilton, R.W., Management

Accounting: Information for Managing and Creating Value, 6th edn, M cG raw-Hill, Sydney, 2 0 1 2 .

Scherr, F.C., Modern Working Capital Management: Text and Cases, Prentice-Hall, Englewood Cliffs, N ew Jersey, 1989. Silver, E.A., Pyke, D.F. & Peterson, R.; Inventory Management and Production Planning and Scheduling, John W ile y & Sons, Hoboken, N ew York, 1998. Smith, K.V. & G allinger, G .W ., Readings on Short­ term Financial Management, 3rd edn, West, St Paul, Minnesota, 1988.

CHAPTER T W E N T Y R E V S W

What reorder point will ensure that there is a 2 per cent chance that a stockout will occur during the lead time? What reorder point will ensure that the expected customer service level during the lead time is 98 per cent?

CHAPTER CONTENTS Introduction

66 7

2 1 .7

Overview of liquidity management Cash budgeting

66 7 — 6 /0

B Q

The choice of short-term securities

673

21 .5

Types of short-term investment

67 4

Evaluation of alternative credit and collection policies

21.6

The corporate treasurer and liquidity management

675

Appendix 21.1 Financial statement analysis

BE1

I

Overview of accounts receivable management Credit policy Collection policy

LEARNING OBJECTIVES After studying this chapter you should be able to: 1

define liquid assets

2

distinguish between liquidity management and treasury management

3

identify the motives for holding liquid assets

4

prepare a cash budget

5

identify avenues for short-term investment by companies

6

define accounts receivable and distinguish between trade credit and consumer credit

7

identify the benefits and costs of holding accounts receivable

8

identify the four elements of credit policy

9

understand the factors in implementing a collection policy

10 apply the net present value method to evaluate alternative credit and collection policies 11 apply financial statement analysis to short-term asset management.

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a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

Introduction In this chapter we continue the discussion o f short-term asset management by considering the management o f a company s liq u id assets (cash and short-term investments) and accounts receivable. Management o f these assets is considered in turn. First, every company needs to m aintain liq u id ity in order to ensure th a t its creditors are paid on time. O f course, this objective could easily be m et by a company holding a large p roportion o f its assets in liqu id form . However, because cash does n o t earn interest, and the retu rn on short-term investments is often quite low, such a policy would conflict w ith the company’s ultim ate goal o f m axim ising shareholders’ wealth. In general, therefore, a company w ill hold a relatively small p roportion o f its short-term assets in the form o f cash. For example, at the end o f the 2013 financial year, Boral Ltd and Paperlinx Ltd held only 8 and 9 per cent respectively o f th e ir short-term assets in the form o f cash, while the comparable percentage fo r BHP B illito n Ltd was 31 per cent. Clearly, the management o f a company s liq u id resources is an im portant aspect o f financial management. This is considered in Sections 21.2 to 21.6. Second, m ost companies sell on credit— th a t is, instead o f a company exchanging its products fo r cash, it w ill agree to deliver the products immediately, in retu rn fo r the customers promise to pay at a later date. For instance, payment may n ot be required u n til a period o f 30 days has elapsed. D uring this period the selling company holds an asset Accounts receivable1. Companies that sell on credit w ill have a considerable p roportion o f th e ir short-term assets in the form o f accounts receivable. For example, at the end o f the 2013 financial year, Boral Ltd held 48 per cent o f its short-term assets in the fo rm o f accounts receivable, while the comparable percentages fo r BHP B illito n Ltd and Paperlinx Ltd were 34 per cent and 60 per cent, respectively. As w ith any other short-term asset, accounts receivable needs to be managed efficiently, w ith the ultim ate goal o f m axim ising shareholders’ wealth. The management o f accounts receivable is considered in Sections 21.7 to 21.10.

21.2 Overview of liquidity management 21.2.1 | W hat are 'liq u id ’ assets?

LEARNING OBJECTIVE 1 Define liquid assets

Liquid a ssets comprise cash and assets th a t can be converted in to cash in a very short tim e, and whose

cash value can be predicted w ith a low degree o f error. Examples o f assets w ith these features include ‘at call’ deposits w ith banks, money m arket dealers or other financial intermediaries, and various short­ term marketable securities, such as bills o f exchange and commercial paper. These assets are described in Chapter 10.

LIQUID ASSETS

comprise cash and assets that are readily convertible into cash such as bills of exchange

2 1 .2 .2 1 Liquidity management and treasury management Liquidity m a n ag em en t refers to the decisions made by the management o f a company about the composition and level o f the company s liqu id resources. In Australia, this typically involves deciding on the m ix o f liqu id assets (such as cash, interest-bearing deposits and securities) th a t a company w ill try to achieve, as well as the level o f bank overdraft usage. It is usual fo r a company in Australia to use an overdraft provided by its bank. Under the terms o f such an agreement, the company is able to overdraw its bank account up to some agreed lim it. This means th a t the company can borrow any am ount up to the agreed lim it. Therefore, a company can guarantee immediate access to cash by m aintaining an unused overdraft lim it. Also, a company may arrange stand-by facilities, such as an approved line o f credit, which can be drawn down i f required. Liq uid ity management is n o t therefore confined to management o f cash and liqu id assets, b u t also extends to the management o f bank overdraft and other sources o f short-term borrowing. T reasu ry m a n a g em en t is a broader concept than liq u id ity management and includes liq u id ity management as one o f its functions. Many companies have established a separate group or departm ent,

LEARNING OBJECTIVE 2 Distinguish between liquidity management and treasury management LIQUIDITY M AN AGEM EN T

involves decisions about the composition and level of a company’s liquid assets

TREASURY MANAGEMENT

involves the management of financial assets and includes the management of short­ term financial assets, long-term financing and risk management

under the control o f the company treasurer, to manage the company s liq u id ity and to oversee its exposure to various kinds o f financial risk. Foreign exchange provides one example o f exposure to risk. I f a company exports, im ports, borrows foreign currency or lends foreign currency, then there is the risk o f loss from exchange rate movements. For example, i f the Australian dollar depreciates, an im p orte r w ill face a higher cost o f im ports in Australian dollar terms. The treasurer w ill advise on whether this risk should be hedged and, i f so, how it is to be hedged. A nother facet o f the treasury s role in a company is the management of interest rate risk. For example, suppose th a t a company has borrowed money on a floating interest rate basis and has lent money on a fixed interest rate basis. I f the general level o f interest rates increases, the company could fin d its e lf in difficulty, because while the interest cost o f its borrowed funds has increased, the interest received on the funds i t has le n t remains fixed. Similarly, if a company holds a p o rtfo lio o f fixed interest securities, or i f i t has plans to buy or sell (issue) fixed interest securities, there is a risk due to the possibility o f changing interest rates. Issues o f this type were considered in Appendix 4.1 and Chapters 17 and 18.

21.2.3! Centralisation of liquidity management M any companies centralise the liq u id ity management function, even i f many other functions are n ot centralised. The m ain reason is th a t centralisation allows the m atching o f inflow s and outflows fo r the whole company, w ith consequent savings. This principle is clearly seen in Example 21.1. The centralisation o f liq u id ity management also facilitates the development o f specialised staff by having them concentrated in one area o f the business. Any economies o f scale can also be exploited. O f course, it should also be borne in m ind th a t there can be diseconomies o f scale. For example, the centralisation o f liq u id ity management is likely to be a failure i f there is poor comm unication between the operating divisions and the group responsible fo r liq u id ity management.

E xample Megacorp Ltd has a manufacturing division and a customer services division. On a particular day, the manufacturing division must meet a net cash outflow of $1500 00; on the same day, the customer services division receives a net cash inflow of $50000. If both divisions are operated independently, the manufacturing division will need to borrow $ 1 500 00 and the customer services division will be able to invest $5000 0. Clearly, it is easier if, instead, the company simply borrows the net requirement of $1000 00, and since the borrowing rate will exceed the lending rate, it is cheaper to do so. For example, if the time period involved is 7 days and the annual interest rates are 15 per cent per annum (borrowing) and 12 per cent per annum (lending), what is the cost saving from centralised liquidity management?

SOLUTION The net interest cost would be calculated as follows: a) If liquidity management were centralised, then the net interest cost would be: $100000

X

0.15

X

7 365

=$287.67

b) If liquidity management were not centralised, then the net interest cost would be: $ 1 5 0 0 0 0 x 0 .1 5

7 3 65'

$50000 x 0.12 x

365 y

=$316.44

The cost saving from centralisation is $316.44 - $287.67 = $28.77. If the situation in this 7-day period is typical of the company's operations, then over a year the savings would amount to 52 x $28.77 = $1496.04. In practice, the savings may be reduced by the transaction and communication costs required to achieve centralisation.

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a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

2 1 .2 .4 1 Motives for holding liquid assets Studies of the motives for holding liquid assets have a long history in the literature of economics. The conventional classification of motives, often attributed to Keynes, divides the motives into three groups: the tra n sa c tio n s m otive, the p re c au tio n a ry m o tive and the sp e c u lativ e m o tiv e .1

Transactions motive Many businesses face a continuous outflow of cash to meet expenses but will often receive a continuous inflow of cash, particularly from sales. If these inflows and outflows were perfectly matched in both timing and amount, then no liquid assets would be required. While the timing of a company s cash outflows can be controlled by management, the timing of many of its inflows depends on the actions of its customers. Consequently, perfect synchronisation is virtually impossible to achieve, with the result that some liquid assets must be held for transaction purposes.

Precautionary motive Future cash inflows and outflows cannot be forecast with perfect certainty. There is, therefore, always the possibility that extra cash will be needed to meet unexpected costs, or to take advantage of unexpected opportunities. Liquid assets are therefore held as a precaution to cover outflows resulting from these unexpected events. However, the precautionary motive will be weaker if a company can arrange a source of finance that can be called on in times of need. In Australia, bank overdrafts, commercial bill facilities and corporate credit cards provide this type of finance.

Speculative motive When interest rates increase, there is a fall in the market value of income-producing assets such as bonds. Keynes hypothesised that when an individual forecasts an increase in interest rates he or she will sell bonds and, instead, hold cash or bank deposits in order to avoid the resulting capital loss. Therefore, liquid asset holdings depend in part on expectations of interest rate changes. Keynes termed this the 'speculative motive*. Speculation may be a potent force for companies in the finance sector. For example, a money market dealer may change the size and/or composition of its portfolio, depending on its expectations of market conditions. However, outside the finance sector it is doubtful whether the speculative motive has a role in liquidity management practices. In summary, for m ost companies, transaction-based motives are probably the dominant influences and are the focus of our discussion of liquidity management.

2 1 .2 .5 ! M ajo r issues in liquidity management All companies have cash receipts and need to make cash payments. Because the cash receipts and payments will not generally be matched in time and amount, the company s cash position must be forecast, monitored and managed. If this is not done, the following situations are likely to arise: a

If the cash payments exceed the cash receipts, the company will need to borrow money to make the payments, or else postpone payment. If it borrows money, it will need to pay interest and, probably, fees. Alternatively, if payment is postponed, the likely result is disruption to its business and/or damage to its financial reputation. b If the cash receipts exceed the cash payments, resulting in a large cash balance, the company is failing to make the best use of its resources. The net funds obtained could be invested to earn interest or used to reduce the company s debt.

In short, the major issues in liquidity management are to ensure that the company has adequate liquid resources to make cash payments as the need arises, without holding such a high level of liquid assets that the company s resources are used inefficiently. This balance is achieved by first forecasting the likely 1

In fa c t, K e y n e s ( 1 9 3 6 , C h - 1 5 ) s p e c if ie d fo u r m o t iv e s t h a t h e te r m e d th e ‘in c o m e m o t iv e ’, th e ‘b u s i n e s s m o t iv e ’, th e p r e c a u t io n a r y m o tiv e * a n d t h e s p e c u la t iv e m o tiv e *. T h e fir s t r e la t e s m a in ly t o t r a n s a c t io n s b y in d iv id u a ls a n d th e s e c o n d to t r a n s a c t io n s b y e n t e r p r is e s ; t h e s e tw o a re th e r e f o r e o ft e n c o m b in e d in t o a s in g le t r a n s a c t io n s m o tiv e .

LEARNING OBJECTIVE 3 Identify the motives for holding liquid assets

B usiness finance

p a tte rn s o f cash re c e ip ts a n d p a y m e n ts , a n d th e n a d o p tin g an a p p ro p ria te m ix o f cash, liq u id assets and s h o r t- te rm b o rro w in g . A s e ve n ts u n fo ld , th e cash p o s itio n is m o n ito re d , n e w fo re ca sts are m ade a n d a n e w m ix a d o p te d . A basic t o o l in fo re c a s tin g cash flo w s is th e cash b u d g e t. This to o l is o u tlin e d in th e n e x t se ctio n .

Cash budgeting

*

A cash b u d g et p ro v id e s a fo re c a s t o f th e a m o u n t an d t im in g o f th e cash re c e ip ts an d p a y m e n ts t h a t w ill

LEARNING OBJECTIVE 4 Prepare a cash budget

re s u lt fr o m th e co m p a n y s o p e ra tio n s o v e r a p e rio d o f tim e . To a ssist in d a y -to -d a y cash m a n a g e m e n t, fo re ca sts o f re c e ip ts a n d p a y m e n ts m a y be m ad e f o r each day o f th e c o m in g w eek. A lte rn a tiv e ly , foreca sts m a y be m a d e o n a w e e k ly basis f o r a n u m b e r o f w eeks in advance, o r f o r each m o n th o f th e n e x t fin a n c ia l year. A cash b u d g e t o n a m o n th - b y - m o n th basis is u s u a lly p re p a re d as p a r t o f th e o v e ra ll m a s te r b u d g e t

C A S H B U DG ET

forecast of the amount and timing of the cash receipts and payments that will result from a company’s operations over a period of time

f o r th e n e x t fin a n c ia l ye a r a n d i t is u s e fu l as an in d ic a tio n o f th e c o m p a n y s s h o r t- r u n d e b t-p a y in g a b ility . In a d d itio n , m o n th ly fo re ca sts s h o u ld ta ke in to a cco u n t seasonal a n d o th e r p re d ic ta b le v a ria tio n s in cash flo w s . C learly, th e cash b u d g e t is o n ly as u s e fu l f o r d e cisio n m a k in g as th e accuracy o f th e e s tim a te s used in its p re p a ra tio n . A c o m p a n y w h o se cash flo w s are su b je c t to a g re a t de al o f u n c e r ta in ty s h o u ld p ro v id e a s a fe ty m a rg in in th e fo r m o f a m in im u m cash balance, o r have re a d y access to b o rro w in g , o r b o th , to tid e i t o v e r p e rio d s w h e n cash p a y m e n ts exceed cash rece ip ts. The cash b u d g e t th e re fo re assists th e tre a s u re r in fo re c a s tin g w h e n such excesses o f p a y m e n ts o v e r re c e ip ts are lik e ly to occur. The ba sic s tru c tu re o f a cash b u d g e t is v e ry sim p le . A fo re c a s t o f cash re ce ip ts a n d p a y m e n ts is m ade f o r each tim e p e rio d . O fte n th is w ill be d o n e b y fo re c a s tin g s e p a ra te ly th e m a jo r c o m p o n e n ts o f th e cash flo w s . F o r exa m ple, separate fo re ca sts m a y be m ad e f o r p a y m e n ts f o r wages, m a te ria ls a n d pow er. In p ra ctice , dozens o f separate foreca sts m a y be m ade. M a n y o f the se fo re ca sts w ill, in t u r n , d e p e n d on th e fo re c a s t le v e l o f sales. Cash re ce ip ts are o b v io u s ly re la te d to th e sales le ve l, b u t so also are m a n y cash p a y m e n ts . F o r e xa m p le , in a m a n u fa c tu rin g com pany, h ig h sales m ea ns h ig h p ro d u c tio n , w h ic h , in tu r n , m ea ns t h a t m o re ra w m a te ria ls w ill n e ed to be p u rcha sed. In a d d itio n , th e c o rp o ra te tre a s u re r m a y sp e cify th a t, f o r s a fe ty reasons, a g iv e n m in im u m re q u ire d cash balance s h o u ld be b u ilt in to th e b u d g e t. The le ve l a t w h ic h th is m in im u m is set is o fte n d e te rm in e d o n a n ad h o c basis. G ive n fo re ca sts o f to t a l re ce ip ts, to t a l p a y m e n ts a n d th e m in im u m re q u ire d balance, th e fo re c a s t cash s h o rta g e (to be b o rro w e d ) o r cash s u rp lu s (to be in v e s te d ) is s im p ly :

(Total receipts) less (Total payments) less (Minimum required balance)

21.3.1 | Forecasting cash receipts The sales fo re ca st is p ro b a b ly th e m o s t im p o r t a n t fa c to r a ffe c tin g th e accuracy o f th e cash b u d g e t. A n e rro r in th e fo re c a s t o f sales w ill be re fle c te d in an e r r o r in th e e xp e cte d c o lle c tio n s fr o m cu sto m e rs. Such an e rro r w ill also a ffe c t b u d g e te d cash p a y m e n ts , as th e c o m p a n y s le v e l o f o p e ra tio n s w ill u s u a lly be a d ju s te d in response to e xp e cte d changes in th e le v e l o f sales. The p re p a ra tio n o f a sales fo re c a s t u s u a lly in v o lv e s th e fo llo w in g steps. F irs t, a th o ro u g h a n a lysis o f p a s t sales p e rfo rm a n c e is m ad e f o r each p ro d u c t. A n y re la tio n s h ip o r tr e n d o b se rve d can th e n be ta k e n in to a c c o u n t in m a k in g th e sales fo re c a s t. F o r exa m ple, a seasonal p a tte r n o f sales m a y be o b se rve d an d th e n b u ilt in to th e fo re ca st. Second, som e fa c to rs e x te rn a l to th e c o m p a n y w i ll have a n im p o r t a n t e ffe ct o n th e sales fo re ca st. F o r exa m ple, th e fo re ca ste rs w ill p ro b a b ly use p ro je c tio n s o f lik e ly b u sin ess an d e c o n o m ic c o n d itio n s p re p a re d b y o u ts id e c o n s u lta n ts or, in v e ry la rg e o rg a n is a tio n s , b y an in -h o u s e e c o n o m is t. A f te r th e sales fo re c a s t has b e en p re p a re d , th e n e x t ste p is to e s tim a te th e cash re c e ip ts fr o m sales. Cash sales p re s e n t n o p ro b le m because th e cash is rece ive d im m e d ia te ly . H o w e ve r, c re d it sales re q u ire e s tim a tio n o f th e t im in g o f cash re ce ip ts. T his w i ll be in flu e n c e d b y th e c o m p a n y s c re d it te rm s , th e ty p e o f c u s to m e r, a n d th e ge n e ra l c re d it a n d c o lle c tio n p o lic ie s o f th e c o m p a n y .2 E xp e rie n ce w i ll u s u a lly in d ic a te th e p r o p o r tio n o f t o ta l sales t h a t are cash sales; th e re m a in d e r w ill be c re d it sales. The ra te o f c o lle c tio n m a y be e s tim a te d fr o m an a n alysis o f p a s t reco rds, ta k in g in to a c c o u n t a n y s pe cia l fa c to rs . 2

The management of accounts receivable is discussed later in this chapter.

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a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

2 1 .3 .2 1 Forecasting cash payments In th e case o f a m a n u fa c tu rin g com p an y, a fte r th e sales fo re c a s t has be en p re p a re d , a p ro d u c tio n schedule c o n s is te n t w it h th is fo re c a s t is e s ta b lis h e d f o r each p ro d u c t. O n th e basis o f th e p ro d u c tio n schedule, m a n a g e m e n t can e s tim a te th e e xp ected p a y m e n ts f o r m a te ria ls a n d la b o u r. A c o m p a n y w ill also in c u r ove rh e a d costs, w h ic h in c lu d e th e cost o f s u p p lie s, in su ra n ce , lig h t a n d p o w e r, a n d re p a irs an d m a in te n a n ce . In som e cases, th e se goods a n d services m a y be o b ta in e d o n c re d it a n d th e re fo re th e re w ill be a la g b e tw e e n th e d a te o f p u rcha se a n d th e da te o f th e cash p a y m e n t. F o r exa m ple, i f s u p p lie rs o f m a te ria ls se ll o n 30 days* c re d it a n d do n o t send in vo ice s u n t il th e e n d o f th e m o n th o f purchase, th e p u rch a se r m a y have a p e rio d o f u p to

2

m o n th s b e tw e e n th e d a te o f p u rcha se a n d th e da te o f cash

p a ym e n t. O th e r re g u la r cash p a y m e n ts m a y in c lu d e a d m in is tra tiv e expenses, m a rk e tin g expenses a n d in te re s t p a y m e n ts . P a ym e n ts t h a t ty p ic a lly are m ade less fre q u e n tly , b u t are n e v e rth e le s s re la tiv e ly p re d icta b le , in c lu d e in c o m e ta x p a y m e n ts , c a p ita l e x p e n d itu re s a n d d iv id e n d p a y m e n ts . The p re p a ra tio n o f a s im p le cash b u d g e t is illu s tra te d in E xa m p le 21.2.

E xample 21.2 Lancaster Ltd has forecast its monthly sales for the next 6 months as shown in Table 21.1.

TABLE 21.1 Monthly sales forecast Month

Sales ($'0001

January

1600

February

1750

M arch

1750

A p ril

1800

M ay

1900

June

1900

It is expected that in each month, 20 per cent of sales will be cash sales and 80 per cent of sales will be credit sales. It is forecast that the collection pattern for credit sales will be as follows: a) 5 per cent in the month of sale b) 80 per cent in the month following sale c) 10 per cent in the second month following sale d) 2.5 per cent in the third month following sale e) 2.5 per cent uncollectable (bad debts). Management requests that you use this information to forecast cash collections (receipts) from Lancaster's customers in April, May and June.

SOLUTION The first step is to divide total sales into cash sales (20 per cent) and credit sales (80 per cent) as shown in Table 21.2.

TABLE 21.2 Cash and credit sales Total sales

Cash sales

($'000)

($，000)

Jan ua ry

1600

320

1280

February

1750

350

1400

M o n th

Credit sales

~]

($'000)

continued

B usiness finance

Table 21.2 continued Total sales

Cash sales

Credit sales

($ ' 0 0 0 )

($ ，0 0 0 )

($ ，0 0 0 )

M arch

1750

350

1400

A p ril

1800

360

1440

M ay

1900

380

1520

June

1900

380

1520

::

::

M o n th

Credit sales then generate cash receipts according to the pattern of collections, as shown in Table 21.3.

TABLE 21.3 Cash receipts for Lancaster Ltd Are collected as cash receipts ($'000) in: 11

III.

March

April

January

February

J a n u a ry (1280)

64

1024

128

32

F ebru ary (1400)

—

70

112 0

140

35

M arch (1400)

—

—

70

112 0

140

35

A p r il (1440)

—

—

—

72

1152

144

M ay (1520)

—

—

—

—

76

1216

June (1520)

一

一

—

—

—

C re d it sales collected

—

—

—

1364

1403

1471

350

350

360

380

380

一

—

1724

1783

1851

I

Cash sales Cash receipts ($*000)

320 一

May

June — —

76

The cash receipts for January, February and March are incomplete because insufficient information has been provided. For example, January will see a cash receipt from the credit sales made in December. Presumably, Lancaster will already have actual (rather than forecast) figures for December's credit sales, and for the cash already collected from these sales. These figures would then be used in forecasting the collections for January and subsequent months. In practice, Lancaster Ltd would then have to forecast other cash receipts, as well as cash payments and the minimum required cash balance to complete its cash budget. The resulting forecasts for the June quarter might be those shown in Table 21.4.

TABLE 21.4 Lancaster Ltd: forecast cash receipts and payments for June quarter, by month April ($，000) Cash balance a t b e g in n in g o f m o n th

May ($'000)

June ($，000)

740

564

547

1 7 24

1783

1851

add Cash receipts: C ollections fro m custom ers

C hapter tw en ty - o ne M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

Table 2 1 . 4 continued

A pril ($，000)

M ay ($’000)

June ($'000)

—

310

—

300

—

—

D ividends on in ve stm e n ts in o th e r companies Sale o f e q u ip m e n t

50

40

140

Total cash receipts

2074

2133

1991

T otal cash available

2814

2697

2538

1400

1600

1300

Wages and salaries

500

525

510

D ividends

—

—

500

Incom e ta x

—

—

—

Purchase o f land

300

O th e r

less Cash paym ents: Payments to cred itors

50

25

30

2250

2150

2340

Cash balance a t end o f m o n th

564

547

198

Required m in im u m cash balance

300

300

300

Cash (required) available fo r

264

247

( 10 2 )

O th e r Total cash paym ents

in ve stm e n t

F in a lly , a c tu a l resu lts s h o u ld

b e c o m p a r e d w ith fo re c a s t re su lts o n a n o n g o in g

b a s is . F a c to rs

in flu e n c in g th e c a s h p o s itio n o f th e c o m p a n y th a t w e r e n o t fo re s e e n w h e n th e c a s h fo re c a s t w a s p r e p a r e d m a y b e d is c lo s e d b y th e c o m p a r is o n s . F o r e x a m p le , c u s to m e rs m a y n o t b e p a y in g th e ir a c c o u n ts as p r o m p tly a s h a d

b e e n e x p e c te d

a n d , as a

re s u lt, c a s h re c e ip ts m a y b e less th a n

th o se fo re c a s t. In th e e v e n t o f la r g e v a r ia tio n s fro m th e c a s h b u d g e t, th e b u d g e t s h o u ld b e re v is e d im m e d ia te ly . C o m p a ris o n s b e tw e e n th e b u d g e te d a n d a c tu a l fig u re s m a y a ls o in d ic a te w a y s in w h ic h th e fo re c a s tin g p r o c e d u r e c a n b e im p r o v e d .

2 1 .4

The choice of short-term securities

There are m a n y typ e s o f in v e s tm e n ts in w h ic h a c o m p a n y can in v e s t te m p o r a r ily id le cash. These in v e s tm e n ts o ffe r a w id e ran ge o f r is k a n d re tu rn . The tre a s u re r has th e o p p o r tu n it y to in v e s t in h ig h e ry ie ld in g se c u ritie s , p ro v id e d t h a t he o r she is p re p a re d to accept th e g re a te r r is k o f such in v e s tm e n ts . The g re a te r ris k m a y re fe r n o t o n ly to th e r is k t h a t rates o f r e tu r n m a y change also to th e p o s s ib ility o f d e fa u lt th e in v e s tm e n t

(liquidity risk).

(default

or

credit risk)

(interest rate risk),

but

a n d to th e r is k a sso cia te d w it h th e liq u id it y o f

F o r exa m ple, an in v e s tm e n t in a ca ll d e p o s it w it h a b a n k is u n c e rta in to

th e e x te n t th a t th e b a n k m a y be u n a b le to m e e t its c o m m itm e n ts . H o w e ve r, f o r m o s t b a n ks, m o s t o f th e tim e , th e p ro b a b ility o f d e fa u lt is v e ry lo w a n d th e re fo re th e d e fa u lt r is k is v e ry s m a ll. A r is k o f g re a te r consequence relates to th e liq u id it y o f th e in v e s tm e n t. The m o re d iff ic u lt i t is to c o n v e rt a s e c u rity in to cash, th e g re a te r is th e liq u id it y r is k o f t h a t s e c u rity . F o r exa m p le , a 3 -m o n th te r m d e p o s it w it h a b a n k is ris k ie r th a n a ca ll d e p o s it w it h th e sam e b a n k , as th e co m p a n y m a y u n e x p e c te d ly n e ed th e cash b e fo re th e 3 m o n th s have elapsed.

B usiness finance

Types of short-term investment The fo llo w in g d iscu ssio n does n o t a tte m p t to c o m p ile a c o m p le te lis t o f p o ssib le in v e s tm e n ts , b u t LEARNING OBJECTIVE 5 Identify avenues for short-term investment by companies

does e x a m in e som e o f th e avenues a va ila b le f o r in v e s tin g a c o m p a n y s te m p o ra rily id le cash. F o r each in v e s tm e n t w e h ig h lig h t th e c h a ra c te ris tic s t h a t are im p o r t a n t to a tre a s u re r w h o m u s t choose th e m o s t a p p ro p ria te fo rm s o f in v e s tm e n t, g iv e n th e c o m p a n y s circu m sta n ce s. Table 2 1 .5 p ro v id e s som e s h o rt­ te r m in te re s t ra te s a n d y ie ld s.

TABLE 21.5 Examples of short-term interest rates and yields Type of investment

Interest rates and yields (% p.a.)

G o ve rn m e n t b o nd s— 5 years

3.393

Cash, average 11 am rate

2.500

90-day b a n k b ills

2.690

180-day b a n k b ills

2.700

Cash m anagem ent tru s ts — M acquarie C M T

2.500

Source: Australian Financial Review, 18 March 2014.

21.5.1 | Deposits of funds with financial institutions Several ty p e s o f fin a n c ia l in s t it u t io n accept d e p o s its .3 The basic te rm s o f th e d e p o s it w i ll d iffe r fr o m one k in d o f in s t it u t io n to a n o th e r a n d a tre a s u re r s choice w i ll d e p e n d o n the :

a

period th a t the funds are available fo r investm ent risk th a t the company is prepared to accept C required rate o f return.

b

Banks A c o m p a n y can in v e s t fu n d s in in te re s t-b e a rin g te r m d e p o s its w it h a b a n k o r p u rch a se c e rtific a te s o f d e p o s it f r o m a b a n k . T erm s to m a t u r ity f o r te r m d e p o s its a n d c e rtific a te s o f d e p o s it are n e g o tia b le . C e rtific a te s o f d e p o s it are m o re liq u id th a n te r m d e p o s its as th e y are m a rk e ta b le . F u n d s can also be in v e s te d f o r v e ry s h o rt te rm s ; f o r exa m ple, fu n d s m a y be p lace d o n 2 4 -h o u r call. The d e fa u lt r is k associated w it h d e p o s itin g fu n d s w ith a b a n k is v e ry lo w an d, i f s u b je c t to th e g o v e rn m e n t g u a ra n te e , n o n -e x is te n t. C o n s e q u e n tly th e in te re s t rates o ffe re d te n d to be less th a n th o s e f o r m o s t a lte rn a tiv e in v e s tm e n ts .

Cash management trusts Cash m a n a g e m e n t tru s ts a ct as in te rm e d ia rie s b e tw e e n s m a ll in v e s to rs a n d th e m o n e y m a rk e ts . M a n y co m p a n ie s are la rge e n o u g h to e n te r th e m o n e y m a rk e ts d ire c tly , b u t s m a lle r c o m p a n ie s m a y fin d in d ire c t access v ia th e tru s ts to be an a ttra c tiv e o u tle t f o r fu n d s a va ila b le f o r in v e s tm e n t f o r p e rio d s as s h o rt as a fe w days.

2 1 .5 .2 1 Discounting of commercial bills The c o m m e rc ia l b ills m a rk e t was discussed in C h a p te r 10. A c o m p a n y can in v e s t its id le cash balances in th is m a rk e t in one o f tw o ways. F irs t, a co m p a n y can be th e o r ig in a l d is c o u n te r o f a c o m m e rc ia l b ill and, as a re s u lt, s u p p ly fu n d s to th e d ra w e r o f th e b ill. Second, a c o m p a n y can
These were discussed in Chapter 8.

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previously been discounted by another party. This sim ply means th a t the b ill is purchased from another investor in the bills m arket. Such purchases are easily arranged as there is an active m arket in bills. The m arketability o f commercial bills is one o f the m ajor advantages o f this form o f investm ent.

21.6 The corporate treasurer and liquidity management The demand fo r liq u id ity stems from transactions th a t result in cash inflows and payments that are n ot synchronised in either tim in g or amount. One means o f reducing the necessary cash balance is to smooth the pattern o f cash flows. For example, the company may be able to negotiate credit terms w ith suppliers so that payment is not required u n til the goods are sold. Similarly, the dates on which employees’ wages are paid could be altered to b ring these dates more in to line w ith times when the company has a cash surplus. In fact, there are opportunities fo r reducing a company s cash requirements wherever the pattern o f cash payments can be brought more in to line w ith the pattern o f cash inflows. Usually this w ill require delaying cash payments fo r as long as possible, in order to bring them closer to the tim e when the goods and services acquired can be converted in to cash inflow s through sales. Acceleration o f the flow o f cash inflows w ill also have a desirable effect on liquidity. In this case the aim is to reduce the tim e th a t elapses between the date o f sale and the date o f the cash inflow. These issues fall into the category o f credit and collection policy* and are discussed in Sections 21.7 to 21.10.

Overview of accounts receivable management The purpose o f our discussion o f accounts receivable management is to id e n tify the variables th a t can be influenced by the manager responsible fo r accounts receivable, and to discuss techniques and procedures that may be employed in choosing the o ptim um values fo r these variables. Collectively, these decisions are often referred to as the company s credit and collection policies. Establishment o f a credit policy involves four elements:

m LEARNING OBJECTIVE 6 Define accounts receivable and distinguish between trade credit and consumer credit

a

Is the company prepared to offer credit? I f credit is to be offered, w hat standards w ill be applied in the decision to grant credit to a customer? C How much credit should a customer be granted? d W hat credit terms w ill be offered?

b

When credit has been offered and accepted, the company m ust then seek to ensure th a t the promised amount is received. Inevitably, some accounts w ill prove d iffic u lt to collect and the company w ill need to take steps to recover the am ount owing— th a t is, the company w ill adopt a collection policy. This requires the manager to determine which procedures w ill be used to encourage payment, and fo r how long these procedures should be followed. In practice, credit and collection policies w ill be interrelated, b ut it is convenient in the firs t instance to consider them separately. Before fu rth e r discussion o f credit and collection policies, we firs t describe the characteristics o f accounts receivable in more detail and indicate the benefits and costs o f holding accounts receivable.

21.7.1 | W hat are accounts receivable? Accounts receivable represent money owed to a company from the sale, on credit, o f goods or services in the norm al course o f business. Trade credit refers to credit sales made to other businesses, whereas consum er credit refers to credit sales made to individuals. Trade credit terms may provide a discount fo r

A C C O U N T S RECEIVABLE

sum of money owed to a seller as a result of having sold goods or services on credit T R AD E CREDIT

arrangement in which a seller of goods or services allows the purchaser a period of time before requiring payment; it is equivalent to a short­ term loan made by the seller to the purchaser, of an amount equal to the purchase price

C O N S U M E R CREDIT

credit extended to individuals by suppliers of goods and services, or by financial institutions through credit cards OPEN ACCOUNT

an arrangement under which goods or services are sold to a customer on credit, but with no formal debt contract. Payment is due after an account is sent to the customer

prom pt payment, whereas consumer credit terms are unlikely to have this feature. Consumer credit may also require the customer to pay a service fee, b ut this is unusual in the case o f trade credit. An individual or business purchasing goods on credit from a retailer may either charge the amount to a credit account or enter in to a longer-term consumer credit agreement, which is likely to require regular repayment o f an agreed amount. W hile some m ajor retailers continue to provide credit, the provision of credit has largely been taken over by financial in s titu tio n s th a t issue credit cards. These cards allow goods and services to be purchased on credit w ith o u t credit being extended by the retailer. Trade credit, however, continues to be provided by manufacturers, wholesalers and other providers o f goods and services. A business purchasing goods on credit may be offered trade credit on open account, or, i f the amount involved is substantial, the business may be required to negotiate a b ill o f exchange.4 Trade credit on open account is the more usual method. For example, a tim be r yard is likely to provide trade credit on open a cco u n t to builders who obtain th e ir supplies regularly from the yard. This requires little or no form al documentation and the selling company sends regular statements to n o tify its customers o f their current indebtedness. In the remainder o f this chapter, decisions relating to trade credit on open account are considered. However, much o f the material presented is applicable to other form s o f trade credit and to consumer credit.

Benefits and costs of granting credit

LEARNING OBJECTIVE 7 Identify the benefits and costs of holding accounts receivable

The m ajor benefits and costs o f granting credit can be illustrated by a simple example. Suppose th a t the manager o f a suburban tim ber yard is reviewing the businesss accounts receivable policy. A lenient policy would be to provide credit to nearly all customers who request it, to allow these customers a long credit period, and to delay taking steps to collect overdue accounts. Such a policy would alm ost certainly attract new customers and perhaps w in more business from existing customers. However, a lenient policy would also increase costs substantially. The long credit period would tie up resources th a t could otherwise be invested elsewhere. Further, the costs o f adm inistering the accounts would rise, and the lower credit standard required o f customers would lead to increased costs o f collection and a higher incidence o f unpaid accounts. Conversely, a very stric t policy would keep these costs at very low levels, b ut would also lead to lost sales as customers turned to competing tim ber yards whose policies were more lenient. The aim o f the manager is to choose the set o f policies th a t w ill maximise the net benefit to the tim ber yard. The benefits and costs are now explained in more detail.

Benefit of increased sales A company w ill offer credit terms to its customers only i f its management believes th a t there w ill be an increase in sales. The benefit is therefore the net increase in sales revenue directly attributable to the credit terms offered. In calculating the effect o f increased sales on p ro fit, it is, o f course, necessary to deduct fro m the increase in sales revenue the cost o f the goods sold and other associated costs, such as delivery costs.

Opportunity cost of investm ent Accounts receivable tie up funds th a t could be invested in some other way. There is, therefore, an o pp o rtu n ity cost, which is equal to the return th a t these funds could otherwise have earned.

Cost of bad debts and delinquent accounts D E L IN Q U E N T ACCOUNTS

accounts where payment has not been made by the due date B A D DEBTS

accounts that have proven to be uncollectable and are written off

Some customers may delay unduly the payment o f th e ir accounts (called d e lin q u e n t accounts) and others may n ot pay th e ir accounts at all (called bad debts). A delinquent account means th a t the supplier m ust w ait a longer tim e before i t receives payment, and therefore the o p p o rtu n ity cost is greater. A bad debt means th a t the supplier incurs the cost o f a credit sale w ith o u t obtaining any benefit.

Cost o f adm inistration Each credit account m ust be administered. A t a m inim um , these costs w ill generally include staff costs, the costs o f checking the credit-worthiness o f customers, and office expenses such as stationery, postage and telephone charges. Delinquent accounts impose fu rth e r costs because o f the collection costs they involve. Collection costs may include fu rth e r staff costs and office expenses and, as a fin al step, the costs 4

See Section 10.5.3 for a description of bills of exchange.

C hapter tw en ty - o ne M

a n a g e m e n t o f short -term assets : u q u id assets a n d a c c o u n t s receivable

o f legal action. Such action may be justified i f the am ount involved is substantial and there is a reasonable probability th a t the debtor has the a b ility to pay.

Cost of additional investm ent Increased sales w ill, o f themselves, generally involve fu rth e r costs. For example, a higher inventory level may be required.5 In the case o f a manufacturer, new investm ent in p la nt and equipment may be needed to meet the increased demand.

21.8

Credit policy

In Section 21.7, fo ur elements o f c r e d it p o lic y were mentioned. These elements are now considered LEARNING OBJECTIVE 8 Identify the four elements of credit policy

further.

21.8.1 I The decision to offer credit In principle, a company m ust decide whether it w ill sell on a s tric tly cash only* basis or whether some credit w ill be extended. In practice an individual company w ill often have little choice b ut to extend credit. I f competitors provide credit to customers, it is likely th a t the company w ill also have to extend credit if it is to retain its customers* business. The reason is simple: an offer o f credit is equivalent to a price reduction and, naturally, a lower price tends to increase demand. It was noted earlier that from the sellers viewpoint the need to w ait fo r payment involves an o pp o rtu n ity cost. Equally, from the buyers view point, the ability to defer payment is equivalent to a price reduction. For example, i f a customer has a required rate o f return o f 1 per cent per m onth, and buys an item fo r $101 on 1 m onth s credit, the effective cost in today’s terms is only $100.6

2 1 .8 .2 1 Selection of credit-worthy customers A company w ill usually offer sim ilar term s to all its credit-w orthy customers, b u t it m ust firs t decide which o f its customers w ill be granted credit and which w ill be refused credit— th a t is, it needs inform a tion about the riskiness o f extending credit to a particular customer at a particular time. In reaching a decision about granting credit, one o f the best guides is often the company s own experience w ith the customer. One technique th a t is a useful aid in deciding whether to grant credit is the decision tree*. This technique was discussed in Chapter 6 and is illustrated in the context o f the selection o f credit-w orthy customers by Example 21.3.

