Find a company that is within the United States. This company will be used in next weeks assignments. Find the last three years of financial statements. Define who the company is, what they do and then forecast the financials for the organization to 2030. What policies would need to change financially? What would be different for cash flow and budget? With forecasting you will need to use NPV(Net Present Value ), FV( Future value) and more.

Summary:

Find a company that is within the United States. This company will be used in next weeks assignments. Find the last three years of financial statements. Define who the company is, what they do and then forecast the financials for the organization to 2030. What policies would need to change financially? What would be different for cash flow and budget?

With forecasting you will need to use NPV(Net Present Value ), FV( Future value) and more. Show your work and define clearly how you used the equations and came up to with the data that you have.

This assignment should be no less than 4 pages, not including title and references.

Essential Activities:

Reading Chapter 6, 12, 14 and 15 in the text will assist you.

Watching the video Budgets (4:27 minutes) will assist you with this paper.

Notes:

This paper must be formatted in APA Style 7th edition.

Please refer to the written assignment rubric on the start here tab for this paper.

This paper is due Saturday.

Be very detailed in your explanation.

https://www.sec.gov/edgar/searchedgar/companysearc… this link could you help you to find 10-K (annual reports) and 10-Q (quarterly reports)

attachment excel is what we used in class for forecasting.

Requirements: in-depth example

178cor91411_ch06_178-225.indd 178 01/20/17 03:45 PMviewpointsPART FOURBusiness ApplicationDPH Corporation needs to issue new bonds either this year or in two years. DPH Corp. is a profitable firm, but if the U.S. economy were to experience a downturn, the company would see a big drop in sales over the next two years as its products are very sensitive to changes in the overall economy. DPH Corp. currently has $10 million in public debt outstanding, but its bonds are not actively traded. What questions must DPH Corp. consider as its managers decide whether to issue bonds today or in two years? How can DPH Corp. get these bonds to potential buyers and thus raise the needed capital? (See the solution at the end of the chapter.)Personal ApplicationJohn Adams wants to invest in one of two corporate bonds issued by separate firms. One bond yields 8.00 percent with a 10-year maturity; the other offers a 10.00 percent yield and a 9-year maturity. The second bond seems to be the better deal if one only looks at the interest rate. Is it necessarily the bond in which John should invest? Once he decides which bond represents the better investment, how can John go about buying the bond? (See the solution at the end of the chapter.)Should John consider bonds from other countries?Understanding Financial Markets and Institutions6Final PDF to printer

179cor91411_ch06_178-225.indd 179 01/20/17 03:45 PMLearning Goals LG6-1 Differentiate between pri-mary and secondary markets and between money and capital markets. LG6-2 List the types of securities traded in money and capital markets. LG6-3 Identify different types of financial institutions and the services that each provides. LG6-4 Know the main suppliers and demanders of loanable funds. LG6-5 Understand how equilibrium interest rates are determined. LG6-6 Analyze specific factors that influence interest rates. LG6-7 Offer different theories that explain the shape of the term structure of interest rates. LG6-8 Demonstrate how forward interest rates derive from the term structure of interest rates.© Brand X Pictures/PunchStockHow do funds flow throughout the economy? How do finan-cial markets operate and relate to one another? As an individual investor or a financial manager you need to know. Your future decision-making skills depend on it. InvestorsÕ funds flow through financial markets such as the New York Stock Exchange and mortgage markets. Financial institutionsÑcommercial banks (e.g., Bank of America), investment banks (e.g., Morgan Stanley), and mutual funds (e.g., Fidelity)Ñact as inter-mediaries to channel funds from individual savers or investors through financial markets. This chapter looks at the nature and operations of finan-cial markets and discusses the finan-cial institutions (FIs) that participate in those markets. Bonds, stocks, and other securities that trade in the mar-kets are covered in Chapters 7 and 8.In this chapter we also examine how significant changes in the way financial institutions deliver ser-vices played a major role in forming the severe financial crisis that began in late 2008. We examine some of the crisisÕs underlying causes, review some of the major events that occurred during that time, and discuss some resulting regulatory and industry changes that are in effect today in Appendix 6A, avail-able in Connect or at mhhe.com/Cornett4e.Final PDF to printer

180 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 180 01/20/17 03:45 PM6.1 ∙ Financial MarketsFinancial markets exist to manage the flow of funds from investors to borrowers as well as from one investor to another. We generally differentiate financial markets by their primary financial instrumentsÕ characteristics (such as bond maturities) or the marketÕs location. Specifically, we can distinguish markets along two major dimensions: 1. Primary versus secondary markets. 2. Money versus capital markets.Primary Markets versus Secondary MarketsPRIMARY MARKETS Primary markets provide a forum in which demanders of funds (e.g., corporations such as IBM or government entities such as the U.S. Treasury) raise funds by issuing new financial instruments, such as stocks and bonds. Corporations or government entities continually have new projects or expanded production needs, but do not have sufficient internally generated funds (such as retained earnings) to support their capital needs. Thus, corporations and governments issue securities in external pri-mary markets to raise additional funds. These entities sell the new financial instrument issues to initial fund suppliers (e.g., households) in exchange for the funds (money) that the issuer requires.In the United States, financial institutions called investment banks arrange most pri-mary market transactions for businesses. Some of the best-known examples of U.S. invest-ment banks include Morgan Stanley, Goldman Sachs, or Merrill Lynch (owned by Bank of America, a commercial bank). These firms intermediate between issuing parties (fund demanders) and investors (fund suppliers). Investment banks provide fund demanders with a number of services, including advising the company or government agency about the securities issue (such as an appropriate offer price and number of securities to issue) and attracting initial public purchasers of the customerÕs securities offerings. Firms that need funds are seldom expert at raising capital themselves, so they avert risk and lower their costs by turning to experts at investment banks to issue their primary market securities.The initial (or primary market) sale of securities occurs either through a public offer-ing or as a private placement to a small group of investors. An investment bank serves as a security underwriter in a public offering. In a private placement, the security issuer engages the group of buyers (usually fewer than 10) to purchase the whole issue. Buy-ers are typically financial institutions. To protect smaller individual investors against a lack of disclosure, publicly traded securities must be registered with the Securities and Exchange Commission (SEC). Private placements, on the other hand, can be unregistered and resold to large, financially sophisticated investors only. Large investors supposedly possess the resources and expertise to analyze a securityÕs risk. Privately placed bonds and stocks traditionally have been among the most illiquid securities in the securities markets; only the very largest financial institutions or institutional investors are able or willing to buy and hold them in the absence of an active secondary market. Issuers of pri-vately placed securities tend to be less well known (e.g., medium-sized municipalities and corporations). Because of this lack of information and its associated higher risk, returns paid to holders of privately placed securities tend to be higher than those on publicly placed securities issues.Figure 6.1 illustrates a time line for the primary market exchange of funds for a new issue of corporate bonds or equity. We will further discuss how companies, the U.S. Treasury, and government agencies that market primary government securities, such as Ginnie Mae and Freddie Mac, go about selling primary market securities in Chapter 8. Throughout this text, we focus on government securities from the buyerÕs, rather than the sellerÕs, point of view. You can find in-depth discussions of government securities from the sellerÕs point of view in a public finance text.LG6-1financial marketsThe arenas through which funds flow.primary marketsMarkets in which corpora-tions raise funds through new issues of securities.investment banksBanks that help companies and governments raise capital.commercial banksDepository institutions whose major assets are loans and whose major liabilities are deposits.Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 181cor91411_ch06_178-225.indd 181 01/20/17 03:45 PMPrimary market financial instruments include stock issues from firms initially going public (e.g., allowing their equity shares to be publicly traded on stock markets for the first time). We usually refer to these first-time issues as initial public offerings (IPOs). For example, on June 16, 2015, Fitbit announced a $732 million IPO of its common stock. Fitbit used several investment banks, including Morgan Stanley, Deutsche Bank, and Bank of America Merrill Lynch, to underwrite the companyÕs stock. Publicly traded firms may issue additional bonds or stocks as primary market securities. For example, on February 25, 2015, American Tower Group announced that it would sell an additional 23.5 million shares of common stock (at $97.00 per share) underwritten by investment banks such as Goldman Sachs,  Bank of America Merrill Lynch, Barclays, Citigroup and J.P. Morgan. The funds were used to finance the acquisition of Verizon. If the acquisition of Verizon was not completed, American Tower expected to use the net proceeds from the offering for general corporate purposes.SECONDARY MARKETS Once firms issue financial instruments in primary markets, these same stocks and bonds are then tradedÑthat is, bought and resoldÑin secondary markets. The New York Stock Exchange (NYSE) and the NASDAQ are two well-known examples of secondary markets for trading stocks (see Chapters 7 and 8). In addition to stocks and bonds, secondary markets also exist for financial instruments backed by mort-gages and other assets, foreign exchange, and futures and options (i.e., derivative securi-ties, discussed later in the chapter).Buyers find sellers of secondary market securities in economic agents that need funds (fund demanders). Secondary markets provide a centralized marketplace where economic agents know that they can buy or sell most securities quickly and efficiently. Secondary markets, therefore, save economic agents the search costs of finding buyers or sellers on their own. Figure 6.2 illustrates a secondary market transfer of funds. Secondary market buyers often use securities brokers such as Charles Schwab or other brokerage firms to act as intermediaries as they exchange funds for securities (see Chapter 8). An impor-tant note: The firm that originally issued the stock or bond is not involved in secondary market transactions in any wayÑno money accrues to the company itself when its stock trades in a secondary market.Secondary markets offer benefits to both investors (fund suppliers) and issuers (fund demanders). Investors gain liquidity and diversification benefits (see Chapter 10). Although corporate security issuers are not directly involved in secondary market transactions, issu-ers do gain information about their securitiesÕ current market value. Publicly traded firms can thus observe how investors perceive their corporate value and their corporate deci-sions by tracking their firmsÕ securitiesÕ secondary market prices. Such price information allows issuers to evaluate how well they are using internal funds as well as the funds initial public offerings (IPOs)The first public issue of financial instruments by a firm.secondary marketsMarkets that trade financial instruments once they are issued.FIGURE 6.1Primary Market Transfer of Funds→→→→→→→→←←←←→→→→←←←←←←←←Primary Markets(Where new issues of Þnancial instruments are offered for sale)Demanders offunds(corporationsissuingdebt/equityinstruments)UnderwritingwithinvestmentbankInitialsuppliersof funds(investors)SecuritiesCashFinancial instrument ßowFunds ßowSecuritiesCashFinal PDF to printer

182 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 182 01/20/17 03:45 PMgenerated from previously issued stocks and bonds and provides indications about how well any subsequent bond or stock offerings might be receivedÑand at what price.Secondary market trading volume can be quite large. Trading volume is defined as the number of shares of a security that are simultaneously bought and sold during a given period. Each seller and each buyer actually contract with the exchangeÕs clearinghouse, which then matches sell and buy orders for each transaction. The clearinghouse is a com-pany whose stock trades on the exchange, and the clearinghouse runs on a for-profit basis.The exchange and the clearinghouse can process many transactions in a single day. For example, on October 28, 1997, NYSE trading volume exceeded 1 billion shares for the first time ever. On October 10, 2008 (at the height of the financial crisis), NYSE trading volume topped 7.3 billion shares, the highest level to date. In contrast, during the mid-1980s, a NYSE trading day during which 250 million shares traded was considered a high-volume day.Money Markets versus Capital MarketsWe noted that financial markets are differentiated in part by the maturity dates of the instruments traded. This distinction becomes important when we differentiate money markets from capital markets. Both of these markets deal in debt securities (capital markets also deal in equity securities); the question becomes one of when the securities come due.MONEY MARKETS Money markets feature debt securities or instruments with maturities of one year or less (see Figure 6.3). In money markets, agents with excess short-term funds can lend (or supply) to economic agents who need (or demand) short-term funds. The suppliers of funds buy money market instruments and the demanders of funds sell money market instruments. Because money market instruments trade for only short periods of time, fluctuations in secondary-market prices are usually quite small. With less volatility, money market securities are thus less risky than longer-term instru-ments. In the United States, many money market securities do not trade in a specific location; rather, transactions occur via telephones, wire transfers, and computer trading. Thus, most U.S. money markets are said to be over-the-counter (OTC) markets.trading volumeThe number of shares of a security that are simultane-ously bought and sold dur-ing a period.money marketsMarkets that trade debt securities or instruments with maturities of less than one year.over-the-counter marketMarkets that do not operate in a specific fixed locationÑrather, transactions occur via telephones, wire trans-fers, and computer trading.FIGURE 6.2Secondary Market Transfer of FundsSecondary Markets(Where Þnancial instruments, once issued, are traded)Financial instruments ßowFunds ßowFinancialmarketsSecuritiesbrokersOthersuppliersof fundsSecuritiesCashSecuritiesCash→→→→←←←←→→→→→→→→→→→→→→←←←←←←←←←←←←←FIGURE 6.3Money versus Capital Market Maturities030 years tomaturity1 year tomaturityNo speciÞedmaturityMoney marketsecuritiesNotes and bondsCapital Market SecuritiesStocks (equities)MaturityFinal PDF to printer

 