E xample 21.3 S u p p o s e th a t C o m p a n y A h a s a la r g e n u m b e r o f c r e d it c u s to m e rs a n d it re c e iv e s fro m C o m p a n y B a re q u e s t f o r c r e d it f o r th e p u rc h a s e o f 1 0 0 u n its o f C o m p a n y A 's p r o d u c t a t $ 1 0 p e r u n it. In th e firs t in s ta n c e , C o m p a n y A h a s th re e c h o ic e s : a)

it m a y g r a n t th e re q u e s t im m e d ia te ly

b)

it m a y re fu s e th e re q u e s t im m e d ia te ly , o r

c)

it m a y p o s tp o n e th e d e c is io n p e n d in g in v e s tig a tio n . A t a m in im u m , th is in v e s tig a tio n w ill u s u a lly in v o lv e c h e c k in g its o w n re c o rd s to se e if C o m p a n y B

ha s re c e iv e d c r e d it fro m C o m p a n y A in th e p a s t.7 S u ch a n in v e s tig a tio n w ill s h o w w h e th e r C o m p a n y B is a lo w c r e d it ris k , a h ig h c r e d it ris k o r is a n e w c u s to m e r a b o u t w h o m n o in fo r m a tio n is a v a ila b le

continued 5 6 7

The costs associated with investments in inventory were discussed in Chapter 20. More formally, from the buyer s viewpoint, the present value of $101 payable in 1 months time is $101/1.01 or $100. Other forms of investigation, such as checking with a credit bureau, are discussed later in this section.

CREDIT P O LIC Y

supplier’s policy on whether credit will be offered to customers and on the terms that will be offered to those customers

continued fro m th e c o m p a n y 's re c o rd s . C o m p a n y A w is h e s to c h o o s e th e c o u rs e o f a c tio n th a t h a s th e lo w e s t e x p e c te d c o s t. T h e p o s s ib le a c tio n s c o n fro n tin g C o m p a n y A a r e s h o w n in th e fo rm o f a d e c is io n tre e in F ig u re 2 1 . 1 .

Figure 21.1 Decision tree showing possible courses of action for Company A

To e m p lo y th is a p p r o a c h , it is n e c e s s a ry to e s tim a te th e c o s t a s s o c ia te d w ith e a c h e n d p o in t o n th e tre e . In tu rn , th is re q u ire s in fo r m a tio n o n th e f o llo w in g ite m s :8 a)

th e m a r g in a l c o s t o f p r o d u c in g e a c h u n it, th e s a le s re v e n u e g e n e r a te d b y e a c h u n it a n d th e m a r g in a l n e t b e n e fit o f e a c h u n it s o ld ; in th is e x a m p le , th e m a r g in a l c o s t o f e a c h u n it is a s s u m e d to b e $ 7 , a n d s in c e th e a s s o c ia te d s a le s re v e n u e is $ 1 0 , th e m a r g in a l n e t b e n e fit is $ 1 0 - $ 7 = $ 3 . T h e re fo re , f o r th is o r d e r th e m a r g in a l c o s t is $ 7 0 0 a n d th e m a r g in a l n e t b e n e fit is $ 3 0 0

b) c)

th e c o s t o f in v e s tig a tio n , a s s u m e d in th is e x a m p le to b e $ 2 p e r in v e s tig a tio n th e p r o b a b ilit y th a t C o m p a n y B is lo w ris k , h ig h ris k o r is a n e w c u s to m e r; in th is e x a m p le , C o m p a n y A 's e x p e r ie n c e s u g g e s ts th a t th e se p r o b a b ilit ie s a r e 0 . 8 0 , 0 . 1 5 a n d 0 . 0 5 , re s p e c tiv e ly

d)

th e c o s t o f c a p it a l, a s s u m e d in th is e x a m p le to b e 2 p e r c e n t p e r m o n th 9

e)

d a t a f o r e a c h c a t e g o r y o n th e p r o b a b ilit y o f p a y m e n t, th e p r o b a b ilit y o f a b a d d e b t o c c u r r in g ( w h ic h is s im p ly 1 m in u s th e p r o b a b ilit y o f p a y m e n t), th e a v e r a g e w a it in g p e r io d fro m th e d a te o f s a le to th e d a te o f p a y m e n t, a n d th e a v e r a g e c o lle c tio n c o s t. T h e se d a ta a r e s h o w n in T a b le 2 1 . 6 .

TABLE 21.6 Data relating to Example 21.3 Probability of payment

Probability of bad debt

Average waiting period (months)

0.93

0.07

2

5

Low risk

1.00

0

1

2

High risk

0.60

0.40

7

20

New customer

0.80

0.20

3

8

Decision No investigation

Average collection cost ($)

：

F in din g o f investigation:

8 9

To simplify the example it is assumed that there are no costs of additional investment in non-current assets or inventory. To simplify the discussion, we use simple interest— that is, 2 per cent for 1 month, 4 per cent for 2 months, and so on.

C hapter tw en ty - o n e M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

To d e te rm in e w h e th e r a c u s to m e r s h o u ld b e g r a n te d c r e d it im m e d ia te ly , re fu s e d c r e d it im m e d ia te ly o r in v e s tig a te d , th e m a n a g e r n e e d s to c o m p a r e th e co sts o f th e s e a lte rn a tiv e s . T he c o s t o f g ra n tin g c r e d it is g iv e n b y : E x p e c te d b a d d e b t c o s t + in v e s tm e n t o p p o r tu n it y c o s t + c o lle c tio n c o s t = ( p r o b a b ilit y o f b a d d e b t) ( $ 7 0 0 ) + ( 0 . 0 2 x $ 7 0 0 ) ( w a itin g p e r io d ) + c o lle c tio n c o s t The c o s t o f refusing c r e d it is g iv e n b y : E x p e c te d v a lu e o f m a r g in a l n e t b e n e fit f o r g o n e = ( p r o b a b ilit y o f p a y m e n t) ( $ 3 0 0 ) U s in g th e s e e q u a tio n s , th e c o s t a t e a c h e n d p o in t o n th e d e c is io n tre e c a n b e c a lc u la te d a s s h o w n b e lo w .

Grant credit immediately C o st = (0 .0 7 x $ 7 0 0 ) + (0 .0 2 x $ 7 0 0 x 2) + $ 5 = $ 8 2

Investigate, with the follow ing findings and decisions L o w r is k / g r a n t :

C o s t = (0 x $ 7 0 0 ) + ( 0 . 0 2 x $ 7 0 0 x 1) + $ 2 = $ 1 6

L o w r is k /r e fu s e :

C ost = jl x $ 3 〇 6| = $ 3 0 0

H ig h r is k / g r a n t :

C o s t= ( 0 .4 x $ 7 0 0 )

+ (0 .0 2 x $ 7 0 0 x 7) + $ 2 0

H ig h r is k /r e fu s e :

C o s t= ( 0 .6 x $ 3 0 0 )

= $180

= $398

N e w c u s t o m e r / g r a n t:

C o s t = ( 0 .2 x $ 7 0 0 )

+ (0 .0 2 x $ 7 0 0 x 3) + $ 8 = $ 1 9 0

N e w c u s to m e r /re fu s e :

C o s t = ( 0 .8 x $ 3 0 0 )

= $240

Refuse credit immediately C o s t= (0 .9 3 )($ 3 0 0 ) = $ 2 7 9 T hese a m o u n ts a r e s h o w n o n th e d e c is io n tre e in F ig u re 2 1 . 2 . If a n in v e s tig a tio n is u n d e rta k e n , th e re is a p r o b a b ilit y o f 0 . 8 0 th a t C o m p a n y B w ill b e fo u n d to b e in th e lo w -ris k c a te g o r y . In th a t c a s e , th e lo w e r c o s t d e c is io n is to g r a n t c r e d it (s in c e $ 1 6 is less th a n $ 3 0 0 ) . If C o m p a n y B is fo u n d to b e in th e h ig h -ris k c a t e g o r y ( p r o b a b ilit y 0 . 1 5 ) , th e re q u e s t w ill b e re fu s e d (co st $ 1 8 0 ) . If C o m p a n y B is fo u n d to b e a n e w c u s to m e r ( p r o b a b ilit y 0 . 0 5 ) , th e re q u e s t w ill b e g r a n te d (c o s t $ 1 9 0 ) . T h e in v e s tig a tio n its e lf w ill c o s t $ 2 . T h e re fo re , th e to ta l e x p e c te d c o s t o f in v e s tig a tin g th e re q u e s t is: $ 2 + ( 0 .8 x $ 1 6 ) + ( 0 . 1 5 x $ 1 8 0 ) + ( 0 . 0 5 x $ 1 9 0 ) = $ 5 1 . 3 0

Figure 21.2 Decision tree showing costs of alternative actions for Company A

continued

B usiness finance

continued F in a lly , c o m p a r in g th e th re e d e c is io n s — g r a n t im m e d ia te ly , re fu s e im m e d ia te ly o r in v e s tig a te — it is fo u n d t h a t th e lo w e s t-c o s t c h o ic e is to in v e s tig a te th is re q u e s t. T h e e x p e c te d c o s t o f in v e s tig a tin g th e re q u e s t is $ 5 1 . 3 0 , a s a g a in s t $ 8 2 fo r a n im m e d ia te g r a n tin g o f c r e d it a n d $ 2 7 9 fo r a n im m e d ia te re fu s a l o f c r e d it. If th e in v e s tig a tio n s h o w s th a t C o m p a n y B is e ith e r a n e x is tin g c u s to m e r in th e lo w ris k c a t e g o r y o r a n e w c u s to m e r, th e re q u e s t w ill b e g r a n te d . H o w e v e r, if C o m p a n y B is a n e x is tin g c u s to m e r in th e h ig h -ris k c a te g o r y , th e re q u e s t w ill b e re fu s e d .

The decision-tree approach discussed in Example 21.3 is appropriate fo r a company th a t relies to a large extent on inform a tion obtained from experience w ith its own customers. Undoubtedly, this is a convenient and very useful source o f inform ation. Frequently, however, companies look to other sources as well. For example, Company A may require Company B to complete a credit application form . Generally, this form w ill require the applicant to provide the names o f b oth trade and bank referees who can be contacted to provide info rm a tio n on the applicants credit-worthiness. Larger companies may have a credit rating assigned by a credit rating agency, such as Fitch Ratings, M oody s Investors Service or Standard & Poors.10 O ther m ajor sources o f info rm a tio n are credit bureaus such as Dun & Bradstreet. These bureaus m aintain records o f companies’ financial details, including th e ir record in paying trade debts, and provide this in fo rm a tio n to interested parties fo r a fee. O ther in fo rm a tio n on the credit-worthiness o f Company B may be obtained from other businesses w ith which i t has an account. These businesses w ill have first-hand knowledge o f Company Bs payment record. Company A may also require inform a tion on the financial condition o f Company B. This is usually obtained from the company s financial statements and from the completed application form . Company As m ain concern is the short-term liq u id ity position o f Company B as this provides a measure o f its a b ility to pay. In addition, the value o f Company Bs unencumbered non-current assets provides some indication o f the degree o f security. The use o f financial statem ent analysis in credit policy is discussed in Appendix 21.1. The credit standards th a t a company applies w ill influence the incidence o f bad debts and delinquent accounts. A company w ill incur v irtu a lly no bad debts i f it applies very high standards, b u t in doing so it w ill probably have to forgo sales.

2 1 .8 .3 ! Limit of credit extended

CREDIT P E R IO D

period between the date that a purchaser is invoiced and the date when payment is due

Even i f Company B is accepted as a credit-w orthy customer by Company A, i t is usual fo r A to place a lim it on the m axim um am ount o f credit it is prepared to extend to B. The lim it w ill depend, in part, on the expected value o f Bs purchases from A. However, A may n o t wish to extend to B sufficient credit to finance the fu ll am ount o f Bs purchases. The most obvious advantage to A o f im posing a credit lim it is that it reduces the m axim um loss th a t A can suffer i f B defaults. The a b ility to set a lim it is particularly useful w ith new customers. A t first, a relatively low lim it can be set in order to reduce the risk, but, as tim e passes, and the account is satisfactorily maintained, higher lim its can be established. In th is way, business is n o t lost because o f refusal to grant credit, b ut the risk exposure is n o t excessive.

D IS C O U N T PE R IO D

period during which a discount for prompt payment is available to the purchaser D IS C O U N T RATE

expression of the price reduction a purchaser will receive if payment is made within the discount period

2 1 .8 .4 ! Credit terms A company s credit term s specify a credit period, and may also specify a discount period(s) and a discount rate(s). The credit period is the period th a t elapses between the date when the purchasing company is invoiced and the date when payment is due.11 The discount period is the period th a t elapses between the date when the purchasing company is invoiced and the date when the discount is forgone. The discount rate expresses, in effect, the price reduction th a t the purchasing company w ill receive i f it pays w ith in the discount period. 10 See Section 4.7 for a description and examples of such ratings. 11 The statement of account is the regular notification that the selling company sends to its debtors to indicate their current indebtedness. These statements are normally sent out monthly, often at the end of the month. This practice is important because the credit period does not commence from the date of sale but rather from the date on the monthly statement. Debtors can use this to their advantage by purchasing at the beginning of the month and stretching a 30-day credit period into an almost 60-day credit period.

C hapter tw en ty - o ne M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

Typical examples o f credit terms are as follows: • •

•

n/30: There is no discount and the credit period is 30 days. A fte r the expiration o f the credit period, the purchaser is in default. 2/10, n/30: The discount rate is 2 per cent, the discount period is 10 days and the credit period is 30 days. Therefore, i f Company B purchases, on credit, goods w o rth $100 from Company A, and the purchase is included in its statement o f account dated 31 March, then Company B would have to pay only $98 i f the account is paid by 10 A p ril. I f it forgoes the discount, Company B is required to pay $100 by the end o f A pril. A fte r th a t date, Company B would be in default. SW/IO, 2y2/30: There are tw o discount periods. A higher discount o f 3Y2 per cent is allowed i f payment is made w ith in 10 days o f being invoiced, while a discount o f 2 V2 per cent is received i f payment is made w ith in 30 days. The credit period is also set at 30 days. Therefore, a company w ill receive a discount fo r paying w ith in the credit period.

A company offers a discount to accelerate its cash in flo w a nd /or to improve its competitive position. If we consider the credit terms 2/10, n/30, the purchasing company obtains an effective reduction in price by paying w ith in 10 days. Therefore, a company may obtain a larger share o f the m arket fo r its product by offering higher discounts than its competitors. Also, the discount w ill encourage the company s credit customers to pay earlier. In percentage terms, the financial inducement to pay earlier can be quite large. Referring again to the credit terms 2/10, n/30, consider the position o f Company B on 10 A p ril. To find a better use fo r its $98, Company B would need to find an investm ent that, w ith zero risk, can tu rn $98 into $100 w ith in 20 days. The annual effective rate o f retu rn required is therefore: 365

V

98/

= 4 4 .6 %

Earlier payments by customers w ill reduce the am ount th a t Company A has tied up in receivables, and w ill also reduce the incidence o f bad debts and delinquent accounts. In tu rn , this w ill reduce its collection costs.

Collection policy A company th a t never has a bad debt almost certainly has a sub-optim al credit policy— th a t is, if a more lenient policy were adopted, then the increase in sales would more than offset the losses imposed by a few bad debts. For m ost companies, some bad debts are inevitable. N otw ithstanding this fact, it is also true th a t in most cases some attem pt to collect overdue debts is w orthw hile. These efforts are referred to as the company s collection policy. The critical problem in collection policy is the need to recognise when an account warrants special attention. Obviously it is n o t sensible to in stitu te legal action on a $10 account th a t is 2 days overdue. But what i f the account were fo r $10 m illion , rather than $10? Is action warranted i f a $1000 account is 30 days overdue? I f so, w hat action should be taken? There are no hard and fast answers to these questions. However, most businesses adopt a set o f procedures. Generally, attem pts to collect an account that is overdue begin w ith a standard rem inder notice, followed by personal letters and telephone calls. Eventually, visits may be made in person. The last resort is legal action, b u t this can be very expensive and may involve long delays. An alternative is to employ a debt collection agency, b ut this too can be expensive. I t may also sometimes pay a business to accept a p artial payment, rather than continue w ith attempts to collect the fu ll am ount owed. As the am ount spent on collection activities increases, i t is to be expected th a t bad debt losses w ill be reduced and the average collection period w ill be shorter. However, these relationships are unlikely to be linear. For example, an in itia l small level o f expenditure is unlikely to have any marked effect in reducing bad debts, or in shortening the average collection period, while additional expenditures are likely to have a much greater effect. However, beyond a certain level o f collection expenditure the benefits w ill dim inish u n til eventually a saturation p o in t is reached. The relationship between the average collection period and the level o f collection expenditures is likely to be similar.

LEARNING OBJECTIVE 9 Understand the factors in implementing a collection policy C O LLEC T IO N P O U C Y

policy adopted by a company in regard to collecting delinquent accounts either informally or by the use of a debt collection agency

B usiness finance

Collection policy involves a trade-off between the costs o f collection and the benefits o f lower bad debt losses and a shorter average collection period, which in tu rn w ill result in a reduction in the company s investm ent in accounts receivable. Comparing these costs and benefits to determ ine a preferred policy is likely to involve considerable judgm ent. Also, in determ ining a collection policy, it is im p o rta n t to take account o f the effect o f the collection policy on sales, as a more forceful collection procedure may adversely affect sales. For example, i f collection procedures are begun too early, customers may be offended and switch to alternative suppliers.

21.10 Evaluation of alternative credit and LEARNING OBJECTIVE 10 Apply the net present value method to evaluate alternative credit and collection policies

collection policies The net present value (NPV) m ethod o f evaluating investm ent projects was discussed in Chapters 5 and 6. The investm ent projects analysed in those chapters related to investments in non-current assets, such as property, plant and equipment. However, in principle, the NPV m ethod is appropriate fo r other types o f investm ent, including investm ent in accounts receivable. In this section, we consider the application o f the NPV m ethod to a company’s credit and collection policies. The benefits associated w ith a change in credit policy can be measured by the net increase in sales revenue, w hile the costs w ill include m anufacturing, selling, collection and adm inistration expenses, and bad debts. In addition, by discounting the net cash flows generated by the credit policy at the cost of capital, the analysis w ill incorporate the cost to the company o f having funds tied up in receivables.12 If all the benefits and costs associated w ith a particular credit policy are quantified and expressed in present value terms, the particular credit policy under consideration w ill be profitable if the net present value is positive. The company s optim um credit policy is the one th a t results in the largest net present value. The application o f NPV analysis to the evaluation o f alternative policies is outlined in the follow ing examples. We begin w ith a highly sim plified in Example 21.4, and introduce additional factors relevant to the decision in subsequent Examples 21.5-21.9. The examples are intended m ainly to illustrate the factors th a t could influence the p ro fita b ility o f a credit policy. In practice, many companies adopt credit policies th a t are sim ilar to those followed by others in the same industry. However, i f sufficient data are available to estimate the effects o f changes in the terms offered, and competitive conditions suggest that changes may be feasible, then a credit manager could use the approach embodied in these examples to assess whether it is desirable to m odify the present policy.

Example 21.4 Z e lc o Ltd, w h ic h c u rre n tly d o e s n o t o ffe r c r e d it, is c o n s id e r in g e x te n d in g c r e d it to its c u s to m e rs f o r a p e r io d o f 6 0 d a y s . T h is is a s s u m e d to re s u lt in a n in c re a s e in s a le s re v e n u e o f $ 2 0 0 0 0 . T he a d d itio n a l c o s t a s s o c ia te d w ith th e se s a le s is $ 1 6 0 0 0 . In itia lly , it is a s s u m e d th a t Z e lc o ’s e x is tin g c a s h c u s to m e rs w ill n o t s e e k c r e d it if th e p r o p o s e d c r e d it p o lic y is in tr o d u c e d . It is a ls o a s s u m e d th a t th e re a r e n o b a d d e b ts , a d m in is tr a tio n co sts o r c o lle c tio n c o sts a n d th a t a ll c r e d it c u s to m e rs w ill ta k e fu ll a d v a n ta g e o f th e c r e d it te rm s b y d e la y in g p a y m e n t u n til th e 6 0 t h d a y . 13 Z e lc o 's c o s t o f c a p it a l is 2 p e r c e n t p e r m o n th .14 W h a t is th e N P V o f e x te n d in g c r e d it to c u s to m e rs ?

12 The required rate of return depends on the risk class of credit customers. In addition, the analysis should take into account the costs of financing any additional inventory or non-current assets that the company requires to support a higher level of operations. In the subsequent examples it will be assumed that these costs have been included in the costs associated with the sale. However, in practice, these costs will only include accounting costs, such as the cost of the goods sold and delivery charges. Therefore, it is usually necessary to impute a figure so as to include the cost of the additional funds invested in inventory and non-current assets. 13 In t±iis and subsequent examples, it is assumed for simplicity that the credit period and the discount period extend from the date of purchase, rather than from the date on the monthly statement. 14 In accordance with business practice, the length of the credit period is referred to in terms of days. However, to make the present value calculations less cumbersome, monthly discounting is used. It is assumed that 1 month equals 30 days and, to ease the exposition, the phrase at the end of the month* will be stated more simply as at month, since all cash flows in these examples are assumed to occur at the end of the month.

C hapter tw en ty - o ne M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

SOLUTION G iv e n th e s e a s s u m p tio n s , th e in v e s tm e n t o p p o r tu n it y b e in g c o n s id e r e d b y Z e lc o c o n s is ts o f a n in itia l o u tla y o f $ 1 6 0 0 0 a t tim e z e r o , a n d a c a s h in flo w o f $ 2 0 0 0 0 a t th e e n d o f M o n th 2 . W it h a c o s t o f c a p ita l o f 2 p e r c e n t p e r m o n th , th e N P V o f th e p r o p o s e d p o lic y is:

N PV = $ 2 ° 0 0 0 - $ 1 6 0 0 0 ( 1. 02)2

=$3223.38 S in c e th e N P V is p o s itiv e , th e p r o p o s e d c r e d it p o lic y is p r o fita b le .

The credit policy proposed in Example 21.4 did n ot offer discounts fo r payments received before the expiration o f the credit period. This possibility is shown in Example 21.5.

E xample S u p p o s e th a t th e a s s u m p tio n s m a d e in E x a m p le 2 1 . 4 a r e r e ta in e d , e x c e p t th a t Z e lc o n o w o ffe rs a d is c o u n t o f 2V2 p e r c e n t f o r p a y m e n ts re c e iv e d w ith in 3 0 d a y s — th a t is, th e p r o p o s e d c r e d it te rm s a re 2 V 2 / 3 0 , n / 6 0 . It is e s tim a te d th a t 7 5 p e r c e n t o f c r e d it c u s to m e rs w ill ta k e a d v a n ta g e o f th e d is c o u n t. W h a t is th e N P V o f e x te n d in g c r e d it o n th e s e re v is e d te rm s?

SOLUTION A s in E x a m p le 2 1 . 4 , th e in it ia l o u t la y is $ 1 6 0 0 0 . T h e c a s h in flo w a t M o n th 1 is (1 - 0 . 0 2 5 ) x 0 . 7 5 x $ 2 0 0 0 0 = $ 1 4 6 2 5 a n d th e c a s h in flo w a t M o n th 2 is 0 . 2 5 x $ 2 0 0 0 0 = $ 5 0 0 0 . T he N P V o f th e p ro p o s e d p o lic y is th e re fo re :

N P V = iI^

1.02

+ l ^

-$ 1 6 0 0 0

( 1. 02)2

= $ 3 1 4 4 .0 8 T he N P V o f th is p o lic y is p o s itiv e a n d it is th e re fo re p r e fe r r e d to th e c u rre n t p o lic y o f n o t o ffe r in g c r e d it a t a ll. H o w e v e r, th e N P V o f th is p o lic y is less th a n th e N P V o f a c r e d it p o lic y th a t o ffe rs n o d is c o u n t fo r e a r ly p a y m e n t. T h is in d ic a te s th a t Z e lc o s h o u ld n o t o ffe r th e d is c o u n t a s s u m e d in th e e x a m p le .

Example 21.5 did n o t allow fo r the possibility th a t the offer o f a discount could well attract even more new customers to Zelco. Because a discount amounts to a reduction in price, i t is possible that demand would increase. The increased demand could be sufficient to ju s tify offering the discount. This is shown in Example 21.6.

E xample 21.6 It is n o w a s s u m e d th a t, a s w e ll as th e a d d itio n a l s a le s o f $ 2 0 0 0 0 a s s u m e d in E x a m p le s 2 1 . 4 a n d 2 1 . 5 , fu rth e r s a le s o f $ 4 0 0 0 (a t a c o s t o f $ 3 2 0 0 ) a r e m a d e to c u s to m e rs , a ll o f w h o m ta k e a d v a n ta g e o f th e 2 p e r c e n t d is c o u n t. W h a t is th e e ffe c t o f th e a d d it io n a l s a le s o n th e N P V o f e x te n d in g c re d it?

continued

continued

SOLUTION T he in it ia l o u tla y is n o w $ 1 6 0 0 0 + $ 3 2 0 0 = $ 1 9 2 0 0 . T h e c a s h in flo w a t M o n th 1 is $ 1 4 6 2 5 + ((1 - 0 . 0 2 5 ) x $ 4 0 0 0 ) = $ 1 8 5 2 5 a n d th e c a s h in flo w a t M o n th 2 re m a in s a t $ 5 0 0 0 . T he N P V o f th e p r o p o s e d p o lic y is th e re fo re : 除

$ 1 8 5 2 5 + $5000

1.02

-$ 1 9 2 0 0

( 1.02)2

= $ 3 7 6 7 .6 1 S in c e th e N P V is p o s itiv e , a n d e x c e e d s th e N P V c a lc u la te d in E x a m p le 2 1 . 6 , th e p r o p o s e d p o lic y t h a t o ffe rs a 2 p e r c e n t d is c o u n t f o r p a y m e n t re c e iv e d w ith in 3 0 d a y s is p r e fe r a b le to a p o lic y th a t o ffe rs n o d is c o u n t f o r e a r ly p a y m e n t.

To summarise the position so far, the in itia l outlay is $19200, the cash in flo w at M o n th 1 is $18525 and the cash inflo w at M on th 2 is $5000. Bad debts and delinquent accounts have so fa r been ignored. The effect o f bad debts and delinquent accounts is illustrated in Example 21.7.

E xample 21.7 It is n o w a s s u m e d th a t th e o ffe r o f a d is c o u n t w ill still re s u lt in a c a s h in flo w o f $1 8 5 2 5 a t M o n th 1 ; b u t o f th e r e m a in in g $ 5 0 0 0 o w in g , $ 3 0 0 0 w ill b e p a id o n tim e (a t M o n th 2), $ 1 0 0 0 w ill b e p a id la te (a t M o n th 3 ), $ 4 0 0 w ill b e p a id still la te r (a t M o n th 4 ) a n d $ 6 0 0 w ill n e v e r b e p a i d — th a t is, b a d d e b ts w ill a m o u n t to u n p a id a c c o u n ts o f $ 6 0 0 . W h a t w ill b e th e e ffe c t o f b a d d e b ts a n d d e lin q u e n t a c c o u n ts o n th e N P V o f e x te n d in g c re d it?

SOLUTION B a s e d o n th e a b o v e a s s u m p tio n s , th e N P V is:

NPV

= $18 525 + $3000 + $ 1000 + $4〇° -$19200 1.02

( 1. 02)2

( 1. 02)3

( 1. 02)4

=$3157.13 S in c e th e N P V is p o s itiv e , th e p r o p o s e d c r e d it p o lic y is still a n a c c e p ta b le in v e s tm e n t.

The costs o f adm inistration and collection s till have to be included in the analysis. A large proportion o f these costs do n o t depend on the value o f the account. For example, the clerical cost o f producing and sending a tax invoice fo r a customer who owes $200 is n o t likely to be different from the cost incurred fo r a customer who owes $10000. A t the level o f the individual account, the to ta l am ount spent in an effort to collect the am ount owing w ill increase, the longer the account remains unpaid. However, taking the company s m on thly spending on collection procedures fo r all accounts th a t have been granted credit at a given p o in t in tim e, the am ount spent each m onth on collection is likely to decrease as tim e passes. For example, suppose th a t 10 accounts are overdue and the company spends $2 per account to send a first rem inder notice. Expenditure on collection procedures fo r th a t m onth is therefore $20. If, in the next m onth, seven o f these accounts have been paid, there are three rem aining unpaid accounts to be sent a second rem inder notice at a to ta l cost o f $6. Expenditure on collection has therefore fallen from $20 to $6. The extent o f this decrease may be lessened by the fact th a t later stages o f the collection procedure may be more expensive on a per account, basis. For example, a personal le tte r uses more staff tim e and therefore imposes more costs than sending a standard rem inder notice. A d m in istra tio n and collection costs are illustrated in Example 21.8.

C hapter tw en ty - o n e M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

Example 21.8 Zelco estimates administration costs to be $200 at Month 0 ; $100 at Month 1 and $150 at Month 2. Collection costs are estimated to be $70 at Month 3 and $40 at Month 4. W hat is the NPV after allowing for administration and collection costs?

SOLUTION After including administration and collection costs, the initial outlay is therefore $ 1 9 2 0 0 + $200 = $19400, and the net cash flows in the following months are $1 8525 - $100 = $1 8 4 25; $3000 $150 = $2850; $1000 - $70 = $930 and $400 - $40 = $360. $18425 $2850 $930 $360 ------------- + -----------^ + --------- - + ----------- - $ 1 9 4 0 0

1.02

( 1. 02

卩

( 1. 02)3

( 1. 02)4

$ 2 6 1 2 .0 0

Since the NPV is positive, the proposed credit policy is still an acceptable investment. So far it has been assumed th a t Zelcos existing customers, all o f whom pay cash, w ill n o t also demand that they be granted credit. W hile many existing customers would no doubt continue to pay cash, i t is inevitable th a t some would now seek to obtain credit. I f these customers are credit-w orthy, a refusal o f credit could well be offensive and may therefore result in lost sales. Some existing cash-paying customers would therefore become credit customers and this would impose fu rth e r costs on Zelco. This is illustrated in Example 21.9.

Example 21.9 It is now assumed that existing customers switch $ 1500 0 worth of business from a cash basis to a credit basis. W hat is the effect of this change on the NPV of extending credit?

SOLUTION Table 21.7 shows the estimated changes to Zelco's cash flows.15

TABLE 21.7 Cash flow effects of existing cash customers switching to credit Administration cost Collection cost

Total

Accounts paid

Discount

Month

($)

($>

($)

($>

($)

0

—

—

-140

—

-140

1

10000

-250

-50

—

9 700

2

4000

—

-150

—

3850

3

500

—

—

-30

470

4

200

—

—

-30

170

The present value of the cash flows is as follows: DV/

$9700

1.02

$3850

$470 (

1. 02)2

$170 (

1. 02) J

(

1. 02)4

= $ 1 3 6 7 0 .2 5

continued

15 Note that there is no entry in Table 21.7 to show the costs of manufacturing the goods. Such costs are not incremental, since they are incurred regardless of whether the sale is for credit or cash.

6

B usiness finance

continued T he c o r r e s p o n d in g c a s h s a le s to ta lle d $ 1 5 0 0 0 , so , in p re s e n t v a lu e te rm s , th e in c re a s e d c o s t im p o s e d b y th e n e e d to g r a n t c r e d it to c u s to m e rs w h o c u r r e n tly p a y c a s h is $ 1 5 0 0 0 - $ 1 3 6 7 0 . 2 5 = $ 1 3 2 9 . 7 5 . T h e N P V o f th e p r o p o s e d c r e d it p o lic y is r e d u c e d b y th is a m o u n t. T h e f in a l e s tim a te o f th e N P V is th e re fo re $ 2 6 1 2 . 0 0 - $ 1 3 2 9 . 7 5 = $ 1 2 8 2 . 2 5 .

We have now examined a num ber o f components o f credit and collection policies and decided th a t each should be set w ith the aim o f m axim ising the net present value resulting from the company s investm ent in accounts receivable. The above examples show that, other things being equal, the net present value w ill be lower i f customers accept discounts offered fo r early payment and i f customers pay late, or fa il to pay at all fo r credit purchases. Net present value w ill also be lowered by collection costs and by cash customers transferring to credit. The credit managers job is to ensure th a t other things are n o t equal— th a t is, the company s policies should be designed so th a t the costs o f extending credit are outweighed by the benefits.

H JLdvHu M SA3H 3NO-A1N3M1 pq

SUMMARY • •

A

•

re s o u rc e s c o m p r is e c a s h a n d

re c e iv a b le a ris e b e c a u s e a c o m p a n y o ffe rs c r e d it to c u s to m e rs in o r d e r to b e n e fit fro m in c re a s e d s ales.

m a n a g e m e n t a b o u t th e c o m p o s itio n a n d le v e l o f a

T he co sts o f o ffe r in g c r e d it in c lu d e th e o p p o r tu n ity

c o m p a n y ’s liq u id re s o u rc e s .

c o s t o f fu n d s tie d u p in a c c o u n ts r e c e iv a b le , th e costs

•

If to o little is h e ld in liq u id fo rm , a c o m p a n y m a y

o f b a d d e b ts a n d d e lin q u e n t (s lo w -p a y in g ) a c c o u n ts

s o m e tim e s b e u n a b le to m e e t its c o m m itm e n ts .

a n d a d d it io n a l a d m in is tr a tio n co sts.

If to o m u c h is h e ld in liq u id fo rm , a c o m p a n y ’s

D e c is io n s

ra te o f re tu rn m a y b e c o m e u n a c c e p ta b ly lo w .

r e c e iv a b le in v o lv e c r e d it a n d c o lle c tio n p o lic ie s .

a c c o u n ts

e n c o m p a s s e s s e le c tio n o f c r e d it- w o r th y c u s to m e rs ,

d e c is io n s

about

th e

c o m p a n y ’s

th a t c r e d it

is to

be

o ffe r e d ,

c r e d it p o lic y

e x p o s u re to v a r io u s k in d s o f f in a n c ia l ris k (fo re ig n

a n d d e te r m in in g c r e d it lim its a n d c r e d it te rm s.

e x c h a n g e a n d in te re s t ra te risk).

•

W h e r e a c o m p a n y h a s a d e q u a te d a ta o b ta in e d

A lth o u g h m o tiv e s fo r h o ld in g liq u id asse ts in c lu d e a :

fro m

e x p e r ie n c e

•

tre e s

m ay

tra n s a c tio n s m o tiv e

be

w ith

u s e fu l

its in

c u s to m e rs , d e c id in g

d e c is io n

w h e th e r to

•

p r e c a u tio n a r y m o tiv e

a c c e p t, re fu s e o r in v e s tig a te p a r tic u la r re q u e s ts

•

s p e c u la tiv e m o tiv e

f o r c r e d it. •

A c o m p a n y 's c r e d it te rm s s p e c ify a c r e d it p e r io d

d e ta il.

and

In p r a c tic e , a m a jo r to o l o f liq u id ity m a n a g e m e n t

p a y m e n t. If c u s to m e rs r e s p o n d b y m a k in g e a r lie r

is th e c a s h

p a y m e n ts , th e a m o u n t tie d u p in r e c e iv a b le s w ill

b u d g e t. T h is sets o u t a fo re c a s t o f a

m ay

a ls o

s p e c ify

a

d is c o u n t

fo r

e a r ly

b e r e d u c e d , a s w ill c o lle c tio n co sts.

c a n th e n b e p la n n e d to e lim in a te a n y fu tu re ca sh

C o lle c tio n

s h o rta g e o r to use a n y c a s h s u rp lu s th a t is fo re c a s t

th e a m o u n t s p e n t o n c o lle c tio n

p o lic y

in v o lv e s

a

tr a d e - o ff

b e tw e e n

a c tiv itie s

(s e n d in g

to o c c u r.

r e m in d e r n o tic e s a n d le tte rs , le g a l a c tio n , a n d so o n )

In s e le c tin g liq u id a sse ts, a f in a n c ia l m a n a g e r ha s

a n d th e b e n e fits o f a r e d u c tio n in b a d d e b t losses

a w id e r a n g e to c h o o s e fro m , in c lu d in g d e p o s its o f

a n d a s h o rte r c o lle c tio n p e r io d .

fu n d s w ith f in a n c ia l in s titu tio n s , a n d d is c o u n tin g o f

•

o f te rm , m a r k e ta b ilit y a n d d e fa u lt ris k . T he fin a n c ia l

In

s e e k in g

an

o p tim a l

c o lle c tio n

p o lic y ,

th e

e ffe c ts o f a lte r n a tiv e p o lic ie s o n sa le s s h o u ld b e c o n s id e r e d .

m a n a g e r fa c e s th e d iff ic u lt ta s k o f c h o o s in g a m ix (o r

T h e n e t p re s e n t v a lu e m e th o d c a n b e u se d to h ig h lig h t

p o r tfo lio ) th a t is s u ita b le f o r th e c o m p a n y .

th e fa c to rs th a t w ill in flu e n c e th e p r o f it a b ilit y o f a

A c c o u n ts r e c e iv a b le a 「 6 m o n ie s o w e d to a c o m p a n y

c o m p a n y 's c r e d it a n d c o lle c tio n p o lic ie s .

o r o th e r b u s in e s s fro m th e s a le , o n c r e d it, o f g o o d s o r

686

of

G iv e n

w ith

c o m m e r c ia l b ills . E a ch o ffe rs a d iffe r e n t c o m b in a tio n

•

m anagem ent

to g e th e r

c o m p a n y 's c a s h re c e ip ts a n d c a s h p a y m e n ts . A c tio n

•

c o n c e r n in g

T re a s u ry m a n a g e m e n t in c lu d e s liq u id it y m a n a g e m e n t

th e c h a p t e r c o n s id e r s o n ly th e firs t o f th e s e in a n y •

s e rv ic e s in th e n o r m a l c o u rs e o f b u s in e s s . A c c o u n ts

L iq u id ity m a n a g e m e n t re fe rs to d e c is io n s m a d e b y

• •

c o m p a n y ’s liq u id

s h o rt-te rm in v e s tm e n ts .

C hapter tw en ty - o ne M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

a c c o u n ts re c e iv a b le b a d d e b ts

675

cash b u d g e t

d is c o u n t p e r io d d is c o u n t ra te

676

liq u id assets

670

680 680

667

c o lle c tio n p o lic y

681

liq u id ity m a n a g e m e n t

c o n s u m e r c r e d it

676

open account

c re d it p e rio d

680

c re d it p o lic y

677

d e lin q u e n t a c c o u n ts

tr a d e c r e d it

667

676 675

tre a s u ry m a n a g e m e n t

668

676

SELF-TEST PROBLEMS 1

W a r n e r Ltd sells o n te rm s o f 2 / 7 , n / 3 0 . C u s to m e r X b u y s g o o d s fro m W a r n e r w ith a n in v o ic e to ta l o f $1500.

2

a)

If X p a y s 7 d a y s a fte r th e in v o ic e d a te , w h a t d is c o u n t c a n he d e d u c t fro m th e b ill?

b)

W h a t e ffe c tiv e a n n u a l in te re s t ra te is im p lic it in th e te rm s o ffe re d ?

A n g e lin e Ltd h a s u n til re c e n tly s o ld its p ro d u c ts o n te rm s o f n / 3 0 , a n d th e a v e r a g e c o lle c tio n p e r io d h a s b e e n 4 5 d a y s . In a n a tte m p t to s h o rte n th e c o lle c tio n p e r io d , it h a s c h a n g e d th e te rm s to 1 / 1 0 , n / 3 0 . It h a s b e e n fo u n d th a t 7 0 p e r c e n t o f c u s to m e rs p a y w ith in 1 0 d a y s a n d c la im th e d is c o u n t. T h e o th e r 3 0 p e r c e n t p a y , o n a v e r a g e , a fte r 5 0 d a y s . T h e re h a s b e e n n o c h a n g e in s a le s v o lu m e a n d th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m . T h e c o s t o f g o o d s s o ld is 7 5 p e r c e n t o f s a le s a n d th e re a r e n o d e fa u lts . H a s th e c h a n g e in te rm s b e e n p r o fita b le ?

Solutions to self-test problem s ore a v a ila b le in A p p e n d ix B.

t

QUESTIONS

y 1

[L O 1 ] W h a t a r e l i q u i d a s s e ts '?

2

[LO 2 ]

3

[L O 3 ] E x p la in th e co sts a n d b e n e fits o f h o ld in g liq u id asse ts.

4

[L O 3

5

For most A ustralian com panies, cash is a ve ry sm all p ro p o rtio n o f total assets, a n d therefore cash m anagem ent is unim portant. D iscu ss th is s ta te m e n t.

：Liquidity risk is m ore im p o rta n t than return risk in the choice betw een alternative short-term investments. D iscuss.

[L O 5 ] A c o m p a n y h a s $1 m illio n in id le fu n d s a n d it is e s tim a te d th a t th e s e w ill b e a v a ila b le f o r in v e s tm e n t fo r a p p r o x im a t e ly 2 m o n th s . T he tre a s u re r is c o n s id e r in g th e f o llo w in g in v e s tm e n ts : a)

p u rc h a s in g a 1-m o n th b a n k c e rtific a te o f d e p o s it

b)

lo d g in g a fix e d d e p o s it w ith a b a n k

c)

p u rc h a s in g c o m m e rc ia l b ills .

D iscuss th e a d v a n ta g e s a n d d is a d v a n ta g e s o f e a c h in v e s tm e n t. 6

[L O 5 ] Y ou a r e th e tre a s u re r o f a c o m p a n y th a t h a s $1 m illio n in id le fu n d s to in v e s t f o r a p e r io d o f 9 0 d a y s . List th e a v a ila b le s h o rt-te rm in v e s tm e n ts a n d o b t a in c u rre n t in te re s t ra te s fro m th e f in a n c ia l p re s s . P re p a re a r e p o r t a n d r e c o m m e n d e d a c tio n f o r c o n s id e r a tio n b y th e B o a rd o f D ire c to rs , p o in tin g o u t th e re tu rn (s) a n d risk(s) in v o lv e d .

7

[L O 6 ] There is no diffe re n ce i f a c o m p a n y offers c re d it to customers that are individuals o r to other

8

[L O

9

[L O 8 ]

businesses, they are still o w e d m oney b y their customers. D iscuss.

7, 8 ]

D iscuss th e re a s o n s fo r a c o m p a n y o ffe r in g c r e d it te rm s to its c u s to m e rs .

a)

A c o m p a n y o ffe rs c r e d it te rm s o f 1 / 7 , n / 3 0 . E x p la in th e m e a n in g o f th e se te rm s.

b)

W h a t e ffe c tiv e a n n u a l in te re s t ra te is im p lic it in th is o ffe r?

OHAPTEH TWENTY-ONE REVIEW

KEY TERMS

10

[ L 0 8 ] W h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f o ffe r in g a d is c o u n t f o r e a r ly p a y m e n t?

n

[ L 0 9 ] W h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f a n a g g r e s s iv e c o lle c tio n p o lic y ?

CA 1

PROBLEMS

Preparing a cash budget [LO 4] In la te Ju n e o f e a c h y e a r, D u r a n g o Ltd p re p a re s a c a sh b u d g e t fo r th e n e x t 6 m o n th s. T he c o m p a n y h a s a p o lic y o f m a in ta in in g a c a sh b a la n c e a t th e b e g in n in g o f e a c h m o n th e q u a l to th e d iffe re n c e b e tw e e n th e e s tim a te d c a sh in flo w s a n d p a y m e n ts fo r th e m o n th , p lus a s a fe ty m a rg in o f $ 4 0 0 0 . A c tu a l sales f o r M a y a n d e s tim a te d sales fo r Ju n e a n d fo r th e n e x t 7 m o n th s a r e a s fo llo w s :

May

$20000

October

$94000

June

$28000

November

$74000

July

$24000

December

$52000

August

$26000

January

$40000

September

$50000

A p p r o x im a te ly 2 5 p e r c e n t o f th e sales a re fo r c a s h a n d 7 5 p e r c e n t a re o n c re d it. E x p e rie n c e h a s s h o w n th a t tw o -th ird s o f a ll c r e d it sales a re c o lle c te d in th e m o n th fo llo w in g sa le , a n d th e r e m a in in g o n e -th ird in th e s e c o n d m o n th fo llo w in g sa le . N o d is c o u n ts a re g iv e n . D u ra n g o fo llo w s a p o lic y o f b a s in g its p u rc h a s e s o n e s tim a te d sales. P urch ase s a re e q u a l to 7 0 p e r c e n t o f th e fo llo w in g m o n th 's e s tim a te d sales. T he p o lic y o f th e c o m p a n y is to e n s u re th a t th e g o o d s n e e d e d in e a c h m o n th a re a c q u ir e d in th e p r e c e d in g m o n th . D u ra n g o 's s u p p lie rs p e rm it it to ta k e a 2 p e r c e n t d is c o u n t if th e g o o d s a re p a id f o r w ith in th e firs t 1 0 d a y s o f th e m o n th fo llo w in g p u rc h a s e . A ll g o o d s m ust b e p a id f o r b y th e e n d o f th e m o n th f o llo w in g p u rc h a s e . O th e r p a y m e n ts a re e x p e c te d to b e :

July

$7 400

October

$11000

August

$7 450

November

$7800

September

$9100

December

$7150

A t th e b e g in n in g o f July, th e c o m p a n y is e x p e c te d to h a v e $ 8 4 0 0 in its b a n k a c c o u n t. P re p a re a m o n th ly c a s h b u d g e t f o r D u r a n g o Ltd f o r th e 6 m o n th s e n d e d 3 1 D e c e m b e r. W ill a n y o u ts id e fu n d s b e re q u ire d ? If so, h o w m u ch ?

2

Selection of credi卜 w orthy customers [LO 10 】 H a y w o r th Ltd uses a d e c is io n -tre e a p p r o a c h fo r s c re e n in g c r e d it a p p lic a n ts . G a b le s Ltd h a s s o u g h t c r e d it fo r th e p u rc h a s e o f 1 0 0 0 u n its p r ic e d a t $ 1 6 e a c h . T he m a r g in a l c o s t o f p r o d u c in g e a c h u n it is $ 1 2 . B a s e d o n its p a s t e x p e rie n c e , H a y w o r th e s tim a te s th a t th e re is a 7 0 p e r c e n t c h a n c e th a t G a b le s fa lls in to th e lo w -ris k c a te g o ry , a 2 0 p e r c e n t c h a n c e th a t it is h ig h risk a n d a 1 0 p e r c e n t c h a n c e th a t it is a n e w c u s to m e r. The ta b le a b o v e s u m m a ris e s o th e r d a ta e s tim a te d b y H a y w o r th 's c r e d it d e p a rtm e n t. D e c is io n

P r o b a b ility o f

P r o b a b ility o f b a d

A v e r a g e w a it in g

A v e r a g e c o lle c tio n

paym ent

debt

p e r io d (m o n th s)

c o s t ($)

0.92

0.08

2

93

Low risk

1.00

0

1

10

High risk

0.70

0.30

5

400

New customer

0.80

0.20

3

60

No investigation Finding of investigation:

C hapter tw en ty - o n e M

a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable

c e n t p e r m o n th . W h a t d e c is io n s h o u ld H a y w o r th m a ke ?

3

Evaluation of alternative credit terms [LO 10] C o m p a n y A a t p re s e n t sells o n ly o n a c a sh b a s is a n d it a v e ra g e s $ 5 0 0 0 0 o f sa le s p e r m o n th , w ith a s s o c ia te d e x p e n s e s o f $ 4 0 0 0 0 . It is th o u g h t th a t a ll cu s to m e rs w o u ld a c c e p t a n o ffe r o f 9 0 - d a y fre e c r e d it te rm s a n d th a t th e c o m p a n y 's m o n th ly s a le s w o u ld in c re a s e to $ 5 5 0 0 0 a n d its a s s o c ia te d e x p e n s e s to $ 4 4 0 0 0 . C o m p a n y A ’s re q u ire d ra te o f re tu rn is 1 p e r c e n t p e r m o n th . a)

A s s u m in g th a t th e re a r e n o costs a s s o c ia te d w ith p r o v id in g c re d it, w ill C o m p a n y A b e n e fit fro m o ffe rin g such c r e d it term s?

b)

If e x p e n s e s re m a in a t 8 0 p e r c e n t o f sa le s, w h a t w o u ld th e in c re a s e in sa le s n e e d to b e in o r d e r to ju s tify th e p ro v is io n o f th e se c r e d it term s?

4

Evaluation of alternative credit and collection policies [LO 10】 E ach m o n th , J u m b o Pty Ltd sells 1 0 0 0 0 units a t $ 2 5 p e r u n it. T he m a r g in a l c o s t o f p r o d u c in g e a c h u n it is $ 1 5 . A t p re s e n t a ll o f J u m b o ’s sales a re m a d e o n a s tric t 'c a s h o n ly ' b a s is . J u m b o ’s m a n a g e r b e lie v e s th a t th e 'c a s h o n ly ' p o lic y h a s le d to m a n y sales b e in g lo s t a s th e re h a v e b e e n a n u m b e r o f e n q u irie s c o n c e r n in g th e p o s s ib ility o f c r e d it sa le s. J u m b o 's m a n a g e r e s tim a te s th a t a c r e d it p o lic y o f 1 / 3 0 , n / 6 0 c o u ld in c re a s e sales b y 1 0 0 0 un its p e r m o n th , o f w h ic h 5 0 0 w o u ld b e p a id f o r a t th e e n d o f M o n th 1 a n d 4 0 0 w o u ld b e p a id fo r a t th e e n d o f M o n th 2 . O f th e re m a in in g 1 0 0 un its, 7 0 a re e x p e c te d to b e p a id fo r a m o n th la te a n d 3 0 a re e x p e c te d to b e b a d d e b ts . A d m in is tr a tio n a n d c o lle c tio n costs a re e s tim a te d to b e $ 2 5 0 (M o n th 0 ), $ 1 0 0 (M o n th 1), $ 1 0 0 (M o n th 2 ) a n d $ 1 5 0 (M o n th 3 ). H o w e v e r, it is e x p e c te d th a t s o m e e x is tin g c u sto m e rs w ill a ls o seek c r e d it in o r d e r to o b ta in th e d is c o u n t o ffe re d . T h is is lik e ly to a ffe c t th e s a le o f 6 0 0 u n its. B uye rs o f th e re m a in in g 9 4 0 0 u n its a r e e x p e c te d to c o n tin u e to p a y c a s h . A d m in is tr a tio n costs a re e s tim a te d to b e $ 1 5 0 (M o n th 0 ) a n d $ 6 0 (M o n th 1 j. J u m b o ’s r e q u ire d ra te o f re tu rn is 1 .5 p e r c e n t p e r m o n th . S h o u ld J u m b o a d o p t th e p ro p o s e d c r e d it a rra n g e m e n ts ?

CHAPTER TWENTY-ONE REVIEW

T he c o s t o f c o n d u c tin g a n in v e s tig a tio n is $ 2 . H a y w o r th e s tim a te s th e o p p o r tu n ity c o s t o f c a p ita l to b e 2 p e r

REFERENCES Bruce R., McKern, B., Pollard, I. & Skully, M . (eds), Handbook of Australian Corporate Finance, 5th edn; Butterworths, Sydney, 1997.

M ian, S.L. & Smith C .W . Jr, 'Accounts receivable management policy: theory and evidence', Journal of Finance, M arch 1992, pp. 1 6 9 -2 0 0 .

Gallinger, G .W . & Healey, P.B., Liquidity Analysis and Management, Addison-Wesley, Reading, Massachusetts,

-------, ------- , 'Extending trade credit and financing7, Journal of Applied Corporate Finance, Spring 1994, pp. 7 5 -8 4 .

1987. Keynes, J.M., The General Theory of Employment Interest and Money, Harcourt Brace & W orld, N e w York, 1936.

N g, C.K., Smith, J.K. & Smith, R.L., 'Evidence on the determinants o f credit terms used in interfirm trade7, Journal of Finance, June 1999, pp. 1 1 0 9 -2 9 .

Lundholm, R. & Sloan, R.; Equity Valuation and Analysis, 2nd edn. M cG raw-Hill. N ew York. 2 0 0 6 .

689

Financial statement analysis Introduction

LEARNING OBJECTIVE 11 Apply financial statement analysis to short-term asset management

In the chapters on short-term asset management, no specific reference has been made to the analysis o f financial statements, which is frequently used by financial managers in short-term asset management. Analysis o f financial statements involves the calculation o f financial ratios using the data in the statem ent o f financial performance (income statement) and the statem ent o f financial position. Financial managers frequently examine the values o f certain 'key* ratios as a way o f m o n itoring a company s management o f short-term assets and liabilities. In this appendix, some o f the more frequently used financial ratios are defined, th e ir application examined and th e ir usefulness fo r short­ term asset management discussed.16

Measurement and interpretation of several financial ratios First we define and calculate a number o f financial ratios, using the financial statements o f Harvey Norm an Holdings Lim ited, shown in Tables A21.1 and A21.2.

Table A 2 1 .1 Harvey Norman Holdings Limited: income statement for the year ended 30 June 2013 C o n s o lid a te d

“：

二 :：

心：

：丨

^ 2 0 1 3 ( $ '0 0 0 )

2 0 1 2 ( $ ,0 0 0 )

Sales revenue

1323481

1407342

Cost of sales

(944229)

(1025 359)

379252

381983

1035 551

1061233

(11047)

(10869)

Marketing expenses

(341460)

(355456)

Occupancy expenses

(286423)

(242986)

Administrative expenses

(393 236)

(404228)

(45 774)

(49455)

(177236)

(164050)

28319

11237

P rofit from continuing operations before income tax expense

187946

227409

Income tax expense

(43469)

(51094)

P ro fit from continuing operations after tax

144477

176315

P ro fit from continuing operations attributable to m in o rity interests

2266

3844

P rofit from continuing operations attributable to members o f the parent

142211

172471

......... .........

:

Gross p rofit Other revenues Distribution expenses

Finance costs Other expenses from ordinary activities Share of net profit of associates, joint venture entities and partnerships accounted for using the equity method

Source: Harvey Norman Holdings Limited, Annual Report 2013, 2013 16 For a more detailed discussion of the usefulness of financial ratios for short-term asset management, see Gallinger and Healey (1987, Chapter 3).

Current assets 161660

172459

1054402

1017973

19072

24396

268781

263421

343

531

27655

20161

1531913

1498941

12 646

10556

175 294

157992

Other financial assets

14223

9355

Investment properties

1694744

1653746

548903

536277

Intangible assets

58913

57442

Deferred income tax assets

28395

27507

Total non-current assets

2533118

2452875

Total assets

4065 031

3 951816

611758

647279

(c)172455

(必234 876

Tax liabilities

23817

13487

Provisions

23338

20497

2 689

1631

834057

917770

647 821

544471

8 900

8954

16 045

14890

194 353

198849

867 119

767164

1 701176

1684934

Cash and cash equivalents Receivables⑷ Other financial assets Inventories ⑻ Intangible assets Other (prepayments) Total current assets Non-current assets Receivables Investments accounted for using equity method

Property, plant and equipment

Current liab ilities Payables Interest-bearing liabilities

Other Total current liabilities Non-current liabilities Interest-bearing liabilities Provisions Other Deferred income tax liabilities Total non-current liabilities Total liabilities

continued

T a b le A 2 1 .2

continued

Net assets

2363855

2266882

259610

259610

61799

19376

Retained profits

2008880

1956966

Parent entity interest

2330 289

2 235 952

33566

30930

2363855

2266882

Equity Contributed equity Reserves

Outside equity interest

Total equity^ Receivables in 201 1 were $1 0 6 5 2 3 2 0 0 0 . (bl Inventories in 2011 were $ 3 36 74 2 000. (cl Includes bank overdraft of $ 3 7 0 9 0 0 0 0 . Idf Includes bank overdraft of $32 366000. (el Shareholders7 equity in 201 1 was $2 228461 000.

Source: Harvey Norman Holdings Limited, Annual Report 2013, 2013, pp. 4 7 -8 .

There are fo ur broad categories o f financial ratios. They are liquidity ratios, activity ratios, leverage ratios and profitability ratios.

Liquidity ratios Liq uid ity ratios are a measure o f a company s a bility to meet its m aturing short-term financial obligations. The follow ing ratios are classified as liq u id ity ratios.

Current ratio Traditionally, the current ratio has been used to measure a company s liquidity. I t is calculated by dividing to ta l current assets by to ta l current liabilities. Its use dates from the nineteenth century and it is s till widely used as an im p o rta n t measure o f a company s a b ility to pay its short-term debts when they are due. Using the data fo r Harvey Norman, the current ratio is as follows:17 ^ • total current assets Current ratio = ----- ------------- . . . . . — total current liabilities _ $ 1 5 3 1 9 1 3 000 $834 057 000 = 1 .8 4 (1 .6 3 )

The higher the current ratio, the greater w ill be the company s a b ility to meet its imm ediate financial obligations. However, the higher this ratio, the greater w ill be the p ro po rtio n o f the company s resources th a t is tied up in relatively unproductive assets. This may have an adverse effect on p rofitability. Management therefore has to decide on the appropriate balance between p ro fita b ility and liquidity.

‘Quick’ ratio The quick ratio is calculated by dividing to ta l current assets, m inus inventories and prepayments, by total current liab ilities minus bank overdraft. Prepayments are deducted because they represent amounts paid fo r services yet to be provided and therefore are n o t easily converted in to cash. Similarly, inventory is the least liq u id current asset and could be d iffic u lt to sell at short notice. Bank overdrafts are deducted from current liabilities because they are unlikely to be w ithdraw n at short notice.18 The quick ratio is more useful than the current ratio as a measure o f the company s a b ility to meet its financial obligations should they become payable almost immediately. 17 The value for each ratio, based on the figures in the 20 11 -12 financial statements, is included in parentheses. 18 See Chapter 10.

A pp en dix 2 1 . 1

Quick ratio =

F in a n c ia l

total current assets - (inventories + prepayments) total current liabilities - bank overdraft $1 531 913 - ($268 781 000 + $27 655) $834 057 000 - $37 090 000

$1235 477 000 _ $796967 000 = 1.55(1.37) As w ith the current ratio, the higher the quick ratio, the greater the company s a b ility to meet its immediate financial obligations.

Activity ratios A ctivity ratios measure the effectiveness o f a company s use o f its assets. These ratios generally relate the amount o f a particular group o f assets (such as inventory, accounts receivable or to ta l assets) to the activity generated by th a t group (such as sales, cost o f goods sold and net p ro fit). We consider three such ratios.

Average inventory turnover period The average inventory tu rn ove r period measures the average tim e a company s inve ntory remains on hand before being sold, and is usually calculated by dividing the average inve ntory by the cost o f goods sold. A . . , average inventory oe「 Average inventory turnover period = ------------------------- x 365 cost o f goods sold =

$268 781 000 + $263 421000 2 $944 249 000

365

= 1 02 .9 days (106.8 days) For Harvey Norman the average inventory turnover period decreased from 106.8 days in 2012 to 102.9 days in 2013 一 th a t is, inve ntory was on hand fo r a shorter period before being sold. We discussed possible solutions to inve ntory management problems in Chapter 20. The ideal average inventory turnover period fo r a company is affected by the optim al inventory level.

Average collection period The average collection period is calculated by dividing the average accounts receivable balance by the average daily credit sales. The average collection period is a measure o f the average num ber o f days a company m ust w ait after m aking a credit sale before i t receives payment, and indicates w hether accounts receivable are being collected w ith in a reasonable period o f time. Assuming th a t all o f Harvey Norm ans sales were on credit in both the 2011-12 and the 2012-13 financial years, the average collection period is calculated as follows: A „ . . average receivables Average collection period = ----------------------------------average daily credit sales =

$1054 402 000 + $1017 973 000 2 $1323 481000/365

= 2 8 6 days (270 days) A short average collection period may indicate high efficiency in collecting accounts receivable. However, in Section 21.10 it was shown th a t reducing the collection period involves various costs and it is possible fo r the collection period to be *too short* because the company s credit policy is too restrictive.

Total asset turnover Total asset turnover measures the turnover o f the company s assets and is calculated by dividing sales by total tangible assets.

statement analysis

Total asset turnover = ---------------------------total tangible assets _ $1323 481000 _ $4 065 031 000 - (59 256 000 + 23 395 000) = 0 .3 3 (0.36) where to ta l tangible assets = to ta l assets - (intangible assets + deferred tax assets) This ratio is a measure o f a company s efficiency in the use o f its assets to generate sales. An efficient company w ill generate a higher level o f sales w ith a given level o f assets than its less efficient competitors. A high ratio could also indicate th a t the company is operating at close to its capacity. I f this is the case, then additional investm ent in assets may be required i f o utp ut and sales are to be increased.

Leverage ratios Leverage ratios show the extent to which a company uses debt in its capital structure and provide evidence o f a company s ability to pay lenders in the long run. There are many measures o f leverage, but we consider only two ratios.

Debt to total assets This is calculated by dividing to ta l liabilities by to ta l assets. ^ " • 、 total liabilities Debts to total assets (leverage r a tio ) = -------------------total assets _ $1701 176 000 $4 065 031 =41.8% (42.6%) The higher this percentage, the greater is the company s reliance on debt in its capital structure. The effects o f leverage on a company s value were considered in Chapter 12, where the use o f m arket values rather than book values was emphasised. A company s a bility to repay lenders w ill ultim ately depend on the m arket value o f its assets relative to the face value o f its debt. However, analysts frequently rely on book values because they are easier to obtain than m arket values.

Interest coverage ratio The interest coverage ratio, which is also referred to as the times interest earned ratio, is calculated by dividing a company s net p ro fit before interest and tax by the interest expense. It is a measure o f a company s a b ility to meet the interest charges on its debt. T net p ro fit before interest and tax Interest coverage ratio = ----- ----------------------------------------interest expense _ $144 477 000 + $43 469 000 + $45 774 000 $45 774 000 = 5 .1 1 (5.60) In many ways this ratio is superior to the leverage ratio as a measure o f financial risk because it attem pts to measure the company s ability to pay the interest on its debt and so avoid future financial difficulties. The higher this ratio, the greater the reduction in the company s earnings th a t can occur before it w ill default on its interest payments. There are two im p o rta n t lim ita tio n s o f the interest coverage ratio. First, it is cash flow and n o t earnings th a t is im p o rta n t fo r debt-servicing purposes. This lim ita tio n can be addressed by using net p ro fit before interest and tax plus depreciation and other accruals in the numerator. Second, in addition to interest payments, there are other financial obligations th a t have to be met. These include dividends on preference shares, lease payments and repayment o f long-term debt. Therefore, it could be useful to m odify the ratio by also including these payments in the denominator.

A pp en dix 2 1 . 1

F in a n c ia l

Profitability ratios The aim o f p ro fita b ility ratios is to measure the effectiveness o f management in using a company s resources to generate returns fo r shareholders.

Profit margin on sales This ratio is calculated by dividing net p ro fit by to ta l sales revenue. I t shows the am ount o f p ro fit generated by the company from each dollar o f sales. Profit margin =

net p ro fit after tax sales revenue $144 477 000 $1323 481 000

=10.91% (12.53%) This is a measure o f relative efficiency, as it reflects managements efforts to generate sales and control costs. Success in reducing costs w ill increase the p ro fit margin.

Return on shareholders’ equity This ratio is calculated by dividing net p ro fit by the book value o f average shareholders* equity. I t is a measure o f the earning power o f the shareholders’ investment. „ , , ,, , . net p ro fit after tax Return on shareholders equity = ------------------ ； ---------shareholders’ equity $144 477 000 inn = ------------------------------------------------------x 100 $2 363 855 000 + $2 266 882 000 2

=6 .2 % (7.8%)

Usefulness of financial ratio analysis So far we have discussed the measurement o f a num ber o f financial ratios, w ith only passing reference to their usefulness. In assessing the usefulness o f financial ratios it is im p o rta n t to note th a t they are a way o f summarising large quantities o f data. Also, ratio analysis is usually the firs t step in financial statement analysis. The purpose o f the analysis differs between ‘insiders’，or managers, and ‘outsiders’，or investors and creditors. Investors and creditors w ill be interested in attem pting to forecast future earnings and dividends and in assessing a company s a b ility to repay debts. Managers w ill seek inform a tion th a t they can use in making decisions about a company s operations. These decisions may lead to changes in the values o f a company s ratios. However, achieving or m aintaining certain ratios should generally n o t be seen as an end in itself. Rather, exam ination o f ratios is most useful as a way o f raising questions and identifyin g issues fo r fu rth e r investigation: it usually does n ot provide answers. To illustrate the use o f ratios, consider Harvey N orm ans current ratio o f 1.84 at 30 June 2013. W hat inform a tion does this figure convey to management? We suggested th a t a very high ratio indicates th a t the company has too many o f its resources tied up in relatively unproductive short­ term assets. Alternatively, if the current ratio is too low, it may indicate th a t there is a liq u id ity problem. There are two types o f analysis th a t management could use to decide whether the current ratio o f 1.84 indicates th a t any action is necessary. These are cross-sectional analysis and time-series analysis. Cross-sectional analysis involves comparing the company s ratio w ith those o f other companies in the same industry. Companies in the same in d u stry have sim ilar assets and operate in a sim ilar environment, so the average ratio o f the other companies in the ind ustry may be useful as a benchmark fo r comparison. If, in our example, the average current ratio o f Harvey N orm ans competitors was, say, 2.68, does this mean th a t Harvey N orm ans current ratio o f 1.84 is too low? The answer to this question is n o t obvious. I t may be th a t its competitors have too high a p roportion o f th e ir resources invested in short-term assets. In general, an industry average does not necessarily reflect an optim al standard o f performance. Nevertheless,

statement analysis

intercom pany comparisons may provide a reason fo r re-examining policies on the management o f short­ term assets and policies on other aspects o f a company s operations. For example, i f a company s current ratio is fa r higher or lower than the in d u stry average, management should seek an explanation fo r the difference. Time-series analysis involves studying values o f a single ratio over tim e to determine whether a company s financial position appears to be im proving, rem aining the same or deteriorating. However, the exam ination o f a tim e series w ill usually n o t provide all the inform a tion th a t may be needed for decision-making purposes. For example, although there may be an improvem ent in the p ro fit m argin from one year to the next, this may s till reflect less than an ideal performance. This m ethod o f evaluation is fu rth e r complicated by the fact th a t the optim al values o f financial ratios are likely to change over time. In these circumstances, m aintaining a stable ratio from one year to the next is not necessarily desirable. For example, the techniques used to determine inventory policy suggest th a t a company s inventory should increase at a much slower rate than sales. Therefore, a company s optim al inventory turnover period w ill increase at a much slower rate than sales. This implies th a t the current ratio should decline as a company s operations grow. Time-series analysis and cross-sectional analysis can be combined by examining a company s ratios over tim e in conjunction w ith benchmarks, such as in d u stry averages.

Financial ratios and short-term asset management We now consider in more detail those ratios considered to be useful fo r short-term asset management.

Current ratio and 'quick' ratio The current ratio and the ^uick* ratio serve as measures o f a company s liq u id ity position and consequently have particular application to liq u id ity management. The current ratio is calculated by dividing the book value o f current assets by the book value o f current liabilities. Current assets include cash and other liqu id assets, accounts receivable and inventories. Current liabilities include accounts payable, debts m aturing w ith in 12 m onths and income tax payable, dividends payable and other payments due w ith in 12 months. Thus, the current ratio provides an indication o f a company s a bility to meet its imm ediate financial obligations using assets th a t are expected to be quickly converted in to cash. I f a company is experiencing financial difficulty, it is likely to pay its creditors more slowly, increase its bank overdraft and, perhaps, draw on lines o f credit. These measures w ill be reflected in increases in accounts payable and other current liabilities and a falling current ratio. However, the current ratio does n ot take in to account either the relative liq u id ity o f the various assets or the relative urgency fo r repayment o f the current liabilities. I t is n o t useful to know th a t the company has a current ratio o f 2 i f all the liabilities are due to be paid w ith in a week, and m ost o f the short-term assets cannot be realised w ith in 2 months. A fu rth e r lim ita tio n o f the current ratio is th a t it includes inventory, which is usually valued at historical cost, whereas the net selling price o f the inve ntory would provide a better indication o f the assets a b ility to generate cash. Indeed, a company may have an apparently healthy current ratio largely because its warehouse is fu ll o f goods th a t are n o t wanted by customers. The main difference between the current ratio and the quick ratio is th a t the la tte r excludes inventories. I t is intended to provide a more stringent test o f a company s liq u id ity by including only assets th a t are highly liquid. A quick ratio o f 1 or more indicates th a t current liabilities can be m et w ith o u t relying on the sale o f inventory. Finally, a lim ita tio n o f both ratios is th a t the financial statements can be ^window dressed7to improve these ratios. This may be achieved either by delaying purchases, or by paying o ff a large pro po rtio n o f the company s current liabilities ju s t before the end o f the financial year. For example, selling marketable securities to repay debt w ill reduce current assets and current liabilities by the same amount, so the company s net assets are unchanged, b u t the current ratio w ill change.

The average inventory turnover period measures the average tim e a company s inventory remains on hand before being sold. This ratio is related to inventory management, because the average inventory turnover period w ill be a direct result o f the company s inve ntory management policy defined in terms o f economic order quantities and reorder points. However, the turnover period w ill norm ally reflect other factors as well. For example, inve ntory levels may increase and the turnover period increase because o f a decrease in the demand fo r the company s products. A decrease in the inve ntory turnover period

A ppen dix

F in a n c ia l

is frequently regarded as desirable since p ro fit is generated as inventory is sold— th a t is, turned over. However, a decrease in the inventory turnover period is n ot necessarily desirable, because it may have been achieved by reducing the q ua n tity o f inventory to such a low level th a t purchasing costs and stockout costs have become excessive. The techniques available fo r determ ining the o ptim um inventory holding and, consequently, the optim um turnover were discussed in Chapter 20. It is im p o rta n t to note th a t the turnover period, which uses the statement o f financial position data, measures only the average turnover period fo r all inventory items, whereas it is desirable to ascertain the optim um inventory policy fo r each individual inventory item or group o f items. The use o f statement o f financial position data can also involve lim ita tio n s i f demand and inventory levels are subject to seasonal variations. This problem can be overcome by using the average o f m onthly inventory figures, i f they are available, instead o f the end-of-year figures.

Average collection period This ratio measures how quickly customers pay fo r purchases and provides useful inform a tion for accounts receivable management since there are benefits th a t can result fro m a reduction in the collection period. A shorter collection period means th a t fewer resources are tied up in accounts receivable and generally indicates efficiency in the collection o f accounts. However, it needs to be recognised th a t a continual reduction in the collection period is n ot necessarily a sign o f increasing efficiency. For example, suppose th a t there are tw o types o f account. The firs t pays at the end o f the credit period (assuming no cash discount). I f all accounts are o f this type, then the average collection period w ill be equal to the credit period. In other words, there is a lower lim it to the average collection period, which is set by the company s credit terms. The second type o f account is a delinquent account, which does n ot pay w ith in the collection period. As discussed in Section 21.10, attem pting to collect all accounts in tim e involves collection expenditures th a t are prohibitively high; a company usually has to accept a certain number o f late collections (that is, delinquent accounts) and non-collections (that is, bad debts). I t follows th a t the optim al average collection period w ill usually be above the lower lim it set by the company s credit terms. It is also possible fo r the average collection period to be *too sh ort1, reflecting unduly restrictive credit terms. The average collection period provides management w ith info rm a tio n about the quality o f the company’s accounts receivable and the efficiency o f its credit control. Valuable info rm a tio n can also be obtained from an ‘age’ analysis o f accounts. This analysis lists debtors’ accounts w ith reference to the period o f tim e they have been outstanding, and highlights the incidence o f delinquent accounts. It therefore directs managements atte ntio n to those accounts on which its collection efforts should be concentrated.

statement analysis

a p p e n d ix a

NUM ERICAL TABLES

Table 1 Future v a lu e o f a p re s e n t sum Table 2 Present v a lu e o f a fu tu re sum Table 3 F uture v a lu e o f a n o r d in a r y a n n u ity Table 4 P resent v a lu e o f a n o r d in a r y a n n u ity Table 5 A re a s u n d e r th e s ta n d a rd n o rm a l c u rv e

TABLE 1 Future value of $1 at the end of n periods (1 + i)n

698

0 .5%

0 .66%

0 .7 5 %

1 1.002 50

1.005 00

1.006 67

1.007 50

1.010 00 1.015 00

1.017 50 1.020 00 1.025 00 1.030 00 1.035 00

1

2 1.005 01

1.010 03

1.013 38

1.015 06

1.020 10 1.030 23

1.035 31 1.040 40 1.050 63 1.060 90 1.071 23

2

3 1.007 52

1.015 08

1.020 13

1.022 67

1.030 30 1.045 68

1.053 42 1.061 21 1.076 89 1.092 73 1.108 72

3

4 1.010 04

1.020 15

1.026 93

1.030 34

1.040 60 1.061 36

1.071 86 1.082 43 1.103 81 1.125 51 1.147 52

4

5 1.012 56

1.025 25

1.033 78

1.038 07

1 .0 5 1 0 1

1.077 28

1.090 62 1.104 08 1.131 41 1.159 27 1.187 69

5

6 1.015 09

1.030 38

1.040 67

1.045 85

1.061 52 1.093 44

1.109 70 1.126 16 1.159 69 1.194 05 1.229 26

6

7 1.017 63

1.035 53

1.047 61

1.053 70

1.072 14 1.109 84

1.129 12 1.148 69 1.188 69 1.229 87 1.272 28

7

8 1.020 18

1.040 71

1.054 59

1.061 60

1.082 86 1.126 49

1.148 88 1.171 66 1.218 40 1.266 77 1.316 81

8

9 1.022 73

1.045 91

1.061 63

1.069 56

1.093 69 1.143 39

1.168 99 1.195 09 1.248 86 1.304 77 1.362 90

9

10 1.025 28

1 .0 5 1 1 4

1.068 70

1.077 58

1.104 62 1.160 54

1.189 44 1.218 99 1.280 08 1.343 92 1.410 60

10

11 1.027 85

1.056 40

1.075 83

1.085 66

1.115 67 1.177 95

1.210 26 1.243 37 1.312 09 1.384 23 1.459 97

11

12 1.030 42

1.061 68

1.083 00

1.093 81

1.126 83 1.195 62

1.231 44 1 .268 24 1.344 89 1.425 76 1.511 07

12

13 1.032 99

1.066 99

1.090 22

1.102 01

1.138 09 1.213 55

1.252 99 1.293 61 1.378 51 1.468 53 1.563 96

13

14 1.035 57

1.072 32

1.097 49

1.110 28

1.149 47 1.231 76

1.274 92 1.319 48 1.412 97 1.512 59 1.618 69

14

15 1.038 16

1.077 68

1 .104 80

1.118 60

1.160 97 1.250 23

1.297 23 1.345 87 1.448 30 1.557 97 1.675 35

15

1.0%

1.5%

1.75%

2.0%

2.5%

3 .0%

3.5%

16 1.040 76

1.083 07

1.112 17

1.126 99

1.172 58 1.268 99

1.319 93 1.372 79 1.434 51 1.604 71 1.733 99

16

17 1.043 36

1.088 49

1.119 58

1.135 44

1.184 30 1.288 02

1.343 03 1.400 24 1.521 62 1.652 85 1.794 68

17

18 1.045 97

1.093 93

1.127 05

1.143 96

1.196 15 1.307 34

1.366 53 1.428 25 1.559 66 1.702 43 1.857 49

18

19 1.048 58

1.099 40

1.134 56

1.152 54

1.208 11 1.326 95

1.390 45 1.456 81 1.598 65 1.753 51 1.922 50

19

20 1.051 21

1.104 90

1.142 13

1 .1 6 1 1 8

1.220 19 1.346 86

1.414 78 1.485 95 1.638 62 1.806 11 1.989 79

20

21 1.053 83

1.110 42

1.149 74

1.169 89

1.232 39 1.367 06

1.434 54 1.515 67 1.679 58 1.860 29 2.059 43

21

22 1.056 47

1.115 97

1.157 40

1.178 67

1.244 72 1.387 56

1.464 73 1.545 98 1 .7 2 1 5 7 1.916 10 2 .1 3 1 5 1

22

23 1.059 11

1.121 55

1.165 12

1.187 51

1.257 16 1.408 38

1.490 36 1.576 90 1.764 61 1.973 59 2.206 11

23

24 1.061 76

1 .1 2 7 1 6

1.172 89

1.196 41

1.269 73 1.429 50

1.516 44 1.608 44 1.808 73 2.032 79 2.283 33

24

25 1.064 41

1.132 80

1.180 71

1.205 39

1.282 43 1.450 95

1.542 98 1.640 61 1.853 94 2.093 78 2.363 24

25

30 1.077 78

1.161 40

1.220 59

1 .2 5 1 2 7

1.347 85 1.563 08

1.682 80 1.811 36 2.097 29 2.427 26 2.806 79

30

35 1 .0 9 1 3 2

1.190 73

1.261 82

1.298 90

1.416 60 1.683 88

1.835 29 1.999 89 2.373 21 2.813 86 3.333 59

35

40 1.105 03

1.220 79

1.304 45

1.348 35

1.488 86 1.814 02

2.001 60 2.208 04 2.685 06 3.262 04 3.959 26

40

45 1.118 92

1.251 62

1.348 52

1.399 68

1.564 81 1.954 21

2.182 98 2.437 85 3.037 90 3.781 60 4.702 36

45

50 1.132 97

1.283 23

1.394 07

1.452 96

1.644 63 2.105 24

2.380 79 2.691 59 3 .4 3 7 1 1 4.383 91 5.584 93

50

60 1.161 62

1.348 85

1.489 85

1.565 68

1.816 70 2.432 20

2.831 82 3.281 03 4.399 79 5.891 60 7.878 09

60

A ppendix A N

umerical tables

TABLE 1 continued (1 + /)"

n

4 .0%

4 .5 %

5 .0%

1

1.040 00

1.045 00

1.050 00

1.060

00

1.070 00

1.080

2

1.081 60

1.092 03

1.102 50

1.123 60

3

1.124

86

1.1 411 7

1.157 63

4

1.169

86

1.192 52

5

1.216 65

6

12.0%

00

1.10 0 00

1.12 0 0

1.150

1.200 1

1.144 90

1.166 40

1.2 10 00

1.254 4

1.322

1.440

2

1.191 01

1.225 04

1.259 71

1.331 00

1.404 9

1.521

1.728

3

1.215 51

1.262 47

1.310 79

1.360 48

1.464 10

1.573 5

1.749

2.074

4

1.246 18

1.276 28

1.338 22

1.402 55

1.469 32

1.610 51

1.762 0

2 .0 11

2.488

5

1.265 32

1.302 26

1.340 10

1.418 51

1.500 73

1.586 87

1.771 56

1.973

8

2.313

2.938

6

7

1.315 93

1.360

86

1.407 10

1.503 63

1.605 78

1.713 82

1.948 72

2.210 7

2.660

3.583

7

8

1.368 57

1.422 10

1.477 46

1.593 84

1.718 18

1.850 93

2.143 59

2.476 0

3.059

4.300

8

9

1.423 31

1.486 10

1.551 33

1.689 47

1.838 45

1.999 00

2.357 95

2.773 1

3.518

5.160

9

10

1.480 24

1.552 97

1.628 89

1.790 84

1.967 15

2.158 92

2.593 74

3.105

8

4.046

6.192

10

11

1.539 45

1.622 85

1.710 34

1.898 29

2.104 85

2.331 63

2.853 12

3.478 5

4.652

7.430

11

12

1.601 03

1.695

86

2.012 19

2.252 19

2.518 17

3.138 43

3.896 0

5.350

8.916

12

13

1.665 07

1.772 20

1.885 65

2.132 92

2.409 84

2.719 62

3.452 27

4.363 5

6.153

10.699 13

14

1.731

68

1.851 94

1.979 93

2.260 90

2.578 53

2.937 19

3.797 50

4.887 1

7.076

12.839 14

15

1.800 94

1.935 28

2.078 93

2.396 55

2.759 03

3.172 16

4.177 25

5.473

6

8.137

15.407 15

16

1.872 98

2.022 37

2.182 87

2.540 35

2.952 16

3.425 94

4.594 97

6.130 3

9.358

18.488 16

17

1.947 90

2.113 38

2.292 02

2.692 77

3.158 81

3.700 01

5.054 47

6.866 1

10.761

22.186 17

18

2.025 82

2.208 48

2.406 62

2.854 33

3.379 93

3.996 01

5.559 92

7.690 0

12.375

26.623 18

19

2.106 85

2.307

86

2.526 95

3.025 59

3.616 52

4.315 70

6.115 91

8.612

8

14.232

31.945 19

20

2.19112

2.411 71

2.653 30

3.207 13

3.869

68

4.660 95

6.727 50

9.646 3

16.367

38.338

20

21

2.278 77

2.520 24

2.785 96

3.399 56

4.140 56

5.033 83

7.400 25

10.803

8

18.821

46.005

21

22

2.369 92

2.633 65

2.925 26

3.603 53

4.430 40

5.436 54

8.140 27

12.100 3

21.645

55.206

22

23

2.464 72

2.752 17

3.071 52

3.819 74

4.740 52

5.871 46

8.954 30

13.552 3

24.891

66.247 23

24

2.563 30

2.876 01

3.225 10

4.048 93

5.072 36

6.3 411 8

9.849 73

15.178

6

28.625

79.497 24

25

2.665 84

3.005 43

3.386 35

4.291 87

5.427 43

6.848 47

10.834 71

17.000 1

32.919

95.396 25 237.376 30

88

1.795

7.0%

1 5.0%

2 0 .0 %

n

10.0%

6 .0%

30

3.243 40

3.745 32

4.321 94

5.743 49

7.612 25

10.062 65

17.449 40

29.960 0

66.212

35

3.946 09

4.667 35

5.516 02

7.686 08 10.676 58

14.785 34

28.102 44

52.800 0

133.175

590.668 35

40

4.801 02

5.816 36

7.039 99 10.285 71 14.974 45

21.724 52

45.259 26

93.051 0

267.862

1 469.771 40

45

5.84118

7.248 25

8.985 01 13.764 61 21.002 45

31.920 44

72.890 48 163.987

6

538.767

3 657.258 45

50

7.106

46.901 61 117.390 85 289.002 1 1 083.652

9 100.427 50

68

9.032 64 11.477 40 18.420 15 29.457 02

60 10.519 63 14.027 41 18.679 19 32.987 69 57.946 43 101.257 06 304.481 64 897.596 9 4 383.999 56 347.514 60