 

chapter 6 Understanding Financial Markets and Institutions 185cor91411_ch06_178-225.indd 185 01/20/17 03:45 PM2008 and 2009. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less than 1½ yearÕs time. This was greater than the decline during the market crash of 1937 and 1938, when it fell 49 percent. However, stock prices recovered along with the economy in the last half of 2009 and first half of 2010, rising 71.1 percent between March 2009 and April 2010. However, it took until March 5, 2013, for the DJIA to surpass its pre-crisis high of 14,164.53, closing at 14,253.77 for the day.Other MarketsFOREIGN EXCHANGE MARKETS Today, most U.S.-based companies operate globally. Competent financial managers understand how events and movements in finan-cial markets in other countries can potentially affect their own companiesÕ profitability and performance. For example, in 2015, IBM experienced a drop in revenue of 9 percent due to foreign exchange trends. Coca-Cola, which gets the majority of its sales from out-side the United States, also saw revenues decrease by approximately 6 percent as the U.S. dollar strengthened relative to foreign currencies.Foreign exchange markets trade currencies for immediate (also called ÒspotÓ) or some future stated delivery. When a U.S. corporation sells securities or goods overseas, the resulting cash flows denominated in a foreign currency expose the firm to foreign exchange risk. This risk arises from the unknown value at which foreign currency cash flows can be converted into U.S. dollars. Foreign currency exchange rates vary day to day with worldwide demand and supply of foreign currency and U.S. dollars. Investors who deal in foreign-denominated securities face the same risk.The actual number of U.S. dollars that a firm receives on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency just as much as it does on the investmentÕs performance. Firms will have to convert the foreign currency into U.S. dollars at the prevailing exchange rate. If the foreign currency depreciates (falls in value) relative to the U.S. dollar (say from 0.1679 dollar per unit of foreign currency to 0.1550 dollar per unit of foreign currency) over the investment period (i.e., the period between when a foreign investment is made and the time it comes to fruition), the dol-lar value of cash flows received will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows received from the foreign investment will increase.Foreign currency exchange rates are variable. They vary day to day with demand for and supply of foreign currency and with demand for and supply of dollars worldwide. Central governments sometimes intervene in foreign exchange markets directlyÑsuch as ChinaÕs valuing of the yuan at artificially high rates relative to the dollar. Governments also affect foreign exchange rates indirectly by altering prevailing interest rates within their own countries. You will learn more about foreign exchange markets in Chapter 19.DERIVATIVE SECURITIES MARKETS A derivative security is a financial security (such as a futures contract, option contract, or mortgage-backed security) with a value that is linked to another, underlying security, such as a stock traded in capital markets or British pounds traded in foreign exchange (forex) markets. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security changes, the value of the derivative security changes.While derivative security contracts, especially for physical commodities like corn or gold, have existed for centuries, derivative securities markets grew increasingly popu-lar in the 1970s, 1980s, and 1990s as traders, firms, and academics figured out how to spread risk for more and more underlying commodities and securities by using derivative contracts. Derivative contracts generally feature a high degree of leverage; that is, the investor only has to put up a very small portion of the underlying commodity or securityÕs value to affect or control the underlying commodity or security.foreign exchange marketsMarkets in which for-eign currency is traded for immediate or future delivery.foreign exchange riskRisk arising from the unknown value at which foreign currency cash flows can be converted into U.S. dollars.derivative securityA security formalizing an agreement between two parties to exchange a stan-dard quantity of an asset at a predetermined price on a specified date in the future.Final PDF to printer

!Want to Know More?Key Words to Search for Updates: JPMorgan, London whale, derivative trading lossesJP Morgan Chase & Co. is reeling after a huge trading bet backfired and left the bank with at least $2 billion in losses from the bad trade. This may be the end of chief executive James DimonÕs run as the so-called ÒKing of Wall Street.Ó The bankÕs Chief Investment Office (CIO), responsible for manag-ing the New York companyÕs risk, placed a series of risky bets and trades. In an article published last month, The Wall Street Journal reported that Òlarge positions taken in that office by a trader nicknamed Ôthe London whaleÕ had roiled a sector of the debt markets. The bank, betting on a continued economic recovery with a complex web of trades tied to the values of corporate bonds, was hit hard when prices moved against it starting last month, causing losses in many of its derivatives positions. The losses occurred while J.P. Morgan tried to scale back that trade.ÓIn April of 2012, The Wall Street Journal reported that investors and hedge funds were trying to take advantage of trades made by ChaseÕs London whale, Bruno Iksil, who worked out of the CIO, by making bets in the market on credit default swaps (CDSs). The CIO group previously had stop-gaps in place to protect and prevent the company from sig-nificant losses during periods of downturn in the economy. However, the Journal reports that earlier in 2012, Òit began reducing that position, [taking] a bullish stance on the finan-cial health of certain companies and selling protection that would compensate buyers if those companies defaulted on debts. Mr. Iksil was a heavy seller of CDS contracts tied to a JP MORGANÕS $2 BILLION BLUNDERfinance at work marketsbasket, or index, of companies.Ó In April of 2012, these pro-tection costs began to go up, which further contributed to the bankÕs losses.According to JP Morgan Chase company filings, Mr. IksilÕs group had approximately $350 billion in investment securi-ties, about 15% of the bankÕs total assets, on December 31, 2011. Mr. Dimon said the bank has an extensive review under way of what went wrong. ÒThese were grievous mistakes, they were self-inflicted, we were accountable and we hap-pened to violate our own standards and principles by how we want to operate the company. This is not how we want to run a business.ÓMr. Dimon held a conference call with investors and ana-lysts on May 10, stating, ÒIn hindsight, the . . . strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective . . . than we thought.Ó Dimon resolves, ÒWe will learn from it, we will fix it, we will move on, hopefully in the end, it will make us a better company.Ó Though JP Morgan Chase came through the financial crisis better off than many other financial institutions, this trading loss certainly tarnishes their reputation. Mr. Dimon reports that the loss is Òslightly more than $2 billionÓ in the second quarter of this year.Sources: Dan Fitzpatrick, Gregory Zuckerman, and Liz Rappaport, ÒJ.P.  MorganÕs $2 Billion Blunder,Ó The Wall Street Journal Online, May 11, 2012. JP Morgan Chase & Co. Business Update Call, May 10, 2012.186 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 186 01/20/17 03:45 PMDerivative securities traders can be either users of derivative contracts (for hedging and other purposes) or dealers (such as banks) that act as counterparties in customer trades for fees. An example of hedging involves commodities such as corn, wheat, or soy-beans. For example, suppose you run a flour mill and will need to buy either soft wheat (Chicago) or hard red winter wheat (Kansas City) in the future. If you are concerned that the price of wheat will rise, you might lock in a price today to meet your needs six months from now by buying wheat futures on a commodities exchange. If you are correct and wheat prices rise over the six months, you may purchase the wheat by closing out your futures positions, buying the wheat at the futures price rather than the higher market price. Likewise, if you know that you will be delivering a large shipment to, say, Europe, in three months, you might take an offsetting position in euro futures contracts to lock in the exchange rate between the dollar and the euro as it stands todayÑand (you hope) eliminate foreign exchange risk from the transaction.Derivative securities markets are the newestÑand potentially the riskiestÑof the financial security markets. Losses associated with off-balance-sheet mortgage-backed securities created and held by FIs were at the very heart of the financial crisis. Signs of significant problems in the U.S. economy first appeared in late 2006 and early 2007 when home prices plummeted and defaults began to affect the mortgage lending industry as a whole, as well as other parts of the economy noticeably. Mortgage delinquencies, particu-larly on subprime mortgages, surged in the last quarter of 2006 through 2008 as home-owners who had stretched themselves to buy or refinance a home in the early 2000s fell Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 187cor91411_ch06_178-225.indd 187 01/20/17 03:45 PMbehind on their loan payments. As mortgage borrowers defaulted, the financial institutions that held their mortgages and credit derivative securities (in the form of mortgage-backed securities) started announcing huge losses on them. These losses reached $700 billion worldwide by early 2009. The situation resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the worldÕs financial and economic sys-tems. More recently, as the nearby Finance at Work box highlights, JPMorgan Chase experienced huge losses from positions in the derivative securities markets.TIME OUT 6-1 How do primary and secondary markets differ?  6-2 What are foreign exchange markets?  6-3 What are derivatives securities? 6.2 ∙ Financial InstitutionsFinancial institutions (e.g., banks, thrifts, insurance companies, mutual funds) perform vital functions to securities markets of all sorts. They channel funds from those with surplus funds (suppliers of funds) to those with shortages of funds (demanders of funds). In other words, FIs operate financial markets. FIs allow financial markets to function by providing the least costly and most efficient way to channel funds to and from these markets. FIs play a second crucial role by spreading risk among market participants. This risk-spreading function is vital to entrepreneurial efforts, for few firms or individuals could afford the risk of launching an expensive new product or process by themselves. Individual investors take on pieces of the risk by buying shares in risky enterprises. Investors then mitigate their own risks by diversifying their holdings into appropriate portfolios, which we cover in Chapters 9 and 10. Table 6.3 lists and summarizes the vari-ous types of FIs.To understand just how important FIs are to the efficient operation of financial mar-kets, imagine a simple world in which FIs did not exist. In such a world, suppliers of funds (e.g., households), generating excess savings by consuming less than they earn, would have a basic choice. They could either hold cash as an asset or invest that cash in the LG6-3financial institutionsInstitutions that perform the essential function of chan-neling funds from those with surplus funds to those with shortages of funds.Commercial banks: Depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial bank loans cover a broader range, including consumer, commercial, and real estate loans, than do loans from other depository institutions. Because they are larger and more likely to have access to public securities markets, commercial bank liabilities generally include more nondeposit sources of funds than do those of other depository institutions.Thrifts: Depository institutions including savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Credit unions oper-ate on a not-for-profit basis for particular groups of individuals, such as a labor union or a particular companyÕs employees.Insurance companies: Protect individuals and corporations (policyholders) from financially adverse events. Life insurance companies pro-vide protection in the event of untimely death or illness, and help in planning retirement. Property casualty insurance protects against per-sonal injury and liability due to accidents, theft, fire, and so on.Securities firms and investment banks: Underwrite securities and engage in related activities such as securities brokerage, securities trad-ing, and making markets in which securities trade.Finance companies: Make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept depos-its, but instead rely on short- and long-term debt for funding, and many of their loans are collateralized with some kind of durable good, such as washer/dryers, furniture, carpets, and the like.Mutual funds: Pool many individualsÕ and companiesÕ financial resources and invest those resources in diversified asset portfolios.Pension funds: Offer savings plans through which fund participants accumulate savings during their working years. Participants then with-draw their pension resources (which have presumably earned additional returns in the interim) during their retirement years. Funds originally invested in and accumulated in a pension fund are exempt from current taxation. Participants pay taxes on distributions taken after age 55, when their tax brackets are (presumably) lower.TABLE 6.3 Types of Financial InstitutionsFinal PDF to printer

188 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 188 01/20/17 03:45 PMUsers of funds(corporations)CashSuppliers of funds(households)SecuritiesFinancial Claims(equity and debt instruments)→→→→→→→→→→→→←←←←←←←←←←←←FIGURE 6.6Flow of Funds in a World without FIssecurities issued by users of funds (e.g., corporations, governments, or retail borrowers). In general, demanders (users) of funds issue financial claims (e.g., equity and debt securities) to finance the gap between their investment expenditures and their internally generated savings, such as retained earnings. As shown in Figure 6.6, in a world without financial institutions, we would have direct transfers of funds from fund suppliers to fund users. In return, financial claims would flow directly from fund users to fund suppliers.In this economy without FIs, the amount of funds flowing between fund suppliers and fund users through financial markets would likely be quite low for several reasons: ¥ Once they have lent money in exchange for financial claims, fund suppliers would need to continually monitor the use of their funds. Fund suppliers must ensure that fund users neither steal the funds outright nor waste the funds on projects that have low or negative returns, since either theft or waste would lower fund suppli-ersÕ chances of being repaid and/or earning a positive return on their investments (such as through the receipt of dividends or interest). Monitoring against theft, misuse, or underuse of their funds would cost any given fund supplier a lot of time and effort, and of course each fund supplier, regardless of the dollar value of the investment, would have to carry out the same costly and time-consuming process. Further, many investors do not have the financial training to understand the nec-essary business information to assess whether a securities issuer is making the best use of their funds. In fact, so many investment opportunities are available to fund suppliers, that even those trained in financial analysis rarely have the time to monitor how their funds are used in all of their investments. The resulting lack of monitoring increases the risk of directly investing in financial claims. Given these challenges, fund suppliers would likely prefer to delegate the task of monitoring fund borrowers to ensure good performance to others. ¥ Many financial claims feature a long-term commitment (e.g., mortgages, corpo-rate stock, and bonds) for fund suppliers, but suppliers may not wish to hold these instruments directly. Specifically, given the choice between holding cash or long-term securities, fund suppliers may choose to hold cash for its liquidity. This is especially true if the suppliers plan to use their savings to finance consumption expenditures before their creditors expect to repay them. Fund suppliers may also fear that they will not find anyone to purchase their financial claim and free up their funds. When financial markets are not very developed, or deep, in terms of the number of active buyers and sellers in the market, such liquidity concerns arise. ¥ Even though real-world financial markets provide some liquidity services by allowing fund suppliers to trade financial securities among themselves, fund suppliers face price risk when they buy securitiesÑfund suppliers may not get their principal back, let alone any return on their investment. The price at which investors can sell a security on secondary markets such as the New York Stock Exchange (NYSE) or NASDAQ may well differ from the price they initially paid for the security. The investment community as a whole may change the securityÕs valuation between the time the fund supplier bought it and the time the fund sup-plier sold it. Also, dealers, acting as intermediaries between buyers and sellers, direct transfersThe process used when a corporation sells its stock or debt directly to investors without going through a financial institution.liquidityThe ease with which an asset can be converted into cash.price riskThe risk that an assetÕs sale price will be lower than its purchase price.Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 189cor91411_ch06_178-225.indd 189 01/20/17 03:45 PMcharge transaction costs for completing a trade. So even if an investor bought a security and then sold it the next day, the investor would likely lose money from transaction and other costs.Unique Economic Functions Performed by Financial InstitutionsBecause of (1) monitoring costs, (2) liquidity costs, and (3) price risk, most average investors may well view direct investment in financial claims and markets as an unat-tractive proposition and, as fund suppliers, they will likely prefer to hold cash. As a result, financial market activity (and therefore savings and investment) would likely remain quite low. However, the financial system has developed an alternative, indirect way for investors (or fund suppliers) to channel funds to users of funds: Financial intermediaries indirectly transfer funds to ultimate fund users. Because of monitoring, liquidity risk, and price risk costs, fund suppliers often prefer to hold financial intermediariesÕ financial claims rather than those directly issued by the ultimate fund users. Consider Figure 6.7, which more closely represents the way that funds flow in the U.S. financial system than does Figure 6.6. Notice how financial institutions standÑor intermediateÑbetween fund suppliers and fund users. That is, FIs channel funds from ultimate suppliers to ultimate fund users. Fund suppliers and users use these FIs to channel funds because of financial intermediariesÕ unique ability to measure and manage risk, and thus reduce monitoring costs, liquidity costs, and price risk.MONITORING COSTS As we noted above, a fund supplier who directly invests in a fund userÕs financial claims faces a high cost of comprehensively monitoring the fund userÕs actions in a timely way. One solution to this problem is that a large number of small investors can group their funds together by holding claims issued by an FI. In turn, the FI will invest in direct financial claims that fund users issue. Financial institutionsÕ aggrega-tion of funds from fund suppliers resolves a number of problems: ¥ First, large FIs now have much greater incentive to collect information and moni-tor the ultimate fund userÕs actions, because the FI has far more at stake than any small individual fund supplier would have. ¥ Second, the FI performs the necessary monitoring function via its own inter-nal experts. In an economic sense, fund suppliers appoint the FI as a delegated monitor to act on their behalf. For example, full-service securities firms such as Bank of America Merrill Lynch carry out investment research on new issues and make investment recommendations for their retail clients (investors), while com-mercial banks collect deposits from fund suppliers and lend these funds to ulti-mate users, such as corporations. An important part of these FIsÕ functions is their ability and incentive to monitor ultimate fund users.indirect transferA transfer of funds between suppliers and users of funds through a financial institution.delegated monitorAn economic agent appointed to act on behalf of smaller investors in collecting information and/or investing funds on their behalf.Users of fundsCashFinancial claims(equity and debt securities)Financial claims(deposits and insurance policies)CashFI(brokers)FI(assettransformers)Suppliers of funds→→→→→→→→→→→→→→→→←←←←←←←←←←↑↑↑↑↑↑↑↓↓↓↓↓↓↓FIGURE 6.7Flow of Funds in a World with FIsFinancial institutions stand between fund suppliers and users.Final PDF to printer