699

A ppendix A N

umerical tables

TABLE 2 Present value of $1 due at the end of n periods ( i + O"

700

= d + 〇- n

n

0.25%

0 .5 0 %

0.66%

0 .7 5 %

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

n

1

0.997 51

0.995 02

0.993 38

0.992 56

0.990 09

0.985 22

0.980 39

0.975 60

0.970 87

0.966 18

1

2

0.995 02

0.990 07

0.986 80

0.985 17

0.980 29

0.970

66

0.9 611 6

0.951 81

0.942 59

0.933 51

2

3

0.992 54

0.985 15

0.980 26

0.977 83

0.970 59

0.956 31

0.942 32

0.928 59

0.915 14

0.901 94

3

4

0.990 06

0.980 25

0.973 77

0.970 55

0.960 98

0.942 18

0.923 84

0.905 95

0.888 48

0.871 44

4

5

0.987 59

0.975 37

0.967 32

0.963 33

0.951 46

0.928 26

0.905 73

0.883 85

0.862 60

0.841 97

5

6

0.985 13

0.970 52

0.960 92

0.956 16

0.942 04

0.914 54

0.887 97

0.862 29

0.837 48

0.813 50

6

7

0.982 67

0.965 69

0.954 55

0.940 94

0.932 71

0.901 02

0.870 56

0.841 26

0.813 09

0.785 99

7

8

0.980 22

0.960 89

0.948 23

0.941 98

0.923 48

0.887 71

0.853 49

0.820 74

0.789 40

0.759 41

8

9

0.977 78

0.956 10

0.941 95

0.934 96

0.914 33

0.874 59

0.836 75

0.800 72

0.766 41

0.733 73

9

10

0.975 34

0.951 35

0.935 71

0.928 00

0.905 28

0.861

66

0.820 34

0.7 811 9

0.744 09

0.708 91

10

11

0.972 91

0.946 61

0.929 52

0.921 09

0.896 32

0.848 93

0.804 26

0.762 14

0.722 42

0.684 94

11

12

0.970 48

0.941 91

0.923 36

0.914 24

0.887 44

0.836 38

0.788 49

0.743 55

0.701 37

0.661 78

12

13

0.968 06

0.973 22

0.917 25

0.907 43

0.878

66

0.824 02

0.773 03

0.725 42

0.680 95

0.639 40

13

14

0.965 65

0.932 56

0.9 111 7

0.900

68

0.869 96

0.811 84

0.757 87

0.707 72

0 .6 611 1

0.617 78

14

15

0.963 24

0.927 92

0.905 14

0.893 97

0.861 34

0.799 85

0.743 01

0.690 46

0.641

86

0.596 89

15

16

0.960 84

0.923 30

0.899 14

0.887 32

0.852 82

0.788 03

0.728 44

0.673 62

0.623 16

0.576 70

16

17

0.958 44

0.918 71

0.893 19

0.880 71

0.844 37

0.776 38

0.714 16

0.657 19

0.605 01

0.557 20

17

18

0.956 05

0.914 14

0.887 27

0.874 16

0.836 01

0.764 91

0.700 15

0.6 411 6

0.587 39

0.538 36

18

19

0.953 67

0.909 59

0.881 40

0.867 65

0.827 73

0.753 60

0.686 43

0.625 52

0.570 28

0.520 15

19

20

0.951 29

0.905 06

0.875 56

0.8 611 9

0.819 54

0.742 47

0.672 97

0.610 27

0.553 67

0.502 56

20

21

0.948 92

0.900 56

0.869 76

0.854 78

0.811 43

0.731 49

0.659 77

0.595 38

0.537 54

0.485 57

21

22

0.946 55

0.896 08

0.864 00

0.848 42

0.803 39

0.720

68

0.646 83

0.580

86

0.521 89

0.469 15

22

23

0.944 19

0.891 62

0.858 28

0.842 10

0.795 44

0.710 03

0.634 15

0.566 69

0.506 69

0.453 28

23

24

0.941 84

0.887 19

0.852 60

0.835 83

0.787 56

0.699 54

0.621 72

0.552 87

0.491 93

0.437 95

24

25

0.939 49

0.882 77

0.846 95

0.829 61

0.779 76

0.689 20

0.609 53

0.539 39

0.477 60

0.423 14

25

30

0.927 83

0.861 03

0.819 27

0.799 19

0.741 92

0.639 76

0.552 07

0.476 74

0.411 98

0.356 27

30

35

0.916 32

0.839 82

0.792 50

0.769

88

0.705 91

0.593

86

0.500 02

0.421 37

0.355 38

0.299 97

35

40

0.904 95

0.819 14

0.766 61

0.741 65

0.671 65

0.551 26

0.452 89

0.372 43

0.306 55

0.252 57

40

45

0.893 72

0.798 96

0.741 56

0.714 45

0.639 05

0.511 71

0.410 19

0.329 17

0.264 43

0.212 65

45

50

0.882 63

0.779 29

0.717 32

0.688 25

0.608 03

0.475 00

0.371 52

0.290 94

0.228

10

0.179 05

50

60

0.860 87

0.741 37

0.671 21

0.638 70

0.550 45

0.409 30

0.304 78

0.227 28

0.169 73

0.126 93

60

TABLE 2 continued

n

4 .0 %

4 .5 %

5.0%

6 .0%

7.0%

8 .0 %

10.0%

12.0%

1 5.0%

20.0%

VI

1

0.961 53

0.956 93

0.952 38

0.943 39

0.934 57

0.925 92

0.909 09

0.892 86

0.869 57

0.833 33

1

2

0.924 55

0.915 72

0.907 02

0.889 99

0.873 43

0.857 33

0.826 45

0.797 19

0.756 14

0.694 44

2

3

0.888 99

0.876 29

0.863 83

0.839 61

0.816 29

0.793 83

0.751 31

0.711 78

0.657 52

0.578 70

3

4

0.854 80

0.838 56

0.822 70

0.792 09

0.762 89

0.735 02

0.683 01

0.635 52

0.571 75

0.482 25

4

5

0.821 92

0.802 45

0.783 52

0.747 25

0.712 98

0.680 58

0.620 92

0.567 43

0.497 18

0.401 88

5

6

0.790 31

0.767 89

0.746 21

0.704 96

0.666 34

0.630 16

0.564 47

0.506 63

0.432 33

0.334 90

6

7

0.759 91

0.734 82

0.710 68

0.665 05

0.622 74

0.583 49

0.513 16

0.452 35

0.375 94

0.279 08

7

8

8

0.730 69

0.703 18

0.676 83

0.627 41

0.582 00

0.540 26

0.466 51

0.403 88

0.326 90

0.232 57

9

0.702 58

0.672 90

0.644 60

0.591 89

0.543 93

0.500 24

0.424 10

0.360 61

0.284 26

0.193 81

9

0.247 18

0.161 51

10

10

0.675 56

0.643 92

0.613 90

0.558 39

0.508 34

0.463 19

0.385 54

0.321 97

11

0.649 58

0.616 19

0.584 67

0.526 78

0.475 09

0.428 88

0.350 49

0.287 48

0.214 94

0.134 59

11

12

0.624 59

0.589 66

0.556 83

0.496 96

0.444 01

0.397 11

0.318 63

0.256 67

0.186 91

0.112 16

12

13

0.600 57

0.564 27

0.530 32

0.468 83

0.414 96

0.367 69

0.289 66

0.229 17

0.162 53

0.093 46

13

14

0.577 47

0.539 97

0.505 06

0.442 30

0.387 81

0.340 46

0.263 33

0.204 62

0.141 33

0.077 89

14

15

0.555 26

0.516 72

0.481 01

0.417 26

0.362 44

0.315 24

0.239 39

0.182 70

0.122 89

0.064 91

15

16

0.533 90

0.494 46

0.458 11

0.393 64

0.338 73

0.291 89

0.217 63

0.163 12

0.106 86

0.054 09

16

17

0.513 37

0.473 17

0.436 29

0.371 36

0.316 57

0.270 26

0.197 84

0.145 64

0.092 93

0.045 07

17

18

0.493 62

0.452 80

0.415 52

0.350 34

0.295 86

0.250 24

0.179 86

0.130 04

0.080 80

0.037 56

18

19

0.474 64

0.433 30

0.395 73

0.330 51

0.276 50

0.231 71

0.163 51

0.116 11

0.070 26

0.031 30

19

20

0.456 38

0.414 64

0.376 88

0.311 80

0.258 41

0.214 54

0.148 64

0.103 67

0.06110

0.026 08

20

21

0.438 83

0.396 78

0.358 94

0.294 15

0.241 51

0.198 65

0.135 13

0.092 56

0.053 13

0.021 74

21

22

0.421 95

0.379 70

0.341 84

0.277 50

0.225 71

0.183 94

0.122 85

0.082 64

0.046 20

0.018 11

22

23

0.405 72

0.363 35

0.325 57

0.261 79

0.210 94

0.170 31

0.111 68

0.073 79

0.040 17

0.015 09

23

24

0.390 12

0.347 70

0.310 06

0.246 97

0.197 14

0.157 69

0.101 53

0.065 88

0.034 93

0.012 58

24

25

0.375 11

0.332 73

0.295 30

0.232 99

0.184 24

0.146 01

0.092 30

0.058 82

0.030 38

0.010 48

25

30

0.308 31

0.267 00

0.231 37

0.174 11

0.131 36

0.099 37

0.057 31

0.033 38

0.015 10

0.004 21

30

35

0.253 41

0.214 25

0.181 29

0.130 10

0.093 66

0.067 63

0.035 58

0.018 94

0.007 51

0.001 69

35

40

0.208 28

0.171 92

0.142 04

0.097 22

0.066 78

0.046 03

0.022 09

0.010 74

0.003 73

0.000 68

40

45

0.1 711 9

0.137 96

0.111 29

0.072 65

0.047 61

0.031 32

0.013 72

0.006 10

0.001 86

0.000 27

45

50

0.140 71

0.110 70

0.087 20

0.054 28

0.033 94

0.021 32

0.008 52

0.003 46

0.000 92

0.000 11

50

60

0.095 06

0.071 29

0.053 54

0.030 31

0.017 26

0.009 88

0.003 28

0.00111

0.000 23

0.000 02

60

701

A ppendix A N

umerical tables

TABLE 3 F u tu re v alu e o f an a n n u ity o f $1 p e r p e rio d fo r n p e rio d s s ( M = ( 】+

i

0 .5 %

0.66%

0 .7 5 %

1.0%

1.5%

2 .0%

2.5%

3.0%

3 .5%

n

1

1.000 00

1.000 00

1.000 00

1.000 00

1.000 00

1.000 00

1.000 00

1.000 0

1.000 0

1.000 0

1

2

2.002 50

2.005 00

2.006 67

2.007 50

2.010 00

2.015 00

2.020 00

2.025 0

2.030 0

2.035 0

2

3

3.007 51

3.015 03

3.020 04

3.022 56

3.030 10

3.045 23

3.060 40

3.075

6

3.090 9

3.106 2

3

4

4.015 03

4.030 10

4.040 18

4.045 23

4.060 40

4.090 90

4.121 61

4.152 5

4.183

6

4.214 9

4

5

5.025 06

5.050 25

5.067 11

5.075 56

5.101 01

5.152 27

5.204 04

5.256 3

5.309 1

5.362 5

5

6

6.037 63

6.075 50

6.100 89

6.113 63

6.152 02

6.229 55

6.308 12

6.387 7

6.468 4

6.550 2

6

7

7.052 72

7.105

88

7.141 57

7.159 48

7.213 54

7.322 99

7.434 28

7.547 4

7.662 5

7.779 4

7

8

8.070 35

8.141 41

8.189 18

8.213 18

8.285 67

8.432 84

8.582 97

8.736 1

8.892 3

9 .0 517

8

9

9.090 53

9.182 12

9.243 77

9.274 78

9.368 53

9.559 33

9.754 63

9.954 5

10.159 1

10.368 5

9

10

10.113 25 10.228 03 10.305 40

10.344 34 10.462 21 10.702 72

10.949 72

11.203 4

11.463 9

11.731 4

10

11

11.138 54 11.279 17 11.374 10

11.421 92 11.566 83 11.863 26

12.168 72

12.483 5

12.807

8

13.142 0

11

12

12.166 38 12.335 56 12.449 93

12.507 59 12.682 50 13.041 21

13.412 09

13.795

14.192 0

14.602 0

12

13 13.196 80 13.397 24 13.532 93

13.601 39 13.809 33 14.236 83

14.680 33

15.140 4

15.617

8

16.113 0

13

14 14.229 79 14.464 23 14.623 15

14.703 40 14.947 42 15.450 38

15.973 94

16.519 0

17.086 3

17.677 0

14

15 15.265 37 15.536 55 15.720 63

15.813

16.682 14

17.931 9

18.598 9

19.295 7

15

16 16.303 53 16.614 23 16.825 54

16.932 28 17.257

17.932 37

18.639 29

19.380 2

20.156 9

20.971 0

16

17 17.344 29 17.697 30 17.937 61

18.059 27 18.430 44 19.201 36

20.012 07

20.864 7

21.761

6

22.705 0

17

18 18.387 65 18.785 79 19.057 19

19.194 72 19.614 75 20.489 38

21.412 31

22.386 3

23.414 4

24.499 7

18

19 19.433 62 19.879 72 20.184 24

20.338

20.810 89 21.796 72

22.840 56

23.946 0

25.116 9

26.357 2

19

20

20.482 20 20.979 12 21.318 80

21.491 22 22.019 00 23.123 67

24.297 37

25.544 7

26.870 4

28.279 7

20

21

21.533 41 22.084 01 22.460 93

22.652 40 23.239 19 24.470 52

25.783 32

27.183 3

28.676 5

30.269 5

21

22

22.587 24 23.194 43 23.610

68

16.096 90 16.533 43

86

66

23.822 30 24.471 59 25.837 58

27.298 98

28.862 9

30.536

8

32.328 9

22

23 23.643 71 24.310 40 24.768 07

25.000 96 25.716 30 27.225 14

28.844 96

30.584 4

32.452 9

34.460 4

23

24 24.702 82 25.431 96 25.933 19

26.188 47 26.973 46 28.633 52

30.421

86

32.349 0

25 25.764 57 26.559 12 27.106 08

27.384

30 31.113 31 32.280 02 33.088 85

33.502 90 34.784 89 37.538

34.426 5

36.666 5

24

28.243 20 30.063 02

32.030 30

34.157

8

36.459 3

38.949 9

25

68

40.568 08

43.902 7

47.575 4

51.622 7

30

35 36.529 24 38.145 38 39.273 73

39.853 81 41.660 28 45.592 09

49.994 48

54.928 2

60.462 1

66.674 0

35

40 42.013 20 44.158 85 45.667 54

46.446 48 48.886 37 54.267 89

60.401 98

67.402

6

75.401 3

84.550 3

40

45 47.566 06 50.324 16 52.277 34

53.290 11 56.481 07 63.614 20

71.892 71

81.516 1

92.719 9 105.781 7

45

60.394 26 64.463 18 73.682 83

84.579 40

97.484 3 112.796 9 130.997 9

50

50 53.188

68

56.645 16 59.110 42

60 64.646 71 69.770 03 73.476

702

68

6

86

88

76.424 14 81.669 67 96.214 65 114.051 54 135.991

6

163.053 4 196.516 9

60

A ppendix A N

umerical tables

W TABLE 3 co n tin u ed S(n ,i)=

(1 + / 广 - 1

n

4.0%

4 .5%

5 .0 %

6 .0%

7 .0%

8 .0%

10.0%

12.0%

1 5 .0 %

20.0%

n

1

1.000 0

1.000 0

1.000 0

1.000 0

1.000 0

1.000 0

1.000 0

1.000

1.000

1.00

1

2

2.040 0

2.045 0

2.050 0

2.060

0

2.070 0

2.080

0

2.100 0

2.120

2.150

2.20

2

3

3.121

6

3.137 0

3.152 5

3.183

6

3.214 9

3.246 4

3.310 0

3.374

3.472

3.64

3

4

4.246 5

4.278 2

4.310 1

4.374

6

4.439 9

4.506 1

4.641 0

4.779

4.993

5.36

4

5

5.416 3

5.470 7

5.525

6

5.627 1

5.750 7

5.866

6

6.105 1

6.353

6.742

7.44

5

6

6.633 0

6.716 9

6.801 9

6.975 3

7.153 3

7.335 9

6

8.115

8.754

9.93

6

7

7.898 3

8.019 2

8.142 0

8.393

8

8.654 0

8.922

8

9.487 2

10.089

11.067

12.92

7

8

9.214 2

9.380 0

9.549 1

9.897 5

8

10.636

6

11.435 9

12.300

13.727

16.50

8

6

11.491 3

11.978 0

12.487

6

13.579 5

14.776

16.786

20.80

9

14.486

6

15.937 4

17.549

20.304

25.96

10

6

16.645 5

18.531 2

20.655

24.349

32.15

11

17.888 5

18.977 1

21.384 3

24.133

29.002

39.58

12

6

21.495 3

24.522 7

28.029

34.352

48.50 13

10.259

7.715

9

10.582

8

10.802

1

11.026

10

12.006

1

12.288

2

12.577 9

13.180

8

13.816 4

11

13.486 4

13.841 2

14.206

8

14.971

6

15.783

12

15.025

8

15.464 0

15.917 1

16.869 9

13

16.626

8

17.159 9

17.713 0

18.882

14

18.291 9

18.932 1

19.598

6

21 .015 1

22.550 5

24.214 9

27.975 0

32.393

40.505

59.20 14

15

20.023

6

20.784 1

21.578

6

23.276 0

25.129 0

27.152 1

31.772 5

37.280

47.580

72.04 15

16

21.824 5

22.719 3

23.657 5

25.672 5

27.888 1

30.324 3

35.949 7

42.753

55.717

87.44 16

17

23.697 5

24.741 7

25.840 4

28.212 9

30.840 2

33.750 2

40.544 7

48.884

65.075

105.93 17

18

25.645 4

26.855 1

28.132 4

30.905 7

33.999 0

37.450 2

45.599 2

55.750

75.836

128.12 18

19

27.671 2

29.063

6

30.539 0

33.760 0

37.379 0

41.446 3

51.159 1

63.440

88.212

154.74 19

20

29.778 1

31.371 4

33.066 0

36.785

6

40.995 5

45.762 0

57.275 0

72.052

102.443

186.69

20

21

31.969 2

33.783 1

35.719 3

39.992 7

44.865 2

50.422 9

64.002 5

81.699

118.810

225.03

21

22

34.248 0

36.303 4

38.505 2

43.392 3

49.005 7

55.456

8

92.502

137.631

271.03

22

23

36.617 9

38.937 0

41.430 5

46.995

8

53.436 1

60.893 3

79.543 0

104.603

159.276

326.24 23

24

39.082

6

41.689 2

44.502 0

50.815

6

58.176 7

66.764

8

88.497 3

118.155

184.167

392.48 24

25

41.645 9

44.565 2

47.727 1

54.864 5

63.249 0

73.105 9

98.347 1

133.334

212.793

471.98 25

30

56.084 9

61.570

6

66.438

8

79.058 2

74.460

8

113.283 2

164.494 0

241.532

434.744

11 81 .8 8 30

35

73.652 2

81.496

6

90.320 3 111.434

8

271.024 4

431.663

881.168

2 948.34 35

40

95.025 5 107.030 3 120.799

8

1

8

20.140

138.236 9

154.762 0 199.635 1

172.316

8

71.402

259.056 5

442.592

6

767.088

1 779.090

7 343.95 40

6

718.904

8

45 121.029 4 138.850 0 159.700 2 212.743 5 285.749 3

386.505

1 358.224

3 585.128

18 281.31 45

50 152.667 1 178.503 0 209.348 0 290.335 9 406.528 9

573.770 2 11 6 3 .9 0 8 5 2 400.008

7 217.716

45 497.19 50

60 237.990 7 289.498 0 353.583 7 533.1281 813.520 4 1253.2133 3 034.816 4 7 471.641 29 219.992 28 1732.57 60

A ppendix A N

umerical tables

TABLE 4 P re se n t v alu e o f an a n n u ity o f $1 p e r p e rio d fo r n p e rio d s P = A (» ") =

1

!

(l +

〇

0.25%

0 .5 %

1

0.997 51

0.995 02

0.993 38

2

1.992 52

1.985 10

3

2.985 06

4

,! 1.0%

1.5%

2 .0 %

0.992 56

0.990 10

0.985 22

0.980 39

0.975

1.980 18

1.977 72

1.970 40

1.955

88

2.970 25

2.960 44

2.955 56

2.940 99

2.912 20

2.883

3.975 12

3.950 50

3.934 21

3.92611

3.901 97

5

4.962 72

4.925 87

4.901 54

4.889 44

6

5.947 85

5.896 38

5.862 45

7

6.930 52

6.862 07

8

7.910 74

9

8.888 52 86

10

9.863

3.0%

3.5%

n

6

0.970 9

0.966 2

1

1.941 56

1.927 4

1.913 5

1.899 7

2

88

2.856 0

2.828

6

3

3.854 38

3.807 73

3.762 0

3.717 1

3.673 1

4

4.853 43

4.782 65

4.713 46

4.645

8

4.579 7

4.515 1

5

5.845 60

5.795 48

5.697 19

5.601 43

5.508 1

5.417 2

5.328

6

6

6.817 01

6.794 64

6.728 19

6.598 21

6.471 99

6.349 4

6.230 3

6.114 5

7

7.822 96

7.765 24

7.736 61

7.651

68

7.485 93

7.325 48

7.170 1

7.019 7

6.874 0

8

8.779 06

8.707 19

8.671 58

8.566 02

8.360 52

8.162 24

7.970 9

7.786 1

7.607 7

9

2 .5%

8.982 54

8.752 1

8.530 2

8.316

6 10

9.786 85

9.514 2

9.252

6

9.001

6 11

6

2.801

9.730 41

9.642 90

9.599 58

9.471 30

9.222 19

11

10.836 77 10.677 03

10.572 42

10.520 67

10.367 63

10.07112

12

11.807 25 11.618 93

11.495 78

11.434 91

11.255 08

10.907 51

10.575 34 10.257

9.663 3

12

13 12.775 32 12.556 15

12.413 03

12.342 35

12.133 74

11.731 53

11.348 37 10.983 2 10.635 0 10.302 7

13

14 13.740 96 13.488 71

13.324 20

13.243 02

13.003 70

12.543 38

12.106 25 11.690 9 11.296 1 10.920 5

14

15 14.704 20 14.416 62

14.229 34

14.136 99

13.865 05

13.343 23

12.849 26 12.381 4 11.937 9 11.517 4

15

16 15.665 04 15.339 93

15.128 48

15.024 31

14.717 87

14.131 26

13.577 71 13.055 0 12.5611 12.094 1

16

17 16.623 48 16.258 63

16.021 67

15.905 02

15.562 25

14.907 65

14.291 87 13.712 2 13.166 1 12.651 3

17

18 17.579 53 17.172 77

16.908 94

16.779 18

16.398 27

15.672 56

14.992 03 14.353 4 13.753 5 13.189 7

18

19 18.533 20 18.082 36

17.790 34

17.646 83

17.226 01

16.426 17

15.678 46 14.978 9 14.323

8

19

20

19.484 49 18.987 42

18.665 90

18.508 02

18.045 55

17.168 64

16.351 43 15.589 2 14.877 5 14.212 4

20

21

20.433 40 19.887 98

19.535

66

19.362 80

18.856 98

17.900 14

17.011 21 16.184 5 15.415 0 14.698 0

21

22

21.379 95 20.784 06

20.399 67

2 0 .2 11 2 1

19.660 38

18.620 83

17.658 05 16.765 4 15.936 9 15.1671

22

68

21.257 95

21.053 31

20.455 82

19.330

24 23.265 98 22.562 87

22.110 54

21.889 15

21.243 39

25 24.205 47 23.445 64

22.957 49

22.718 76

30 28.867 87 27.794 05

27.108 85

35 33.472 43 32.035 37

31.124 55

30.682

40 38.019

86

36.172 23

45 42.510

88

23 22.324 14 21.675

704

4i

86

8

9.954 0

18.292 20 17.332 1 16.443

8

6

13.709

15.620 4

23

20.030 41

18.913 93 17.885 0 16.935 5 16.058 4

24

22.023 16

20.719 61

19.523 46 18.424 4 17.413 1 16.481 5

25

26.775 08

25.807 71

24.015 84

22.396 46 20.930 3 19.600 4 18.392 0

30

66

29.408 58

27.075 60

24.998 62 23.145 2 21.487 2 20.000 7

35

35.009 03

34.446 94

32.834 69

29.915 85

27.355 48 25.102

21.355 1

40

40.207 20

38.766 58

38.073 18

36.094 51

32.552 34

29.490 16 26.833 0 24.518 7 22.495 5

45

50 46.946 17 44.142 79

42.401 34

41.566 45

39.196 12 34.999 69

31.423 61 28.362 3 25.729

8

23.455

6

50

60 55.652 36 51.725 56

49.318 43

48.173 37

44.955 04

34.760 89 30.908 7 27.675

6

24.944 7

60

39.380 27

8

23.114

8

r

A ppendix A N

umerical tables

TABLE 4 co n tin u ed P = A(n,i) = -

l1 〇+ 〇nJ1 8 .0%

10.0%

12.0%

15.0%

20.0%

n

0.934 5

0.925 9

0.909 1

0.892 9

0.869 5

0.833 3

1

0

1.783 2

1.735 5

1.690 1

1.625 7

1.527

8

2

2.673 0

2.624 3

2.577 0

2.486

8

2.401

8

2.283 2

2.106 5

3

3.465 1

3.387 2

3.312 1

3.169

8

3.037 3

2.854 9

2.588 7

4

3.992 7

3.790 7

3.604

8

3.352 1

2.990

6

5

8

4.355 2

4.111 4

3.784 4

3.325 5

6

5.389 2

5.206 3

4.868 4

4.563

8

4.160 4

3.604

6

7

6.209 7

5.971 2

5.746

6

5.334 9

4.967

6

4.487 3

3.837 2

8

6

6.515 2

6.246

8

5.759 0

5.328 2

4.771 5

4.031 0

9

7.721 7

7.360 0

7.023 5

6.710 0

6.144 5

5.650 2

5.018 7

4.192 5

10

8.528 9

8.306 4

7.886

8

7.498

6

7.138 9

6.495 0

5.937 7

5.233 7

4.327 1

11

6

8.863 3

8.383

8

7.942

6

7.536 0

6.813

6

6.194 4

5.420

6

4.439 2

12

9.393

6

8.852

6

8.357

6

7.903 7

7.103 3

6.423 5

5.583 1

4.532 7

13

10.222 8

9.898

6

9.294 9

8.745 4

8.244 2

7.366

2

5.724 4

4.610

6

14

11.118 4

10.739 5

10.379 7

9.712 2

9.107 9

8.559 4

7.606 0

6.810 9

5.847 3

4.675 5

15

16

11.652 3

11.234 0

10.837

6

8.851 3

7.823 7

6.974 0

5.954 2

4.729

6

16

17

12.165 7

11.707 2

11.274 1

10.477 2

9 .7 632

9 .1 216

8.021 5

7.119

6

6.047 1

4.774

6

17

18

12.659 3

12.160

6

10.059 0

9.371

8

8 .2 0 1 4

7.249 7

6.127 9

4.812 2

18

19

13.133 9

12.593 3

12.085 3

11.158 1

10.335 5

9.603 5

8.364 9

7.365

8

6.198 2

4.843 5

19

20

13.590 3

13.007 9

12.462 2

11.469 9

10.594 0

9.818 1

8.513 5

7.469 4

6.259 3

4.869

6

20

21

14.029 2

13.404 7

12.821

2

11.764 0

10.835 5

6

7.562 0

6.312 4

4.891 3

21

22

14.4511

13.784 4

13.163 0

12.041 5

11.061

2

10.200 7

8.771 5

7.644

6

6.358

6

4.909 4

22

23

14.856

24

n

4 .0%

4 .5%

5 .0%

6 .0 %

1

0.961 5

0.956 9

0.952 4

0.943 3

2

1.886 1

1.872 7

1.859 4

1.833 3

1.808

3

2.775 1

2.749 0

2.723 2

4

3.629 9

3.587 5

3.546 0

5

4.451

8

4.390 0

4.329 5

4.212 3

4.100 1

6

5.242 1

5.157 9

5.075 7

4.917 3

4.766 5

4.622

7

6.002 1

5.892 7

5.786 4

5.582 3

8

6.732 7

6.595 9

6.463 2

9

7.435 3

7.268

10

8.110 9

7.912 7

11

8.760 5

12

9.385 1

9.118

13

9.985

6

9.682 9

14

10.563 1

15

8

0

7.107

11.689

8

8 6

6.801

10.105

10.827

7.0%

8

9.446

10.016

8

8.648

6

6.628

8

13.488

6

12.303 3

11.272 1

10.371 0

8.883 2

7.718 4

6.398

8

4.924 5

23

15.247 0

14.495 5

13.798

6

12.550 3

11.469 3

10.528 7

8.984 7

7.784 3

6.433 7

4.937 1

24

25

15.622 1

14.828 2

14.093 9

12.783 3

11.653 5

10.674 7

9.077 0

7.843 1

6.464 1

4.947

6

25

30

17.292 0

16.288 9

15.372 5

13.764

8

12.409 0

11.257 7

9.426 9

8.055 2

6.565 9

4.978 9

30

35

18.664

6

17.461 0

16.374 2

14.498 2

12.947

6

11.654 5

9 .6 441

8.175 5

6.616

6

4.991 5

35

40

19.792

8

18.401

6

17.159 1

15.046 2

13.331 7

11.924

6

9.779 0

8.243

45

20.720 0

19.156 3

17.774 1

15.455

8

13.605 5

12.108 4

9.862

50

21.482 2

19.762 0

18.255 9

15.761

8

13.800 7

12.233 4

9.914

60

22.623 5

20.638 0丨

18.929 3

16.161 4

14.039 2

12.376

8

14.147

6

8

6.641 7

4.996

6

40

8

8.282 5

6.654 2

4.998

6

45

8

8.304 5

6.660 5

4.999 5

50

9.967 2

8.324 0

6.665 1

4.999 9

60

705

A ppendix A N umerical

tables

TABLE 5 A reas u n d e r th e n o rm a l cu rve fro m -

to th e v alu e o f z

z

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

•09 0.4641

0.0

0.5000

0.4960

0.4920

0.4880

0.4840

0.4801

0.4761

0.4721

0.4681

- 0.1

0.4602

0.4562

0.4522

0.4483

0.4443

0.4404

0.4364

0.4325

0.4286

0.4247

- 0.2

0.4207

0.4168

0.4129

0.4090

0.4052

0.4013

0.3974

0.3936

0.3897

0.3859

-0 .3

0.3821

0.3783

0.3745

0.3707

0.3669

0.3632

0.3594

0.3557

0.3520

0.3483

-0 .4

0.3446

0.3409

0.3372

0.3336

0.3300

0.3264

0.3228

0.3192

0.3156

0.3121

-0 .5

0.3085

0.3050

0.3015

0.2981

0.2946

0.2912

0.2877

0.2843

0.2810

0.2776

0.6

0.2743

0.2709

0.2676

0.2643

0.2611

0.2578

0.2546

0.2514

0.2483

0.2451

-0 .7

0.2420

0.2389

0.2358

0.2327

0.2296

0.2266

0.2236

0.2206

0.2177

0.2148

- 0.8

0.2119

0.2090

0.2061

0.2033

0.2005

0.1977

0.1949

0.1922

0.1894

0.1867

-0 .9

0.1841

0.1814

0.1788

0.1762

0.1736

0.1711

0.1685

0.1660

0.1635

0.1611

1.0 1 .1

0.1587

0.1562

0.1539

0.1515

0.1492

0.1469

0.1446

0.1423

0.1401

0.1379

0.1357

0.1335

0.1314

0.1292

0.1271

0.1251

0.1230

0 .12 10

0.1190

0.1170

- 1.2

0.1151

0.1131

0 .1112

0.1093

0.1075

0.1056

0.1038

0.1020

0.1003

0.0985

-1 .3

0.0968

0.0951

0.0934

0.0918

0.0901

0.0885

0.0869

0.0853

0.0838

0.0823

-1 .4

0.0808

0.0793

0.0778

0.0764

0.0749

0.0735

0.0721

0.0708

0.0694

0.0681

-1 .5

0.0668

0.0655

0.0643

0.0630

0.0618

0.0606

0.0594

0.0528

0.0571

0.0559

1.6

0.0548

0.0537

0.0526

0.0516

0.0505

0.0495

0.0485

0.0475

0.0465

0.0455

-1 .7

0.0446

0.0436

0.0427

0.0418

0.0409

0.0401

0.0392

0.0384

0.0375

0.0367

1.8

0.0359

0.0351

0.0344

0.0336

0.0329

0.0322

0.0314

0.0307

0.0301

0.0294

-1 .9

0.0287

0.0281

0.0274

0.0268

0.0262

0.0256

0.0250

0.0244

0.0239

0.0233

- 2.0

0.0228

0.0222

0.0217

0.0212

0.0207

0.0202

0.0197

0.0192

0.0188

0.0183

- 2.1

0.0179

0.0174

0.0170

0.0166

0.0162

0.0158

0.0154

0.0150

0.0146

0.0143

2.2

0.0139

0.0136

0.0132

0.0129

0.0125

0.0122

0.0119

0.0116

0.0113

0.0110

-2 .3

0.0107

0.0104

0.0102

0.0099

0.0096

0.0094

0.0091

0.0089

0.0087

0.0084

-2 .4

0.0082

0.0080

0.0078

0.0075

0.0073

0.0071

0.0069

0.0068

0.0066

0.0064

-2 .5

0.0062

0.0060

0.0059

0.0057

0.0055

0.0054

0.0052

0.0051

0.0049

0.0048

- 2.6

0.0047

0.0045

0.0044

0.0043

0.0041

0.0040

0.0039

0.0038

0.0037

0.0036

-2 .7

0.0035

0.0034

0.0033

0.0032

0.0031

0.0030

0.0029

0.0028

0.0027

0.0026

0.0024

0.0023

0.0023

0.0022

0.0021

0.0021

0.0020

0.0019

-

-

-

-

-

-

2.8

0.0026

0.0025

-2 .9

0.0019

0.0018

0.0018

0.0017

0.0016

0.0016

0.0015

0.0015

0.0014

0.0014

-3 .0

0.0014

0.0013

0.0013

0.0012

0.0012

0.0011

0.0011

0.0011

0.0010

0.0010

-3 .1

0.0010

0.0009

0.0009

0.0009

0.0008

0.0008

0.0008

0.0008

0.0007

0.0007

-3 .2

0.0007

0.0007

0.0006

0.0006

0.0006

0.0006

0.0006

0.0005

0.0005

0.0005

-3 .3

0.0005

0.0005

0.0005

0.0004

0.0004

0.0004

0.0004

0.0004

0.0004

0.0003

-3 .4

0.0003

0.0003

0.0003

0.0003

0.0003

0.0003

0.0003

0.0003

0.0003

0.0002

-3 .5

0.0002

0.0002

0.0002

0.0002

0.0002

0.0002

0.0002

0.0002

0.0002

0.0002

-3 .6

0.0002

0.0002

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

-3 .7

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

-3 .8

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

-3 .9

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

-4 .0

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

-

706

〇〇

A ppendix A N

umerical tables

TABLE 5 con tin u ed 2

0.00

0 .0 1

0.02

0.0 3

0.0 4

0.0 5

0.0 6

0 .0 7

0.0 8

0 .0 9

0.0

0.5000

0.5040

0.5080

0.5120

0.5160

0.5199

0.5239

0.5279

0.5319

0.5359

0.1

0.5398

0.5438

0.5478

0.5517

0.5557

0.5596

0.5636

0.5675

0.5714

0.5753

0.2

0.5793

0.5832

0.5871

0.5910

0.5948

0.5987

0.6026

0.6064

0.6103

0.6141

0.3

0.6179

0.6217

0.6255

0.6293

0.6331

0.6368

0.6406

0.6443

0.6480

0.6517

0.4

0.6554

0.6591

0.6628

0.6664

0.6700

0.6736

0.6772

0.6808

0.6844

0.6879

0.5

0.6915

0.6950

0.6985

0.7019

0.7054

0.7088

0.7123

0.7157

0.7190

0.7224

0.6

0.7257

0.7291

0.7324

0.7357

0.7389

0.7422

0.7454

0.7486

0.7517

0.7549

0.7

0.7580

0.7611

0.7642

0.7673

0.7704

0.7734

0.7764

0.7794

0.7823

0.7852

0.8

0.7881

0.7910

0.7939

0.7967

0.7995

0.8023

0.8051

0.8078

0.8106

0.8133

0.9

0.8159

0.8186

0.8212

0.8238

0.8264

0.8289

0.8315

0.8340

0.8365

0.8389

1.0

0.8413

0.8438

0.8461

0.8485

0.8508

0.8531

0.8554

0.8577

0.8599

0.8621

1 .1

0.8643

0.8665

0.8686

0.8708

0.8729

0.8749

0.8770

0.8790

0.8810

0.8830

1.2

0.8849

0.8869

0.8888

0.8907

0.8925

0.8944

0.8962

0.8980

0.8997

0.9015

1.3

0.9032

0.9049

0.9066

0.9082

0.9099

0.9115

0.9131

0.9147

0.9162

0.9177

1.4

0.9192

0.9207

0.9222

0.9236

0.9251

0.9265

0.9279

0.9292

0.9306

0.9319

1.5

0.9332

0.9345

0.9357

0.9370

0.9382

0.9394

0.9406

0.9418

0.9429

0.9441

1.6

0.9452

0.9463

0.9474

0.9484

0.9495

0.9505

0.9515

0.9525

0.9535

0.9545

1.7

0.9554

0.9564

0.9573

0.9582

0.9591

0.9599

0.9608

0.9616

0.9625

0.9633

1.8

0.9641

0.9649

0.9656

0.9664

0.9671

0.9678

0.9686

0.9693

0.9699

0.9706

1.9

0.9713

0.9719

0.9726

0.9732

0.9738

0.9744

0.9750

0.9756

0.9761

0.9767

2.0

0.9772

0.9778

0.9783

0.9788

0.9793

0.9798

0.9803

0.9808

0.9812

0.9817

2.1

0.9821

0.9826

0.9830

0.9834

0.9838

0.9842

0.9846

0.9850

0.9854

0.9857

2.2

0.9861

0.9864

0.9868

0.9871

0.9875

0.9878

0.9881

0.9884

0.9887

0.9890

2.3

0.9893

0.9896

0.9898

0.9901

0.9904

0.9906

0.9909

0.9911

0.9913

0.9916

2.4

0.9918

0.9920

0.9922

0.9925

0.9927

0.9929

0.9931

0.9932

0.9934

0.9936

2.5

0.9938

0.9940

0.9941

0.9943

0.9945

0.9946

0.9948

0.9949

0.9951

0.9952

2.6

0.9953

0.9955

0.9956

0.9957

0.9959

0.9960

0.9961

0.9962

0.9963

0.9964

2.7

0.9965

0.9966

0.9967

0.9968

0.9969

0.9970

0.9971

0.9972

0.9973

0.9974

2.8

0.9974

0.9975

0.9976

0.9977

0.9977

0.9978

0.9979

0.9979

0.9980

0.9981

2.9

0.9981

0.9982

0.9982

0.9983

0.9984

0.9984

0.9985

0.9985

0.9986

0.9986

3.0

0.9986

0.9987

0.9987

0.9988

0.9988

0.9989

0.9989

0.9989

0.9990

0.9990

3.1

0.9990

0.9991

0.9991

0.9991

0.9992

0.9992

0.9992

0.9992

0.9993

0.9993

3.2

0.9993

0.9993

0.9994

0.9994

0.9994

0.9994

0.9994

0.9995

0.9995

0.9995

3.3

0.9995

0.9995

0.9995

0.9996

0.9996

0.9996

0.9996

0.9996

0.9996

0.9997

3.4

0.9997

0.9997

0.9997

0.9997

0.9997

0.9997

0.9997

0.9997

0.9997

0.9998

3.5

0.9998

0.9998

0.9998

0.9998

0.9998

0.9998

0.9998

0.9998

0.9998

0.9998

3.6

0.9998

0.9998

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

3.7

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

3.8

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

0.9999

3.9

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

4.0

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000

1.0000 707

CHAPTER 3 1.

U sing E q u a tio n 3 .2 : S = P (1 + T h e re fo re :

$6250 = $6000

1+

S o lv in g this e q u a tio n , w e fin d th a t r = 0 . 2 5 3 4 7 2 o r a p p ro x im a te ly 2 5 . 3 5 p e r c e n t p e r a n n u m .

2.

The series o f d e p o s its consists o f th e in itia l d e p o s it plus a n o r d in a r y a n n u ity w ith a term o f 1 0 ye a rs. (a)

U sin g E q u a tio n 3 .4 , the fu tu re v a lu e o f th e first d e p o s it is: S = P (1 + / ] n = $ 5 0 0 0 ( 1 .0 8 ) 10 = $ 5 0 0 0 x 2 .1 5 8 9 2 4 9 9 7 = $ 1 0 7 9 4 .6 2 U sin g E q u a tio n 3 . 2 8 , the fu tu re v a lu e o f the 1 0 la te r d e p o s its is:

,r - i] $1000

[( 1 .0 8 ) 10

0 .0 8 = $ 1 0 0 0 x 1 4 .4 8 6 5 6 2 4 7 = $ 1 4 4 8 6 .5 6 T he re fore , w h e n A n g e la has m a d e the last d e p o s it, she w ill h a ve $ 1 0 7 9 4 . 6 2 + $ 1 4 4 8 6 . 5 6 = $ 2 5 2 8 1 .1 8 . (b)

The a m o u n t to b e d e p o s ite d n o w is the p re se n t v a lu e o f $ 2 5 2 8 1 .1 8 in 1 0 y e a rs ' tim e . U sin g E q u a tio n 3 .5 , this a m o u n t is:

_ $ 2 5 2 8 1 .1 8 ( 1 .0 8 ) 10 $ 2 5 2 8 1 .1 8 _ 2 .1 5 8 9 2 4 9 9 7 = $ 1 1 7 1 0 .0 8 3

3.

(b)

U sing E q u a tio n 3 .6 :

= 0 .1 0 3 6 1 8

709

A ppendix B S o lutio ns

(b)

t o self-test problems

The re p a y m e n ts a re a n o r d in a r y a n n u ity fo r 2 5 9 9 — p e rc e n t = 0 .8 2 5 p e r ce n t. U sin g E q u a tio n 3 .1 9 :

$75 0 0 0 = — - — 0 .0 0 8 2 5

x

12 = 3 0 0

m onths w ith

a m o n th ly interest rate o f

( 1 .0 0 8 2 5 )300

$ 7 5 0 0 0 = C x 1 1 0 .9 0 6 4 3 7 c _

$75 000 1 1 0 .9 0 6 4 3 7

= $ 6 7 6 . 2 5 per month

CHAPTER 4 1•

The e s tim a te d v a lu e o f o n e sh a re is th e p re se n t v a lu e o f th e d iv id e n d s fo r th e n e x t 2 y e a rs plus th e p re se n t v a lu e o f the sh a re as a t th e e n d o f 2 y e a rs . The la tte r v a lu e ca n be e stim a te d u sin g E q u a tio n 4 .8 .

D〇(1 + g') t D〇(l + g')2* | ___ 1 _ D〇(1 + g,)2(l +g)

p 0

|1 + M

(1 + M 2

_ $ 0 .7 5 (1 .0 8 ) 1 .1 4 ~

(1 + M 2

$ 0 .7 5 ( 1 .0 8 )2 + ~ ( 1 . 1 4 ) 2~

1

[k e -g ]

$ 0 .7 5 ( 1 ,0 8 )2 (1 .04)

+ (1 .1 4 )2 ~

( 0 .1 4 - 0 .0 4 )

= $ 8 .3 8

2.

The in te re st p a y m e n ts o f $ 5 . 5 0 p e r h a lf y e a r a re a n o r d in a r y a n n u ity. The y ie ld is 1 3 / 2 = 6 . 5 p e r c e n t p e r h a lf y e a r, th e re fo re the c u rre n t p ric e P is:

$100

_ $ 5 .5 0 _ 0 .0 6 5

(1 .0 6 5 )6

(1 .0 6 5 )6

= $ 9 5 .1 6

3.

O n th e b a sis o f th e e x p e c ta tio n s th e o ry o f th e term structure o f in te re st rates, w e have:

3 ( ] + z 0,3)

= 〇 + z 0,l ) 〇 + z l ,2) 〇 + z 2,3)

T h e re fo re , the 1-ye a r z e ro rates in fu tu re y e a rs a re fo u n d as fo llo w s : In Year 2:

(1.,1 170)2 = (1 .1 3 9 0 ) (1 + z ] 2)

Therefore In Year 3:

^ 2 = 9 .5 4 2 % (1 .1 0 6 0 ) 3 = (1 .1 3 9 0 ) (1 .0 9 5 4 2 ) (1 + z 2 3)

Therefore Equivalently:

z 2 3 = 8 .4 3 2 % (1 .1 0 6 0 )3 Z2' 3 _ ( 1 . 1 1 7 0 ) 2 _ 1 = 8 .4 3 2 %

710

A ppendix B S o lutio ns

t o self-test problems

CHAPTER 5

Q

NPV= J 2

r

“ r

= $ 101 8 0 0 + $ 9 0 0 0 0 + $ 8 0 0 0 0

1.10

(1.10)2

_

$18〇 〇 〇 〇

(1.10)3

= $ 9 2 5 4 5 + $ 7 4 3 8 0 + $ 6 0 105 - $ 1 8 0 0 0 0 =$47030

2.

$180000=

$ 1〇 18 〇 〇

+ M

^

+ M

(1 + i ] 2

1+r

^

(1 + r1 3

If w e try a d is c o u n t ra te o f 2 5 p e r cent, w e fin d that: $ 1 8 0 0 0 0 = $81 4 4 0 + $ 5 7 6 0 0 + $ 4 0 9 6 0

NPV=0 T h e re fo re , the in te rn a l ra te o f return is 2 5 p e r cent. ^

〇•

_

r.

present value o f net cash flow s

Benerit-cost ratio = ---------------- ----------------------------in itia l cash outlay $227030 ~ $180000 = $ 1 .2 6

CHAPTER 6 1.

The a n n u a l d e p re c ia tio n c h a rg e w ill b e e q u a l to $ 8 4 0 0 0 / 1 2 = $ 7 0 0 0 . The in cre a se in p ro fit e a c h y e a r (ig n o rin g the e x p e n d itu re on a n o v e rh a u l e v e ry 2 years) is $ 2 0 0 0 0 - $ 7 0 0 0 = $ 1 3 0 0 0 . The c o m p a n y in c o m e ta x rate is 0 .3 0 % th e re fo re , the in c re a s e in ta x a tio n is $ 1 3 0 0 0 x 0 . 3 0 = $ 3 9 0 0 p e r a n n u m . The net p re se n t v a lu e from p u rc h a s in g the e q u ip m e n t is th e re fo re e q u a l to the p re se n t v a lu e o f the a n n u a l sa vin g s o f $ 2 0 0 0 0 - $ 3 9 0 0 , less the p re se n t v a lu e o f the o v e rh a u ls e v e ry 2 y e a rs , less th e in itia l o u tla y.

The n e t p re se n t v a lu e is th e re fo re e q u a l to:

( 1 .1 )12

($ 2 0 0 0 0 - $ 3 9 00 1

0.1 $ 2 0 0 0 (1 -0 .3 0 )

$ 2 0 0 0 (1 -0 .3 0 )

$ 2 0 0 0 (1 - 0 . 3 0 )

$ 2 0 0 0 (1 - 0 . 3 0 )

l.l2

l.l4

$ 2 0 0 0 (1 -0 .3 0 )

t0 /1 ™

-------------a------------------------- 〇------------------------- Tn---------- 4 > «4 U U U

l.l6

l.l8

l . l 10

$21 6 0 4 As the net p re se n t v a lu e is p o s itiv e , th e e q u ip m e n t sh o u ld be p u rc h a s e d .

2.

The o p tim u m re p la c e m e n t p o lic y c a n b e c a lc u la te d u sin g th e m e th o d o u tlin e d in S e ctio n 6 . 2 . In th e ca se o f th e TMT, the o b je c tiv e is to m in im is e the p re se n t v a lu e o f cash o u tflo w s , a ssu m in g th a t o p e ra tin g cash in flo w s re m a in c o n s ta n t e a ch y e a r. For re p la c e m e n t e v e ry y e a r, the N P V is:

^ ,= -$ 6 4 0 0 0 -^ °

$50000 1 .1 5

-$ 3 0 0 8 7 71 1

A ppendix B S o lutio ns

to self-test problems

If the m a c h in e is re p la c e d e v e ry y e a r in p e rp e tu ity, the N P V is:

^ | l ,

) = -$ 3 0 0 8 7 ^ ^

〇〇

= -$ 2 3 0 6 6 7 The net p re se n t v a lu e 3 assu m in g re p la c e m e n t in p e rp e tu ity a t the e n d o f 2 , 3 ; 4 a n d 5 y e a rs a re :

N W (2,oc) ==-$217953 卿

P'ocl := -$220463

NPV[4,oo) -= -$223 708 NPV(5,oo) -= -$240906 T h e re fo re , the m a c h in e s h o u ld b e re p la c e d a t the e n d o f 2 ye a rs.

3.

(a)

Retain semi-trailers fo r 3 years a n d then replace w ith Flexivans. W e assum e th a t the F lexivan s a re to b e re p la c e d in p e rp e tu ity. (i)

R e sidual v a lu e o f se m i-tra ile rs: $ 1 0 0 0 0 ( 1 . 1 )-3 = $ 7 5 1 3

(ii)

N e t ca sh flo w s o f se m i-tra ile rs:

$300000

(1 + 0 .1 0 )3

0.10

$746056

C o n s id e r o n e F le xiva n : In itia l o u tla y = $ 7 0 0 0 0 PV o f net cash flo w s :

$40000

(1+0.10 广 0.10

$ 1 5 1 631

PV o f re s id u a l va lu e : $ 5 0 0 0 ( 1 . 1)"5 = $ 3 1 0 5 N P V o f o n e F le xiva n : - $ 7 0 0 0 0 + $ 1 5 1 631 + $ 3 1 0 5 = $ 8 4 7 3 6 (iii)

PV o f a p e rp e tu a l c h a in o f six F lexivan s b e g in n in g in 3 ye a rs:

6 ($ 8 4 7 3 6 )

(II)5

( l . l ) - 3 = $1 0 0 7 6 5 5

.( i.ii5 N e t p re se n t v a lu e : (i) + (ii) + (iii) = $ 7 5 1 3 + $ 7 4 6 0 5 6 + $1 0 0 7 6 5 5 = $1 7 6 1 2 2 4 (b)

R eplace se m i-tra ile rs w ith F lexivan s n o w . (i) (ii)

S a lv a g e v a lu e o f se m i-tra ile rs: $ 5 0 0 0 0 PV o f a p e rp e tu a l c h a in o f six F le xiva n s b e g in n in g n o w :

6 ($ 8 4 7 3 6 )

( i. ir .( l.l) 5 - '

712

$1 3 1 4 1 8 9

N e t p re se n t v a lu e : (i) + (ii) = $1 3 9 1 1 8 9 S in ce the net p re se n t v a lu e o f re ta in in g the CB se m i-tra ile rs fo r 3 y e a rs a n d then re p la c in g them w ith A Z F lexivan s is g re a te r than the net p re se n t v a lu e o f re p la c in g the CB se m i-tra ile rs w ith the A Z F lexivan s now , the CB se m i-tra ile rs sh o u ld be re ta in e d fo r 3 ye a rs .

CHAPTER 7 1.

(a)

U sin g E q u a tio n 7 .1 , th e e x p e c te d return on th e p o rtfo lio is:

E[Rp) = wx E(Rx) +

w yE(Ry)

= (0 .3 1 (0 .1 2 ) + (0 .7 )(0 .1 8) = 0 .1 6 2 o r 1 6 .2 % (b)

U sing E q u a tio n 7 .4 , the v a ria n c e o f the p o rtfo lio is:

aP =

+ ^

yg y

+ ^ w x w y P 0 X0 Y

= (0.3)2(0.2)2 + (0.7)2(0.15)2 + 2(0.3) (0.7) p(0.2) (0.15) = 0 . 0 0 3 6 + 0 .0 1 1 0 2 5 + 0 . 0 1 2 6 p

jjj

p = + 1 .0 , a p = 0 .0 2 7 2 2 5

(ii)

p = + 0 .7 , (jp = 0 .0 2 3 4 4 5

jjjjj

p = 0,

jjv j

p = - 0 . 7 , ap = 0 .0 0 5 8 0 5

〇

p = 0 .0 1 4 6 2 5

These results illu s tra te the fa c t th a t, o th e r th in g s b e in g e q u a l, d iv e rs ific a tio n is m o re e ffe c tiv e the lo w e r the c o rre la tio n c o e ffic ie n t.

2.

The v a ria n c e - c o v a ria n c e m a trix w ill be a 3 x 3 m a trix w ith the v a ria n c e s o f th e th re e se cu ritie s on th e m ain d ia g o n a l a n d c o v a ria n c e s in a ll o th e r cells. For e x a m p le , the v a ria n c e o f X is ( 0 .2 2 ) 2 = 0 . 0 4 8 4 a n d the c o v a ria n c e b e tw e e n X a n d Y is (0 .6 ) (0 .2 2 ) (0 .1 5 ) = 0 . 0 1 9 8 . The m a trix is:

=

X

0 .0 4 8 4

0 .0 1 9 8

0 .0 1 3 2

Y

0 .0 1 9 8

0 .0 2 2 5

0 .0 0 9 0

Z

0 .0 1 3 2

0 .0 0 9 0

0 .0 1 0 0

+

+

+ 2 w ^ 2 w 2 C 〇y [R x ，Ry) + 2 w ^V V yC Q y

R^) + 2w yV V 2C 〇y (Ry>

= (0 .2 )2 (0 .0 4 8 4 ) + (0 .3 )2 (0 .0 2 2 5 ) + (0 .5 )2 (0 .0 1 0 0 ) + 2 (0 .2 )(0 .3 )(0 .0 1 9 8 ) + 2 (0 .2 ) (0.5 ) (0 .0 1 3 2 ) + 2 (0 .3 ) (0.5) (0 .0 0 9 0 ) = 0 .0 0 1 9 3 6 + 0 .0 0 2 0 2 5 + 0 .0 0 2 5 + 0 .0 0 2 3 7 6 + 0 .0 0 2 6 4 + 0 .0 0 2 7 = 0 .0 1 4 1 7 7 = 0 .0 0 1 9 3 6 + 0 .0 0 2 0 2 5 + 0 .0 0 2 5 + 0 .0 0 2 3 7 6 + 0 .0 0 2 6 4 + 0 .0 0 2 7 = 0 .0 1 4 1 7 7 The s ta n d a rd d e v ia tio n is:

〇

= V

〇

.0 3 8 4 7 7

= 0 .1 9 6 1 5

713

A ppendix B So lu tio n s

3.

to self-test problems

The C A P M ca n b e used to c a lc u la te the re q u ire d return o n e a c h sh a re . For e x a m p le , fo r C a rlto w n th e re q u ire d return is c a lc u la te d as fo llo w s :

E iR ^ R ^ p ^ R ^ - R f ] = 0 . 0 8 + (0.7) (0 .0 6 ) = 0 .1 2 2 o r 1 2 .2 % The e x p e c te d a n d re q u ire d returns on the fo u r shares a re as fo llo w s :

S h a re

Expected return (% )

Required return (% )

C a rlto w n

1 3 .0

1 2 .2

Pivot

1 7 .6

1 7 .6

Forresters

1 4 .0

1 4 .6

B runsw ick

1 0 .4

1 0 .4

Pivot a n d B ru n s w ic k a re c o rre c tly v a lu e d , C a rlto w n is u n d e rv a lu e d a n d Forresters is o v e rv a lu e d .

C H A P T E R 10 1•

The p ric e is fo u n d b y d is c o u n tin g the fa c e v a lu e usin g sim p le interest. U sin g E q u a tio n 1 0 .1 , the p ric e is:

1 + (r)(d/365) =

$500000

_ 1 + (0 .0 5 5 ) ( 9 0 /3 6 5 ) $500000 _ 1 .0 1 3 5 61 6 4 3 = $ 4 9 3 3 0 9 .9 1 The b ill is p u rc h a s e d fo r $ 4 9 3 3 0 9 .9 1 .

2.

W h e n the b ill is so ld 3 0 d a y s la te r, its term to m a tu rity has b e c o m e 6 0 d a y s . A g a in u sin g E q u a tio n 1 0 .1 , the p ric e is:

1 + (r)[d /3 6 5 )

_

$500000

_ 1 + (0 .0 5 3 ) ( 6 0 /3 6 5 ) $500000 _ 1 .0 0 8 7 1 2 3 2 8 = $ 4 9 5 6 8 1 .4 6 The b ill is so ld fo r $ 4 9 5 6 8 1 . 4 6 . T h e re fo re , th e d o lla r return to th e h o ld e r o v e r the 3 0 -d a y p e rio d is: $ 4 9 5 6 8 1 . 4 6 - $ 4 9 3 3 0 9 .9 1 = $ 2 3 7 1 . 5 5 The im p lie d in te re st ra te is: $ 2 3 7 1 .5 5 $ 4 9 3 3 0 9 .9 1 = 0 .0 0 4 8 0 7 4 2 4

714

A ppendix B So lutio ns

to self-test problems

T h e re fo re , the e ffe c tiv e a n n u a l in te re st ra te is: 365 (1 .0 0 4 8 0 7 4 2 4 ) 3 0 - 1 = 0 . 0 6 0 0 8 6 152

^6 .0 1 %

C H A P T E R 12 0

100 0 0 0

200 000

0

10

20

2 5 000

25 000

25 000

-2 5 000

75 000

175 0 0 0

-3 .3 3

10

2 3 .3 3

75 000

75 000

75 000

-7 5 000

25 000

125 00 0

-3 0

10

50

A n n u a l net cash flo w ($) F in a n cin g p la n (a) A ll equity Rate on return on $1 0 0 0 0 0 0 (%) (b) $750 000 equity and $ 2 5 0 0 0 0 loan Interest p a id ($) P rofit a fte r interest ($) Rate o f return on $ 7 5 0 0 0 0 (%) (c) $250 000 equity and $ 7 5 0 0 0 0 loan Interest p a id ($) Profit a fte r interest ($) Rate o f return on $ 2 5 0 0 0 0 (%)

N o te th a t the c h o ic e o f fin a n c in g p la n has n o e ffe c t o n the ra te o f return on B a rry 's in ve stm e n t o n ly w h e n the net o p e ra tin g cash flo w is $ 1 0 0 0 0 0 p e r a n n u m . For cash flo w s g re a te r th a n o r less th a n $ 1 0 0 0 0 0 p e r a n n u m , the effects o f fin a n c ia l le v e ra g e a re e v id e n t fo r fin a n c in g p la n s (b) a n d (c).

2.

(a)

The first step is to use E q u a tio n 1 2 .3 to fin d fc〇 :

ke = k〇 + ( k o - k j)

21.5 = ^0 + (/c0 - 8 ) G ) R e a rra n g in g this e q u a tio n sho w s th a t /c〇 = 1 7 p e r cent. A fte r th e n e w lo a n is ta ke n ou t, th e d e b t- e q u ity ra tio is 1 :1 . U sing E q u a tio n 1 2 .3 a g a in :

/ce = 17 + (17 一 81 ( j ) = 26% (b)

The a v e ra g e co st o f c a p ita l is c a lc u la te d u sing E q u a tio n 1 2 .2 :

W ith the o r ig in a l c a p ita l structure:

U 2i-5(I)+8G) = 17%

715

A ppendix B S o lutio ns

t o self-test problems

A fte r the in c re a s e in le v e ra g e :

U 2 6 ⑷

+8

= 17% C o n siste n t w ith th e M M p ro p o s itio n s , th e c o m p a n y ’s w e ig h te d a v e ra g e co st o f c a p ita l is n o t c h a n g e d b y the c h a n g e in its c a p ita l structure.

3.

(a)

C o s m ic 's v a lu e w ith a ll-e q u ity fin a n c e is: w

$ 6 0 0 0 0 0 (1 - 0 .3 0 )

Vu =

---------------------------0 .1 5

=$420000 _

0 .1 5

= $2 800000 (b)

(i)

Intere st o n the lo a n is $ 1 0 0 0 0 0 p e r a n n u m w h ic h is ta x d e d u c tib le . A fte r-ta x cash flo w = $ ( 6 0 0 0 0 0 - 1 0 0 0 0 0 ) (1 - 0 .3 0 ) + $ 1 0 0 0 0 0 = $ 4 5 0 0 0 0 w h ic h is a n in c re a s e o f $ 3 0 0 0 0 p e r an nu m .

(ii)

The v a lu e o f the c o m p a n y c a n b e c a lc u la te d u sing E q u a tio n 1 2 .6 :

VL = V U+ tcD = $ 2 8 0 0 0 0 0 + 0 .3 0 x $ 1 0 0 0 0 0 0 = $ 2 800 0 0 0 + $300 000 = $ 3 100000

C H A P T E R 14 1•

(a)

The cost o f c a p ita l fo r the p ro je c t fc- ca n b e e s tim a te d u sing E q u a tio n 1 4 .1 :

= 0 .1 2 + 0 .7 5 ( 0 .1 8 - 0 .1 2 ) = 0 .1 6 5

NPV--

Ci -C,0 1 + kj $235000

-$200000

1 .1 6 5 $1717 S in ce the N P V is p o s itiv e , the p ro je c t is a c c e p ta b le , (b)

If Pj = ^• = 0 .1 2 + ( 0 . 1 8 - 0 . 1 2 ) = 0 .1 8

NPV= $ 2 3 5 0 0 0 = $ 2 0 0 0 0 0 1.1 8 = -$ 8 4 7 In this ca se , the p ro je c t is n o t a c c e p ta b le .

716

A ppendix B S olutions

to self-test problems

W 2.

(a)

U sing the C A P M , th e costs o f c a p ita l fo r the p ro je c ts a re : M a rs t = 9 + 0 . 7 0 ( 1 6 .5 - 9) = 1 4 .2 5 % Pluto )c = 9 + 0 . 8 5 ( 1 6 .5 - 9 ) = 1 5 .3 7 5 % N e p tu n e

= 9+

1 . 2 0 ( 1 6 . 5 - 9 ) = 1 8 .0 %

The p ro je c ts th a t sh o u ld b e a c c e p te d a re M a rs a n d N e p tu n e . (b)

If a ll p ro je c ts w e re e v a lu a te d u sing the c o m p a n y 's co st o f c a p ita l, M a rs w o u ld b e in c o rre c tly re je c te d a n d Pluto w o u ld b e in c o rre c tly a c c e p te d .

3.

The a n n u a l d e p re c ia tio n c h a rg e w ill b e e q u a l to $ 8 4 0 0 0 / 1 2 = $ 7 0 0 0 . The in c re a s e in p ro fit e a ch y e a r (ig n o rin g the e x p e n d itu re on a n o v e rh a u l e v e ry 2 yea rs) is $ 2 0 0 0 0 - $ 7 0 0 0 = $ 1 3 0 0 0 . The e ffe c tiv e c o m p a n y in c o m e ta x ra te is 0 .3 0 (1 - 0 .7 5 ) = 0 . 0 7 5 . T h e re fo re , the in c re a s e in ta x a tio n is $ 1 3 0 0 0 x 0 . 0 7 5 = $ 9 7 5 p e r a n n u m . The net pre sen t v a lu e fro m p u rc h a s in g the e q u ip m e n t is th e re fo re e q u a l to th e p re se n t v a lu e o f the a n n u a l s a vin g s o f $ 2 0 0 0 0 - $ 9 7 5 , less the p re se n t v a lu e o f the o v e rh a u ls e v e ry 2 y e a rs , less th e in itia l o u tla y. The net p re se n t v a lu e is th e re fo re e q u a l to:

($ 2 0 0 0 0 - $ 9 7 5 )

(1 .1 )2

$ 2 0 0 0 (1 - 0 . 0 7 5 )

~〇? i ~ $ 2 0 0 0 (1 - 0 . 0 7 5 )

$ 2 0 0 0 (1 - 0 . 0 7 5 )

rr1

i.i4

$ 2 0 0 0 (1 - 0 . 0 7 5 )

$ 2 0 0 0 (1 -0 .0 7 5 )

l.l8

l . l 10

$8>)〇〇〇

=$40217 A s th e n e t p re s e n t v a lu e is p o s itiv e , th e e q u ip m e n t sh o u ld b e p u rc h a s e d .

C H A P T E R 15 1.

(a)

The N P V o f th e le ase to D o n a sh is th e co st o f th e c o m p u te r ( $ 4 4 0 0 0 0 ) less the p re se n t v a lu e o f th e cash o u tflo w s fo r the le ase . S in ce D o n a sh w ill n o t b e p a y in g c o m p a n y in c o m e ta x d u rin g th e term o f th e le a se , the o n ly cash o u tflo w s a re the le a se re n ta ls a n d the d is c o u n t ra te is 1 5 p e r c e n t p e r y e a r. The N P V to D o n a sh is:

NPV= $ 4 4 0 0 0 0 - $ 1 0 0 0 0 0 i 1 + — ' ― \

0 .1 5

= $ 4 4 0 0 0 0 -$ 4 3 5 216 =$4784 (b)

C o m le a s e w ill p u rc h a s e th e c o m p u te r fo r $ 4 4 0 0 0 0 , re ce ive th e le ase re n ta ls ( $ 7 0 0 0 0 p e r a n n u m a fte r tax) a n d re c e iv e d e p re c ia tio n ta x s a v in g s (0 .3 x ( 1 / 3 ) x $ 4 4 0 0 0 0 = $ 4 4 0 0 0 p e r an n u m ) in Years 1, 2 a n d 3 . The a fte r-ta x d is c o u n t ra te is 15(1 - 0 . 3 ) = 1 0 .5 p e r c e n t p e r y e a r. The N P V to C o m le a s e is:

NPV = - $ 4 4 0 0 0 0 + $ 7 0 0 0 0 i 1 + — ' ― \

0 .1 0 5

1

1

(0 .1 0 5 )5 . J '

$44 000 0 .1 0 5

[i [

1 1 (l.l〇 5 )3 J

=$466 (c)

The o v e ra ll g a in on the tra n s a c tio n is: $4784 + $446 =$5250

717

A ppendix B S o lutio ns

t o self-test problems

C H A P T E R 17 1•

The c u rre n t s itu a tio n is: S e p te m b e r p ric e :

$ 12 6 0

June p ric e :

$ 12 0 0

S p re a d :

$

60

The s p re a d is e x p e c te d to w id e n — th a t is, th e S e p te m b e r c o n tra c t w ill b e c o m e re la tiv e ly d e a re r a n d the June c o n tra c t w ill b e c o m e re la tiv e ly c h e a p e r. T h e re fo re , w e w o u ld b u y th e S e p te m b e r c o n tra c t a n d sell the Jun e c o n tra c t. If the su b s e q u e n t p ric e s a re $1 3 0 0 (June) a n d $1 3 8 0 (S ep tem be r), the o u tc o m e is:

June

Sell at:

$1200

(+)

Buy b a ck at:

$1300

H

O u tco m e :

September

$100

Buy at:

$1260

Sell at:

$1380

O u tco m e : O v e ra ll o u tc o m e = - $ 1 0 0

$120 + $120

= $20

(loss) H w (p ro fit)

(p ro fit). The p ro fit ($ 2 0 )

is e q u a l to th e c h a n g e in the s p re a d

(= $ 8 0 -$ 6 0 ).

2.

The sale on 2 S e p te m b e r is a t a q u o te d p ric e o f 9 2 . 0 0 . This p ro v id e s an a n n u a l y ie ld o f 1 0 0 - 9 2 . 0 0 = 8 . 0 0 p e r cent. U sing E q u a tio n 1 7 .1 0 , the c o n tra c t p ric e is:

$1 000000 1 + (0 .0 8 ) ( 9 0 /3 6 5 ) = $ 9 8 0 6 5 5 .5 6 The c lo s in g o u t on 8 S e p te m b e r is a t a q u o te d p ric e o f 9 2 . 5 0 . This p ro v id e s an a n n u a l y ie ld o f 1 0 0 - 9 2 . 5 0 = 7 . 5 0 p e r cent. The c o n tra c t p ric e is:

$1 000000 1 + (0 .0 7 5 ) ( 9 0 /3 6 5 ) = $ 9 8 1 8 4 2 .6 4 H a ro ld w ill m a k e a loss o f $ 9 8 1 8 4 2 . 6 4 - $ 9 8 0 6 5 5 . 5 6 = $1 1 8 7 .0 8 on e a ch c o n tra c t. O n 1 5 co n tra c ts he w ill lose $ 1 1 8 7 . 0 8 x 15 = $ 1 7 8 0 6 . 2 0 .

C H A P T E R 18 1•

(a)

The m in im u m th e o re tic a l p ric e is g iv e n b y E q u a tio n 1 8 .3 :

Min c = Max 0,s-

X

In this p ro b le m , c = $ 1 . 7 0 a n d the risk-free in te re st ra te fo r an 8-m o nth p e rio d is p e r cent. T h e re fo re , the p re se n t v a lu e o f the e x e rc is e p ric e is

718

丨二:

% $ 1 4 .1 3 .

(1 .0 0 7 5 )8

6 .1 6

A ppendix B S o lutio ns

A/lax

to self-test problems

= M a x [0 , $ 1 4 . 9 0 - $ 1 4 . 1 3 ] = M a x [0 , $ 0 .7 7 ] = $ 0 .7 7

T h e re fo re the c u rre n t c a ll p ric e ( $ 1 .7 0 ) e xce e d s its m in im u m th e o re tic a l p ric e ( $ 0 .7 7 ) . (b)

The d e ta ils o f the a rb itr a g e a re set o u t in th e ta b le b e lo w . The p re se n t v a lu e o f the e x e rc is e p ric e , as c a lc u la te d in (a), is $ 1 4 .1 3 .

Future ca sh f lo w ($) if Current transaction

Current ca sh f lo w ($)

S* > $15

5* <

Buy p u t

-0 .8 3

0

+ (1 5 -S *)

Sell call

+ 1 .7 0

-(S *-1 5 )

0

Buy share

-1 4 .9 0

+S*

+S*

B o rro w $ 1 4 .1 3

+ 1 4 .1 3

-1 5

-1 5

0

0

+ 0 .1 0

Total

The ta b le sh o w s th a t the su g g e ste d tra n s a c tio n s c re a te a n a rb itra g e : a cash in flo w o f $ 0 . 1 0 p e r o p tio n is a c h ie v e d to d a y , w h ile th e fu tu re ca sh flo w is g u a ra n te e d to be z e ro . (c)

The a r b itra g e is p o s s ib le b e ca u s e p u t-c a ll p a r ity (E q u a tio n 1 8 .1 ) is v io la te d in this p ro b le m . P u t-c a ll p a rity is g iv e n b y:

In this p ro b le m , p = $ 0 .8 3 but:

c-S+

1 +〆

= $ 1 . 7 0 - $ 1 4 . 9 0 + $ 1 4 .1 3 = $ 0 .9 3

¥ P

2.

The b in o m ia l la ttic e fo r this p ro b le m is:

F ig u re B . l

Lattice o f sh a re p ric e s a n d call p ric e s $ 7 .1 6 6 3 $1.1663

$ 6 .8 2 5 0 5 0 .8 8 4 4 ^ -^

$ 6 .5 0 0 0

$ 6 .5 0 0 0

$0.6354

$0.5000

$0.2922

$ 5 .8 9 5 7 $0.0

N o te th a t s h a re p ric e s a re s h o w n in

bold a n d o p tio n p ric e s a re s h o w n in italics.

719

A ppendix B S o lu tio n s

to self-test problems

S h a re p ric e c a lc u la tio n s a re : $ 6 . 5 0 x 1 .0 5

= $ 6 .8 2 5 0

$ 6 . 8 2 5 0 x 1 .0 5 = $ 7 . 1 6 6 3 $ 6 .5 0 /1 .0 5

= $ 6 .1 9 0 5

$ 6 .1 9 0 5 /1 .0 5

= $ 5 .8 9 5 7

The 'u p 7 p r o b a b ility (p) a n d the /d o w n , p r o b a b ility (1 - p) a re g iv e n b y : $ 6 5〇 = p ($ 6 .8 2 5 ) + ( 1 - p ) ( $ 6 . 1 9 0 5 )

• 一

1.01

w h ic h solves to g iv e p = 0 . 5 9 0 2 a n d 1 - p = 0 . 4 0 9 8 . The p a y o ffs a t e x p ir y a re : M a x [$ 0 , $ 7 .1 6 6 3 - $ 6 .0 0 ] = $ 1 .1 6 6 3 M a x [$ 0 , $ 6 . 5 0 - $ 6 . 0 0 ]

= $ 0 .5 0

M a x [$ 0 , $ 5 .8 9 5 7 - $ 6 .0 0 ] = $ 0 The o p tio n p ric e c a lc u la tio n s a re : ( 0 .5 9 0 2 )($ 1 .1 6 6 3 ) + (0 .4 0 9 8 )($ 0 .5 0 ) =

1.01

$〇8 8 4 4

~

$〇2 9 2 2 一 .

(0 .5 9 0 2 )($ 0 .5 0 ) + (0 .4 0 9 8 )($ 0 .0 0 ) = 1.01

( 0 .5 9 0 2 )($ 0 .8 8 4 4 ) + ( 0 .4 0 9 8 )($ 0 .2 9 2 2 ) =

1.01

$〇6 3 5 4

一

•

The c u rre n t p ric e o f the c a ll o p tio n is th e re fo re c a lc u la te d to b e $ 0 . 6 3 5 4 , o r a p p ro x im a te ly 6 4 cents.

3.

The B la c k -S c h o le s m o d e l to p ric e c a ll o p tio n s is E q u a tio n 1 8 .5 :

c = SN(d1)- X e - r， TN(d2)

£n(S/X) + ( / + Acr2^ T

山三 ---------------- ^

w h e re

^ z----- — oVT

1

en[S/X\ + ( / + l a 2) 7

d2S------- 〇7f-------= c/] - a v T In this p ro b le m , S = $ 1 2 . 1 5 , X = $ 1 2 . 0 0 , 〆 = 0 . 1 0 p e r a n n u m , 7" = 0 . 2 5 y e a rs a n d

d

M 1 2 . 1 5 / 1 2 ) + [0.1 + ( 0 .5 ) ( 0 .2 ) 2](0 .2 5 ) 0 .2 v /〇 ^5

1

0 . 0 1 2 4 2 2 5 + 0 .0 3

« 0 .4 2 4 2 and d 2 = 0 . 4 2 4 2 - 0.1 = 0 .3 2 4 2

720

= 0 . 2 p e r a n n u m . T h e re fo re :

Using Table 5 in Appendix A: N/(0.4242卜 0.6643 and N(0.3242) ^0.6271 The present value of the exercise price is given by: e-(0.1)(0.25)x $ 1 2

=0.975 3099

x

$12

« $11.703719 Therefore the call price, c, is given by: ($12.15)(0.6643) - ($11.707371 9)(0.6271) =$0.7296 ~ 73 cents C H A P T E R 19

1.

2.

(a)

The value of Beta to Alpha is $750000 = $3 〇〇〇〇〇〇. As there are 2 million shares on issue, Beta is a zero0.25 NPV investment at a price of $1.50 per share.

(b)

The value of Beta as an independent entity is

(c)

If $2.6 million cash is paid for Beta, the wealth of its shareholders will increase by $2.6 million - $2000000 =$600000. The answers to (a) and (b) show that the gain from the takeover is $ 1 million. If $600000 of this gain accrues to Beta's shareholders, then the wealth of Alpha's shareholders must increase by $400000.

(a)

The increase in the value of B's equity is $380000000 - $320000000 = $60000000. To achieve this increase B must purchase 10 million shares at $5 each: an outlay of $50000000. Therefore, B's shareholders benefit by $10000000, so it should proceed with the takeover. B will have to issue 15 million shares to acquire 50 per cent of C, after which it will have 95 million shares on , , n , M, , $380000000 。 issue and each B share will be worth —-~ ____ = 》 4. 95 000000 The value of the outlay for the takeover is 15000000 x $4 = $60000000, so the wealth of B’s shareholders will not be changed by the takeover.

(b)

丨〇〇= $2 000000.

CHAPTER 20

1.

Using Equation 20.2: Q* /(2)(3000)(500)

V

48

=250 sprockets where

〇

= $3000 (per run)

D = 500 (units per annum) c = $48 (per sprocket per annum) 721

A ppendix B S o lutio ns

t o seif-test problems

The e c o n o m ic p ro d u c tio n run is 2 5 0 sp ro cke ts, a n d th e re fo re

= 2. T w o p ro d u c tio n runs p e r a n n u m a re

in d ic a te d .

2.

^

A re o rd e r p o in t o f 2 2 0 0 w ill a c h ie v e a sto cko u t p r o b a b ility o f 5 p e r ce n t. If a re o rd e r p o in t o f 2 0 0 0 is a d o p te d , the e x p e c te d cu sto m e r-se rvice le vel is:

0 . 1 0 + 0 . 2 0 + 0 . 5 0 + (0 .1 5 )

'

2000

'

2200

(0 .0 3 )

2000

—

(

0 . 02)

.2 4 0 0 .

2000 2600

= 0 .9 7 6 7 A s this e x c e e d s the ta rg e t level o f 9 5 p e r cent, a lo w e r re o rd e r p o in t w ill b e trie d . If a re o rd e r p o in t o f 1 8 0 0 is a d o p te d , the e x p e c te d cu sto m e r-se rvice level is:

0 .1 0 + 0 .2 0 + (0 .5 0 )

2800'

2000 .

+ (0.15 )

1800

2200

+ (0.03 )

*1 8 0 0 ' .2 4 0 0 .

1800

+ (0 . 02 )

2600

= 0 .9 0 9 1 The re q u ire d re o rd e r p o in t thus lies b e tw e e n 1 8 0 0 a n d 2 0 0 0 . Let the re q u ire d p o in t e x c e e d 1 8 0 0 b y x units, w h e re it is k n o w n th a t 0 < x < 2 0 0 . The e x p e c te d cu sto m e r-se rvice le vel is as fo llo w s :

0 .9 5 = 0 . 1 0 + 0 .2 0 + (0.50 )

1800 + x

2000

+ (0 .1 5 )

1800 + x

2200

+ (0.03 )

"1 8 0 0 + x ' +

.2 4 0 0

= 0 , 0 + 0 .2 0 + 0 .4 5 + 0 , 2 2 7 3 + 0 .0 2 2 5 + 0 . 0 13 8 5 + [ _

.