 

chapter 6 Understanding Financial Markets and Institutions 191cor91411_ch06_178-225.indd 191 01/20/17 03:45 PMshows the growth in bank loan secondary market trading from 1991 through 2015. Note the huge growth in bank loan trading even during the financial crisis of 2008 and 2009. When loans trade, the secondary market produces information that can substitute for the information and monitoring of banks. Further, banks may have lower incentives to col-lect information and monitor borrowers if they sell loans rather than keep them as part of the bankÕs portfolio of assets. Indeed, most large banks are organized as financial service holding companies to facilitate these new activities.More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the Òoriginate and holdÓ model of commercial banking to the Òoriginate and distributeÓ banking model. Participants in the shadow banking system include structured investment vehicles (SIVs), special pur-pose vehicles (SPVs), asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, money market mutual funds (MMMFs), and credit hedge funds. In the shadow banking system, savers place their funds with money market mutual and sim-ilar funds, which invest these funds in the liabilities of other shadow banks. Borrowers get loans and leases from shadow banks such as finance companies rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers. However, instead of the bank serving as the middleman, it is the nonbank financial service firm, or shadow bank, that inter-mediates. Further, unlike the traditional banking system, where the complete credit inter-mediation is performed by a single bank, in the shadow banking system it is performed through a series of steps involving many nonbank, unregulated financial service firms.These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking, they have little incentive to screen and monitor activities of borrow-ers to whom they originate loans. Thus, FIsÕ role as specialists in risk measurement and management is reduced.The economy relies on financial institutions to act as specialists in risk measurement and management. The importance of this was demonstrated during the global financial crisis. When FIs failed to perform their critical risk measurement and management functions, a crisis of confidence that disrupted financial markets ensued. The result was a worldwide breakdown in credit markets, as well as an enhanced level of equity market volatility.TIME OUT 6-4 List the major types of financial institutions.  6-5 What three main issues would deter fund suppliers from directly purchasing securities?  6-6 What events resulted in banksÕ shift from the traditional banking model of Òoriginate and holdÓ to a model of Òoriginate and distributeÓ? 6.3 ∙ Interest Rates and the Loanable Funds TheoryWe often speak of Òthe interest rateÓ as if only one rate applies to all financial situations or transactions. In fact, we can list tens or hundreds of interest rates that are appropriate in various conditions or situations within the U.S. economy on any particular day. LetÕs explore a bit how the financial sector sets these rates and how the rates relate to one another. We actually observe nominal interest rates in financial marketsÑthese are the rates most often quoted by financial news services. As we will see in Chapters 7 and 8, nominal interest rates (or, simply, interest rates) directly affect most tradable securitiesÕ LG6-3nominal interest ratesThe interest rates actu-ally observed in financial markets.Final PDF to printer

 

chapter 6 Understanding Financial Markets and Institutions 193cor91411_ch06_178-225.indd 193 01/20/17 03:45 PMto 4.00 percent in the early 2000s, then rose to as high as 8.25 percent in the mid-2000s. During the financial crisis of 2008 and 2009, the Fed took aggressive actions to stimulate the economy, including dropping interest rates to historic lows. As a result, the prime rate fell to 3.25 percent and stayed there until December 2015.Interest rates play a major part in the determination of the value of financial instru-ments. For example, in September 2015 the Federal Reserve unexpectedly announced that it would not raise interest rates. The financial markets reacted significantly: The Dow Jones Industrial Average declined almost 300 points, 1.75 percent in value; the interest rate on Treasury securities decreased (i.e., the yield on 10-year T-notes decreased 0.123 percent); gold prices increased 1.6 percent; and the U.S. dollar strengthened against for-eign currencies. Given the impact a change in interest rates has on security values, finan-cial institution and other firm managers spend much time and effort trying to identify factors that determine the level of interest rates at any moment in time, as well as what causes interest rate movements over time.One model that is commonly used to explain interest rates and interest rate move-ments is the loanable funds theory. The loanable funds theory views the level of interest rates as resulting from factors that affect the supply of and demand for loanable funds. It categorizes financial market participantsÑconsumers, businesses, governments, and foreign participantsÑas net suppliers or demanders of funds.Supply of Loanable FundsThe supply of loanable funds is a term commonly used to describe funds provided to the financial markets by net suppliers of funds. In general, the quantity of loanable funds sup-plied increases as interest rates rise. Figure 6.10 illustrates the supply curve for loanable funds. Other factors held constant, more funds are supplied as interest rates increase (the reward for supplying funds is higher). Table 6.4 presents data on the supply of loanable funds from the various groups of market participants from U.S. flow of funds data as of 2015.The household sector (consumer sector) is the largest supplier of loanable funds in the United StatesÑ$70.27 trillion in 2015. Households supply funds when they have excess income or want to reallocate their asset portfolio holdings. For example, during times of high economic growth, households may replace part of their cash holdings with earning assets (i.e., by supplying loanable funds in exchange for holding securities). As the total health of a consumer increases, the total supply of loanable funds from that consumer will also generally increase. Households determine their supply of loanable funds not only on the basis of the general level of interest rates and their total wealth, but also on the risk of securities investments. The greater the perceived risk of securities invest-ments, the less households are willing to invest at each interest rate. Further, the supply of loanable funds from households also depends on their immediate spending needs. For example, near-term educational or medical expenditures will reduce the supply of funds from a given household.loanable funds theoryA theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds.LG6-4Quantity of Loanable FundsSupplied and DemandedDemandSupplyInterest RateFIGURE 6.10Supply of and Demand for Loanable FundsThe demand and supply of loanable funds varies with interest rates.Final PDF to printer

194 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 194 01/20/17 03:45 PMHigher interest rates will also result in higher supplies of funds from the U.S. business sector ($22.3 trillion from nonfinancial business and $53.69 trillion from financial busi-ness in 2015), which often has excess cash, or working capital, that it can invest for short periods of time in financial assets. In addition to the interest rates on these investments, the expected risk on financial securities and their businessesÕ future investment needs will affect their overall supply of funds.Loanable funds are also supplied by some governments ($26.61 trillion in 2015). For example, some governments (e.g., municipalities) temporarily generate more cash inflows (e.g., through local taxes) than they have budgeted to spend. These funds can be loaned out to financial market fund users until needed. During the recent financial crisis, the federal government significantly increased the funds it supplied to businesses and con-sumers as it attempted to rescue the U.S. economy from a deep economic recession (see Appendix 6A online in Connect or at mhhe.com/Cornett4e).Finally, foreign investors increasingly view U.S. financial markets as alternatives to their domestic financial markets ($23.26 trillion of funds were supplied to the U.S. finan-cial markets in 2015). When interest rates are higher on U.S. financial securities than they are on comparable securities in their home countries, foreign investors increase their sup-ply of funds to U.S. markets. Indeed the high savings rates of foreign households (such as Japanese households) has resulted in foreign market participants being major suppliers of funds to U.S. financial markets in recent years. Similar to domestic suppliers of loanable funds, foreigners assess not only the interest rate offered on financial securities, but also their total wealth, the risk on the security, and their future expenditure needs. Addition-ally, foreign investors alter their investment decisions as financial conditions in their home countries change relative to the U.S. economy and the exchange rate of their countryÕs currency changes vis-ˆ-vis the U.S. dollar (see Chapter 19). For example, during the recent financial crisis, investors worldwide, searching for a safe haven for their funds, invested huge amounts of funds in U.S. Treasury securities. The amount of money invested in Trea-sury bills was so large that the yield on the three-month Treasury bill went below zero for the first time ever; investors were essentially paying the U.S. government to borrow money.Demand for Loanable Funds  The demand for loanable funds is a term used to describe the total net demand for funds by fund users. In general, the quantity of loanable funds demanded is higher as interest rates fall. Figure 6.10 also illustrates the demand curve for loanable funds. Other factors held constant, more funds are demanded as interest rates decrease (the cost of borrowing funds is lower).Households (although they are net suppliers of funds) also borrow funds in financial markets ($23.95 trillion in 2015). The demand for loanable funds by households reflects the demand for financing purchases of homes (with mortgage loans), durable goods (e.g., car loans, appliance loans), and nondurable goods (e.g., education loans, medical loans). Additional nonprice conditions and requirements (discussed below) also affect a householdÕs demand for loanable funds at every level of interest rates.Funds SuppliedFunds DemandedNet Funds Supplied (Funds Supplied Ð Funds Demanded)Households$70.27$23.95$46.32BusinessÑnonfinancial  22.30 58.15−35.85BusinessÑfinancial  53.69 81.68 −27.99Government units  26.61 18.43 8.18Foreign participants  23.26 13.92 9.34Source: Federal Reserve Board, ÒFlow of Fund Accounts,Ó December 2015, www.federalreserve.govTABLE 6.4 Funds Supplied and Demanded by Various Groups (in trillions of dollars)Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 195cor91411_ch06_178-225.indd 195 01/20/17 03:45 PMBusinesses demand funds to finance investments in long-term (fixed) assets (e.g., plant and equipment) and for short-term working capital needs (e.g., inventory and accounts receivable) usually by issuing debt and other financial instruments ($58.15 trillion for non-financial businesses and $81.68 trillion for financial businesses in 2015). When interest rates are high (i.e., the cost of loanable funds is high), businesses prefer to finance invest-ments with internally generated funds (e.g., retained earnings) rather than through bor-rowed funds. Further, the greater the number of profitable projects available to businesses, or the better the overall economic conditions, the greater the demand for loanable funds.Governments also borrow heavily in the markets for loanable funds ($18.43 trillion in 2015). For example, state and local governments often issue debt instruments to finance temporary imbalances between operating revenues (e.g., taxes) and budgeted expendi-tures (e.g., road improvements, school construction). Higher interest rates can cause state and local governments to postpone borrowings and thus capital expenditures. Similar to households and businesses, governmentsÕ demand for funds varies with general eco-nomic conditions. The federal government is also a large borrower partly to finance cur-rent budget deficits (expenditures greater than taxes) and partly to finance past deficits. The cumulative sum of past deficits is called the national debt, which in the United States in 2015 stood at a record $18.94 trillion. Thus, the national debt and especially the inter-est payments on the national debt have to be financed in large part by additional govern-ment borrowing.Finally, foreign participants (households, businesses, and governments) also borrow in U.S. financial markets ($13.92 trillion in 2015). Foreign borrowers look for the cheapest source of dollar funds globally. Most foreign borrowing in U.S. financial markets comes from the business sector. In addition to interest costs, foreign borrowers consider non-price terms on loanable funds as well as economic conditions in their home country and the general attractiveness of the U.S. dollar relative to their domestic currency (e.g., the euro or the yen). In Chapter 19, we examine how economic growth in domestic versus foreign countries affects foreign exchange rates and foreign investorsÕ demand and supply for funds.Equilibrium Interest RateThe aggregate supply of loanable funds is the sum of the quantity supplied by the sepa-rate fund-supplying sectors (e.g., households, businesses, governments, foreign agents) discussed above. Similarly, the aggregate demand for loanable funds is the sum of the quantity demanded by the separate fund-demanding sectors. As illustrated in Figure 6.11, the aggregate quantity of funds supplied is positively related to interest rates, while the aggregate quantity of funds demanded is inversely related to interest rates. As long as LG6-5LG6-5 Quantity of Loanable Funds Suppliedand DemandedInterest RateiLiHi*Q*SSDDEFIGURE 6.11Determination of Equilibrium Interest RatesInterest rates always move toward the equilibrium.Final PDF to printer