(

0 . 02 )

1800 + x ' 2600

0 .1 5

0 .0 3

2200

2400 + 2600

.

0 .0 2

= 0 .9 0 9 0 8 + 0 .0 0 0 3 3 8 3 7 x _ 0 .9 5 -0 .9 0 9 0 8 •

X 一 0 .0 0 0 3 3 8

37

= 1 2 0 .9 3

=121 A s a result, a re o rd e r p o in t o f 1 8 0 0 +

121

=

1921

sh o u ld a c h ie v e a n e x p e c te d cu sto m e r se rv ic e le vel o f

a p p ro x im a te ly 9 5 p e r cent. This is c o n firm e d in th e fo llo w in g c a lc u la tio n :

0 .1 0 + 0 . 2 0 + (0 .5 0 )

1921

2000

+ (0 .1 5 )

1921

2200

(0 .0 3 )

1921 —

+ (

2400.

0 . 02)

1921' .2 6 0 0 .

：0 . 10 + 0.20 + 0.480 25 + 0 . 1 3 0 9 8 + 0 .0 2 4 0 1 + 0 .0 14 7 8 0 .9 5 0 0 2 = 9 5 per cent

C H A P T E R 21 1•

(a)

The d is c o u n t fo r p a y m e n t 7 d a y s a fte r the in v o ic e d a te is $ 1 5 0 0 x 0 . 0 2 = $ 3 0 .

(b)

C u s to m e r X saves $ 3 0 b y p a y in g 2 3 d a y s e a rly. The e ffe ctive a n n u a l in te re st ra te is: 365

/ 3 0 \^ 3 " (1 + - 1 = 0 . 3 7 7 9 6 o r 3 7 .8 % V 1470/

722

A ppendix B S olutions

to self-test problems

C o n s id e r sales o f $ 1 0 0 0 . The cost o f g o o d s sold w ill be $ 7 5 0 . W ith the o r ig in a l term s, a n d u sing s im p le interest, the N P V p e r $ 1 0 0 0 o f sales is:

NPV= —

$1〇〇° = ^ - - $ 7 5 0

\365J = $ 2 3 7 .8 3 W ith the revise d term s, th e N P V is: N p y __

$ 7 0 0 x 0 .9 9

1 + 〇.i ( V365/

+ _ $ 3 0 0

i

_ $75〇

V365；

= $ 2 3 0 .5 1 The d iffe re n c e in p ro fita b ility is sm all, b u t the o r ig in a l term s a re m o re p ro fita b le .

GLOSSARY W a b n o r m a l re tu rn s re tu rn s in e x c e s s o f th e re tu rn

b e n e fi 卜 c o st r a tio in d e x c a lc u la t e d b y d i v id i n g

e x p e c te d fr o m a s e c u r ity

th e p r e s e n t v a lu e o f th e fu tu r e n e t c a s h f lo w s

ac ce p to r (o r d r a w e e ) in a b ill o f e x c h a n g e , th e

b y th e in it ia l c a s h o u t la y (a ls o k n o w n a s a

p a r t y a g r e e in g t o p a y th e h o ld e r th e b ill's f a c e

p ro fita b ility index)

v a lu e o n th e m a t u r ity d a t e ; u s u a lly a b a n k o r o t h e r

b e ta m e a s u r e o f a s e c u r ity 's s y s te m a tic ris k ,

f in a n c ia l in s titu tio n

d e s c r ib in g th e a m o u n t o f r is k c o n t r ib u t e d b y th e

a c c o u n ts re c e iv a b le su m o f m o n e y o w e d to a

s e c u r ity t o th e m a r k e t p o r t f o lio

s e lle r a s a re s u lt o f h a v in g s o ld g o o d s o r s e r v ic e s

bill a c c e p ta n c e fa c ility a g r e e m e n t in w h ic h

o n c r e d it

o n e e n t it y ( n o r m a lly a b a n k ) u n d e r ta k e s to a c c e p t

a c c o u n tin g ra te o f return e a r n in g s fr o m a n

b ills o f e x c h a n g e d r a w n b y a n o t h e r e n t it y (th e

in v e s tm e n t e x p r e s s e d a s a p e r c e n t a g e o f th e

b o rro w e r)

in v e s tm e n t o u t la y

bill d is c o u n t fa c ility a g r e e m e n t in w h ic h o n e

a c c u m u la tio n p r o c e s s b y w h ic h , t h r o u g h th e

e n t it y ( n o r m a lly a b a n k ) u n d e r ta k e s to d is c o u n t

o p e r a t io n o f in te re s t, a p r e s e n t su m b e c o m e s

(b u y ) b ills o f e x c h a n g e d r a w n b y a n o t h e r e n t it y (th e

a g r e a t e r s u m in th e fu tu r e

b o rro w e r)

a n n u it y s e rie s o f c a s h f lo w s , u s u a lly o f e q u a l

bill o f e x c h a n g e m a r k e ta b le s h o rt-te rm d e b t s e c u r it y

a m o u n t, e q u a lly s p a c e d in tim e

in w h ic h o n e p a r t y (th e d r a w e r ) d ir e c t s a n o t h e r

a n n u it y -d u e a n n u it y in w h ic h th e f ir s t c a s h f lo w is to o c c u r 'im m e d ia t e ly ' (i.e . o n th e v a lu a t io n d a te )

a r b it r a g e s im u lta n e o u s t r a n s a c t io n s in d if f e r e n t m a rk e ts t h a t re s u lt in a n im m e d ia t e r is k - fr e e p r o f it

a t call m o n e y r e p a y a b le im m e d ia te ly , a t th e o p t io n o f th e le n d e r

a u th o r is e d d e p o s it -t a k in g in stitu tio n a c o r p o r a t io n t h a t is a u t h o r is e d u n d e r th e B a n k in g A c t 1 9 5 9 to a c c e p t d e p o s its fr o m th e p u b lic

p a r t y (th e a c c e p t o r ) to p a y a s ta te d su m o n a s ta te d fu tu r e d a t e

b o n d d e b t s e c u r ity is s u e d w it h a m e d iu m o r lo n g te rm to m a t u r ity b y b o r r o w e r s s u c h a s g o v e r n m e n t s , s ta te a u t h o r itie s a n d c o r p o r a t io n s in r e tu r n f o r c a s h fr o m in v e s to rs

b o o k - t o - m a r k e t r a tio b o o k v a lu e o f a c o m p a n y ’ s e q u it y d i v id e d b y m a r k e t v a lu e o f th e c o m p a n y ’ s e q u it y

b r e a k -e v e n a n a l y s i s a n a ly s is o f th e a m o u n ts b y b a d d e b ts a c c o u n ts t h a t h a v e p r o v e n to b e

w h ic h o n e o r m o r e in p u t v a r ia b le s m a y c h a n g e

u n c o lle c t a b le a n d a r e w r it t e n o f f

b e f o r e a p r o je c t c e a s e s to b e p r o f it a b le

b a n k bill ( b a n k a c c e p te d bill) b ill o f e x c h a n g e t h a t

b r id g in g fin a n c e s h o rt-te rm lo a n to c o v e r a n e e d

has b e e n a c c e p te d o r e n d o rs e d b y a b a n k

o fte n a r is in g f r o m t im in g d iff e r e n c e s b e t w e e n t w o o r

b a n k r u p tc y c o sts d ir e c t a n d in d ir e c t c o s ts

m o r e t r a n s a c t io n s

a s s o c ia te d w it h f in a n c ia l d i f f ic u lt y t h a t le a d s to

b u b b le p e r io d in w h ic h p r ic e s ris e s tr o n g ly ,

c o n t r o l o f a c o m p a n y b e in g tr a n s f e r r e d to le n d e r s

d e p a r t in g fr o m t h e ir 'tr u e v a lu e ’ ，f r e q u e n t ly f o llo w e d

b a s is s p o t p r ic e a t a p o in t in t im e m in u s th e fu tu re s

b y a s u d d e n d e c r e a s e in p r ic e s

p r ic e (fo r d e liv e r y a t s o m e la te r d a te ) a t t h a t p o in t

b u s in e s s r is k v a r i a b ili t y o f fu tu r e n e t c a s h f lo w s

in tim e

a t t r ib u t e d t o th e n a tu r e o f th e c o m p a n y ’s o p e r a tio n s .

b a s is p o in t 0 . 0 1 p e r c e n t, o fte n a b b r e v ia t e d to 1 b p B B S W B B S W is th e b a n k b ill r e f e r e n c e r a te a n d is th e s t a n d a r d b e n c h m a r k f o r th e f lo a t in g - r a t e c a s h f lo w s in s h o rt-te rm in te r e s t r a t e s w a p s in A u s t r a lia . It is a s e t o f r e p r e s e n t a t iv e m a r k e t in te r e s t ra te s f o r

It is th e r is k s h a r e h o ld e r s f a c e if th e c o m p a n y h a s no d e b t

b u y - a n d - h o ld p o lic y in v e s tm e n t s tr a te g y in w h ic h s h a re s a r e b o u g h t a n d th e n r e t a in e d in th e in v e s to r 's p o r t f o lio f o r a lo n g p e r io d

b a n k b ills a n d s im ila r s e c u r itie s , q u o t e d o n a p e r

b u y o u t (o r g o in g - p r iv a t e ) tr a n s a c tio n t r a n s f e r

a n n u m b a s is u s in g e x a c t d a y - c o u n ts . S ix B B S W

fr o m p u b lic o w n e r s h ip to p r iv a t e o w n e r s h ip o f a

ra te s a r e c a lc u la t e d d a i l y a t a p p r o x im a t e ly

c o m p a n y t h r o u g h p u r c h a s e o f its s h a r e s b y a s m a ll

1 0 : 1 0 a m S y d n e y t im e f o r te rm s o f 1 , 2 , 3 , 4 , 5

g r o u p o f in v e s to r s t h a t s o m e tim e s in c lu d e s th e

a n d 6 m o n th s

e x is tin g m a n a g e m e n t

725

G

lossary

call n o tic e g iv e n b y a c o m p a n y t h a t th e h o ld e r s

s e p a r a t e ly — t h a t is, p r o f it p a id a s a d iv id e n d is

o f p a r t ly p a id s h a r e s m u s t m a k e a n a d d it io n a l

e f f e c t iv e ly t a x e d t w ic e

c o n t r ib u t io n o f e q u it y

co llectio n p o lic y p o lic y a d o p t e d b y a c o m p a n y

call o p tio n r ig h t t o b u y a n u n d e r ly in g a s s e t a t a

in r e g a r d to c o lle c t in g d e lin q u e n t a c c o u n ts e ith e r

f ix e d p r ic e

in f o r m a lly o r b y th e u s e o f a d e b t c o lle c t io n a g e n c y

ca ll o p tio n o n a fu tu re s c o n tra c t o p t io n t h a t g iv e s

c o m m e r c ia l p a p e r (o r p r o m is s o r y n o te ) s h o rt-te rm

th e b u y e r th e r ig h t to e n t e r in to th e fu tu re s c o n t r a c t

m a r k e t a b le d e b t s e c u r ity in w h ic h t h e b o r r o w e r

a s a b u y e r a t a p r e d e t e r m in e d p r ic e

p r o m is e s t o p a y a s ta te d su m o n a s ta te d fu tu r e

c a p ita l m a r k e t m a r k e t in w h ic h lo n g - te r m fu n d s a r e

d a t e . A ls o k n o w n a s one-nom e p a p e r

r a is e d a n d lo n g - te r m d e b t a n d e q u it y s e c u r itie s a r e

c o m p a n y s e p a r a te le g a l e n t it y f o r m e d u n d e r th e

tra d e d

C o rp o ra tio n s A c t 2 0 0 1 ; s h a r e h o ld e r s a r e th e

c a p ita l m a r k e t lin e e f f ic ie n t s e t o f a ll p o r t f o lio s

o w n e rs o f a c o m p a n y

t h a t p r o v id e s th e in v e s t o r w it h th e b e s t p o s s ib le

c o m p o u n d in te re st in te r e s t c a lc u la t e d e a c h p e r io d

in v e s tm e n t o p p o r t u n it ie s w h e n a ris k -fre e a s s e t is

o n th e p r in c ip a l a m o u n t a n d o n a n y in te r e s t e a r n e d

a v a ila b le . It d e s c r ib e s th e e q u ilib r iu m r is k - r e tu r n

o n th e in v e s tm e n t u p t o t h a t p o in t

r e la t io n s h ip f o r e f f ic ie n t p o r t f o lio s , w h e r e th e

c o m p o u n d o p tio n o p t io n o n a n o p t io n (e .g . a n

e x p e c t e d re tu r n is a f u n c tio n o f th e ris k -fre e in te r e s t r a te , th e e x p e c t e d m a r k e t r is k p r e m iu m a n d th e p r o p o r t io n a t e ris k o f th e e f f ic ie n t p o r t f o lio to th e ris k o f th e m a r k e t p o r t f o lio

c a p it a 丨 r a tio n in g a c o n d it io n w h e r e a f ir m h a s lim it e d re s o u rc e s a v a ila b l e f o r in v e s tm e n t

c a p ita l stru ctu re m ix o f d e b t a n d e q u it y f in a n c e used b y a c o m p a n y

726

o p t io n to b u y a n o p t io n )

c o n g lo m e r a t e t a k e o v e r t a k e o v e r o f a t a r g e t c o m p a n y in a n u n r e la t e d t y p e o f b u s in e s s

c o n s iste n c y p rin c ip le in a p p l y in g th e N P V m o d e l, th e n e t c a s h f lo w s in th e n u m e r a to r s h o u ld b e d e f in e d a n d m e a s u r e d in a w a y t h a t is c o n s is te n t w it h th e d e f in it io n o f th e d is c o u n t r a t e

c o n s ta n t c h a in o f re p la c e m e n t a s s u m p t io n m a y

c a r r y in g c o st c o s t o f h o ld in g a c o m m o d it y f o r a

b e u s e d to e v a lu a t e m u t u a lly e x c lu s iv e p r o je c ts o f

s p e c if ie d p e r io d o f tim e

u n e q u a l liv e s ; in th is c a s e , e a c h p r o je c t is a s s u m e d

c a s h b u d g e t f o r e c a s t o f th e a m o u n t a n d t im in g o f

to b e r e p la c e d a t th e e n d o f its e c o n o m ic lif e b y a n

th e c a s h r e c e ip ts a n d p a y m e n ts t h a t w i ll re s u lt fr o m

id e n t ic a l p r o je c t

a c o m p a n y ’s o p e r a t io n s o v e r a p e r io d o f tim e

c o n s u m e r cre d it c r e d it e x t e n d e d to in d iv id u a ls b y

c a sh f l o w p a y m e n t (c a s h o u t flo w ) o r r e c e ip t (c a s h

s u p p lie r s o f g o o d s a n d s e r v ic e s , o r b y f in a n c ia l

in flo w ) o f m o n e y

in s titu tio n s t h r o u g h c r e d it c a r d s

c a te rin g th e o r y t h e o r y t h a t s u g g e s ts t h a t

c o n tin g e n t c la im a s s e t w h o s e v a lu e d e p e n d s o n th e

m a n a g e r s c a t e r t o c h a n g e s o v e r t im e in in v e s t o r

v a lu e o f s o m e o t h e r a s s e t

d e m a n d f o r d iv id e n d s

c o n tin u o u s in te re st m e th o d o f c a lc u la t in g in te r e s t in

c e n tra l b a n k a b a n k t h a t c o n t r o ls th e is s u e o f

w h ic h in te r e s t is c h a r g e d s o f r e q u e n t ly t h a t th e tim e

c u r r e n c y , a c ts a s b a n k e r to th e g o v e r n m e n t a n d

p e r io d b e t w e e n e a c h c h a r g e a p p r o a c h e s z e r o

th e b a n k in g s y s te m a n d sets th e in te r e s t r a te f o r

c o n trib u tin g s h a r e s s h a re s o n w h ic h o n ly p a r t o f

o v e r n ig h t c a s h

th e is s u e p r ic e h a s b e e n p a id . A ls o k n o w n a s p o rtly

c e r t a in ty -e q u iv a le n t a p p r o a c h t h a t in c o r p o r a t e s

p a id shores

ris k b y a d ju s t in g t h e c a s h f lo w s r a t h e r th a n th e

c o n v e r s io n ra tio r e la t io n s h ip t h a t d e t e r m in e s h o w

d is c o u n t r a te

m a n y o r d in a r y s h a re s w i ll b e r e c e iv e d in e x c h a n g e

chattel m o r t g a g e a lo a n s e c u r e d b y a m o r t g a g e

f o r e a c h c o n v e r t in g s e c u r ity w h e n t h e c o n v e r s io n

o v e r m o v a b le p r o p e r t y

o c c u rs

c la s sic a l t a x s y s t e m t a x s y s te m t h a t o p e r a te s

c o n v e rtib le s e c u r ity is s u e d f o r a f ix e d te r m ,

in th e U S a n d w h ic h o p e r a t e d in A u s t r a lia u n til

u s u a lly a t a f ix e d in te r e s t r a te , w it h t h e a d d it io n a l

3 0 J u n e 1 9 8 7 ; u n d e r th is s y s te m c o m p a n y p r o fits ,

f e a tu r e t h a t th e h o ld e r h a s th e r ig h t t o c o n v e r t th e

a n d d iv id e n d s p a id fr o m th o s e p r o fits , a r e t a x e d

s e c u r it y to o r d in a r y s h a re s o n a s p e c if ie d fu tu re

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d eb en tu re a t y p e o f f ix e d in te r e s t s e c u r ity is s u e d

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c a s h f lo w , u s u a lly c a lc u la t e d u s in g a n in te r e s t ra te ,

o fte n a t h a lf - y e a r ly in te r v a ls , o n d e b t s e c u r itie s s u c h

to th e p r o v id e r o f fu n d s (th e le n d e r )

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coupons f ix e d in te re s t p a y m e n ts m a d e o n b o n d s

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ta k e n a n d o th e r s r e f r a in e d f r o m

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credit fo ncie r loan t y p e o f lo a n t h a t in v o lv e s r e g u la r

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r e p a y m e n ts t h a t in c lu d e p r i n c ip a l a n d in te r e s t

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a g r e e m e n t u n d e r w h ic h th e p r o v id e r is n o t

p u r c h a s e r is in v o ic e d a n d th e d a t e w h e n p a y m e n t

r e im b u r s e d b y th e b o r r o w e r if th e d e b t o r d e f a u lts

is d u e

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b e o f f e r e d t o c u s to m e rs a n d o n t h e te rm s t h a t w i ll

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t im e p e r io d b e t w e e n e a c h s u b s e q u e n t c a s h f lo w

cum rights w h e n s h a re s a r e t r a d e d c u m r ig h ts th e

d e la ye d e q u ity c o n v e r t ib le w h ic h is p r e d o m in a n t ly

b u y e r is e n t it le d to p a r t ic ip a t e in th e f o r t h c o m in g

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n o t b e e n m a d e b y th e d u e d a t e

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disclosure d ocum ent p r o s p e c tu s , p r o f ile s ta te m e n t

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o r o f f e r in f o r m a t io n s ta te m e n t t h a t m u s t b e s u p p lie d

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c a s h f lo w s t h a t a r e m a d e p r i o r to m a t u r ity

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com pany

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v a lu e e q u a ls t h e n e t p r e s e n t v a lu e o f th e p r o je c t

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e x -d iv id e n d d a te d a t e o n w h ic h a s h a r e b e g in s

n u m b e r o f fo r m s

t r a d in g e x - d iv id e n d . A s h a r e p u r c h a s e d e x - d iv id e n d

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a t a c o n s t a n t r a te

t r a d in g e x - r ig h ts . A f t e r th is d a t e a s h a r e d o e s

d iv id e n d re in v e s tm e n t p la n (D R P ) a r r a n g e m e n t

n o t h a v e a t t a c h e d to it th e r ig h t to p u r c h a s e a n y

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e x p e c t a tio n s t h e o r y o f th e te rm s tr u c tu r e is t h a t

d iv id e n d s p e r io d ic d is t r ib u t io n s , u s u a lly in c a s h , b y

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a c o m p a n y to its s h a r e h o ld e r s

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to a c h ie v e th e s a m e r e tu r n o v e r a n y fu tu r e p e r io d ,

th e c r e a t io n o f th e b i ll; u s u a lly th e b o r r o w e r

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a d e b t s e c u rity , s u c h a s c o m m e r c ia l p a p e r o r a b ill

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finance lease lo n g - te r m le a s e t h a t e f f e c t iv e ly

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a p r i n c ip a l , w i ll g r o w ( a c c u m u la te ) a t a fu tu r e d a te ,

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hedgers in d iv id u a ls a n d c o m p a n ie s w h o e n t e r in to c o n t r a c t s in o r d e r to r e d u c e ris k

h ire-purchase a gree m e nt a g r e e m e n t u n d e r w h ic h a n a s s e t o w n e d b y a f in a n c ie r is h ir e d b y a u s e r w h o h a s th e r ig h t o r a n o b lig a t io n to p u r c h a s e th e a s s e t w h e n th e a g r e e m e n t e x p ir e s

h o riz o n ta l ta k e o v e r t a k e o v e r o f a t a r g e t c o m p a n y o p e r a t in g in th e s a m e lin e o f b u s in e s s a s th e a c q u ir in g c o m p a n y

th a t, o n a s ta te d fu tu r e d a t e , o n e o f th e p a r tie s w i ll b u y a n d th e o t h e r p a r t y w i l l s e ll a n u n d e r ly in g a s s e t

im m u n is a tio n s tr a te g y d e s ig n e d to a c h ie v e a t a r g e t

a t a p r ic e d e c id e d t o d a y

s u m o f m o n e y a t a fu tu r e p o in t in tim e , r e g a r d le s s o f

fra n k e d d ivid e n d d iv id e n d p a id o u t o f A u s t r a lia n

in te r e s t r a te c h a n g e s

c o m p a n y p r o fits o n w h ic h c o m p a n y in c o m e t a x h a s

im p u ta tio n ta x system s y s te m u n d e r w h ic h

b e e n p a id a n d w h ic h c a r r ie s a f r a n k in g c r e d it

in v e s t o r s in s h a r e s c a n u s e t a x c r e d it s

fra n k in g credit c r e d it f o r A u s t r a lia n c o m p a n y t a x

a s s o c ia t e d w i t h f r a n k e d d i v id e n d s t o o f f s e t t h e ir

p a id , w h ic h , w h e n d is t r ib u t e d to s h a r e h o ld e r s , c a n

p e r s o n a l in c o m e t a x . T h e s y s te m e lim in a t e s th e

b e o ffs e t a g a in s t t h e ir t a x l i a b i lit y

d o u b le t a x a t i o n in h e r e n t in t h e c la s s ic a l t a x s y s te m

729

G

lossary

ind ep en d en t p ro je ct a p r o je c t t h a t m a y b e

d is c o u n t r a te a t w h ic h th e n e t p r e s e n t v a lu e is

a c c e p t e d o r r e je c t e d w it h o u t a f f e c t in g th e

e q u a l to z e r o

a c c e p t a b ilit y o f a n o t h e r p r o je c t

intrinsic v a lu e v a lu e o f a n o p t io n if e x e r c is e d

in d ica to r rate in te r e s t r a te s e t a n d p u b lis h e d b y

im m e d ia t e ly

a le n d e r f r o m tim e to tim e a n d u s e d a s a b a s e

in v e n to ry c o m p r is e s r a w m a te r ia ls , w o r k in

o n w h ic h in te r e s t r a te s o n in d iv id u a l lo a n s a r e

p r o g r e s s , s u p p lie s u s e d in o p e r a t io n s a n d f in is h e d

d e t e r m in e d , u s u a lly b y a d d in g a m a r g in

goods

ind iffe re nce curve c u r v e s h o w in g a s e t o f

in v e s tin g in s titu tio n a c c e p t s f u n d s f r o m th e

c o m b in a t io n s s u c h t h a t a n in d iv id u a l d e r iv e s e q u a l

p u b lic a n d in v e s ts th e m in a s s e ts ; in c lu d e s

u t ilit y f r o m ( a n d th u s is in d if f e r e n t b e tw e e n ) a n y

s u p e r a n n u a t io n f u n d s , lif e in s u r a n c e c o m p a n ie s

c o m b in a t io n s in t h e se t

a n d u n it tru s ts

in fo rm a tio n a s y m m e try s it u a t io n w h e r e a ll

investm ent h orizo n th e p a r t ic u la r fu tu r e d a t e o n

r e le v a n t in f o r m a t io n is n o t k n o w n b y a ll in te r e s te d

w h ic h a n in v e s to r in te n d s to liq u id a t e (se ll) th e ir

p a r tie s . T y p ic a lly , th is in v o lv e s c o m p a n y ’ in s id e r s ’

in v e s tm e n t

( m a n a g e r s ) h a v in g m o r e in f o r m a t io n a b o u t th e c o m p a n y 's p r o s p e c ts th a n 'o u t s id e r s ’ （ s h a r e h o ld e r s a n d le n d e rs )

invoice d iscounting f o r m o f d e b t o r f in a n c e in w h ic h th e b o r r o w e r r e ta in s c o n t r o l o f its s a le s le d g e r a n d d e b t c o lle c t io n fu n c tio n s a n d p a s s e s a c c o u n t

in fo rm a tio n efficiency s it u a t io n in w h ic h p r ic e s

p a y m e n ts o n to th e d is c o u n t e r

a c c u r a t e ly r e fle c t a v a ila b l e in f o r m a t io n

issue costs c o s ts o f r a is in g n e w c a p it a l b y is s u in g

in itia l public o ffe rin g a c o m p a n y 's f ir s t o f f e r in g o f

s e c u r itie s , in c lu d in g u n d e r w r it in g fe e s a n d le g a l,

s h a re s to th e p u b lic

a c c o u n t in g a n d p r in t in g e x p e n s e s in c u r r e d in

in sta lm e n t receipt m a r k e ta b le s e c u r ity f o r w h ic h

p r e p a r in g a p r o s p e c tu s o r o t h e r o f f e r d o c u m e n ts .

o n ly p a r t o f th e is s u e p r ic e h a s b e e n p a id . T h e

A ls o k n o w n a s flo ta tio n costs

b a la n c e is p a y a b le in a f in a l in s ta lm e n t o n o r b e f o r e a s p e c if ie d d a t e

in te rb a n k cash ra te th e in te r e s t r a te o n o v e r n ig h t lo a n s b e tw e e n a b a n k a n d a n o t h e r b a n k ( in c lu d in g th e R e s e rv e B a n k o f A u s t r a lia )

Ja n u a ry effect o b s e r v a tio n th a t, o n a v e r a g e , s h a re p r ic e s in c r e a s e m o re in J a n u a r y th a n in o th e r m o n th s

jo in t test p ro b le m p r o b le m t h a t a n y te s t o f m a r k e t e f f ic ie n c y is s im u lt a n e o u s ly a te s t o f s o m e m o d e l o f 'n o r m a l’ a s s e t p r ic in g

interest rate r a te o f re tu r n o n d e b t in te re s t ra te s w a p a g r e e m e n t b e t w e e n t w o

730

lessee in a le a s e c o n t r a c t , th e p a r t y u s in g th e a s s e t

c o u n t e r p a r t ie s t o e x c h a n g e in te r e s t p a y m e n ts f o r

lessor in a le a s e c o n t r a c t , th e p a r t y t h a t o w n s th e

a s p e c if ic p e r io d , r e la t e d to a n a g r e e d p r i n c ip a l

asset

a m o u n t. T h e m o s t c o m m o n t y p e o f in te r e s t r a t e

le ve ra g ed b u y o u t c o m p a n y t a k e o v e r t h a t is

s w a p in v o lv e s a n e x c h a n g e o f a s e t o f f ix e d -

la r g e ly f in a n c e d u s in g b o r r o w e d f u n d s ; th e

in te r e s t p a y m e n ts f o r a s e t o f f lo a t in g - in t e r e s t

r e m a in in g e q u it y is p r iv a t e ly h e ld b y a s m a ll g r o u p

p a y m e n ts . A ll p a y m e n t s a r e in th e s a m e c u r r e n c y ,

o f in v e s to rs

in te re st-o n ly loa n lo a n in w h ic h th e b o r r o w e r is

leve ra g ed lease f in a n c e le a s e w h e r e th e le s s o r

r e q u ir e d to m a k e r e g u la r p a y m e n ts to c o v e r in te re s t

b o r r o w s m o s t o f th e fu n d s to a c q u ir e th e a s s e t

a c c r u e d b u t is n o t r e q u ir e d to m a k e p a y m e n ts to

lim ite d lia b ility le g a l c o n c e p t t h a t p r o te c ts

r e d u c e th e p r i n c ip a l . O n th e m a t u r ity d a t e o f th e

s h a r e h o ld e r s w h o s e l i a b i lit y t o m e e t a c o m p a n y ’s

lo a n , th e p r i n c ip a l is r e p a id in a lu m p su m

d e b ts is lim it e d to a n y a m o u n t u n p a id o n th e s h a re s

in te rm e d ia tio n p r o c e s s in w h ic h a b a n k o r o th e r

th e y h o ld

f in a n c ia l in s titu t io n ra is e s fu n d s fr o m in v e s to rs a n d

liq u id assets c o m p r is e c a s h a n d a s s e ts t h a t a r e

th e n le n d s th o s e f u n d s to b o r r o w e r s

r e a d ily c o n v e r t ib le in to c a s h , s u c h a s b ills o f

in te rn a l ra te o f re tu rn (IRR) th e d is c o u n t r a te

exchange

t h a t e q u a te s th e p r e s e n t v a lu e o f a n in v e s tm e n t’s

liq u id ity m a n a g e m e n t in v o lv e s d e c is io n s a b o u t th e

n e t c a s h f lo w s w it h its in it ia l c a s h o u t la y ; it is th e

c o m p o s it io n a n d le v e l o f a c o m p a n y 's liq u id a s s e ts

G

lossary

liq u id ity p r e m iu m (ris k p r e m iu m ) t h e o r y o f th e

n o m in a l in te re s t ra te q u o t e d in te r e s t r a te

te rm s tru c tu re is t h a t a lt h o u g h fu tu r e in te r e s t ra te s

w h e r e in te r e s t is c h a r g e d m o r e f r e q u e n t ly t h a n

a r e d e t e r m in e d b y in v e s to r s ' e x p e c t a t io n s , in v e s to rs

t h e b a s is o n w h ic h th e in te r e s t r a t e is q u o t e d .

r e q u ir e s o m e r e w a r d ( liq u id it y p r e m iu m ) to b e a r th e

T h e in te r e s t r a t e a c t u a ll y u s e d t o c a lc u la t e

in c r e a s e d ris k o f in v e s tin g lo n g te rm

th e in te r e s t c h a r g e is t a k e n a s a p r o p o r t i o n

lo g price re la tiv e n a t u r a l lo g a r it h m o f th e r a t io o f

o f th e q u o t e d n o m in a l r a t e .

Note:

T h e te r m

s u c c e s s iv e s e c u r ity p r ic e s . Im p lic it ly , it is a s s u m e d

'n o m i n a l in te r e s t r a t e ' a ls o h a s a n o t h e r m e a n in g

t h a t p r ic e s h a v e g r o w n ( o r d e c a y e d ) in a c o n tin u o u s

(s e e S e c t io n 3 . 4 . 4 )

fa s h io n b e t w e e n th e t w o d a t e s o n w h ic h th e p r ic e s

n o n - b a n k bill b ill o f e x c h a n g e t h a t h a s b e e n

logarithmic rote o f continuous rote o f return

a r e o b s e r v e d . A ls o k n o w n a s a

n e it h e r a c c e p t e d n o r e n d o r s e d b y a b a n k

return

n o n -d e b t t a x s h ie ld s (N D T S s ) t a x d e d u c tio n s f o r

and a

lo n g h e d g e r h e d g e r w h o h e d g e s b y m e a n s o f

ite m s s u c h a s d e p r e c ia t io n o n a s s e ts a n d t a x lo s s e s

b u y in g fu tu re s c o n t r a c t s t o d a y

c a r r ie d f o r w a r d

n o n -re c o u rse lo a n t y p e o f lo a n u s e d in le v e r a g e d m a in te n a n c e le a s e o p e r a t in g le a s e w h e r e th e

le a s e s w h e r e th e le n d e r h a s n o r e c o u r s e to th e

le s s o r is r e s p o n s ib le f o r a ll m a in t e n a n c e a n d s e r v ic e

le s s o r in th e e v e n t o f d e f a u lt b y th e le s s e e

o f th e le a s e d a s s e t

n o t io n a l p r in c ip a l (o r n o t io n a l a m o u n t ) o f a n

m a n a g e m e n t b u y o u t p u r c h a s e o f a ll o f a c o m p a n y ’s is s u e d s h a re s b y a g r o u p

丨 ed

b y th e

in te re st ra te s w a p e a c h g r o s s s w a p p a y m e n t is c a lc u la t e d b y m u lt ip ly in g a n in te r e s t r a te

c o m p a n y 's m a n a g e m e n t

b y th e n o t io n a l a m o u n t . T h e n o t io n a l a m o u n t

m a r g in call d e m a n d f o r e x t r a fu n d s t o b e d e p o s it e d

c o r r e s p o n d s t o th e p r i n c ip a l o f t h e lo a n in te r e s t

in to a t r a d e r ’s a c c o u n t

f lo w s t h a t th e s w a p m im ic s . In n e a r ly a ll c a s e s ,

m a r k e t m o d e l tim e s e rie s r e g r e s s io n o f a n a s s e t’s

t h e n o t io n a l a m o u n t in a n in te r e s t r a t e s w a p is

re tu rn s

n e v e r p a id

m a r k e t o p p o r t u n it y line lin e t h a t s h o w s th e c o m b in a t io n s o f c u r r e n t a n d fu tu r e c o n s u m p tio n t h a t a n in d iv id u a l c a n a c h ie v e fr o m a g iv e n w e a lt h le v e l, u s in g c a p it a l m a r k e t t r a n s a c tio n s

m a r k e t p o rtfo lio p o r t f o lio o f a ll r is k y a s s e ts , w e ig h t e d a c c o r d in g to t h e ir m a r k e t c a p it a lis a t io n

m a r k in g - t o - m a r k e t p r o c e s s o f a d ju s t in g t r a d e r s ' a c c o u n t b a la n c e s to r e f le c t c h a n g e s in m a r k e t p r ic e s

m o m e n tu m effect e f f e c t in w h ic h g o o d o r b a d p e r fo r m a n c e o f s h a re s c o n tin u e s o v e r tim e

m o r t g a g e a t y p e o f s e c u r it y f o r a lo a n in w h ic h s p e c ific la n d o r o t h e r t a n g ib le p r o p e r t y is p le d g e d b y th e b o r r o w e r ( m o r t g a g o r ) to th e le n d e r

o p e n a c c o u n t a n a r r a n g e m e n t u n d e r w h ic h g o o d s o r s e r v ic e s a r e s o ld t o a c u s to m e r o n c r e d it , b u t w it h n o f o r m a l d e b t c o n t r a c t . P a y m e n t is d u e a f t e r a n a c c o u n t is s e n t t o th e c u s to m e r

o p e r a t in g le a s e le a s e u n d e r w h ic h th e ris k s a n d b e n e fits o f o w n e r s h ip o f th e le a s e d a s s e t r e m a in w it h th e le s s o r

o p p o r t u n it y c o st h ig h e s t p r ic e o r r a te o f re tu r n t h a t w o u ld b e p r o v id e d b y a n a lt e r n a t iv e c o u r s e o f a c t io n . T h e

opportunity cost o f capital

is th e r a te o f

r e tu r n t h a t c o u ld b e e a r n e d o n a n o t h e r in v e s tm e n t w it h th e s a m e r is k

o p t im a l c a p ita l stru ctu re th e c a p it a l s tru c tu re th a t m a x im is e s a c o m p a n y ’s v a lu e

( m o r tg a g e e )

m u tu a lly e x c lu s iv e pro je cts a lt e r n a t iv e in v e s tm e n t p r o je c ts , o n ly o n e o f w h ic h c a n b e a c c e p t e d

o p tio n th e r ig h t b u t n o t th e o b lig a t io n to b u y o r se ll u n d e r ly in g a s s e ts a t a f ix e d p r ic e f o r a s p e c if ie d p e r io d

net p re se n t v a lu e (N P V ) th e d if f e r e n c e b e tw e e n

o p tio n to a b a n d o n r ig h t to d is c o n tin u e a n

th e p r e s e n t v a lu e o f th e n e t c a s h f lo w s f r o m a n

in v e s tm e n t p r o je c t

in v e s tm e n t d is c o u n t e d a t th e r e q u ir e d r a te o f r e tu r n ,

o p tio n to d e fe r r ig h t to b e g in a n in v e s tm e n t p r o je c t

a n d th e in it ia l c a s h o u t la y o n th e in v e s tm e n t

a t a la te r d a t e

731

G

lossary

o p tio n to e x p a n d right to increase the scale o f an investment project

poison p ill strategic move by a com pany that may

o p tio n to reopen rig h t to restart a shut-down

attractive to an acquirer by increasing the cost o f a

investment project o p tio n to stu dy rig ht to gather more inform ation on

takeover (e.g. an issue o f securities that w ill convert to shares if a takeover bid occurs)

an investment project

p o rtfo lio com bined holding o f more than one asset

o rd in a ry a n n u ity annuity in w hich the time period

preference shares shares that rank before o rdinary

from the date o f valuation to the date o f the first

shares for the payment o f dividends and, usually, in

cash flo w is equal to the time period between each subsequent cash flo w

the event of liquidation o f the issuing company. They often provide an entitlement to a fixed dividend

o rd in a ry p e rp e tu ity o rdinary annuity with the special

present va lu e am ount that corresponds to today's

feature that the cash flows are to continue forever

value o f a promised future sum

o rd in a ry shares securities that represent an

present va lu e o f a co ntract the value to da y that is

ow nership interest in a com pany and provide

equivalent to the stream o f cash flow s promised in a

the ow ner w ith voting rights. Holders o f o rd in a ry

financial contract

shares have a residual interest in the net assets of

p ric e -e a rn in g s ra tio share price d ivid e d by

the issuing com pany and are therefore exposed to greater risk than other classes o f investors

p rim a ry m a rk e t m arket for new issues o f securities

o ver-the -co un te r m a rk e t there is no organised

w here the sale proceeds go to the issuer of the

exchange and the m arket consists o f financial

securities

institutions that are w illin g to trade w ith a

princip al the amount borrow ed at the outset of a loan

counterparty

earnings per share

o v e rd ra ft lim it level to w hich a com pany is

p rin c ip a 卜 a rid -in te re s t loa n loan repaid by a sequence o f equal cash flows, each o f w hich is

permitted to o verdraw its account

sufficient to cover the interest accrued since the

o verre octio n biased response o f a price to

previous paym ent and to reduce the current balance

inform ation in w hich the initial price movement can

o w in g. Therefore, the debt is extinguished when the

be expected to be reversed

sequence o f cash flows is com pleted. Also known as a cre d it foncier loan

p a rtia l ta k e o v e r takeover in w hich a b id de r seeks to acquire no more than p art o f a com pany's issued shares p a rtn e rs h ip business ow ned by tw o or more people acting as partners

p ro d u ctio n p ossibilities curve curve that displays the investment opportunities and outcomes a va ila b le to the com pany; its shape therefore determines the com binations o f current dividends,

p a yb a ck p e rio d the time it takes for the progressive

investments and future dividends that a com pany can achieve

accum ulated net cash flows generated by an

p ro gressive d iv id e n d p olicy directors aim to

investment to equal the initial cash outlay

steadily increase or at least m aintain the dividend at

p a y o ff structure set of future cash flows

each paym ent

pecking o rd e r th e o ry theory that proposes that

p ro p o rtio n a l b id p artial takeover b id to acquire

com panies fo llo w a hierarchy o f financing sources

a specified proportion o f the shares held by each shareholder

in w hich internal funds are preferred and, if

732

become a takeover target to make its shares less

external funds are needed, b o rro w in g is preferred to issuing riskier securities

prospectus a docum ent that, am ong other things,

perfect ca p ita l m a rk e t frictionless capital m arket in

the issue o f securities, w hich must be provided to

w hich there are no transaction costs and no barriers to the free flo w o f inform ation

potential investors by a com pany seeking to issue shares or other securities

placem ent an issue o f securities direct to chosen

pure p la y com pany that operates almost entirely in

investors rather than the general public

only one industry or line o f business

provides details o f the com pany and the terms of

G

lossary

p ut o ptio n r ig h t to s e ll a n u n d e r ly in g a s s e t a t a

ris k -s e e k in g in ve sto r a n in v e s to r w h o lik e s ris k

f ix e d p r ic e

a n d w h o w i ll c h o o s e a r is k y in v e s tm e n t e v e n if th e

p u t o p tio n on a fu tu re s co ntract o p t io n t h a t g iv e s

e x p e c t e d r e tu r n is le ss th a n th e e x p e c t e d r e tu r n o n a

th e b u y e r th e r ig h t to e n t e r in to th e fu tu r e s c o n t r a c t

le ss r is k y in v e s tm e n t

a s a s e lle r a t a p r e d e t e r m in e d p r ic e

p u t-ca ll p a rity r e la t io n s h ip t h a t e x is ts b e t w e e n th e p r ic e o f a c a ll o p t io n a n d th e p r ic e o f th e c o r r e s p o n d in g p u t o p t io n

s a fe ty stock a d d i t i o n a l in v e n t o r y h e ld w h e n d e m a n d is u n c e r t a in , to r e d u c e th e p r o b a b il it y o f a s to c k o u t

sale and lease-back agreem ent a g r e e m e n t in rate o f retu rn c a lc u la t io n t h a t e x p r e s s e s th e r a t io o f n e t c a s h in flo w s to c a s h o u t f lo w s

real interest ra te in te re s t r a te a f t e r t a k in g o u t th e e ffe c ts o f in fla t io n

real o ptions th e f le x i b il it y t h a t a m a n a g e r h a s in c h o o s in g w h e t h e r t o u n d e r ta k e o r a b a n d o n a p r o je c t o r c h a n g e th e w a y a p r o je c t is m a n a g e d

real o ptio ns a n a lysis m e t h o d o f e v a lu a t in g a n in v e s tm e n t o p p o r t u n it y t h a t a c c o u n ts f o r t h e v a lu e a s s o c ia t e d w it h m a n a g e r s h a v in g f l e x i b i l i t y in t h e ir d e c is io n s a b o u t w h e n t o in v e s t, h o w t o m a n a g e

w h ic h a c o m p a n y se lls a n a s s e t a n d th e n le a s e s it b a c k

seasoned e q u ity o ffe rin g o f f e r t o s e ll e q u it y s e c u r itie s o f a c la s s t h a t is a lr e a d y t r a d e d

secondary m a rk e t m a r k e t w h e r e p r e v io u s ly is s u e d s e c u r itie s a r e t r a d e d

secondary m a rk e t tran sactio n p u r c h a s e o r s a le o f a n e x is tin g s e c u r ity

securities in th e c o n t e x t o f f in a n c ia l m a rk e ts , f in a n c ia l a s s e ts t h a t c a n b e t r a d e d

securitisation th e p r o c e s s o f m a k in g a s s e ts

th e in v e s t m e n t a n d w h e n t o d iv e s t t h e m s e lv e s o f

m a r k e ta b le b y a g g r e g a t in g in c o m e - p r o d u c in g

th e in v e s t m e n t a s s e t

a s s e ts in a p o o l a n d is s u in g n e w s e c u r itie s b a c k e d

redeem able preference share a p r e fe r e n c e s h a re

b y th e p o o l

th a t h a s a f in it e life

security m a rk e t line g r a p h ic a l r e p r e s e n t a t io n o f th e

rediscounting s e llin g a s h o rt-te rm d e b t s e c u r ity in

c a p it a l a s s e t p r ic in g m o d e l

th e s e c o n d a r y m a r k e t

s e n sitivity a na lysis a n a ly s is o f th e e f f e c t o f

reset preference share a p r e fe r e n c e s h a r e w h e r e

c h a n g in g o n e o r m o r e in p u t v a r ia b le s to o b s e r v e

th e d iv id e n d r a te c a n b e v a r ie d a t s p e c if ie d

th e e ffe c ts o n th e re s u lts

in te r v a ls

s h o rt hed ge r h e d g e r w h o h e d g e s b y m e a n s o f

residual claim c la im to p r o f it o r a s s e ts t h a t r e m a in

s e llin g fu tu r e c o n tr a c ts t o d a y

a ft e r th e e n title m e n ts o f a ll o t h e r in te r e s te d p a r tie s

sh ort selling p r o c e s s o f f ir s t e n t e r in g in to a c o n t r a c t

ha ve been m et

to s e ll a n d la te r e n t e r in g in to a c o n t r a c t t o b u y

residual va lu e d is p o s a l v a lu e o f a p r o je c t ’s a s s e ts

s h o rtfa ll fa c ility a m e c h a n is m u n d e r w h ic h a

le ss a n y d is m a n t lin g a n d r e m o v a l c o s ts a s s o c ia te d

c o m p a n y m a y is s u e s h o r tf a ll s h a r e s t o e lig i b l e

w it h th e p r o je c t's t e r m in a t io n

s h a r e h o ld e r s o r o t h e r in v e s to rs

re vo lvin g cre d it b ill fa c ility b ill f a c il it y in w h ic h

s h o rtfa ll shares n e w s h a re s n o t s u b s c r ib e d f o r b y

th e b o r r o w e r c a n is s u e b ills a s r e q u ir e d , u p to th e

e l ig i b l e s h a r e h o ld e r s a c c o r d in g to t h e ir e n title m e n ts

a g r e e d lim it

u n d e r a r ig h ts is s u e

ris k n e u tra lity s it u a t io n in w h ic h in v e s to r s a r e

s im p le a n n u ity a n n u it y in w h ic h th e f r e q u e n c y

in d if f e r e n t to ris k ; a s s e ts a r e t h e r e f o r e p r ic e d

o f c h a r g i n g in te r e s t m a t c h e s t h e f r e q u e n c y o f

s u c h t h a t t h e y a r e e x p e c t e d to y ie ld th e ris k -fre e

paym ent

in te re s t r a te

sim ple interest m e th o d o f c a lc u la t in g in te r e s t in

risk-averse in ve sto r a n in v e s to r w h o d is lik e s ris k

w h ic h , d u r in g th e e n t ir e te rm o f th e lo a n , in te r e s t is

a n d w h o w ill o n ly c h o o s e a r is k y in v e s tm e n t if th e

c o m p u t e d o n th e o r i g in a l su m b o r r o w e d

e x p e c t e d re tu rn is h ig h e n o u g h to c o m p e n s a t e f o r

s im u la tio n a n a ly s is o f th e e f f e c t o f c h a n g in g a ll o f

b e a r in g th e ris k

th e in p u t v a r ia b le s w h o s e v a lu e s a r e u n c e r t a in to

ris k -n e u tra l inve sto r a n in v e s to r w h o n e it h e r lik e s

o b s e r v e th e e ffe c ts o n th e re s u lts

n o r d is lik e s ris k

sole p ro p rie to rs h ip b u s in e s s o w n e d b y o n e p e r s o n

733

G

lossary

speculators individuals and com panies w ho enter

systematic (market-related or non-diversifiable)

into contracts in ord er to p rofit from correctly

risk that com ponent of total risk that is due to

anticipating price movements

econom y-w ide factors

spin-off the separation o f certain assets (or a division) from a com pany upon w hich are issued

takeover acquisition o f control o f one com pany by

new shares that are allocated to the com pany’s existing shareholders

target com pany object o f a takeover bid

spot price price of the com m odity when the

ta x loss selling investm ent strategy in w hich

buyer pays im m ediately and the seller delivers

the tax rules make it a ttractive fo r an investor

im m ediately spread long (bought) position in one m aturity

to sell certa in shares just before the end o f the tax ye ar

date, paired w ith a short (sold) position in another

term structure of interest rates relationship

maturity date

between interest rates and term to m aturity for debt

standard deviation square root o f the variance

securities in the same risk class

stapled securities tw o or more legally separate

terminal value of a contract the value, as at the

instruments, typ ically an o rd in a ry share plus units in

date o f the final cash flo w promised in a financial

one or more related trusts, w hich cannot be traded separately

contract, that is equivalent to the stream o f promised cash flows

static trade-off theory theory that proposes that

tests for private information research method that

com panies have an optim al capital structure based

tests whether systematic profits can be generated by

on a trade-off between the benefits and costs of

m aking investment decisions on the basis o f private

using debt

inform ation

step-up preference share a preference share

tests of return predictability research method

w here the d ivid en d rate is reset at a higher rate

designed to detect systematic patterns in asset

on a specified date unless the securities have been

prices

re-marketed, redeemed or converted

theoretical ex-righfs share price the expected

subordinated debt debt that ranks below other debt

price o f one share when shares begin to be traded

in the event that a com pany is w ound up

ex-rights

subscription price the price that must be paid to

theoretical rights price the expected price o f one

obtain a new share

rig h t ca lcu late d on the basis o f the cum-rights

sunk cost cost that has a lre a d y been incurred and

share price

is irrelevant to future decision making

time value value o f an option in excess o f its

sw a p an agreem ent between tw o counterparties to

intrinsic value

exchange sets o f future cash flows

time value of m oney principle that a d o lla r is worth

sweetened debt co n ve rtib le w hich is p re do m in an tly d e b t but has some equity-like

more (less), the sooner (later) it is to be received, all other things being equal

features; ty p ic a lly has a lo w p ro b a b ility o f being

trade credit arrangem ent in w hich a seller o f goods

converted to equity

or services allow s the purchaser a period o f time

syndicated loan loan arranged by one or more

before requiring paym ent; it is equivalent to a short­

lead banks, funded by a syndicate that usually

term loan made by the seller to the purchaser, o f an

includes other banks

am ount equal to the purchase price

syne rgy in takeovers, the situation w here the

treasury m anagem ent involves the managem ent

perform ance and therefore the value o f a com bined

o f financial assets and includes the m anagem ent of short-term financial assets, long-term financing and risk m anagem ent

entity exceeds the sum o f the previously separate components

734

another

p

G

treasury stock US term for a com pany's own shares that have been repurchased and held rather than cancelled

lossary

vertical takeover takeover o f a target com pany that is either a supplier o f goods to, or a consumer of goods produced by, the a cqu iring com pany volatility v a ria b ility o f a share price; can be

underreaction biased response o f a price to

measured by the variance (or the standard

inform ation in w hich the initia l price movement can

deviation) o f the distribution o f returns on the share

be expected to continue unsubordinated debt d eb t that has not been

w eighted ave rage cost of capital (WACC) the cost

subordinated

o f capital determ ined by the w eighted average cost

unsystematic (diversifiable) risk that com ponent of

o f all sources o f finance

total risk that is unique to the com pany and may be

w inner’s curse problem that arises in b id d in g

elim inated by diversification

because the b id de r w ho 'w in s 7 is likely to be the one w ho most overestimates the value o f the assets

value at risk worst loss possible under normal market conditions for a given time horizon variable interest rate loan loan w here the lender

offered for sale withholding tax the tax deducted by a com pany from the dividend payable to a non-resident shareholder

can change the interest rate charged, usually in line with movements in the general level o f interest rates

yield curve graph o f yield to m aturity against bond

in the economy

term at a given point in time

variance measure o f v a ria b ility ; the mean o f the squared deviations from the mean or

zero-coupon bonds (zeros) bonds that pay only

expected value

one cash flow, the paym ent at m aturity

735

INDEX 10-year Treasury bond futures contracts 5 3 2 -5 30-day interbank cash rate futures contract 5 3 5 -6 90-day bank-accepted bill futures contract 5 2 5 -3 2

2 2 2 , 335 APA 2 9 7 -8

Australian Securities and Investments Commission (ASIC) 2 1 8 , 2 4 0 ,

arbitrage 7, 3 6 5 with bank bill futures

318, 619 Australian Securities Exchange

5 3 1 -2 Asay, M.R. 5 9 4

5 0 8 , 5 1 2 -1 3 Australian Small Scale

A

Asciano 6 28

AASB 1 17 Leases 4 5 5 -6 ,

Asia Pacific Stock Exchange 216, 242

O fferings Board 2 1 6 Australian Stock Exchange Ltd

long-term borrowing from 2 8 5 -9 short-term borrowing from 2 8 2 -4 short-term investments 674 Banksia Financial G roup 296 Barber, B. 4 9 4 , 4 9 8 Barberis, N . 4 8 2 , 4 9 7

(ASX) 2 1 6

Barclay, M . 4 0 0 , 4 0 4 -5 , 4 0 8

Asquith, P. 2 6 9

2 0 0 futures contract 5 3 7

ABC Limited 3 0 7

asset allocation (portfolio

and futures trading

Barings 5 3 9 Bartov, E. 341

abnorm al returns 4 8 0

performance) 198 asset-backed commercial

5 1 2 -1 3 indicies 5 3 6 - 7 listing rules 2 4 2 , 25 9 ,

468 ABC Com pany 3 22

Accelerated NonRenounceable Entitlement O ffer 2 5 9 Accelerated Renounceable Entitlement O ffer (AREO) 2 5 9 acceptor (bills of exchange) 2 92 accounting accruals 4 8 4 accounting for leases 4 5 5 - 6 accounting rate o f return 1 1 8 -2 0

paper (ABCP) 2 23 asset characteristics 4 1 0 asset growth 4 8 4

2 6 1 , 2 6 2 , 3 03 market statistics 2 1 7 value of share listinqs

asset pricing 6 -7 asset risk 179

2 33

of an individual asset 1 87 assets current 6 4 7 liquid 6 4 7 , 6 4 8 , 6 6 7 ,

See a lso financial futures on the ASX Australand 2 6 9 authorised deposit-taking

669

institutions (ADIs)

valuation based on

accounts receivable 6 4 7 , 6 4 8

(takeovers) 6 1 9

definition 6 7 5 management 6 7 5 —7

S e e a lso short-term asset management; short­

accumulation 34 acquisition costs 6 5 0

term assets assets, company

2 1 4 -1 5 , 2 1 8 average collection period 6 9 7 average inventory turnover period 6 9 6 -7

B

Basel Committee on Banking Supervision 213 basis points 5 4 8 basis risk 5 1 9 -2 0 Bautista, A. 4 5 8 BBSW 5 4 6 beating the market 4 9 9 Beggs, D. 3 3 1 -2 behavioural factors (payout policy) 3 3 9 behavioural finance and market efficiency 4 9 5 -7 Bellamy, D. 3 3 0 Benartzi, S. 333 benchmark indexes (portfolio performance) 199 Bendigo Bank 6 2 3 benefit-cost ratio (profitability

activity ratios 6 9 3 -4

overvaluation 3 8 5 -6

bad debts 6 7 6

Adelaide Bank 623

undervaluation 3 8 3 -5 at call 282

Baker, H. 106, 124, 6 1 3 Baker, M . 3 3 9 , 4 0 4

Benmelech, E. 4 0 5 Berk, J. 3 9 8

Australia banks 2 2 0 -2

Balachandran, B. 2 58 Ball, R. 4 8 2

Bernardo, A. 3 3 4 beta 1 87

capital markets 2 1 2 -1 3

bank accepted bills 2 93

equity markets 2 1 6 financial institutions, assets of 2 1 5

bank accepted bill futures contract

Bettman, j.L. 4 8 1 ,4 8 4 BHP Billiton 3 2 0 - 1 , 5 6 4 - 5 ,

adjusted present value (APV) 4 3 6 agency costs 3 3 5 -8 , 3 4 1 , 3 7 9 -8 1 , 3 9 9 - 4 0 1 ,4 6 9 agency relationships 7 -8 A g ra w a l, A . 3 9 8 Aitken, M . 4 8 8 Alesco Corporation 2 6 4 All Black Ltd 3 2 7 Allen, F. 3 3 4 , 411

financial markets 2 1 2 -1 3 investment banking 2 1 8 -1 9

allocated costs (project

profit and dividend

evaluation) 131 Alpert, K. 5 7 7

announcements

Alpha Books 383

4 9 1 -2 securitisation 2 2 3 -4

Annam ay Ltd 5 2 7 -3 0

share repurchases 3 4 3 -5

Anderson, D. 4 8 3 , 4 8 4 Anderson, H. 3 3 2 Andrade, G. 3 9 8 -9 , 6 0 7 , 630, 634 annuities 5 0 - 7 deferred 5 0 -2 definition 5 0 -2 future vale o f 5 6 - 7 general 6 3 -5 ordinary 5 0 types o f 5 0 -2 annuity-date 5 0 present value o f an 5 2 -3

736

A N Z Banking G roup

Treasury’s currency swaps crash 5 53 Australian Competition and Consumer Commission (ACCC) 6 1 0 Australian Equipment Lessors Association 4 5 1 ,4 5 3 Australian Financial Markets Association (AFMA) 218, 544 Australian Prudential Regulation Authority (APRA) 213, 218, 221, 225

hedging 5 2 7 -9

index) 1 1 7 -1 8

573, 624, 647, 667 biased price reaction 4 7 9 -8 0

specification 5 2 6 -7

bill acceptance facility 2 9 4

speculation 5 2 7

bill discount facility 2 9 4 bill facilities 2 9 4 -5

uses 5 2 7 -3 2 bank bill futures 5 3 1 -2

Billabong 2 5 9

bank bill futures contracts

bills o f exchange 2 9 2 -5

valuation 5 4 0 -1

binom ial option pricing 5 7 7 -8 2

bank bills 2 9 3 , 5 2 5 -6 bank deposits, government guarantee 222

Bishop, S. 6 0 6 , 6 3 7

Bank for International

Black-Scholes equation 5 8 3 -7 , 5 9 4

Settlements (BIS) 5 4 4 Bank o f M elbourne 6 2 3 -4 bank overdraft 2 8 2 -3 bankruptcy costs 3 7 7 -8 banks as financial intermediaries

220-2 and global financial crisis 222 investment 2 1 7 -2 0

Black, S. 2 9 8

Black-Scholes model o f call option pricing 5 8 2 -8 Block, S. 1 24 Board Ltd 6 1 5 , 6 1 6 , 6 1 7 -1 8 Boart Longyear 2 6 9 bond duration 9 7 -9 bond price changes and duration 100 bond pricing 5 3 2 -3 bonds 8 0 - 1 , 2 9 8 - 3 0 0

Index

W convertible 3 0 3 -4 , 5 9 6

and the security market

term structure to price 8 3 -5

line 1 9 2 -4 capital market line

bonus issues 2 6 8 -9 book building 2 4 4 book-to-market ratio 4 8 5 -6 Boral 6 4 7 , 6 6 7 Bowers, J. 4 8 2 Bradley, M . 4 0 2 , 631 Brailsford, T. 192, 1 9 6 ; 198, 4 8 1 ,4 8 6 Brambles 5 7 5 Brav, A. 2 5 1 , 3 2 0 , 3 35 break-even analysis 1 5 1 -2 break fees and takeovers 624 bridging finance 2 8 4

1 9 1 -2 implementation 1 9 5 -7 risk and return 197 capital expenditure process 104 tasks and outcomes 1 0 5 -6 capital gains tax and dividend policy with imputation 3 2 8 -9 and im putation 3 2 7 -8 capital market 1 2 -1 3 , 1 6 -1 9 , 2 1 0 -3 0

Brock, W . 481

Australia 2 1 2 -1 3

broker and the stock

business funding

exchange 2 1 6 -1 7 Brooks, R. 2 4 7 , 2 52 Brounen, D. 4 0 5 Brown, C. 3 3 0 , 345 Brown, P. 4 8 4 , 4 9 1 ,4 9 4 , 630, 631, 635, 636 Brown, R. 5 7 7 Brown, R.L. 263 Brown, S. 481 bubbles 4 9 6 business angels 238 business funding 2 1 4 -1 5 business risk 3 5 7 , 4 0 9 business structures 3 -5 buy-and-hold policies 4 9 8 -9 buyouts 6 2 8 -9 leveraged 6 2 7 management 2 3 6 , 6 2 7

c

current share price 5 6 8 -9 definition 5 6 4 excise price 5 6 9 minimum value 5 7 6 -7 prices, factors affecting 5 6 7 -7 1 pricing, Black-Scholes

types 21 2 capital market efficiency 4 7 7 -5 0 1 and behavioural finance 4 9 5 -7 categories 4 8 0 efficient market hypothesis 4 7 8 -8 0 event studies 4 8 7 -9 1 and financial managers 4 9 9 -5 0 0 investors in securities 4 9 7 -9

macro level 4 9 5 test o f return predictability 4 8 1 -6 tests for private inform ation 4 9 3 -5 capital market line 1 9 1 -2 capital raising regime for listed companies 2 5 2 -3 capital rationing 1 5 7 -8 capital structure agency costs 3 7 9 -8 1 , 3 9 9 -4 0 1

513 payoff structure 5 6 6 -7

4 0 6 -8 choice o f maturity

capital asset pricing model (CAPM) 6 and cost o f capital 4 2 1 ,4 3 1

system 3 7 4 -7 evidence o 门 3 9 5 -4 0 6 information costs 4 0 1 -3 with information asymmetry 3 8 2 -6 M od ig lia n i and M iller analysis 3 6 0 , 3 6 1 -9 , 3 9 4 , 4 0 8 optimal 3 5 7 , 3 8 1 -2 pecking order theory 3 8 2 -3 , 3 9 4 , 4 0 1 -3 , 4 0 7 -8

spin-offs 4 0 3 - 4

assessing the theories

Camp, G. 2 5 0

an imputation tax

flo w o f funds 21 1 perfect 361

model 5 8 2 -8 on a futures contract

single-period 5 7 7 -8 term to expire 5 6 9 -7 0

effects o f taxes under

principles of 3 5 6 -8 7 priority o f debt 4 0 4 -5

problem 4 8 0

call 2 3 4 call option

classical tax system 3 6 9 -7 4

2 1 4 -1 5 definition 21 1 -1 2

and the joint test

Cabcharge Australia Ltd 3 5 8 Cahan, S. 332

effects o f taxes under a

4 0 4 -5 costs o f financial distress 3 7 7 -9 , 3 9 7 -9 definition 3 5 7 dual issues 4 0 3 -4 effects o f financial leverage 3 5 7 -6 1

valuation o f contracts with multiple 4 6 -5 0 S e e a lso discounted cash flo w methods cash management trusts 6 7 4 cash payments 671 cash receipts 6 7 0 Cassilis Ltd 4 3 8 catering theory 3 3 9 Cannavan, D. 331 central bank 2 13 certainty 25 financial asset valuation under 7 5 - 6 valuation o f shares assuming 7 6 - 7 certainty-equivalent 4 3 7 certainty-equivalents to allow for risk 4 3 7 -9 Chan, H.W . 2 6 3 , 481 Chappie, L_ 6 2 4

static trade-off theory 394, 403, 4 0 6 -7

C harting 4 9 7

surveys 4 0 5 -6

Chestertheaton Investment

taxes 3 9 5 -7 capital structure decisions 3 9 3 -4 1 2

chattel mortgages 471 fund 531 C hicago Board of Trade 5 0 8

company financing

C hicago Board O ptions Exchange 5 6 6 , 5 8 7 Chopra, N. 4 8 2 , 4 9 7

3 9 4 -5 financing as a marketing

Chow, D. 398 Christensen, B. 6 2 4

asset characteristics 4 1 0 business risk 4 0 9

problem 4 0 8 -9 financing strategy 4 0 9 -1 1 inflation risk 41 1

C itigroup G lobal Markets Australia 2 6 0 Clarendon Com pany 1 3 7 -9

political risk 41 1

Clarke, A. 3 3 0

reserve borrow ing capacity 41 1

Clarke's Photography Store

tax position 4 1 0 CAPstart Private Equity

6 5 4 , 6 5 7 -8 Clarkson, P. 6 2 4 classical tax system, effects

M arket 2 1 6 Carhart, M . 198

on capital structure under a 3 6 9 -7 4

carrying costs 5 1 3 , 651

com pany income tax 3 6 9 -7 1

cash budgeting 6 7 0 -3 cash flows definition 29 estimation in project evaluation 13 0 -3 free 3 3 6 incremental (project evaluation) 130-1 inform ation in project evaluation with taxes 1 3 7 -9 effect of taxes on net (project evaluation) 1 3 4 -7 and takeovers 61 1 timing (project evaluation) 131

com pany tax and personal tax 3 7 1 -3 M iller's analysis 3 7 3 -4 Claus J . 197 Cliff, M . 2 4 9 CME G roup 5 0 8 Coleman, L. 198, 4 0 5 Coles 2 88 collection policy 6 8 1 -6 Comer, A. 2 5 0 commercial bills, discounting o f 6 7 4 -5 commercial paper 2 9 0 -2 Commonwealth Bank of Australia 2 22

737

Index

companies 4 -5 capital raising regime

control, effect of debt

for listed 2 5 2 -3 conflict of interest with

conversion ratio 3 0 7

employees 401 m anaging equity

of capital (WACC) 4 2 2 -3 , 4 3 1 ,4 3 5 , 4 3 6 -7

convertible notes/bonds 3 0 3 -4 , 5 9 6

cost of debt 4 2 4 -7

converting preference shares

cost o f long-term debt 4 2 6 - 7

and com pany cost of capital 4 2 9 cost o f 4 2 4 -7 cost o f long-term 4 2 6 -7 cost o f short-term 4 2 5 -6 effect on control 2 7 9

Cooper, M . 4 8 4

cost of o rd in a ry shares 4 2 7 -9

Copperam a 4 7 9 corporate bonds 2 9 7 -3 0 0

cost o f preference shares 427

4 2 9 -3 0 , 4 3 1 -6

corporate (company)

cost of short-term debt 4 2 5 -6

long-term borrowing 2 8 5 -9

company financing 3 9 4 -5

decisions 2 corporate finance 2

coupon payments 2 9 0

and overinvestment

corporate governance 3 3 5 -8

Cranfield M anufacturing Ltd 6 5 4

structure 2 6 8 -9 S e e a lso public company, floating company cost of capital 4 2 2 ,

com pany income tax 3 6 9 -7 1 company-issued share options 2 6 2 -3 company managers, conflict o f interest with shareholders 3 8 0 -1 com pany life cycle and payout policy 3 4 7 -8

3 0 6 -7

and takeovers 6 2 4 corporate raiders 6 0 9 corporate restructuring buyouts 6 2 8 -9

collection policies

short-term borrowing

6 8 2 -6 decision to offer 6 7 7

C o rp o ra tio n s Legislation A m endm ent (S im pler R e gulato ry System ] A c t 20 0 7 256

formula development

cost of capital 4 1 7 -4 8

4 4 -5 nominal and effective interest rates 3 7 -4 0 real interest rate 4 0 -1

lim it 6 8 0 period 6 8 0 policy 6 7 7 -8 1 risk 5 5 6

317, 318, 493, 619,

Correia Da Silva, L. 3 3 7 -8 Corrigan, Chris 6 2 6

3 4 -7

evaluation of alternative 6 8 2 -6

621, 622, 625

continuous interest rate 4 2 -4 definition 33

qeometric rates of return

4 2 1 -3 alternative evaluation techniques 4 3 6 - 7 company cost of capital 422

(CBL) 4 5 5 CSL Limited 268

cumulative preference shares 3 0 5

recourse 2 8 3 debtor finance without

cum rights 2 53

replacement assumption 140

debtor finance with

recourse 2 8 3

currency swaps 5 4 4 , 5 5 1 -5 current assets 6 4 7

debtors 6 4 7 , 6 4 8 default risk 2 2 1 , 3 6 6 default-risk structure of

current ratio 6 9 6 customer credit 6 7 5

defaults 2 7 7

interest rates 82, 8 9 -9 1 deferred annuity 5 0 -1

formulae 4 4 7 -9

D

issue costs 4 3 0 -1

Da Silva Rosa, R. 2 4 7 ,

and leasing 4 6 8 -9 project 4 3 1 -6

2 8 9 -9 0 unsecured notes 2 9 7 valuation o f 80-1 debtor finance 2 8 3 -4

cum-dividend 31 7

constant chain of

2 9 7 -3 0 0 debentures 8 0 -1 ,

cumulative average abnorm al returns (CAR) 491

direct estimation approach 4 3 4 -5

431- 6 estimation 4 2 3 -3 1

commercial paper

2 9 5 -6 general principles

cross-border leasing

definition 41 8

company 4 2 2 , 4 2 9 -3 0 ,

bills of exchange 2 9 2 -5

creeping takeovers 6 2 2

conglomerate takeovers 6 0 8 ConnectEast G roup 3 0 2 Conquest Investments 5 9 0 -1 Conrad, J. 4 8 1 ,4 8 2 conservation of capital

direct use of CAPM 421

3 9 9 -4 0 0 debt securities 2 8 9 -3 0 0

2 9 0 -2 corporate bonds

alternative approaches to estimation

2 8 2 -4 types of 4 2 5 and underinvestment

terms 6 8 0 -1 credit fo n d e r loan 2 8 6 credit-worthy customers 6 7 7 -8 0

compound option 5 9 7

(leasing) 4 6 7 -8 consistency principle 41 8

shares 3 08 project finance 3 0 1 -2

divestures 6 2 7

C o rp o ra tio n s A c t 2 0 0 1 4, 2 4 0 , 2 4 1 ,2 5 2 - 3 , 2 5 6 ,

basic idea 3 3 -4

4 0 0 -1 and preference

security for 2 8 0 -1 sweete 门ed 3 0 4

objective 5 Com petition a n d C o n su m e r

compound interest 3 3 -4 5

credit

hybrids 3 0 2 -8 interest cost of 2 7 8 -9

benefits and costs of granting 6 7 6 -7

com pany’s financial

A c t 2 0 1 0 6 ] 0 , 623

covenants 2 7 7 , 2 8 0

effect on risk 2 7 9

6 2 7 -9

spin-offs 6 2 7 -8 corporate treasurer 6 7 5

competitive capital markets (finance leasing) 4 6 1 -2

present value o f an 2 5 2 , 6 3 0 ,6 3 1 , 6 3 5 , 636, 638

5 3 -5 delayed equity 3 0 4 delinquent accounts 6 7 6

continuous interest 42

'pure play' approach 432- 4

d a ily return patterns 4 8 2 day trading 5 1 7

delta 5 7 8 Denis, D. 2 4 9 , 3 3 6

continuous interest rate 4 2 - 4

and risk, return 41 8-1 9

De Angelo, H. & L. 3 2 3 ,

deposits (futures trading)

contracts present value 4 7 principle-and-interest

risk independence 4 1 9

contingent claim 5 6 4 , 5 9 5 - 8

loan 5 8 -6 3 terminal value 4 7 valuation with multiple cash flows 4 6 - 5 0 contributing shares 2 6 2

738

weighted average cost

on 2 7 9

and taxes 4 1 9 -2 1 under alternative systems 4 4 7 -8 using certainty equivalents to a llow for risk 4 3 7 -9

3 2 4 , 3 2 5 , 3 4 7 —8, 3 7 4 de Jong, A. 4 0 5 decision-tree analysis (projects) 1 5 3 -6 debentures 8 0 - 1 , 2 9 5 - 6 DeBondt, W .F.M. 4 8 2 debt 3 0 , 2 7 5 -3 0 9 characteristics 2 7 7 -8 1

5 1 1 -1 2 deposits o f funds with financial institutions 6 7 4 derivative securities 7 Desai, H_ 2 6 9 , 631 Diacono Fidelity 5 9 5 Dill, D. 4 5 8 Dimovsky, W . 2 4 7 , 2 52

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Index

finance companies 223 finance leases 4 5 2 -3 establishing an

effects on capital structure 3 5 7 -6 1

gearing 3 5 7 general annuities 6 3 -5 qeometric rates of return

financial managers 4 9 9 -5 0 0

floating charge 2 8 0

advantage 4 6 2 -3 evaluation of 4 5 8 -6 4

financial markets, Australia's

flotation costs 3 2 5

imputation tax

financial mathematics cash flows 29

system 4 6 4 leasing and investment decisions 4 6 0 taxes and the size of leasing gains 4 6 3 -4 valuation in competitive capital markets 4 6 1 -2 Financial Accounting Standards Board (FASB) 4 5 6 financial agency institution 21 4 , 2 1 5 -1 9 broker and the stock exchange 2 1 6 -1 7 investment banks 2 1 7 -2 0 financial asset valuation under certainty 7 5 -6 financial assets 21 1

2 1 2 -1 3

global financial crisis and bank deposits 2 2 2

foreign bonds 3 0 0

Goetzmann, W . 196

time value of money

foreign currency options 5 8 8 -9 1

going-private transaction 6 2 8 -9

financial ratio analysis,

Foreign Investment Review

Gompers, P. 2 5 1 -2

usefulness o f 6 9 5 -6 financial ratios measurement and

Board (FIRB) 6 2 3 Fortescue M etals G roup 2 6 8 forw ard contract 5 0 9

G ong, N. 2 4 7 goods and service tax (GST) 4 5 8 , 471

forw ard rate agreements

Goss G old 5 2 3 - 4

(FRAs) 5 4 2 -4 forw ards 5 9 1 -3

Government Insurance Office (GIO) 2 4 4

Frank, M . 3 9 4 , 4 0 3 , 4 0 8

G oyal, V. 3 9 4 , 4 0 3 , 4 0 8 GPT G roup 2 6 9

30- 1

interpretation 6 9 0 -2 and short-term asset management 6 9 6 -7 financial risk 2 7 9 financial slack 41 1 financial statement analysis 6 9 0 -7

Takeovers A c t 1 9 7 5 623

franked dividends 3 1 7 franking credits 31 8

problem 4 0 8 -9

financial distress 2 7 9

financing strategy (capital financinq decision) 4 0 9 -1 1

G riffin, J.M. 481 G rinblatt, M . 4 8 1 ,4 8 2

French, K.R. 197, 198, 3 4 2 , 403, 482, 485, 486

Grundy, B.D. 4 8 2 guarantee 281

fundamental analysis 4 9 8

Guay, W . 342 Gulen, H. 4 8 4

finished goods inventories

future sum 3 1 -2

650, 652 Finn, F. 3 3 1 ,4 9 1 , 4 9 4 , 6 0 7 Fisher’s Separation Theorem

futures 5 9 1 -3 options on 5 9 3 -5 pricing options on 5 9 4

assumptions 1 1 -1 2 , 14

deposits, margins and market-to-market

futures contract

securitisation 2 2 3 - 4 financial institutions, deposits of funds with 6 7 4 financial leverage definition 358

present value 5 12 put option 51 3 selectinq the number 5 2 2 -4

making 2 2 -4

4 0 , 5 9 4 -5 introduction 1 1 investment decisions 23 financial intermediaries 21 4 , and net present value 2 2 0 -4 1 3 -1 4 banks 2 2 0 -2 definition 21 1 optimal policy 19 -2 2 shareholders 1 5 -1 6 finance companies 223 corporations (MMCs) 2 2 3

rule 5 1 1 -1 2

dividend decisions 23 financial decision

536-

money market

futures contract 5 6 6 , 5 9 3

com pany’s decision 26 the com pany 15

financing decisions 23 formal approach 1 4 -2 4

shareholders' consumption

futures market hedging 5 1 7 -2 1

borrow ing 13 summary 14

Gup, B.E. 2 13

H Hall, j. 3 3 0 -1 H alliwell, J. 4 8 5 Hameed, A. 491 Hancock, P. 491 Harford J . 3 4 2 , 6 0 7 , 6 1 3 Harris, R.S. 4 3 4 Harris Scarfe 3 9 5 Harvey, C. 3 2 0 , 3 3 5 , 4 0 5 Harvey N orm an Holdinqs Ltd 6 9 0 -2 Hathaway, N. 3 3 0 H edy, P. 2 6 9 , 3 3 3 ,

organisation 5 0 9 -1 1 regretting 521

637, 638 Heaney, R. 4 8 5

speculating 5 1 6 -1 7

Heaton, J. 1 97

strategies 5 1 5 -2 4

Heavy Haulage Ltd 4 5 8 -9 hedge ratio 5 7 8 hedgers 5 0 8

futures prices determinants 51 3 -1 5 futures trading deposits 51 1 -1 2

opportunities and preferences 12 solution 1 2 -1 3 , 1 6 -1 9 solution requiring

3 4 1 , 343

fully paid shares 2 3 4 fund managers 2 3 9

call option 5 1 3 definition 5 0 8 , 5 0 9 -1 2

share price index S& P/ ASX 2 0 0 (SPI 200)

Grullon, G. 3 3 3 -4 , 3 3 6 ,

fully draw n bill facilities 2 9 4

analysis using rates of return 13

5 2 5 -3 2

3 9 6 -7 , 4 0 2 , 4 0 5 , 406, 407 Gray, S. 3 3 0 -1

5 3 2 -5

90-day bank-accepted bill futures contract

G raham , J. 3 2 0 , 335,

free cash flow 3 8 1 ,6 1 1

1 1 -2 4

rate futures contract 535- 6

G oergen, M . 3 3 7 -8

franking premium 421

futures co 门tracts 30-day interbank cash

and investment banks 2 1 9 -2 0

market value of 3 2 9 -3 2

financing as a marketing

financing policy, information asymmetry for 3 8 6

valuation 5 4 0 -2

finance 2 8 4 flo w o f funds 211

rate of return 2 9 -3 0

financial decisions 2 -3 short-term 6 4 7

financial futures on the ASX 10-year Treasury bond

G eorge, TJ. 481

F o re ig n A cq u isitio n s a n d

financial contract 29

definition 3 7 7 financial futures contracts,

4 4 -5

floor-plan (or wholesale)

fundamental concepts 2 9 - 31 interest rate 30

financing decisions (Fisher's Separation Theorem) 23

costs of 3 7 7 -9 , 3 9 7 -9

740

fixed charge 2 8 0 fixed-rate term loans 2 8 7

margins 51 1 -1 2

hedging 5 1 5 , 5 1 7 -1 8 with 10-year bond futures 5 3 2 -5

G

with bank bill futures 5 2 7 -9

Garm aise, M . 4 0 5 Gaunt, C. 198

currency swaps 5 5 4

basis risk 5 1 9

Index

imperfect convergence 518

undervaluation of com pany assets 3 8 3 -5

interest rate swaps 5 4 7 -8 specification differences 5 2 0 -1 SPI 2 0 0 futures 5 3 7 Heemskirk Consolidated 6 4 7 hire-purchase agreement 471

inform ation costs 4 0 1 -3 inform ation disclosure 2 4 0 -2 offer information statements 2 4 1 -2

Hoberg, G. 3 3 9

offers of unlisted securities 2 4 0 -1

Hodgson, A. 6 0 7

offers that do not need

Hong, H. 4 8 2 horizontal takeovers 6 0 7

2 4 1 -2 information efficiency 4 8 0

Hovakimian, A. 4 0 3 -4 Hovakimian, G . 4 0 3 -4

inform ation gaps 2 3 7

How, J. 2 5 0 hybrids of debt and equity 3 0 2 -8 convertible notes/bonds 3 0 3 -4 preference shares 3 0 5 -8 Hwang, C.Y. 481

information leakage 2 3 7 information problems and new ventures 2 3 7 initial public offerings (IPOs) 2 3 3 , 2 3 7 , 2 4 2 , 2 4 6 -7 ,

instalment receipts 2 6 2

and duration 1 0 0 -2 imperfect convergence 51 8 imputation tax system 317, 369 and capital gains tax 3 2 7 -8 definition 3 7 4 -5 dividend policy 3 2 8 -9 and dividends 3 2 5 -7 effects o f tax on capital structure 3 7 4 -7 and leasing 4 6 4 Incite Pivot 2 6 8 , 2 6 9