196 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 196 01/20/17 03:45 PMcompetitive forces are allowed to operate freely in a financial system, the interest rate that equates the aggregate quantity of loanable funds supplied with the aggregate quantity of loanable funds demanded for a financial security, Q*, is the equilibrium interest rate for that security, i*, point E in Figure 6.11. For example, whenever the rate of interest is set higher than the equilibrium rate, such as iH, the financial system has a surplus of loanable funds. As a result, some suppliers of funds will lower the interest rate at which they are willing to lend and the demanders of funds will absorb the loanable funds surplus. In con-trast, when the rate of interest is lower than the equilibrium interest rate, such as iL, there is a shortage of loanable funds in the financial system. Some borrowers will be unable to obtain the funds they need at current rates. As a result, interest rates will increase, caus-ing more suppliers of loanable funds to enter the market and some demanders of funds to leave the market. These competitive forces will cause the quantity of funds supplied to increase and the quantity of funds demanded to decrease until a shortage of funds no longer exists.Factors That Cause the Supply and Demand Curves for Loanable Funds to ShiftWhile we have alluded to the fundamental factors that cause the supply and demand curves for loanable funds to shift, in this section we formally summarize these factors. We then examine how shifts in the supply and demand curves for loanable funds deter-mine the equilibrium interest rate on a specific financial instrument. A shift in the supply or demand curve occurs when the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in another factor besides the interest rate. In either case, a change in the supply or demand curve for loanable funds causes interest rates to move. Table 6.5 recaps the factors that affect the supply and demand for loanable funds discussed in this section, their impact on the supply and demand for loanable funds for a specific security, and the impact on the market clearing (or equilibrium) interest rates holding all other factors constant.SUPPLY OF FUNDS We have already described the positive relation between inter-est rates and the supply of loanable funds along the loanable funds supply curve. Factors that cause the supply curve of loanable funds to shift, at any given interest rate, include the wealth of fund suppliers, the risk of the financial security, future spending needs, monetary policy objectives, and economic conditions.Panel A: The Supply of FundsFactorImpact on Supply of FundsImpact on Equilibrium Interest Rate*Interest rateMovement along supply curveDirectTotal wealthShift supply curveInverseRisk of financial securityShift supply curveDirectNear-term spending needsShift supply curveDirectMonetary expansionShift supply curveInverseEconomic conditionsShift supply curveInversePanel B: The Demand for FundsFactorImpact on Supply of FundsImpact on Equilibrium Interest RateInterest rateMovement along demand curveDirectUtility derived from asset purchased with borrowed fundsShift demand curveDirectRestrictiveness of nonprice conditionsShift demand curveInverseEconomic conditionsShift demand curveDirectTABLE 6.5 Factors That Affect the Supply of and Demand for Loanable Funds for a Financial Security*A ÒdirectÓ impact on equilibrium interest rates means that as the ÒfactorÓ increases (decreases), the equilibrium interest rate increases (decreases). An ÒinverseÓ impact means that as the factor increases (decreases), the equilibrium interest rate decreases (increases).Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 197cor91411_ch06_178-225.indd 197 01/20/17 03:45 PMWealth As the total wealth of financial market participants (households, businesses, etc.) increases, the absolute dollar value available for investment purposes increases. Accordingly, at every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. For example, as the U.S. economy grew in the early 2010s, total wealth of U.S. investors increased as well. Consequently, the supply of funds available for investing (e.g., in stock and bond markets) increased at every available inter-est rate. We show this shift (increase) in the supply curve in Figure 6.12(a) as a move from SS to SS″. The shift in the supply curve creates a disequilibrium between demand and supply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls, from i* to i*″, which is associated with an increase in the quantity of funds loaned between fund suppliers and fund demanders, from Q* to Q*″.Conversely, as the total wealth of financial market participants decreases, the absolute dollar value available for investment purposes decreases. Accordingly, at every inter-est rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The decrease in the supply of funds due to a decrease in the total wealth of market participants results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (traded).Risk As the risk of a financial security decreases (e.g., the probability that the issuer of the security will default on promised repayments of the funds borrowed), it becomes more attractive to suppliers of funds. At every interest rate, the supply of loan-able funds increases, or the supply curve shifts down and to the right, from SS to SS″ in Interest Ratei*i*”Quantity of Funds SuppliedQ*Q*”SS”SS”E”ESSDD(a) Increase in the supply of loanable fundsDDSSInterest Ratei*i*”Quantity of Funds DemandedQ*Q*”DD”DD”E”ESSDDDD(b) Increase in the demand for loanable fundsSSFIGURE 6.12The Effect on Interest Rates from a Shift in the Supply Curve of or a Demand Curve for Loanable FundsChanges in the supply of and demand for loanable funds have varying effects.Final PDF to printer

198 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 198 01/20/17 03:45 PMFigure 6.12(a). Holding all other factors constant, the increase in the supply of funds, due to a decrease in the risk of the financial security, results in a decrease in the equilibrium interest rate, from i* to i*″, and an increase in the equilibrium quantity of funds traded, from Q* to Q*″.Conversely, as the risk of a financial security increases, it becomes less attractive to suppliers of funds. Accordingly, at every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. Holding all other factors constant, the decrease in the supply of funds due to an increase in the financial securityÕs risk results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (or traded).Near-Term Spending Needs When financial market participants have few near-term spending needs, the absolute dollar value of funds available to invest increases. For exam-ple, when a familyÕs son or daughter moves out of the family home to live on his or her own, current spending needs of the family decrease and the supply of available funds (for investing) increases. At every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. The financial market, holding all other factors constant, reacts to this increased supply of funds by decreasing the equilibrium interest rate and increasing the equilibrium quantity of funds traded.Conversely, when financial market participants have increased near-term spending needs, the absolute dollar value of funds available to invest decreases. At every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve creates a disequilibrium in the financial market that results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (or traded).Monetary Expansion One method used by the Federal Reserve to implement mon-etary policy is to alter the availability of funds, the growth in the money supply, and thus the rate of economic expansion of the economy.When monetary policy objectives are to allow the economy to expand (as was the case in the late 2000s, during the financial crisis, and in the early 2010s), the Federal Reserve increases the supply of funds available in the financial markets. At every interest rate, the supply of loanable funds increases, the supply curve shifts down and to the right, and the equilibrium interest rate falls, while the equilibrium quantity of funds traded increases.Conversely, when monetary policy objectives are to restrict the rate of economic expan-sion (and thus inflation), the Federal Reserve decreases the supply of funds available in the financial markets. At every interest rate, the supply of loanable funds decreases, the supply curve shifts up and to the left, and the equilibrium interest rate rises, while the equilibrium quantity of funds loaned or traded decreases.Economic Conditions Finally, as the underlying economic conditions themselves (e.g., the inflation rate, unemployment rate, economic growth) improve in a country relative to other countries, the flow of funds to that country increases. This reflects the lower risk (country or sovereign risk) that the country, in the guise of its government, will default on its obligation to repay funds borrowed. For example, the severe economic crisis in Greece in the early 2010s resulted in a decrease in the supply of funds to that country. An increased inflow of foreign funds to U.S. financial markets increases the supply of loanable funds at every interest rate and the supply curve shifts down and to the right. Accordingly, the equi-librium interest rate falls and the equilibrium quantity of funds loaned or traded increases.Conversely, when economic conditions in foreign countries improve, domestic and foreign investors take their funds out of domestic financial markets (e.g., the United States) and invest abroad. Thus, the supply of funds available in the financial markets decreases and the equilibrium interest rate rises, while the equilibrium quantity of funds traded decreases.Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 199cor91411_ch06_178-225.indd 199 01/20/17 03:45 PMDEMAND FOR FUNDS We explained above that the quantity of loanable funds demanded is negatively related to interest rates. Factors that cause the demand curve for loanable funds to shift include the utility derived from assets purchased with borrowed funds, the restrictiveness of nonprice conditions on borrowing, and economic conditions.Utility Derived from Assets Purchased with Borrowed Funds As the utility (i.e.,  satisfaction or pleasure) derived from an asset purchased with borrowed funds increases, the willingness of market participants (households, businesses, etc.) to borrow increases and the absolute dollar value borrowed increases. Accordingly, at every interest rate, the demand for loanable funds increases, or the demand curve shifts up and to the right. For example, suppose a change in jobs takes an individual from Arizona to Min-nesota. The individual currently has a convertible automobile. Given the move to Min-nesota, the individualÕs utility from the convertible decreases, while it would increase for a car with heated seats. Thus, with a potential increased utility from the purchase of a new car, the individualÕs demand for funds in the form of an auto loan increases. We show this shift (increase) in the demand curve in Figure 6.12(b) as a move from DD to DD″. The shift in the demand curve creates a disequilibrium in this financial market. Holding all other factors constant, the increase in the demand for funds due to an increase in the util-ity from the purchased asset results in an increase in the equilibrium interest rate, from i* to i*″, and an increase in the equilibrium quantity of funds traded, from Q* to Q*″.Conversely, as the utility derived from an asset purchased with borrowed funds decreases, the willingness of market participants (households, businesses, etc.) to bor-row decreases and the absolute dollar amount borrowed decreases. Accordingly, at every interest rate, the demand for loanable funds decreases, or the demand curve shifts down and to the left. The shift in the demand curve again creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the demand for funds due to a decrease in the utility from the purchased asset results in a decrease in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned or traded.Restrictiveness of Nonprice Conditions on Borrowed Funds As the nonprice restric-tions put on borrowers as a condition of borrowing decrease, the willingness of mar-ket participants to borrow increases and the absolute dollar value borrowed increases. Such nonprice conditions may include fees or collateral. The lack of such restrictions makes the loan more desirable to the user of funds. Accordingly, at every interest rate, the demand for loanable funds increases, or the demand curve shifts up and to the right, from DD to DD″. As competitive forces adjust, and holding all other factors constant, the increase in the demand for funds due to a decrease in the restrictive conditions on the borrowed funds results in an increase in the equilibrium interest rate, from i* to i*″, and an increase in the equilibrium quantity of funds traded, from Q* to Q*″. Conversely, as the nonprice restrictions put on borrowers as a condition of borrowing increase, market participantsÕ willingness to borrow decreases, and the absolute dollar value borrowed decreases. Accordingly, the demand curve shifts down and to the left. The shift in the demand curve results in a decrease in the equilibrium interest rate and a decrease in the equilibrium quantity of funds traded.Economic Conditions When the domestic economy experiences a period of growth, such as that in the United States in the mid-2000s and early 2010s, market participants are willing to borrow more heavily. For example, state and local governments are more likely to repair and improve decaying infrastructure when the local economy is strong. Accordingly, the demand curve for funds shifts up and to the right. Holding all other factors constant, the increase in the demand for funds due to economic growth results in an increase in the equilibrium interest rate and an increase in the equilibrium quan-tity of funds traded. Conversely, when domestic economic growth is stagnant, market Final PDF to printer

200 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 200 01/20/17 03:45 PMparticipants reduce their demand for funds. Accordingly, the demand curve shifts down and to the left, resulting in a decrease in the equilibrium interest rate and a decrease in the equilibrium quantity of funds traded.Movement of Interest Rates over TimeAs discussed in the previous section of this chapter, the loanable funds theory of interest rates is based on the supply of and demand for loanable funds as functions of interest rates. The equilibrium interest rate (point E in Figure 6.12) is only a temporary equilibrium. Changes in underlying factors that determine the demand and supply of loanable funds can cause continuous shifts in the supply and/or demand curves for loanable funds. Market forces will react to the resulting disequilibrium with factors that influence a change in the equilib-rium interest rate and quantity of funds traded in that market. Refer again to Figure 6.12(a), which shows the effects of an increase in the supply curve for loanable funds, from SS to SS″ (and the resulting decrease in the equilibrium interest rate, from i* to i*″), while Figure 6.12(b) shows the effects of an increase in the demand curve for loanable funds, from DD to DD″(and the resulting increase in the equilibrium interest rate, from i* to i*″). TIME OUT 6-7 Who are the main suppliers and demanders of loanable funds?   6-8 What happens to the equilibrium interest rate when the demand for (supply of) loanable funds increases?   6-9 How do supply and demand together determine interest rates?  6.4 ∙ Factors That Influence Interest Rates for Individual SecuritiesSo far we have looked at the general determination of equilibrium (nominal) interest rates for financial securities in the context of the loanable demand and supply theory of the flow of funds. In this section, we examine the specific factors that affect differences in interest rates across the range of real-world financial markets (i.e., differences among interest rates on individual securities, given the underlying level of interest rates deter-mined by the demand and supply of loanable funds). These factors include ¥ Inflation. ¥ The real risk-free rate. ¥ Default risk. ¥ Liquidity risk. ¥ Special provisions regarding the use of funds raised by a particular security issuer. ¥ The securityÕs term to maturity.We will discuss each of these factors after summarizing them in Table 6.6.InflationThe first factor that influences interest rates is the economy-wide actual or expected infla-tion rate. Specifically, the higher the level of actual or expected inflation, the higher will be the level of interest rates. We define inflation of the general price index of goods and services (or the inflation premium, IP) as the (percentage) increase in the price of a stan-dardized basket of goods and services over a given period of time. The U.S. Department LG6-6inflationThe continual increase in the price level of a basket of goods and services.Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 201cor91411_ch06_178-225.indd 201 01/20/17 03:45 PMof Commerce measures inflation using indexes such as the consumer price index (CPI) and the producer price index (PPI). For example, the annual inflation rate using the CPI index between years t and t + 1 would be equal to IP = CPI t + 1 − CPI t ____________ CPI t × 100 (6-1)The positive relationship between interest rates and inflation rates is fairly intuitive: When inflation raises the general price level, investors who buy financial assets must earn a higher interest rate (or inflation premium) to compensate for continuing to hold the investment. Holding on to their investments means that they incur higher costs of forgo-ing consumption of real goods and services today, only to have to buy these same goods and services at higher prices in the future. In other words, the higher the rate of inflation, the more expensive the same basket of goods and services will be in the future.Real Risk-Free RateA real risk-free rate is the rate that a risk-free security would pay if no inflation were expected over its holding period (e.g., a year). As such, it measures only societyÕs relative time preference for consuming today rather than tomorrow. The higher societyÕs prefer-ence to consume today (i.e., the higher its time value of money or rate of time prefer-ence), the higher the real risk-free rate (RFR) will be.FISHER EFFECT Economists often refer to the relationship among real risk-free rates (RFR), expected inflation (expected IP), and nominal risk-free rates (i), described previously, as the Fisher effect, named for Irving Fisher, who identified these economic relationships early last century. The Fisher effect theorizes that nominal risk-free rates that we observe in financial markets (e.g., the one-year Treasury bill rate) must compensate investors for ¥ Any inflation-related reduction in purchasing power lost on funds lent or principal due. ¥ An additional premium above the expected rate of inflation for forgoing present consumption (which reflects the real risk-free rate issue discussed previously). i = Expected IP + RFR (6-2)Thus, the nominal risk-free rate will equal the real risk-free rate only when market participants expect inflation to be zero: Expected IP = 0. Similarly, the nominal risk-free rate will equal the expected inflation rate only when the real risk-free rate is zero. We can rearrange the nominal risk-free rate equation to show what determines the real interest rate:1 RFR = i − Expected IP (6-3)real risk-free rateThe interest rate that would exist on a risk-free security if no inflation were expected.Inflation: A continual increase in the price level of a basket of goods and services throughout the economy as a whole.Real risk-free rate: Risk-free rate adjusted for inflation; generally lower than nominal risk-free rates at any particular time.Default risk: Risk that a security issuer will miss an interest or principal payment or continue to miss such payments.Liquidity risk: Risk that a security cannot be sold at a price relatively close to its value with low transaction costs on short notice.Special provisions: Provisions (e.g., taxability, convertibility, and callability) that impact a security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions.Time to maturity: Length of time until a security is repaid; used in debt securities as the date upon which the security holders get their principal back.TABLE 6.6 Factors Affecting Nominal Interest Rates1Often the Fisher effect formula is written as (1 + i) = (1 + IP) × (1 + RFR), which, when solved for i, becomes: i = Expected IP + RFR + (Expected IP × RFR), where Expected IP × RFR is the inflation pre-mium for the loss of purchasing power on the promised nominal interest rate payments due to inflation. For small values of Expected IP and RFR this term is negligible. The approximation formula used here assumes these values are small.Final PDF to printer

 

 

204 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 204 01/20/17 03:45 PMinterest rates (all other characteristics remaining the same). Likewise, if a security is illiq-uid, investors add a liquidity risk premium (LRP) to the interest rate on the security. In the United States, most government securities sell in liquid markets, as do large corpora-tionsÕ stocks and bonds. Securities issued by smaller companies trade in relatively less liquid markets.A different type of liquidity risk premium may also exist if investors dislike long-term securities because their prices (present values, as discussed below and in Chapters 4 and 7) react more to interest rate changes than short-term securities do. In this case, a higher liquidity risk premium may be added to a security with a longer maturity because of its greater exposure to price risk (loss of capital value) on the longer-term security as interest rates change.Special Provisions or CovenantsSometimes a securityÕs issuing party attaches special provisions or covenants to the secu-rity issued. Such provisions affect the interest rates on these securities relative to securities without such provisions attached to them. Some of these special provisions include the securityÕs taxability, convertibility, and callability. For example, investors pay no federal taxes on interest payments received from municipal securities. So a municipal bondholder may demand a lower interest rate than that demanded on a comparable taxable bondÑsuch as a Treasury bond (which is taxable at the federal level but not at the state or local levels) or a corporate bond (the interest on which is taxable at the state, local, and federal levels).Another special covenant is convertibility: A convertible bond offers the holder the opportunity to exchange the bond for another type of the issuerÕs securitiesÑusually preferred or common stockÑat a preset price (see Chapter 7). This conversion option can be valuable to purchasers, so convertible security buyers require lower interest rates than a comparable nonconvertible security holder would require (all else equal). In general, special provisions that benefit security holders (e.g., tax-free status and convertibility) bring with them lower interest rates, and special provisions that benefit security issuers (e.g., callability, by which an issuer has the option to retire, or call, the security prior to maturity at a preset price) require higher interest rates to encourage purchase.Term to MaturityInterest rates also changeÑsometimes dailyÑbecause of a bondÕs term to maturity. Financial professionals refer to this daily or even hourly changeability in interest rates as the term structure of interest rates, or the yield curve. The shape of the yield curve derives directly from time value of money principles. The term structure of interest rates compares interest rates on debt securities based on their time to maturity, assuming that all other characteristics (i.e., default risk, liquidity risk) are equal. Interest rates change as the maturity of a debt security changes; in general, the longer the term to maturity, the higher the required interest rate buyers will demand. This addition to the required interest rate is the maturity premium (MP). The MP, which is the difference between the required yield on long- versus short-term securities of the same characteristics except maturity, can be positive, negative, or zero.The financial industry most often reports and analyzes the yield curve for U.S. Trea-sury securities. The yield curve for U.S. Treasury securities has taken many shapes over the years, but the three most common shapes appear in Figure 6.15. In graph (a), the yield curve on January 15, 2016, yields rise steadily with maturity when the yield curve slopes upward. This is the most common yield curve. On average, the MP is positive, as you might expect. Graph (b) shows an inverted, or downward-sloping, yield curve, reported on November 24, 2000, in which yields decline as maturity increases. Inverted yield curves do not generally last very long. In this case, the yield curve inverted as the U.S. Treasury began retiring long-term (30-year) bonds as the country began to pay off the term structure of interest ratesA comparison of market yields on securities, assum-ing all characteristics except maturity are the same.liquidity riskThe risk that a security can-not be sold at a predictable price with low transaction costs on short notice.Final PDF to printer

 

206 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 206 01/20/17 03:45 PM i j * = f ( IP, RFR, DR P j , LR P j , SC P j , M P j ) (6-5)whereIP = Inflation premium.RFR = Real risk-free rate.DRPj = Default risk premium on the jth security.LRPj = Liquidity risk premium on the jth security.SCPj = Special covenant premium on the jth security.MPj = Maturity premium on the jth security.The first two factors, IP and RFR, are common to all financial securities, while the other factors can uniquely influence the price of a single security.Determinants of Interest Rates for Individual SecuritiesMorningstar Corp.Õs eight-year bonds are currently yielding a return of 6.85 percent. The expected inflation premium is 1.15 percent annually and the real risk-free rate is expected to be 2.25 percent annually over the next eight years. The default risk premium on MorningstarÕs bonds is 1.35 percent. The maturity risk premium is 0.50 percent on two-year securities and increases by 0.05 percent for each additional year to maturity. Calculate the liquidity risk pre-mium on MorningstarÕs eight-year bonds.SOLUTION: 6.85% = 1.15% + 2.25% + 1.35% + LRP + [0.50% + (0.05% × 6)]= > DRP = 6.85% − [1.15% + 2.25% + 1.35% + (0.50% + [0.05% × 6] )] = 1.30% Similar to Problems 6-3, 6-4, Self-Test Problem 2EXAMPLE 6-2LG6-6 TIME OUT 6-10 What is the difference between nominal and real risk-free rates?   6-11 What does Òthe term structure of interest ratesÓ mean?   6-12 What shape does the term structure usually take? Why?  6.5 ∙ Theories Explaining the Shape of the Term Structure of Interest Rates2We just explained the necessity of a maturity premium, the relationship between a secu-rityÕs interest rate and its remaining term to maturity. We can illustrate these issues by showing that the term structure of interest rates can take a number of different shapes. As you might expect, economists and financial theorists with various viewpoints differ LG6-72This section, which contains more technical details, may be included or dropped from the chapter reading, depending on the rigor of the course.For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Final PDF to printer

chapter 6 Understanding Financial Markets and Institutions 207cor91411_ch06_178-225.indd 207 01/20/17 03:45 PMamong themselves in theorizing why the yield curve takes different shapes. Explanations for the yield curveÕs shape fall predominantly into three categories: 1. The unbiased expectations theory. 2. The liquidity premium theory. 3. The market segmentation theory.Look again at Figure 6.15 (a), which presents the Treasury yield curve as of January 15, 2016. We see that the yield curve on this date reflected the normal upward-sloping rela-tionship between yield and maturity. Now letÕs turn to explanations for this shape based on the three predominant theories noted above.Unbiased Expectations TheoryAccording to the unbiased expectations theory of the term structure of interest rates, at any given point in time, the yield curve reflects the marketÕs current expectations of future short-term rates. As illustrated in Figure 6.16, the intuition behind the unbiased expectations theory is this: If investors have a four-year investment horizon, they could either buy current four-year bonds and earn the current (or spot) yield on a four-year bond (1R4, if held to maturity) each year, or they could invest in four successive one-year bonds [of which they know only the current one-year spot rate (1R1)]. But investors also expect what the unknown future one-year rates [E(2r1), E(3r1), and E(4r1)] will be. Note that each interest rate term has two subscripts, e.g., 1R4. The first subscript indicates the period in which the security is bought, so that 1 represents the purchase of a security in period 1. The second subscript indicates the maturity on the security. Thus, 4 represents the purchase of a security with a four-year life. Similarly, E(3r1) is the expected return on a security with a one-year life purchased in period 3.According to the unbiased expectations theory, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds (as long as the market is in equilibrium). If this equality does not hold, an arbitrage opportunity exists. That is, if investors could earn more on the one-year bond invest-ments, they could short (or sell) the four-year bond, use the proceeds to buy the four successive one-year bonds, and earn a guaranteed profit over the four-year investment horizon. So, according to the unbiased expectations theory, if the market expects future one-year rates to rise each successive year into the future, then the yield curve will slope upward. Specifically, the current four-year T-bond rate or return will exceed the three-year bond rate, which will exceed the two-year bond rate, and so on. Similarly, if the market expects future one-year rates to remain constant each successive year into the future, then the four-year bond rate will equal the three-year bond rate. That is, the term structure of interest rates will remain constant (flat) over the relevant time period. Spe-cifically, the unbiased expectation theory states that current long-term interest rates are geometric averages of current and expected future short-term interest rates. The math-ematical equation representing this relationship is(1 + 1RN)N = (1 + 1R1) [1 + E(2r1)] . . . [1 + E(Nr1)] (6-6)Buy four 1-year bondsBuy one 4-year bondYear01234←(1 + 1R1) →←[1 + E(2r1)] →←[1 + E(3r1)] →←[1 + E(4r1)]Year01234← (1 + 1R4)4 →FIGURE 6.16Unbiased Expectations Theory of the Term Structure of Interest RatesReturn from buying four 1-year maturity bonds versus buying one 4-year maturity bond.Final PDF to printer

 

chapter 6 Understanding Financial Markets and Institutions 209cor91411_ch06_178-225.indd 209 01/20/17 03:45 PMLiquidity Premium TheoryThe second popular explanationÑthe liquidity pre-mium theory of the term structure of interest ratesÑbuilds on the unbiased expectations theory. The liquidity premium idea is as follows: Investors will hold long-term maturities only if these securities with longer term maturities are offered at a premium to compensate for future uncertainty in the securityÕs value. Of course, uncertainty or risk increases with an assetÕs maturity. This theory is thus consistent with our discussions of market risk and liquidity risk, above. Specifically, in a world of uncertainty, short-term securities provide greater marketability (due to their more active secondary markets) and have less price risk than long-term securities do. As a result (due to smaller price fluctuations for a given change in interest rates), investors will prefer to hold shorter-term securities because this kind of paper can be converted into cash with little market risk. Said another way, investors face lit-tle risk of a capital loss, that is, a fall in the price of the security below its original purchase price. So, investors must be offered a liquidity premium to buy longer-term securities that carry higher capital loss risk. This difference in market and liquidity risk can be directly related to the fact that longer-term securities are more sensitive to interest rate changes in the market than are shorter-term securitiesÑChapter 7 discusses bond interest rate sensitiv-ity and the link to a bondÕs maturity. Because longer maturities on securities mean greater market and liquidity risk, the liquidity premium increases as maturity increases.The liquidity premium theory states that long-term rates are equal to geometric aver-ages of current and expected short-term rates (like the unbiased expectations theory), plus liquidity risk premiums that increase with the securityÕs maturity (this is the exten-sion of the liquidity premium added to the unbiased expectations theory). Figure 6.17 illustrates the differences in the shape of the yield curve under the unbiased expecta-tions theory versus the liquidity premium theory. For example, according to the liquid-ity premium theory, an upward-sloping yield curve may reflect investorsÕ expectations that future short-term rates will be flat, but because liquidity premiums increase with maturity, the yield curve will nevertheless slope upward. Indeed, an upward-sloping yield MATH COACH When putting interest rates into the equation, enter them in decimal format, not percentage format.Correct: (1 + 0.0294)Not correct: (1 + 2.94)Upward-SlopingTerm to MaturityTerm to MaturityLPTLPTUETUETInverted or Downward-SlopingYield to MaturityYield to Maturity(a)(b)Term to MaturityLPTUETFlatYield to Maturity(c)FIGURE 6.17Yield Curve Using the Unbiased Expectation Theory (UET) versus the Liquidity Premium Theory (LPT)Notice the differences in the shape of the yield curve under the UET and the LPT.Final PDF to printer

 

chapter 6 Understanding Financial Markets and Institutions 211cor91411_ch06_178-225.indd 211 01/20/17 03:45 PMMarket Segmentation TheoryThe market segmentation theory does not build on the unbiased expectations theory or the liquidity premium theory, but rather argues that individual investors and FIs have spe-cific maturity preferences, and convincing them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium). The main thrust of the market segmentation theory is that investors do not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have dis-tinctly preferred investment horizons dictated by the dates when their liabilities will come due. For example, banks might prefer to hold relatively short-term U.S. Treasury bonds because their deposit liabilities also tend to be short-termÑrecall that bank customers can access their funds on demand. Insurance companies, on the other hand, may prefer to hold long-term U.S. Treasury bonds because life insurance contracts usually expose insurance firms to long-term liabilities. Accordingly, distinct supply and demand condi-tions within a particular maturity segmentÑsuch as the short end and long end of the bond marketÑdetermine interest rates under the market segmentation theory.The market segmentation theory assumes that investors and borrowers generally do not want to shift from one maturity sector to another without adequate compensationÑthat is, an interest rate premium. Figure 6.18 demonstrates how changes in supply for short- versus long-term bond market segments result in changing shapes of the yield to maturity curve. Specifically, as shown in Figure 6.18, the higher the demand for securities is, the higher the yield on those securities.4 Further, as the supply of securities decreases in the short-term market and increases in the long-term market, the slope of the yield curve becomes steeper. If the supply of short-term securities had increased while the sup-ply of long-term securities had decreased, the yield curve would have a flatter slope and might even have sloped downward. Indeed, the U.S. TreasuryÕs large-scale repurchase of long-term Treasury bonds (i.e., reductions in supply) in early 2000 has been viewed as the major cause of the inverted yield curve that appeared in February 2000.Yield PercentYield PercentYield PercentYield PercentYield PercentYield PercentShort-Term SecuritiesShort-Term SecuritiesrSrLSSSLDSDLLong-Term SecuritiesLong-Term SecuritiesTime to MaturityTime to MaturityYieldcurveSLSLrSSSDSrLSLDLYieldcurveFIGURE 6.18Market Segmentation and Determination of the Slope of the Yield CurveThe higher the demand for securities, the higher the yield on those securities.TIME OUT 6-13 What three theories explain the shape of the yield curve?   6-14 Explain how arbitrage plays a role in the unbiased expectations explanation of the shape of the yield curve. 4In general, the price and yield on a bond are inversely related. Thus, as the price of a bond falls (become cheaper), the demand for the bond will rise. This is the same as saying that as the yield on a bond rises, it becomes cheaper and the demand for it increases. See Chapter 7.Final PDF to printer