Income Tax Assessment Act 134, 135 independent investments 1 12 independent project 107

program 2 3 9

continuous 4 2 -4 default-risk structure of 82, 8 9 -9 1 effective 3 7 -4 0

indicator rate 282

nominal 3 7 -4 0 real 4 0 -1

indifference curve 15

structures 91

inflation chain of replacement methods 145

term structure of 8 2 -9 interest-only loan 37 intermediation 2 7 6

and project evaluation

internal capital rationing 157

1 3 1 -3 and term structure 89 89

internal funds 2 6 6 -7 internal rate o f return (IRR) definition 107

inflation risk 41 1 information asymmetry 2 3 7 capital structure 3 8 2 -6 for financing policy 3 8 6 overvaluation of company assets 3 8 5 -6 pecking order theory 3 8 2 -3

inventory loans 2 8 4

sensitivity analysis

inventory management and /just-in-time, system

149-51 simulation 1 5 2 -3

6 6 1 -2 overview 6 5 0

multiple and indeterminate

110-12 project evaluation 10 7 , 1 0 9 -1 2 International Accounting Standards Board (IASB) 4 5 6

investments 2 independent 1 1 2 mutually exclusive

inventory management under

112-17

certainty 6 5 2 -8

6 5 2 -5 EO Q model with

short-term 6 4 8 , 6 7 4 -5 investor(s) decisions 3 information effects and signalling to 3 3 2 -5 reactions to managers'

positive lead time

decisions 2 4 -5

656

risk-averse 6, 176 risk-neutral 176

EO Q model with

specifying an

interest rate swaps 5 4 4 -5 2 interest rates 30

constraints 1 5 7 -8

wholesaling 6 5 0 -1

uncertainty 6 5 8 -6 1

simple 3 1 -3 interest rate risk 8 1 -2

selection with resource

retailing and

futures 5 3 5 -6

elasticity and duration 9 9 -1 0 0

risk analysis 1 4 9 -5 3 selection (qualitative factors) 156

inventory costs manufacturing 6 5 1 -2

quantity discounts 6 5 7 -8 inventory management under

compound 3 3 -4 5 cost of debt 2 7 8 -9

1 4 6 -7

materials 651 inventory 6 4 7 , 6 4 8

insurance companies 2 2 5 -8 interbank cash rate 2 7 8 interest

1 4 7 -9 retirement decisions

inventories o f raw

economic order quantity (EOQ) model

Ibbotson, R.G. 196 Ikenberry, D. 341

replacement decisions

goods 6 5 2

lonq-term performance

I

break-even analysis 1 5 1 -2

intrinsic value 5 6 9 inventories o f finished

cost estimation 6 5 5 -6

2 5 0 -2 of o rd in a ry shares 243

investment projects

2 8 5 -6

2 4 8 -5 2

Inman, Launa 2 5 9 Innovation Investment Fund

immunisation 9 7 -1 0 2

interest rate on a term loan

risk-seeking 176 in securities 4 9 7 - 9 utility function 1 7 6 -9 investing institution 2 1 4

acceptable

invoice discounting 2 83

expected customer

irredeemable preference

service level 6 6 0 -1 specifying an acceptable p ro b a b ility of

shares 3 05 issue costs and cost of capital 4 3 0 definition 4 3 0

stockout 6 6 0 investing institutions 2 2 4 -9 insurance companies 2 2 5 -8

Jagadeesh, N. 4 8 1 , 482, 494 Jagannathan, M . 3 4 2

investment companies 2 2 8 -9

Jain, P. 2 6 9

overseas sources and

Jameson Ltd 4 3 9

markets 2 2 9 superannuation funds

January effect 4 8 3

2 2 5 -8 unit trusts 2 2 8 -9 investment banks 2 1 7 -2 0 Australia 2 1 8 -1 9 and the global financial crisis 2 1 9 -2 0 regulation 21 8 role of 2 1 7 -1 8 investment companies 2 2 8 -9 investment decisions finance leasing 4 6 0 Fisher’s Separation Theorem 23 investment horizons 87

Jarrell, G . 3 4 1 ,4 0 2 , 631 Jegadeesh, N . 198 Jensen, M ichael 2 0 2 , 3 8 1 , 3 9 4 , 4 0 0 , 4 0 1 ,4 0 2 , 6 0 6 , 6 0 7 , 6 1 1 ,6 3 6 Jensen's alpha (portfolio performance) 2 0 2 -3 Ji, X. 481 joint test problem 4 8 0 Jung, J. 4 7 8 just-in-time system 6 6 1 -2

K Kaplan, S. 3 9 8 -9 Kathmandu Holdings 2 4 4 Kaul, G . 4 8 1 ,4 8 2

741

Index

Keswin, A. 4 9 4

Lee, C .M .C . 4 8 2 , 4 9 3 , 4 9 4

Kim, Y. 3 9 8 , 4 0 2 Kinney, W . 4 8 2

Lee, P. 2 4 7 , 2 4 8 , 2 5 0 , 2 52 Leeson, N ick 5 3 9

Kiymaz, H. 6 1 3

legal ownership 2 8 0

2 5 1 ,6 3 5 Lucas, D. 197

Koedijk, K. 4 0 5

Lehman Brothers 2 1 9 , 222

Lynch, A. 4 8 3

Krishnamurti, C. 3 33

Lehn, K. 6 3 6

Kusnadi, Y. 481

lenders, conflict of interest

M

L

with shareholders 3 7 9 -8 0 Lerner, J. 2 5 1 -2

M cConnell, J. 6 13 MacKay, P. 3 95

lessee 451 lessor 451

M acKinlay, A.C . 481 M adison Com pany 1 4 4 -5

leverage and pecking order

Maher, T.R.B. 481

La Porta, R. 3 3 6 -8 Lakonishok, J. 3 4 1 ; 4 8 1 ; 4 8 1 ,4 8 4 , 4 9 3 Lancaster Ltd 6 7 1 -3 Lang, L. 3 3 6 , 6 3 6

theory 4 0 2 leverage ratios 6 9 4

Lanis, R. 3 9 7 lease contracts, types of 4 5 1 -5

o f Australia listed companies 3 5 9

lease rentals, setting 4 5 6 -7

leveraged buyouts 6 2 7

Leaseurope 451 leasing 4 5 0 -7 2

leveraged leasing 4 5 4 -5 Levi, M . 6 3 2

accounting treatment

Li, K. 632

455- 6 advantages 4 6 2 -3 , 4 6 6 -7 0

liabilities, short-term 6 4 9 Liang, N . 3 42

and agency costs 4 6 9 and company tax

Lieu, D. 5 9 4 limited lia b ility 4

466-

7

comparative advantage in asset

Lie, E. 3 3 6

shareholders 2 3 4 lintner, J. 190 liquid assets 6 4 7 , 6 4 8 , 6 6 7

disposal 4 7 0 conservation o f capital 467- 8 cost of capital 4 6 8 -9 cross-border 4 5 5 decisions 4 6 0 disadvantages 4 6 6 -7 0 finance 4 5 2 -3 finance, evaluation of 4 5 8 -6 4 flexibility and transaction costs 4 7 0 and imputation tax system 4 6 4

liquidity management 6 6 7 -7 0 , 6 75

M aheswaran, K. 196, 198, 405, 626

management buyout (MBO) 236, 627 managers conflict of interest with shareholders 3 8 0 -1 and payout decisions 3 2 0 managers' decisions, investors' reactions to 2 4 -5 manufacturing (inventory costs) 6 5 1 -2 margin call 51 2 margins (futures trading) 5 1 1 -1 2

definition 6 6 7

market efficiency 6 - 7

85, 87 liquidity ratios 6 9 2 -3 listed investment companies (LICs) 2 2 9 listed management investments (LMIs) 2 28

leveraged 4 5 4 -5 off-balance-sheet

Litzenberger, R. 3 3 6 Lo, A .W . 4 8 1 ,4 9 7

3 3 6 , 3 4 0 , 3 4 1 , 343 M iguel, A.F. 4 9 4 Mikkelson, W . 4 0 4 Miller, M (MM) 3 2 0 -5 , 335, 3 4 7 , 4 6 1 ,4 6 8 - 9 M iller's analysis (classical tax system) 3 7 3 -4 capital structure analysis 3 6 0 , 3 6 1 -9 , 394, 408 M itchell, M . 6 3 0 , 6 3 4 , 6 3 6 M o d ig lia n i, F. (MM) 3 2 0 -5 , 3 3 5 , 3 4 7 , 461

maintenance leases 4 5 3 Mamaysky, H. 4 8 1 ,4 9 7

market bids (takeovers) 621

m ajor issues in 6 6 9 -7 0 liquidity (risk) premium

Michaely, R. 3 2 0 , 3 3 3 -5 ,

MacKie*Mason, J. 3 9 6 , 4 0 7

centralisation 6 6 8

listed securities 241 Little, Paul 6 2 6

finance 4 6 8

and behavioural finance 4 9 5 -7 implications of evidence 4 9 7 -5 0 0 at the macro level 4 9 5

capital structure analysis 3 6 0 , 3 6 1 -9 , 394, 408 momentum effect 481 money purchasing pow er of 6 time value o f 5 , 30-1 money market corporations (MMCs) 223 M onlease 4 5 7 monthly return patterns 4 8 2 -3 M orck, R. 6 3 6 m ortgage 2 8 0 M oskowitz, T. 4 0 5 , 481 Mossin, J. 190 Mukherjee, T.K. 6 13 mutually exclusive investments 1 1 2 -1 7 ranking 1 1 3 -1 7 mutually exclusive projects 1 13 Myers, S. 3 9 4 , 4 0 2 , 4 0 3 , 4 0 6 -7 , 4 5 8

market opportunity line

17-18

N

market portfolio 192

N ational Association of

market risk 6

Securities Dealers 251 N ational Australia Bank 2 2 2

market risk premium 1 9 6 -7 market timing (portfolio performance) 1 9 8 -9

N ational Stock Exchange of

operating 4 5 1 ,4 5 3 operating, evaluation of

loan, syndicated 2 8 7 loan repayments 2 8 6

market-tom a rket 51 1- 12 M arket Volatility Index (VIX)

Australia 2 1 6 , 2 42 negative pledge 2 8 0 -1

4 6 5 -6 policy 4 6 9 -7 0

loans

587, 588 M artin, K. 61 3

net present value (NPV)

sale and lease back agreements 4 5 3 -4 setting lease rentals 456- 7

fixed-rate term 2 8 7 term 2 8 7 , 2 8 8 -9 variable interest rate 62 variable-rate term 2 8 6 -7

taxation treatment 4 5 6 ,

long hedge 5 1 7

4 6 3 -4 , 4 6 6 - 7 transaction costs 4 6 7

long-term abnorm al returns (takeovers) 6 3 5

types o f 451 - 5

long-term borrow ing from

valuation in competitive capital markets 4 6 1 -2 LeBaron, B. 481

742

motives for holding 6 6 9

Lopez-De-Silanes, F. 3 3 6 -8 Loughran, T. 2 4 7 , 2 4 8 , 2 4 9 ,

banks/financial institutions 2 8 5 -9 long-term /overnight position taking 5 1 7

M artin, S. 4 8 1 ,4 8 2

597, 682 definition 107

M artlake Ltd 1 4 6 -7 Masulis, R. 2 5 1 , 3 7 4

and Fisher’s Separation Theorem 13 -1 4

M athiou, N. 4 8 3 M atsa, D. 3 9 8 , 401

project evaluation 107,

M a yfa ir Ltd 6 1 5 , 6 1 6 , 6 1 7 -1 8 M egacorp Ltd 6 6 8

project evaluation application 1 3 0 -4 net share issues 4 8 4

M ehra, R. 196

new venture finance 2 3 7 -8

M ehrotra, V. 4 0 4 M erton, R.C. 5 7 3

new ventures and information problems 2 3 7

M etallgesellschaft 5 2 4

N ine Entertainment 2 4 4

1 0 8 -9 , 4 1 8

Index

foreign currency 5 8 8 -9 1

no liability companies 2 3 4 -5 nominal amount (concept in

on futures 5 9 3 -5 risk-free interest

finance) 6 nominal interest rates 3 7 -4 0 definition 3 7 , 4 0

rate 571 trading 5 6 5 -6

non-bank bill 2 93

volatility of the share 570

non-debt tax shields (NDTSs) 3 9 6 non-instantaneous price reaction 4 7 9 non-participating preference

See a lso call options; put options o rd in a ry annuity 5 0 present value of an 5 1 -2 , 5 5 -6

partial takeovers 6 2 2 partly paid shares 2 3 4 Partington, G . 331 partnerships 3 -4 Patrick Corporation 6 2 6

definition 179 performance appraisal

puts 5 6 6 -7 payout policy 3 1 5 -4 9 agency costs 3 3 5 -8 alternative 3 1 9 -2 0

o rd in a ry perpetuity 51

non-votinq preference shares 3 0 5 -6

o rd in a ry shares advantages and

and com pany life cycle 3 4 7 -8

N o r li, 〇 .2 5 1

disadvantages

constant 3 2 0

2 3 5 -6

corporate governance

characteristics

Norman, D. 3 45 notional principle (or notional

2 3 4 -6 cost o f 4 2 7 -9

amount) o f the interest rate swap 5 45 notes, convertible 3 0 3 -4

definition 2 3 4 franked dividends 3 1 7

N ow ra Ltd 3 7 1 , 3 75

franking credits 31 8,

Nufarm Limited 281

3 2 9 -3 2 franking premium 421

o

fully paid and partly

O 'Brien, M . 198, 4 8 1 ,4 8 6 O ’Brien, TJ. 4 3 4

paid 2 3 4 initial public offerings (IPOs) 2 3 3 , 2 3 7 , 2 4 2 , 2 4 3 , 2 4 6 -7 ,

O dean, T. 4 9 8 off-balance-sheet finance

2 4 8 -5 2 limited liab ility 2 3 4

(leasing) 4 6 8 off-market bids (takeovers)

option contracts 5 6 6 option markets 5 6 4 -7 7 option pricing, binomial 5 7 7 -8 2 option to abandon 5 9 7 option to defer 5 9 7 option to expand 5 9 7 option to reopen 5 9 7 option to study 5 9 7 options 2 5 5 -6 , 5 6 4 -7 7 , 5 9 1 -3 company-issued share

3 1 9 -2 4

Poulsen, A. 6 3 2 Prabhala, N.R. 3 3 9 preference shares 3 0 5 -8 classification as debt or equity 3 0 8 cost of 4 2 7 modern 3 0 6 -8 traditional 3 0 5 - 6 w hy companies issue? 308 Prescott, E.C. 196 present value 32

price-earnings ratio

2 5 2 -6 5 underwriting and m anaging a new issue 2 4 4 -6 See a lso shares O rigin Energy 2 6 4

introduction 3 1 6 -1 9

decisions 3 2 0 in practice 3 2 4

and future returns 4 8 3 share valuation 7 9 -8 0 and takeovers 612, 618

repurchasing shares 3 18 share buybacks

price stabilisation 2 4 5 -6 pricing a new issue (shares)

3 3 9 -4 5 signalling to investors

pricing o f risky assets 1 9 0 -7

3 3 2 - 5, 3 4 0 -1 transaction costs 3 2 4 -5 taxes 3 2 5 -3 2

Otchere, I. 3 4 5

pecking order theory 3 8 2 -3 , 3 9 4 , 4 0 1 -3 , 4 0 7 -8

overdraft lim it 2 8 2 overinvestment and debt

Pedersen, L.H. 481 Penman, S.H. 61 8

2 4 3 -4 prim ary markets 21 2 principal 3 1 , 2 7 7 principle-and interest loan 5 8 -6 3 , 2 8 6 balance owing a i any given date 6 0 -1 basic features 58

perfect capital market 361

changing the interest

overreaction 4 7 9

Perco Parts Ltd 4 3 3 -4

over-the-counter market 21 2

Perrigo 61 1 Pham, T_ 398 Phang, G . 5 7 7

rate 6 2 -3 definition 58

4 0 0 -1

P

2 6 2 -3 creation of 5 6 5 -6

Palepu, K. 2 6 9 , 3 3 3 ,

definition 5 6 4 -5

Paperlinx 6 4 7 , 6 6 7 Partch, M . 4 0 4

expected dividends 571

3 3 2 -5 im portance to shareholders

unsystematic risk 1 8 6 -7

3 1 7 -1 8 managers and payout

subsequent issues of

3 5 7 ,3 8 1 - 2

flotation costs 3 2 5 im portance of 323 information effects

asset 18 7 -9 systematic and

pricinq a new issue 2 4 3 -4

issue 2 4 6 shareholder rights 2 3 5

static trade-off theory

dividends 3 2 5 -3 2

efficient frontier 18 9 -9 0 risk o f an individual

present value of futures contract 5 1 2

rights issue 2 5 3 -6 0 selling a new

of investments 651 optimal capital structure definition 3 5 7

plans 3 4 6 -7

multiple assets 1 8 4 -6

legal and tax considerations

operating leases 4 5 1 ,4 5 3

opportunity cost 41 8

dividend election schemes 3 4 6 -7 dividend reinvestment

diversification 17 9 - 9 0 diversification with

placements (private issues) 2 6 0 -1

oi, Y.H. 481 open account 6 7 6

2 3 4 -5

Opler, T. 3 98

procedures 3 1 6 -1 7

measures 19 9 -2 0 3 portfolio theory and

present value o f the contract 4 7

no lia b ility companies

evaluation of 4 6 5 -6

3 3 5 -8 dividend declaration

1 9 8 -2 0 3 performance, alternative

irrelevance o f 3 2 1 -3

6 2 0 -1 Officer, R. 3 3 0 , 6 0 6 , 6 3 7 〇

political risk 41 1 portfolio

payback period 1 18, 12 0 -1 payoff structure for calls and

non-recourse loan 4 5 4

N o rfo lf Ltd 3 3 0

poison pills 6 2 5

Pattenden, K. 3 9 7

behavioural factors 3 3 9 catering theory 3 3 9

shares 305

placements (private issues) 2 6 0 -5

637, 638

Phillips, G .M . 395 Pilotte, E. 4 0 2 Pincus, M . 4 8 4 Pinder, S. 198, 4 0 5 , 6 2 6

loan term required 6 1 -2 principal and interest components 5 9 -6 0 private vs public ownership (companies) 2 4 2 -3

743

Index

private equity 2 3 6 -9

tax issues 13 4 -9 and W A C C 4 3 6 -7

definition 2 3 3 , 2 3 6 from business angles 2 38 information

project finance 3 0 1 -2 projects

problems 2 3 7 new ventures 2 3 7 -8 private equity funds 2 3 8 -9 private information, tests for 4 8 0 , 4 9 3 -5 probability distribution 173 production possibility

mutually exclusive 1 13

real estate investment trusts (REITs) 2 2 7 , 2 2 8 , 2 2 9 real amount (concept in

selection with resource

finance) 6 real interest rate 4 0 -1

2 4 2 -5 2 costs 2 4 6 -5 0 initial public offering of ordinary

progressive dividend policy 3 2 0

shares 2 43

redeemable preference shares 3 0 5 rediscounting (bills of exchange) 2 9 2 regretting 521 regulation of a rights

project cost o f capital 431 - 6

long-term performance

project evaluation 1 0 3 -2 5

of IPOs 2 5 0 -2 pricing a new issue

Renneboog, L 3 3 7 -8 replacement decisions

118-20

2 4 3 -4

alternative 4 3 6 -7 application 12 9 -5 9

public vs private ownership 2 4 2 -3 selling a new issue 2 4 6

benefit-cost ratio (profitability index)

underwriting and

117-18

managing a new issue 2 4 4 -6

capital-expenditure process 104 cash flows, estimation of 1 3 0 -3 com paring mutually exclusive projects that have different lives 1 3 9 -4 5

public vs private ownership 2 4 2 -3 purchasing power of money 6

3 0 7 -8 residential mortgage-backed securities (RMBS) 223

definition 5 6 4 on a futures contract 513

retailing (inventory costs) 6 5 0 -1

minimum value 5 7 6 -7

retirement decisions (projects) 1 4 6 -7

payoff structure 5 6 6 -7 pricing 5 7 1 -3 PXT Ltd 4 2 0

methods 1 0 4 -7

payback period 1 1 8,

qualitative factors (selection

Qantas 2 4 4 , 2 9 7 -8

120-1

residual dividend policy 3 1 9

return

of projects) 156 Queensland Gas Com pany (QGC) 261 quick ratio 6 9 6

481-

2

482-

3

net share issues 4 8 4 predictive future returns 483- 6 presence o f seasonal effects of returns 4 8 2 -3 price-earnings ratio 4 83 relationship between past and future returns 481 - 2 short-term patterns 481 size 4 8 4 -5 revolving credit bill facility 2 9 4 Rhee, S.G. 481 Richardson, G . 3 9 7 rights issues 2 5 3 -6 0 , 5 9 5 -6 accelerated 2 5 9 -6 0 designing a successful 2 5 7 -9 disclosure and regulation 2 5 6 significance 2 5 6 -7 traditional 2 5 9 -6 0 and underwriters 2 6 0 risk 5 analysis (projects) 1 4 9 -5 3 of assets 179 business 3 5 7 and certainty equivalents 4 3 7 -9 and cost o f capital 4 1 8 -1 9

a dditional factors that explain returns 197- 8

Q

project selection with

reset preference shares

residual value (project evaluation) 131

and net present value method 1 3 0 -4

1 4 9 -5 3

reserve borrow ing capacity 41 1

put option

1 5 3 -6 discounted cash flo w

project risk, analysing

(RBAj 2 1 3 , 2 2 1 , 2 6 6 -7 , 2 7 8

residual claim 2 3 4

decision-tree analysis

methods 1 0 8 -1 7 and inflation 1 3 1 -3

(projects) 1 4 7 -9 repurchasing shares 3 1 8 -1 9 Reserve Bank o f Australia

pure plays 4 3 2 put-call parity 5 7 3 -6

economic value added (EVA) 1 2 1 -2

and cost o f capital 4 1 8 -1 9 portfolio performance appraisals 198-

203

independence 4 1 9 of an individual asset 187 interest rate 81 - 2 investor's utility function 1 7 6 -9 portfolio theory and diversification

Q uintro Electronics Ltd 65 9 , 6 6 0 -1

portfolio theory and diversification 1 7 9 -9 0

1 7 9 -9 0 and return 1 7 3 -6

qualitative factors (selection of

QR National 2 4 5 -6 , 2 4 7

and risk 1 7 3 -6

systematic risk 6, 1 8 6 -7

projects) 156 and real options 5 9 7 -8

R Rajan, R. 3 9 5 , 401

4 8 0 , 4 8 1 -6

risk-averse investor 6, 176

and real options

Rajgopal, S. 4 8 4 Ralph Review 623

accounting accruals 484

risk aversion 6

Ramos, S.B. 4 9 4 Rampini, A. 4 6 7

asset growth 4 8 4

risk-free interest rate 195, 571

book-to-market ratio

risk-neutral investor 176

rate o f return 2 9 -3 0 , 173 accounting 1 18 -2 0

485— 6 daily return patterns 482

risk neutrality 5 7 9 risk premium 8 5 , 87

definition 4 8 0

risk-seeking investor 176

resource constraints 1 5 7 -8

analysis 1 2 3 -4 resource constraints 1 5 7 -8 retire (abandon) or replace a project 1 4 6 -9

744

real options analysis 1 2 3 -4

issue 2 5 6 Reinganum, M.R. 4 8 3

accounting rate of return

dividend yield 483 long-term patterns monthly return patterns

selection (qualitative factors) 156

prospectuses 2 4 0 -1 public company, floating

profitability ratios 6 9 5 -6

raw materials inventories 6 5 0 , 651

constraints 1 5 7 -8 proportional bid 6 2 2

curve 15 profitability index 1 1 7 -1 8

Raven Enterprises Ltd (REL) 2 5 4 -5

See also rate o f return return predictability, tests of

measuring 4 9 -5 0

return and CAPM 197 unsystematic risk 6, 1 8 6 -7

Index

risky assets, pricing of 1 9 0 -7 CAPM and the security market line 1 9 2 -4 capital market line 1 9 1 -2 implementation of CAPM 1 9 5 -7 risk, return and CAPM 197 risky coupon-paying debt 5 9 6 -7 risky zero-coupon debt 5 9 6 Ritter, J.R. 196, 2 4 7 , 2 4 9 , 25 0 , 2 5 1 ,2 5 2 Rock, K. 2 48 Roll, Richard 197, 6 3 2 Rose, L 332 Ross, M. 345 Rozeff, M . 4 8 2 Royal Dutch Shell 6 2 7 Ruback, R. 6 3 6 , 6 3 7 Rubenstein, M . 4 9 7

share buybacks 3 1 8 -1 9 , 3 3 9 -4 5 in Australia 3 4 3 -4 why companies repurchase shares 3 4 0 -3 share consolidations 2 6 9 share options company-issued 2 6 2 -3 share price index futures contracts valuation 5 4 1 -2 share price index (SPI 200) futures contract 5 3 6 -4 0 , 5 9 4 -5 share price response to new financing 4 0 2 share splits 2 6 8 -9 shareholders 4 conflict of interest with lenders 3 7 9 -8 0 conflict of interest with

S safety stock 6 5 8 Saint, M ichael 5 3 8 -9 sale and lease back agreements 4 5 3 -4 Sarin, A. 3 3 6 Sault, SJ. 4 8 1 ,4 8 4 Sawicki, J. 4 8 5 scalping 5 1 6 schemes o f arrangement (takeovers) 6 2 2 -3 Schwert, G . 6 2 6 seasonal effect on returns 4 8 2 -3 seasoned equity offering (SEOs) 251 secondary market transactions 2 8 9 secondary markets 21 2 securities

Societe Generale 5 4 0

valuation assuming certainty 7 6 -7

sole proprietorship 3 Soltes, E. 3 3 4

valuation of 7 6 -8 0

special purpose vehicle

valuation under

(SPV) 2 23

unc^rtai 门ty 7 7 -8 volatility o f 5 7 0 , 5 7 5

specification differences 5 2 0 -1

See a lso ordinary

speculation

shares; preference shares share’s systematic risk 1 9 5 -6 Sharpe, W illiam 190, 1 9 9 -2 0 0 Sharpe ratio (portfolio

10-year bond futures 5 3 2 -5 SPI 2 0 0 futures 5 3 7 speculators 5 0 8 , 5 1 5 speculating 5 1 5 -1 7 currency swaps 5 5 2 -3 interest rate swaps 5 4 7

limited lia b ility 2 3 4

stable (or progressive) dividend policy 3 1 9 -2 0

and payout policy 3 1 9 -2 4

short hedge 5 1 7 short selling 51 1

Stafford, E. 6 0 6 , 6 0 7 , 630, 634

rights 2 35

shortfall facility 258

standard deviation 174 Stanton, R. 3 98

shareholders' consumption opportunities and preferences 12

shortfall shares 2 58 short-term asset management 6 4 8 -9 , 6 6 7 , 6 9 6 -7

Sharemarket Research Ltd

short-term assets 6 4 9

(SRL) 4 5 9 -6 0 , 4 6 3 shares 5

introduction 6 4 7 , 6 6 7 types 6 4 8 short-term borrowing

bonus issues 2 6 8 -9 company-issued options 2 6 2 -3 contributing 262 employee share options 3 42 employee plans 2 6 5 -6 franked dividends 3 1 7

fully paid and partly paid 2 3 4 placements (private issues) 2 6 0 -1

security for debt 2 8 0 -1

price-earnings ratio

security market line and the CAPM 1 9 2 -4 security selection (portfolio

7 9 -8 0 , 4 83 pricing a new issue 2 4 3 -4

performance) 199 self-managed superannuation

purchase plans 262 repurchasing 31 8 -1 9

funds (SMSFs) 2 25 Sembawang Kimtrans Ltd 6 28

rights issue 2 5 3 -6 0 selling a new

Shapiro 4 0 8

4 0 2 , 4 0 4 -5 , 4 0 8 , 469, 470

258, 260 valuation 7 9 -8 0

spreads 5 16

3 2 9 -3 2 franking premium 421

sensitivity analysis 149-51 Seyhun, H. 4 93

Smith, C.W . 2 5 1 ,2 5 5 , 4 0 0 ,

495, 497, 636 Shiller, Robert 4 7 8 , 4 9 5 , 4 9 7

franking credits 31 8,

unlisted 2 4 0 -1 securitisation 2 2 3 -4

issue 2 4 4 -6 ,

Shleifer, A. 3 3 6 -7 , 4 8 2 ,

and Fisher’s Separation Theorem 1 5 -1 6

investors in 4 9 7 -9 random selection of 4 9 8 short-term 6 7 3

managing a new

Skinner, D. 3 2 4 , 3 3 3 , 3 3 4 , 343

spin-offs 4 0 3 -4 , 6 2 7 -8 spot price 5 1 4 spreading 5 1 6 -1 7

definition 2 7 6 listed 241

underwriting and

Skeels, C. 3 3 1 -2

performance) 1 9 9 -2 0 0 Shekhar, C. 2 4 7

com pany managers 3 8 0 -1

Saadi, S. 106, 124

subsequent issues of 2 5 2 -6 5

from banks/financial institutions 2 8 2 -4 short-term financial decisions 6 4 7 short-term investments 6 4 8 types of 6 7 4 -5

stapled securities 2 2 9 , 233 static trade-off theory 3 8 1 -2 , 394, 403, 4 0 6 -7 Stein, J.C. 4 8 2 step-up preference shares (SPSs) 3 0 8 stock exchange 2 1 6 -1 7 automation of trading 2 1 6 stockbrokers 2 1 7 stockout costs 651

short-term liabilities 6 4 9

Stoll, H.R. 5 7 3 straddling 5 1 7

short-term securities 673 Shyam-Sunder, L 4 0 3

strike price 5 6 4 Stulz, R. 6 3 6

signalling to investors

subordinated debt 2 7 9

3 3 2 -5 , 3 4 0 -1 simple annuity 63 simple interest 3 1 -3 applications 3 2 -3 basic idea 31 definition 31 formula development 3 1 -2 Simultaneous Accelerated Renounceable Entitlement O ffer (SAREO) 2 5 9

subscription price 2 5 3 Suncorp-Metway 2 6 0 sunk costs (project evaluation) 131 superannuation funds 2 2 5 -8 Swaminathan, B. 3 3 3 -4 , 346, 482 swaps 5 0 8 , 5 4 4 -5 6 currency 5 4 4 , 5 5 1 -5 definition 5 4 4

simulation 1 5 2 -3

interest rate 5 4 4 -5 2 sweetened debt 3 0 4

shareholder rights 235

Sinclair, N . 4 9 2

Symbion Health 6 2 4

shortfall 2 58

size effect 4 8 4 -5

syndicated loan 2 8 7

issue 2 4 6

745

Index

1 estimating cost for a

synergy 608

share-exchange takeover 6 1 7 -1 8

systematic risk 6, 1 8 6 -7

T takeover defences 6 2 5 -7

takeovers, reasons for 6 0 8 -1 4 complementary

acquisition by friendly

assets 6 0 9

parties 6 2 5

cost reductions 6 1 0 diversification benefits

claims and appeals 6 2 6 disclosure of favourable inform ation 6 2 5 -6 effects o f 6 2 6 -7

6 1 0 -1 1 evaluation of 6 0 9 -1 2

poison pills 6 2 5

excess liquidity 61 1 free cash flo w 61 1 increased earnings per

takeovers 6 0 5 -3 9 and acquiring company

share 61 2 increased market power 6 1 0

6 3 1 -3 alternative valuation approaches 6 1 8 -1 9

motives 61 3 price-earnings ratio

break fees 6 2 4

effects 6 1 2

conglomerate 6 08

roles 6 1 3 -1 4 target company management 6 0 9

controls 6 2 3 corporate governance 6 2 4 creeping 6 22

target company undervalued 6 0 9

definition 6 0 6

tax benefits 61 1

disclosure requirements 6 2 1 -2 distinguishing between good and bad 6 3 6 em pirical evidence 6 3 0 -8 fluctuations in activity

Takeovers Panel 6 1 9 target com pany 6 0 6 , 6 0 9 , 631 management 6 0 9 valuation 6 0 9 Tasman Industries Ltd

6 0 6 -7 horizontal 6 0 7 introduction 6 0 6 -8 long-term abnorm al

tax benefits o f takeovers 61 1

system; imputation tax system tax issues in project

time value of money 5, 30-1 timing o f cash flows (project

effect on net cash flow 1 3 4 -7

Titman, S. 198, 3 7 8 -9 , 3 9 8 , 4 8 1 ,4 8 2 , 4 8 4

tax loss selling 4 83 Taylor, S. 2 4 7 , 24 8 ,

Toyota M otor Corporation 6 6 1 -2

Ten Network Holdings 245 term loans 2 8 7 , 2 8 8 -9

trade credit 6 7 5 transaction costs 3 2 4 -5

term structure 8 2 -3

Treasury bond futures

empirical evidence 8 8 -9 and inflation 89 o f interest rates 8 2 -9

Treasury W in e Estates 651 Treasury’s currency swaps

terminal value of the contract 4 7

Treynor, Jack 2 0 0 Treynor ratio (portfolio

4 8 0 , 4 9 3 -5 tests o f return predictability 4 8 0 , 4 8 1 -6

asset growth 4 8 4 book-to-market ratio 485— 6

481-

2

monthly return patterns 482- 3 net share issues 4 8 4

comments on estimation of takeover gains 6 1 5 -1 6 comparing gains and costs 6 1 6 -1 7

im putation 3 1 7 im putation and capital

2 4 4 -6 , 2 5 8 , 2 6 0 unique risk 6 unlisted securities 2 4 0 unit trusts 2 2 8 -9 unsecured notes 2 9 7 unsubordinated debt 2 7 9 unsystematic risk 6, 1 8 6 -7

predictive future returns

Upton, C. 4 6 8 -9 utility function, inverter's

6 2 3 -4 effects on capital

vertical takeovers 6 0 8

3 9 9 -4 0 0 underreaction 4 7 9 underwriting a new issue

types of 6 0 7 -8 valuation based on

takeovers, economic evaluation o f 6 1 4 -1 8

underinvestment and debt

patterns 4 8 2

effects of returns

system 3 7 4 -7

valuation o f shares under 7 7 -8 0

accruals 4 8 4

system 3 2 5 -7

earnings 61 8 -1 9

u uncertainty 25

effects of takeovers

structure under a imputation tax

performance) 2 0 0 -1

accounting

tax effects 6 2 3 -4

assets 6 1 9 valuation based on

crash 5 5 3

tests for private information

483- 6 presence o f seasonal

sources of gains 6 3 7 -8

6 6 7 -8

theories 8 5 -8 term to e xpiry (options) 5 6 9 -7 0

dividend policy with

dividends and imputation tax

contracts 5 3 2 -5 treasury stock 31 8 treasury management

to price bonds 8 3 -5

partial 6 2 2

schemes of arrangement 6 2 2 -3

3 0 6 -7

Telstra 2 4 4 , 3 3 6 , 3 3 8 Tehranian, H. 4 0 3 -4

off-market bids 6 2 0 -1

regulation 6 1 9 -2 4

Tobin's Q 3 3 6 Toll Holdings 2 6 8 , 6 2 6 , 6 2 8 Toowomba Resources Ltd

250, 252

dividend yield 4 8 3 long-term patterns

imputation and capital gains tax 3 2 8 -9

evaluation) 131

technical analysis 4 9 7

and cost of capital 4 1 9 -2 1

poor investments? 6 3 3 -5

Thomas, S. 6 3 8 Thorburn, K. 6 2 7 , 6 3 5

cash-flow information, illustration 13 7 -9

d a ily return

net effect o f 6 3 6 - 7

Theobold, M . 3 3 3 Thomas, J. 197

evaluation 13 4 -9

capital structure 3 9 5 -7 company income 3 6 9 -7 1

returns 635 market bids 621

746

(TIL) 4 2 4

S e e a lso classical tax

1 7 6 -9 Uylangco, K. 4 9 4

4 8 2 -3 price-earnings ratio 4 83 relationship between past and future returns 481 - 2 short-term patterns 481 size 4 8 4 -5

V valuation based on assets (takeovers) 6 1 9 valuation based on earnings (takeovers) 6 1 8 -1 9

gains tax 3 2 7 -8 and leases 4 5 6 , 4 6 3 -4

Thaler, R. 3 3 3 , 4 8 2 , 496, 497

leasing and com pany tax 4 6 6 -7

Theobald, M . 2 58 theoretical ex-rights share

multiple cash flows

personal 3 7 1 -3 position 4 1 0

price 2 5 4 theoretical rights price 2 5 4

4 6 -5 0 formula development 48

valuation of bank bill futures contracts 5 4 0 -1 valuation of contracts with

Index

measuring rate of return 4 9 -5 0 present value 4 7

variable interest rate loans 62 variable-rate term loans

terminal value 4 7 value additivity 4 6 -7

variance 174

valuation of debt securities 80-1

2 8 6 -7 Veda G roup 2 4 4 Velayuthen, G . 2 4 7 , 2 5 2 Venkatachalam, M . 4 8 4

valuation of financial futures contracts 5 4 0 -2

venture capital 2 3 9 Vermaelen, T. 341

valuation of share price

vertical takeovers 6 0 8

index futures contracts 5 4 1 -2 valuation of shares 7 6 -8 0 valuation of levered shares and risky coupon-paying debt 5 9 6 -7

Vijh, A. 6 35 Vishney, R. 3 3 6 -8 , 4 8 2 , 6 3 6 Vital 6 2 7 volatility o f shares 5 7 0 , 5 7 5

W

valuation of levered shares and risky zero-coupon

W akeman, D. 4 3 4 Wakeman, L.M. 4 6 9 ; 4 7 0

debt 5 9 6 value (concept in finance) 5

W a ld , J. 3 9 5 , 4 0 2 W alker, S. 331

value additivity 4 6 - 7 value at risk 18 7 -9

W alkling, R. 6 3 6

Vanguard 4 9 9

W alter, T. 2 4 7 , 2 4 8 , 2 5 0 , 252, 638

W ang, J. 4 8 1 ,4 9 7

W oolworths 24 4 ,

W arner, J. 3 98 Watts, R. 4 0 0 , 4 0 5 , 4 0 8

3 4 3 -5 , 6 4 7 w ork in progress inventory

weighted average cost of capital (WACC) 4 2 2 -3 , 4 3 1 ,4 3 5 ,

W otif.com 395 W right, S. 3 9 4

4 3 6 -7 Welch, I. 2 4 7 , 2 4 9 , 3 3 4

650

W urgler, J. 3 3 9 , 4 0 4 , 631

Wermers, R. 4 8 2

X

Wesfarmers 2 88 Western Computer

Xstrata 6 2 4

Services Ltd (WCS)

Y

4 6 1 -2

Yan Du, D. 4 8 1 ,4 8 2

Westpac Banking Corporation 2 2 2 , 5 8 9 -9 0 , 6 2 3 -4

yield curve 84

W haley, Robert 5 8 7

Zechner, J. 3 98 Zenacom Ptyh Ltd 3 9 9

W H K G roup 2 68 wholesaling (inventory costs) 6 5 0 -1 w ithholding tax 31 8 W M C Resources 6 2 4 W om ack, K. 3 33

Z

zero-coupon bonds 82 zero-coupon debt 5 9 6 Zhang, F. 6 3 2 Zhang, L. 198, 4 8 1 , 4 8 6 Zingales, L. 3 9 5 , 4 0 1 ,4 0 2

747

ABBREVIATIONS APRA...

Australian Prudential Regulation Authority

APT … •

arbitrage pricing theory

ASIC...

Australian Securities and Investments Commission

ASX…

Australian Stock Exchange

CAPM .

capital asset pricing model

CGT....

capital gains tax

C M L ...

capital market line

CPI

Consumer Price Index

DCF ....

discounted cash flow

DES…

dividend election scheme

DRP…

dividend reinvestment plan

EAV…

equivalent annual value

EBIT.....

earnings before interest and tax

EMH ….

efficient market hypothesis

E〇Q._.

economic order quantity

EPS …

earnings per share

EVA…

economic value added

FRA…

forward-rate agreement

FV.......

future value

GST…

goods and services tax

IPO .....

initial public offering

IRR……

.internal rate of return

LIBOR..

London interbank offered rate

NIF

note issuance facility

NPV....

.net present value

O IS .....

offer information statement

PAR … .

.prime assets ratio

PV.......

.present value

RBA…

.Reserve Bank o f Australia

SEATS..

.Stock Exchange Automated Trading System

SFE …

.Sydney Futures Exchange

TLC …

.transferable loan certificate

WACC

.weighted average cost of capital

Now in its 44th year of publication, this 12th edition of the iconic and market-leading Business Finance continues to provide rigorous and authoritative coverage of major corporate finance topics. The only wholly Australian textbook offered at this level, its strong analytical approach is well suited to students continuing further studies in corporate finance.

W h a t’s new ? • Currency：New developments as well as important topics in the field are incorporated, including revised coverage of behavioural finance and a new appendix on the Australian taxation system in Chapter 14. • Real world examples：Covering highly technical concepts, the text deals with complex theories in conjunction with real world examples in order to better assist student learning and more adequately prepare students for future careers in finance. • Easy navigation：With clear differentiation between the concepts, cases, questions and worked examples, students can follow the text with ease. •Di g i t a l resources：The updated Connect digital package is the perfect accompaniment to the text. It will not only assist student learning, but will also provide teaching and assessment support for instructors.

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