212 part four Valuing of Bonds and Stockscor91411_ch06_178-225.indd 212 01/20/17 03:45 PM6.6 ∙ Forecasting Interest Rates5 We noted in the time value of money (TVM) chapters (Chapters 4 and 5) that as interest rates change, so do the values of financial securities. Accordingly, both individual inves-tors and public corporations want to be able to predict or forecast interest rates if they wish to trade profitably. For example, if interest rates rise, the value of investment port-folios of individuals and corporations will fall, resulting in a loss of wealth. So, interest rate forecasts are extremely important for the financial wealth of both public corporations and individuals.Recall our discussion of the unbiased expectations theory in the previous section of this chapter. That theory indicated that the marketÕs expectation of future short-term interest rates determines the shape of the yield curve. For example, an upward-sloping yield curve implies that the market expects future short-term interest rates to rise. So, we can use the unbiased expectations theory to forecast (short-term) interest rates in the future (i.e., forward one-year interest rates). A forward rate is an expected, or implied, rate on a short-term security that will originate at some point in the future. Using the equations in the unbiased expectations theory, we can directly derive the marketÕs expec-tation of forward rates from existing or actual rates on spot market securities.To find an implied forward rate on a one-year security to be issued one year from today, we can rewrite the unbiased expectations theory equation as follows: 1 R 2 = [ ( 1 + 1 R 1 ) ( 1 + 2 f 1 ) ] 1/2 − 1 (6-9)  where 2 f1 = expected one-year rate for year 2, or the implied forward one-year rate for next year.Saying that 2 f1 is the expected one-year rate for year 2 is the same as saying that, once we isolate the 2 f1 term, the equation will give us the marketÕs estimate of the expected one-year rate for year 2. Solving for 2 f1 we get 2 f 1 = [ ( 1 + 1 R 2 ) 2 / ( 1 + 1 R 1 ) ] − 1 (6-10)In general, we can find the forward rate for any year, N, into the future using the fol-lowing generalized equation derived from the unbiased expectations theory: N f1 = [(1 + 1RN)N / (1 + 1RN−1)N−1] − 1 (6-11)LG6-8forward rateAn expected rate (quoted today) on a security that originates at some point in the future.5This section, which contains more technical details, may be included in or dropped from the chapter reading depending on the rigor of the course.Estimating Forward RatesIn the mid-2010s, the existing or current (spot) one-, two-, three-, and four-year zero coupon Treasury security rates were as follows: 1 R 1 = 0.70%, 1 R 2 = 0.87%, 1 R 3 = 1.04%, 1 R 4 = 1.34% Using the unbiased expectations theory, calculate one-year forward rates on zero coupon Treasury bonds for years 2, 3, and 4.SOLUTION: 2f1 = [(1.0087)2/(1.0070)] − 1 = 1.04%3f1 = [(1.0104)3/(1.0087)2] − 1 = 1.38%4f1 = [(1.0134)4/(1.0104)3] − 1 = 2.25% Similar to Problems 6-15, 6-16, Self-Test Problem 4EXAMPLE 6-5LG6-8 For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Final PDF to printer

cor91411_ch06_178-225.indd 213 01/20/17 03:45 PM 213summary of learning goalsIn this chapter, we reviewed the basic operations of financial markets and institutions. We described the ways in which funds flow through an economic system from lenders to borrowers and outlined the markets and instruments that lend-ers and borrowers employ to complete this process. We also reviewed factors that determine nominal interest rates and interest ratesÕ effects on security prices and values in financial markets. We described how interest rate levels change over time and how these changes are determined. Finally, the chapter introduced theories regarding the determination of the shape of the term structure of interest rates. The learning goals for the chapter included:TIME OUT 6-15 What is a forward rate?  6-16 How can we obtain an implied forward rate from current short- and long-term interest rates?  6-17 Why is it useful to calculate forward rates? viewpoints REVISITEDBusiness Application SolutionIn deciding when to issue new debt, DPH Corporation needs to consider two main factors. First, what might happen to specific factors that affect interest rates on any debt the firm may issue? Such specific factors include changes in the firmÕs default risk, liquidity risk, any special provisions regarding the use of funds raised by the firmÕs security issuance, and the debtÕs term to maturity. An increase (decrease) in any of these risks over the next two years would increase (decrease) the rate of interest DPH Corp. would be required to pay to holders of the new debt and would potentially make the debt issue in two years less (more) attractive. Second, what might happen to the general level of interest rates in the U.S. economy over the next two years? This involves an analysis of any changes in inflation or the real risk-free rate. DPH can estimate how interest rates may change by examining the term structure of interest rates or the current yield curve. In addition to any internal analysis of these factors, DPH Corp. can get expert advice about the timing of its debt issue and get the new debt to the capital market with help from an investment bank. These financial institutions underwrite securities and engage in related activities, such as making a market in which securities can trade.Personal Application SolutionIn deciding which corporate bond to buy, John Adams needs to consider specific factors that affect differences in interest rates on debt. These specific factors include the general level of inflation and the real risk-free rate in the U.S. economy, as well as the default risk, liquidity risk, any special provisions regarding the use of funds raised by a security issuance, and the term to maturity of the two debt issues. While one bond earns more (10.00 percent) than the other (8.00 percent), it may be that the higher-yielding bond has more default, liquidity, or other risk than the lower-yielding bond. Thus, the higher yield brings with it more risk. John Adams must consider whether he is willing to incur higher risk to get higher returns. In addition to his own analysis of these factors, John Adams can get expert advice about which bond to buy and then buy the bond with a securities firmÕs help. These financial institutions engage in activities such as securities brokerage, securities trading, and making markets in which securities can trade.Final PDF to printer

214cor91411_ch06_178-225.indd 214 01/20/17 03:45 PMDifferentiate between primary and secondary markets and between money and capital markets. Primary markets are markets in which demanders of funds (e.g., corporations) raise funds through new issues of financial instruments, such as stocks and bonds. Once financial instruments such as stocks are issued in primary markets, they are then tradedÑthat is, rebought and resold in secondary markets. Money markets are markets that trade debt securities or instruments with maturities of one year or less. Capital markets are markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year.List the types of securities traded in money and capital markets. A variety of money market securities are issued by corporations and government units to obtain short-term funds. These securities include Treasury bills, federal funds and repurchase agreements, commercial paper, negotiable certificates of deposit, and bankerÕs acceptances. Capital market securities include Treasury notes and bonds, state and local government bonds, U.S government agency bonds, mortgages and mortgage-backed securities, corporate bonds, and corporate stocks.Identify different types of financial institutions and the services that each provides. Financial institutions (banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, and pension funds) perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (demanders of funds).Know the main suppliers and demanders of loanable funds. The household sector is the largest supplier of loanable funds in the United States. Higher interest rates will also result in higher supplies of funds from the U.S. business sector and some governments. Finally, when interest rates are higher on U.S. financial securities than they are on comparable securities in their LG6-1LG6-2LG6-3LG6-4home countries, foreign investors increase their supply of funds to U.S. markets. Households also borrow funds in financial markets. Businesses demand funds to finance investments in long-term assets and for short-term working capital needs. Governments also borrow heavily in the markets for loanable funds. Finally, foreign participants also borrow in U.S. financial markets. Understand how equilibrium interest rates are determined. Holding all other factors constant, the increase in the demand for loanable funds results in an increase in the equilibrium interest rate and an increase in the equilibrium quantity of funds traded. As the supply of loanable funds increases, or the supply curve shifts down and to the right, the shift in the supply curve creates a disequilibrium between demand and supply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls.Analyze specific factors that influence interest rates. Specific factors that affect differences in interest rates include inflation, the real risk-free rate, default risk, liquidity risk, special provisions that impact a security holder beneficially or adversely, and the term to maturity of the security.Offer different theories that explain the shape of the term structure of interest rates. Explanations for the shape of the yield curve fall predominantly into three theories: the unbiased expectations theory, the liquidity premium theory, and the market segmentation theory.Demonstrate how forward interest rates derive from the term structure of interest rates. A forward rate is an expected, or implied, rate on a short-term security that is to be originated at some point in the future. Using the equations representing unbiased expectations theory, the marketÕs expectation of forward rates can be derived directly from existing or actual rates on securities currently traded in the spot market.LG6-5LG6-6LG6-7LG6-8chapter equations 6-1 IP = CP I t+1 − CP I t ____________ CP I t × 100 6-2 i = Expected IP + RFR 6-3 RFR = i − Expected IP 6-4 DR P j = i jt − i Tt Final PDF to printer

215cor91411_ch06_178-225.indd 215 01/20/17 03:45 PM 6-5 ij* = f(IP, RFR, DR P j , LR P j , SC P j , M P j ) 6-6 (1 + 1RN)N = (1 + 1R1)[1 + E(2r1)] . . . [1 + E(Nr1)] 6-7 1RN = {[1 + 1R1][1 + E(2r1)] . . . [1 + E(Nr1)]}1/N − 1 6-8 1RN = {[1 + 1R1][1 + E(2r1) + L2] . . . [1 + E(Nr1) + LN]}1/N − 1 6-9 1R2 = [(1 + 1R1)(1 + 2 f1)]1/2 − 1 6-10 2  f1 = [(1 + 1R2)2/(1 + 1R1)] − 1 6-11 N f1 = [(1 + 1RN)N/(1 + 1RN−1)N−1] − 1 key termsasset transformer Service provided by financial institu-tions in which financial claims issued by an FI are more attractive to investors than are the claims directly issued by corporations. p. 190capital markets Markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year. p. 183commercial banks Depository institutions whose major assets are loans and whose major liabilities are depos-its. p. 180default risk  The risk that a security issuer will default on that security by being late on or missing an interest or principal payment. p. 202delegated monitor An economic agent appointed to act on behalf of smaller investors in collecting information and/or investing funds on their behalf. p. 189derivative security A security formalizing an agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future. p. 185direct transfer The process used when a corporation sells its stock or debt directly to investors without going through a financial institution. p. 188financial institutions Institutions that perform the essen-tial function of channeling funds from those with surplus funds to those with shortages of funds. p. 187financial markets The arenas through which funds flow. p. 180foreign exchange markets Markets in which foreign cur-rency is traded for immediate or future delivery. p. 185foreign exchange risk Risk arising from the unknown value at which foreign currency cash flows can be con-verted into U.S. dollars. p. 185forward rate An expected rate (quoted today) on a secu-rity that originates at some point in the future. p. 212indirect transfer A transfer of funds between suppliers and users of funds through a financial institution. p. 189inflation The continual increase in the price level of a basket of goods and services. p. 200initial public offerings (IPOs) The first public issue of financial instruments by a firm. p. 181investment banks Banks that help companies and gov-ernments raise capital. p. 180liquidity The ease with which an asset can be converted into cash. p. 188liquidity risk The risk that a security cannot be sold at a predictable price with low transaction costs on short notice. p. 204loanable funds theory A theory of interest rate determi-nation that views equilibrium interest rates in financial markets as a result of the supply of and demand for loan-able funds. p. 193money markets Markets that trade debt securities or instruments with maturities of less than one year. p. 182nominal interest rates The interest rates actually observed in financial markets. p. 191over-the-counter market Markets that do not operate in a specific fixed locationÑrather, transactions occur via telephones, wire transfers, and computer trading. p. 182price risk The risk that an assetÕs sale price will be lower than its purchase price. p. 188primary markets Markets in which corporations raise funds through new issues of securities. p. 180real risk-free rate The interest rate that would exist on a risk-free security if no inflation were expected. p. 201secondary markets Markets that trade financial instru-ments once they are issued. p. 181secondary securities Packages or pools of primary claims. p. 190term structure of interest rates A comparison of market yields on securities, assuming all characteristics except maturity are the same. p. 204trading volume The number of shares of a security that are simultaneously bought and sold during a period. p. 182Final PDF to printer

216cor91411_ch06_178-225.indd 216 01/20/17 03:45 PMself-test problems with solutions1 Calculating Real Risk-Free Rates One-year Treasury bill rates in 20XX averaged 3.25 percent and inflation (measured by the consumer price index) for the year was 2.10 percent. If investors had expected the same inflation rate as that actually realized, calculate the real risk-free rate for 20XX according to the Fisher effect.Solution:3.25% Ð 2.10% = 1.15%2 Determinants of Interest Rates for Individual Securities NikkiGÕs, Inc.Õs, 10-year bonds are currently yielding a return of 7.25 percent. The expected inflation premium is 1.25 percent annually and the real risk-free rate is expected to be 2.60 percent annually over the next 10 years. The liquidity risk premium on NikkiGÕs bonds is 1.25 percent. The maturity risk premium is 0.40 percent on two-year securities and increases by 0.03 percent for each additional year to maturity. Calculate the default risk premium on NikkiGÕs 10-year bonds.Solution: 7.25% = 1.25% + 2.60% + DRP + 1.25% + [0.40% + (0.03% × 8)] => DRP = 7.25% Ð [1.25% + 2.60% + 1.25% + (0.40% + [0.03% × 8])] = 1.51%3 Unbiased Expectations Theory versus Liquidity Premium Theory Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bond rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: 1 R 1 = 1.94%, E ( 2 r 1 ) = 2.50%, E ( 3 r 1 ) = 3.74%, E ( 4 r 1 ) = 4.10% In addition, investors charge a liquidity premium on longer-term securities such that L 2 = 0.05%, L 3 = 0.10%, L 4 = 0.20% Construct a yield curve using the unbiased expectations theory and using the liquidity premium theory.Solution:Using the unbiased expectations theory, current (or todayÕs) rates for one-, two-, three-, and four-year maturity Treasury securities should be 1R1 = 1.94%, 1R2 = [(1 + 0.0194)(1 + 0.025)]2 Ð 1 = 2.22% 1R3 = [(1 + 0.0194)(1 + 0.025)(1 + 0.0374)]1/3 Ð 1 = 2.72% 1R4 = [(1 + 0.0194)(1 + 0.025)(1 + 0.0374)(1 + 0.041)]1/4 Ð 1 = 3.07%and the current yield to maturity curve will be upward sloping as shown as the curve UET in the following figure.Using the liquidity premium theory, current rates for one-, two-, three-, and four-year maturity Treasury securities should be 1R1 = 1.94% 1R2 = [(1 + 0.0194)(1 + 0.025 + 0.0005)]1/2 Ð 1 = 2.24% 1R3 = [(1 + 0.0194)(1 + 0.025 + 0.0005)(1 + 0.0374 + 0.001)]1/3 Ð 1 = 2.77% 1R4 = [(1 + 0.0194)(1 + 0.025 + 0.0005)(1 + 0.0374 + 0.001) (1 + 0.041 + 0.002)]1/4 Ð 1 = 3.15%LG6-6 LG6-6 LG6-7 Final PDF to printer

217cor91411_ch06_178-225.indd 217 01/20/17 03:45 PMand the current yield to maturity curve will be upward sloping as shown as the curve LPT in the following figure:3.15%1.94%2.22%Yield to MaturityTerm to Maturity(in years)012342.72%LPTUETComparing the yield curves in the graph above, notice that the liquidity premium in year 2 (L2 = 0.05%) produces a 0.02 percent premium on the yield to maturity on a two-year T-note, the liquidity premium for year 3 (L3 = 0.10%) produces a 0.05 percent premium on the yield to maturity on the three-year T-note, and the liquidity premium for year 4 (L4 = 0.20%) produces a 0.08 percent premium on the yield to maturity on the four-year T-note.4 Estimating Forward Rates The Wall Street Journal reports that the existing or current (spot) one-, two-, three-, and four-year Treasury security rates are as follows: 1 R 1 = 1.94%, 1 R 2 = 2.25%, 1 R 3 = 2.75%, 1 R 4 = 3.15% Using the unbiased expectations theory, calculate one-year forward rates on Treasury bonds for years 2, 3, and 4.  Solution: 2 f1 = [(1.0225)2/(1.0194)] Ð 1 = 2.56% 3 f1 = [(1.0275)3/(1.0225)2] Ð 1 = 3.76% 4 f1 = [(1.0315)4/(1.0275)3] Ð 1 = 4.36%LG6-8 questions 1. Classify the following transactions as taking place in the primary or secondary markets (LG6-1): a. IBM issues $200 million of new common stock. b. The New Company issues $50 million of com-mon stock in an IPO. c. IBM sells $5 million of GM preferred stock out of its marketable securities portfolio. d. The Magellan Fund buys $100 million of previ-ously issued IBM bonds. e. Prudential Insurance Co. sells $10 million of GM common stock. 2. Classify the following financial instruments as money market securities or capital market securities (LG6-2): a. Federal funds b. Common stock c. Corporate bonds d. Mortgages e. Negotiable certificates of deposit f. U.S. Treasury bills g. U.S. Treasury notes h. U.S. Treasury bonds i. State and government bondsFinal PDF to printer

218cor91411_ch06_178-225.indd 218 01/20/17 03:45 PM 3. What are the different types of financial institu-tions? Include a description of the main services offered by each. (LG6-3) 4. How would economic transactions between suppli-ers of funds (e.g., households) and users of funds (e.g., corporations) occur in a world without FIs? (LG6-3) 5. Why would a world limited to the direct transfer of funds from suppliers of funds to users of funds likely result in quite low levels of fund flows? (LG6-3) 6. How do FIs reduce monitoring costs associated with the flow of funds from fund suppliers to fund users? (LG6-3) 7. How do FIs alleviate the problem of liquidity risk faced by investors wishing to invest in securities of corporations? (LG6-3) 8. Who are the suppliers of loanable funds? (LG6-4) 9. Who are the demanders of loanable funds? (LG6-4) 10. What factors cause the supply of funds curve to shift? (LG6-5) 11. What factors cause the demand for funds curve to shift? (LG6-5) 12. What are six factors that determine the nominal interest rate on a security? (LG6-6) 13. What should happen to a securityÕs equilibrium interest rate as the securityÕs liquidity risk increases? (LG6-6) 14. Discuss and compare the three explanations for the shape of the yield curve. (LG6-7) 15. Are the unbiased expectations and liquidity pre-mium theories explanations for the shape of the yield curve completely independent theories? Explain why or why not. (LG6-7) 16. What is a forward interest rate? (LG6-8) 17. If we observe a one-year Treasury security rate that is higher than the two-year Treasury security rate, what can we infer about the one-year rate expected one year from now? (LG6-8)problems 6-1 Determinants of Interest Rates for Individual Securities A particular secu-rityÕs default risk premium is 2 percent. For all securities, the inflation risk pre-mium is 1.75 percent and the real risk-free rate is 3.50 percent. The securityÕs liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the securityÕs equilibrium rate of return. (LG6-6) 6-2 Determinants of Interest Rates for Individual Securities You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that one-year T-bills are cur-rently earning 1.25 percent. Your broker has determined the following informa-tion about economic activity and Moore Corporation bonds: Real risk-free rate = 0.75% Default risk premium = 1.15% Liquidity risk premium = 0.50% Maturity risk premium = 1.75% a. What is the inflation premium? (LG6-6) b. What is the fair interest rate on Moore Corporation 30-year bonds? (LG6-6) 6-3 Determinants of Interest Rates for Individual Securities Dakota Corpora-tion 15-year bonds have an equilibrium rate of return of 8 percent. For all secu-rities, the inflation risk premium is 1.75 percent and the real risk-free rate is 3.50  percent. The securityÕs liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the bondÕs default risk premium. (LG6-6) 6-4 Determinants of Interest Rates for Individual Securities A two-year Treasury security currently earns 1.94 percent. Over the next two years, the real risk-free basic problemsFinal PDF to printer

219cor91411_ch06_178-225.indd 219 01/20/17 03:45 PMrate is expected to be 1.00 percent per year and the inflation premium is expected to be 0.50 percent per year. Calculate the maturity risk premium on the two-year Treasury security. (LG6-6) 6-5 Unbiased Expectations Theory Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: 1 R 1 = 6%, E ( 2 r 1 ) = 7%, E ( 3 r 1 ) = 7.5%, E ( 4 r 1 ) = 7.85% Using the unbiased expectations theory, calculate the current (long-term) rates for one-, two-, three-, and four-year-maturity Treasury securities. Plot the resulting yield curve. (LG6-7) 6-6 Unbiased Expectations Theory Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: 1 R 1 = 1%, E ( 2 r 1 ) = 3.75%, E ( 3 r 1 ) = 4.25%, E ( 4 r 1 ) = 5.75% Using the unbiased expectations theory, calculate the current (long-term) rates for one-, two-, three-, and four-year-maturity Treasury securities. Plot the resulting yield curve. (LG6-7) 6-7 Unbiased Expectations Theory One-year Treasury bills currently earn 1.45  percent. You expect that one year from now, one-year Treasury bill rates will increase to 1.65 percent. If the unbiased expectations theory is correct, what should the current rate be on two-year Treasury securities? (LG6-7) 6-8 Unbiased Expectations Theory One-year Treasury bills currently earn 2.15  percent. You expect that one year from now, one-year Treasury bill rates will increase to 2.65 percent and that two years from now, one-year Treasury bill rates will increase to 3.05 percent. If the unbiased expectations theory is correct, what should the current rate be on three-year Treasury securities? (LG6-6-7) 6-9 Liquidity Premium Theory One-year Treasury bills currently earn 3.45 percent. You expect that one year from now, one-year Treasury bill rates will increase to 3.65 percent. The liquidity premium on two-year securities is 0.05 percent. If the liquidity premium theory is correct, what should the current rate be on two-year Treasury securities? (LG6-7) 6-10 Liquidity Premium Theory One-year Treasury bills currently earn 2.25  percent. You expect that one year from now, one-year Treasury bill rates will increase to 2.45 percent and that two years from now, one-year Treasury bill rates will increase to 2.95 percent. The liquidity premium on two-year securities is 0.05 percent and on three-year securities is 0.15 percent. If the liquidity premium theory is correct, what should the current rate be on three-year Treasury securi-ties? (LG6-7) 6-11 Liquidity Premium Theory Based on economistsÕ forecasts and analysis, one-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows: R 1 = 0.65% E ( 2 r 1 ) = 1.75% L 2 = 0.05% E ( 3 r 1 ) = 1.85% L 3 = 0.10% E ( 4 r 1 ) = 2.15% L 4 = 0.12% Using the liquidity premium theory, plot the current yield curve. Make sure you label the axes on the graph and identify the four annual rates on the curve both on the axes and on the yield curve itself. (LG6-7)Final PDF to printer

220cor91411_ch06_178-225.indd 220 01/20/17 03:45 PM 6-12 Liquidity Premium Theory Based on economistsÕ forecasts and analysis, one-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows: R 1 = 1 . 25% E ( 2 r 1 ) = 2.15% L 2 = 0.08% E ( 3 r 1 ) = 2.55% L 3 = 0.10% E ( 4 r 1 ) = 3.00% L 4 = 0.15% Using the liquidity premium theory, plot the current yield curve. Make sure you label the axes on the graph and identify the four annual rates on the curve both on the axes and on the yield curve itself. (LG6-7)intermediate problems 6-13 Determinants of Interest Rates for Individual Securities Tom and SueÕs Flow-ers, Inc.Õs, 15-year bonds are currently yielding a return of 8.25 percent. The expected inflation premium is 2.25 percent annually and the real risk-free rate is expected to be 3.50 percent annually over the next 15 years. The default risk premium on Tom and SueÕs FlowersÕ bonds is 0.80 percent. The maturity risk premium is 0.75 percent on five-year securities and increases by 0.04 percent for each additional year to maturity. Calculate the liquidity risk premium on Tom and SueÕs Flowers, lnc.Õs, 15-year bonds. (LG6-6) 6-14 Determinants of Interest Rates for Individual Securities NikkiGÕs Corpora-tionÕs 10-year bonds are currently yielding a return of 6.05 percent. The expected inflation premium is 1.00 percent annually and the real risk-free rate is expected to be 2.10 percent annually over the next 10 years. The liquidity risk premium on NikkiGÕs bonds is 0.25 percent. The maturity risk premium is 0.10 percent on two-year securities and increases by 0.05 percent for each additional year to maturity. Calculate the default risk premium on NikkiGÕs 10-year bonds. (LG6-6) 6-15 Unbiased Expectations Theory Suppose we observe the following rates: 1R1 = 8%, 1R2 = 10%. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year interest rate expected one year from now, E(2r1)? (LG6-7) 6-16 Unbiased Expectations Theory The Wall Street Journal reports that the rate on four-year Treasury securities is 1.60 percent and the rate on five-year Treasury securities is 2.15 percent. According to the unbiased expectations theories, what does the market expect the one-year Treasury rate to be four years from today, E(5r1)? (LG6-7) 6-17 Liquidity Premium Theory The Wall Street Journal reports that the rate on three-year Treasury securities is 5.25 percent and the rate on four-year Treasury securities is 5.50 percent. The one-year interest rate expected in three years is, E(4 r1), is 6.10 percent. According to the liquidity premium hypotheses, what is the liquidity premium on the four-year Treasury security, L4? (LG6-7) 6-18 Liquidity Premium Theory Suppose we observe the following rates: 1R1 = 0.75%, 1R2 = 1.20%, and E(2r1) = 0.907%. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L2? (LG6-7) 6-19 Forecasting Interest Rates You note the following yield curve in The Wall Street Journal. According to the unbiased expectations theory, what is the one-year forward rate for the period beginning one year from today, 2 f1? (LG6-8)Final PDF to printer

221cor91411_ch06_178-225.indd 221 01/20/17 03:45 PM 6-20 Forecasting Interest Rates On March 11, 20XX, the existing or current (spot) one-, two-, three-, and four-year zero coupon Treasury security rates were as follows: 1 R 1 = 0.75%, 1 R 2 = 1.35%, 1 R 3 = 1.75%, 1 R 4 = 1.90% Using the unbiased expectations theory, calculate the one-year forward rates on zero coupon Treasury bonds for years 2, 3, and 4 as of March 11, 20XX. (LG6-8)advanced problems 6-21 Determinants of Interest Rates for Individual Securities The Wall Street Jour-nal reports that the current rate on 10-year Treasury bonds is 7.25 percent, on 20-year Treasury bonds is 7.85 percent, and on a 20-year corporate bond issued by MHM Corp. is 8.75 percent. Assume that the maturity risk premium is zero. If the default risk premium and liquidity risk premium on a 10-year corporate bond issued by MHM Corp. are the same as those on the 20-year corporate bond, calculate the current rate on MHM Corp.Õs 10-year corporate bond. (LG6-6) 6-22 Determinants of Interest Rates for Individual Securities The Wall Street Journal reports that the current rate on 8-year Treasury bonds is 5.85 percent, the rate on 15-year Treasury bonds is 6.25 percent, and the rate on a 15-year corporate bond issued by MHM Corp. is 7.35 percent. Assume that the maturity risk premium is zero. If the default risk premium and liquidity risk premium on an 8-year corporate bond issued by MHM Corp. are the same as those on the 15-year corporate bond, calculate the current rate on MHM Corp.Õs 8-year corpo-rate bond. (LG6-6) 6-23 Determinants of Interest Rates for Individual Securities The Wall Street Jour-nal reports that the current rate on 5-year Treasury bonds is 1.85 percent and on 10-year Treasury bonds is 3.35 percent. Assume that the maturity risk premium is zero. Calculate the expected rate on a 5-year Treasury bond purchased five years from today, E(5r5). (LG6-6) 6-24 Determinants of Interest Rates for Individual Securities The Wall Street Jour-nal reports that the current rate on 10-year Treasury bonds is 2.25 percent and the rate on 20-year Treasury bonds is 4.50 percent. Assume that the maturity risk premium is zero. Calculate the expected rate on a 10-year Treasury bond pur-chased 10 years from today, E(10 r10). (LG6-6) 6-25 Unbiased Expectations Theory Suppose we observe the three-year Treasury security rate (1R3) to be 8 percent, the expected one-year rate next yearÑ E(2r1)Ñto be 4 percent, and the expected one-year rate the following yearÑE(3r1)Ñto be 6 percent. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year Treasury security rate, 1R1? (LG6-7) 6-26 Unbiased Expectations Theory The Wall Street Journal reports that the rate on three-year Treasury securities is 1.20 percent and the rate on five-year Treasury securities is 2.15 percent. According to the unbiased expectations theory, what does the market expect the two-year Treasury rate to be three years from today, E(3r2)? (LG6-7) 6-27 Forecasting Interest Rates Assume the current interest rate on a one-year Trea-sury bond (1R1) is 4.50 percent, the current rate on a two-year Treasury bond Maturity   YieldOne day     2.00%One year    5.50Two years   6.50Three years9.00Final PDF to printer

integrated mini-case: Calculating Interest RatesFrom discussions with your broker, you have determined that the expected inflation premium is 1.35 percent next year, 1.50 percent in year 2, 1.75 percent in year 3, and 2.00 percent in year 4 and beyond. Further, you expect that real risk-free rates will be 3.20 percent next year, 3.30 percent in year 2, 3.75 percent in year 3, and 3.80 percent in year 4 and beyond. You are considering an investment in either five-year Treasury securities or five-year bonds issued by PeeWee Corporation. The bonds have no special covenants. Your broker has determined the following information about economic activity and PeeWee Corporation five-year bonds: Default risk premium = 2.10%Liquidity risk premium = 1.75Maturity risk premium = 0.75 Further, the maturity risk premium on PeeWee bonds is 0.1875 percent per year starting in year 2. PeeWeeÕs default risk premium and liquidity risk premium do not change with bond maturity. a. What is the fair interest rate on five-year Treasury securities? b. What is the fair interest rate on PeeWee Corporation five-year bonds? c. Plot the five-year yield curve for the Treasury securities. d. Plot the five-year yield curve for the PeeWee Corporation bonds.222cor91411_ch06_178-225.indd 222 01/20/17 03:45 PM(1R2) is 5.25 percent, and the current rate on a three-year Treasury bond (1R3) is 6.50 percent. If the unbiased expectations theory of the term structure of interest rates is correct, what is the one-year forward rate expected on Treasury bills dur-ing year 3, 3 f1? (LG6-8) 6-28 Forecasting Interest Rates A recent edition of The Wall Street Journal reported interest rates of 1.25 percent, 1.60 percent, 1.98 percent, and 2.25 percent for three-, four-, five-, and six-year Treasury security yields, respectively. According to the unbiased expectation theory of the term structure of interest rates, what are the expected one-year forward rates for years 4, 5, and 6? (LG6-8)research it! SpreadsGo to the Federal Reserve BoardÕs website at www.federalreserve.gov and get the latest rates on 10-year T-bills and Aaa-and Baa-rated corporate bonds using the following steps.Go to the Federal ReserveÕs website at www.federalreserve.gov. Click on ÒEconomic Research and Data,Ó then click on ÒSelected Interest Rates-H.15.Ó Click on the most recent date. This will bring the file onto your computer that contains the relevant data. Click on ÒHistorical DataÓ and then Ò10-YearÓ under ÒTreasury Constant Maturities,Ó or ÒAaaÓ and ÒBaaÓ under ÒCorporate BondsÓ to get past data. Calculate the current spread of Aaa- and Baa-rated bonds over the 10-year Treasury-bond rate. How have these spreads changed over the last two years?Final PDF to printer

223cor91411_ch06_178-225.indd 223 01/20/17 03:45 PMANSWERS TO TIME OUT 6-1 Primary markets provide a forum in which demanders of funds (e.g., corporations such as IBM or government entities such as the U.S. Treasury) raise funds by issuing new financial instruments, such as stocks and bonds. Corporations or government enti-ties continually have new projects or expanded production needs, but do not have sufficient internally generated funds (such as retained earnings) to support their capi-tal needs. Thus, corporations and governments issue securities in external primary markets to raise additional funds. Once firms issue financial instruments in primary markets, these same stocks and bonds are then tradedÑthat is, bought and resoldÑin secondary markets. 6-2 Foreign exchange markets trade currencies for immediate (also called spot) or for some future stated delivery. 6-3 A derivative security is a financial security (such as a futures contract, option contract, or swap contract) that is linked to another underlying security, such as a stock traded in capital markets or British pounds traded in foreign exchange (forex) markets. Deriva-tive securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the value of the underlying security changes, the value of the derivative security changes. 6-4 The following are the major types of financial institutions: Commercial banks are depository institutions whose major assets are loans and whose major liabilities are deposits. Thrifts are depository institutions, including savings associations, savings banks, and credit unions, that generally perform services similar to commercial banks but tend to concentrate their loans in one segment, such as real estate loans or con-sumer loans. Insurance companies protect individuals and corporations (policyholders) from finan-cially adverse events, such as untimely death, illness, retirement, and personal injury and liability due to accidents, theft, fire, and so on. Securities firms and investment banks underwrite securities and engage in related activities such as securities brokerage, securities trading, and making markets in which securities trade. Finance companies make loans to both individuals and businesses. The loans are funded by short- and long-term debt, and many are collateralized with some kind of durable good, such as washer/dryers, furniture, carpets, and the like. Mutual funds pool many individualsÕ and companiesÕ financial resources and invest those resources in diversified asset portfolios. Pension funds offer savings plans through which fund participants accumulate savings during their working years. 6-5 First, once they have lent money in exchange for financial claims, fund suppliers would need to continually monitor the use of their funds to guard against theft and waste. Second, many financial claims feature a long-term commitment (e.g., mortgages, cor-porate stock, and bonds) for fund suppliers, thus creating another disincentive for fund suppliers to hold direct financial claims that fund users may issue. Third, even though real-world financial markets provide some liquidity services by allowing fund suppliers to trade financial securities among themselves, fund suppliers face price risk when they buy securitiesÑfund suppliers may not get their principal back, let alone any return on their investment. 6-6 A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As FIs adjusted to regulatory changes brought about in the 1980s and 1990s, one result was a dramatic increase in systemic risk of the Final PDF to printer

224cor91411_ch06_178-225.indd 224 01/20/17 03:45 PMfinancial system, caused in large part by a shift in the banking model from that of Òorig-inate and holdÓ to Òoriginate to distribute.Ó In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer-term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk trade-offs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform bank-ing services, have facilitated the change from the originate-and-hold model of com-mercial banking to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutual and similar funds, which invest these funds in the liabilities of other shadow banks. Like the traditional bank-ing system, the shadow banking system intermediates the flow of funds between net savers and borrowers. However, instead of the bank serving as the middleman, it is the nonbank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system where the complete credit intermediation is performed by a single bank, in the shadow banking system, it is performed through a series of steps involving many nonbank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking, they have little incentive to screen and monitor activities of borrowers to whom they originate loans. Thus, FIsÕ role as specialists in risk measurement and management is reduced. 6-7 The household sector (consumer sector) is the largest supplier of loanable funds in the United States. Households supply funds when they have excess income or want to reallocate their asset portfolio holdings. Higher interest rates will also result in higher supplies of funds from the U.S. business sector who often have excess cash, or work-ing capital, that they can invest for short periods of time in financial assets. Loanable funds are also supplied by some governments. Finally, foreign investors increasingly view U.S. financial markets as alternatives to their domestic financial markets. When interest rates are higher on U.S. financial securities than they are on comparable securities in their home countries, foreign investors increase their supply of funds to U.S. markets. Households (although they are net suppliers of funds) also borrow funds in financial markets. Businesses demand funds to finance investments in long-term (fixed) assets (e.g., plant and equipment) and for short-term working capital needs (e.g., inventory and accounts receivable) usually by issuing debt and other financial instru-ments. Governments also borrow heavily in the markets for loanable funds. Higher interest rates can cause state and local governments to postpone borrowings and thus capital expenditures. Finally, foreign participants (households, businesses, and governments) might also borrow in U.S. financial markets. Foreign borrowers look for the cheapest source of dollar funds globally. 6-8 Holding all other factors constant, the increase in the demand for loanable funds results in an increase in the equilibrium interest rate and an increase in the equilibrium quantity of funds traded. As the supply of loanable funds increases, or the supply curve shifts down and to the right, the shift in the supply curve creates a disequilib-rium between demand and supply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls. 6-9 Changes in underlying factors that determine the demand and supply of loanable funds can cause continuous shifts in the supply and/or demand curves for loanable funds. Market forces will react to the resulting disequilibrium with a change in the equilibrium interest rate and quantity of funds traded in that market. 6-10 We actually observe nominal risk-free rates in financial marketsÑthese are the rates most often quoted by financial news services. Real risk-free rates are inter-est rate adjusted for inflation; generally lower than nominal risk-free rates at any particular time.Final PDF to printer

225cor91411_ch06_178-225.indd 225 01/20/17 03:45 PM 6-11 The term structure of interest rates compares interest rates on debt securities based on their time to maturity, assuming that all other characteristics (i.e., default risk, liquidity risk) are equal. 6-12 The yield curve for U.S. Treasury securities has taken many shapes over the years, but the three most common shapes are: (1) the upward-sloping yield curve (most common) where yields rise steadily with maturity; (2) an inverted or downward-sloping yield curve in which yields decline as maturity increases; and (3) a flat yield curve, when the yield to maturity is virtually unaffected by the term to maturity. 6-13 Explanations for the yield curveÕs shape fall predominantly into three categories: the unbiased expectations theory, the liquidity premium theory, and the market segmenta-tion theory. 6-14 According to the unbiased expectations theory, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds (as long as the market is in equilibrium). If this equality does not hold, an arbi-trage opportunity exists. That is, if investors could earn more on the one-year bond investments, they could short (or sell) the four-year bond, use the proceeds to buy the four successive one-year bonds, and earn a guaranteed profit over the four-year investment horizon. 6-15 A forward rate is an expected, or implied, rate on a short-term security that will originate at some point in the future. 6-16 To find an implied forward rate on a one-year security to be issued one year from today, we can rewrite the unbiased expectations theory equation as follows: 1 R 2 = [ ( 1 + 1 R 1 ) ( 1 + 2 f 1 ) ] 1/2 − 1 (6-9) where 2f1 = Expected one-year rate for year 2, or the implied forward one-year rate for next year. Saying that 2f1 is the expected one-year rate for year 2 is the same as saying that, once we isolate the 2f1 term, the equation will give us the marketÕs estimate of the expected one-year rate for year 2. 6-17 As interest rates change, so do the values of financial securities. Accordingly, both individual investors and public corporations want to be able to predict or forecast interest rates if they wish to trade profitably. For example, if interest rates rise, the value of investment portfolios of individuals and corporations will fall, resulting in a loss of wealth. So, interest rate forecasts are extremely important for the financial wealth of both public corporations and individuals.Final PDF to printer

392cor91411_ch12_392-425.indd 392 01/25/17 08:29 PMviewpointsPART SIXBusiness ApplicationSuppose that McDonaldÕs is considering introducing the McTurkey Dinner (MTD). The company anticipates that the MTD will have unit sales, prices, and cost figures as shown in the following table for the next five years, after which the firm will retire the MTD. Introducing the MTD will require $7 million in new assets, which will fall into the MACRS five-year class life. McDonaldÕs expects the necessary assets to be worth $2 million in market value at the end of the project life. In addition, the company expects that NWC requirements at the beginning of each year will be approximately 13  percent of the projected sales throughout the coming year and fixed costs will be $2 million per year. McDonaldÕs uses an 11  percent cost of capital for similar projects and is subject to a 35  percent marginal tax rate. What will be this projectÕs expected cash flows? (See the solution at the end of the chapter.)Estimating Cash Flows on Capital Budgeting Projects12McTurkey Dinner ProjectionsYearEstimated Unit SalesEstimated Selling Price Per UnitEstimated Variable Cost Per Unit1400,000$7.00$3.3521,000,0007.213.5231,000,0007.433.7041,000,0007.653.895500,0007.884.08Thinking about an MBA? What returns can you expect from the investment?Personal ApplicationAchmed contemplates going back to school part time to get an MBA. He anticipates that it would take him four years to get his MBA, and the program would cost $15,000 per year in books and tuition (payable at the beginning of each year). He also thinks that he would need to get a new laptop (which he was going to buy anyway as a portable gaming system) for $2,500 when he starts the program, and he just paid $250 to take the GMAT. After graduation, Achmed anticipates that he will be able to earn approximately $10,000 more per year with the MBA, and he thinks heÕll work for about another 20 years after getting the MBA. What total cash flows should Achmed consider in his decision? (See the solution at the end of the chapter.)Final PDF to printer

393cor91411_ch12_392-425.indd 393 01/25/17 08:29 PMLearning Goals LG12-1 Explain why we use pro forma statements to analyze project cash flows. LG12-2 Identify which cash flows we can incrementally apply to a project and which ones we cannot. LG12-3 Calculate a projectÕs expected cash flows using the free cash flow approach. LG12-4 Explain how accelerated depreciation affects project cash flows. LG12-5 Calculate free cash flows for replacement equipment. LG12-6 Calculate cash flows asso-ciated with cost-cutting proposals. LG12-7 Demonstrate the EAC approach to choosing among alternative cash streams for recurring projects. LG12-8 Adjust initial project invest-ments to account for flota-tion costs.To evaluate capital budgeting projects, we have to estimate how much cash outflow each project will need and how much cash inflow it will generate, as well as exactly when such outflows and inflows will occur. Estimating these cash flows isnÕt difficult, but it is complicated, as there are lots of little details to keep track of. Accordingly, as you look through this chapterÕs examples, questions, and problems, youÕll notice that these types of prob-lems involve a lot more information than those youÕve seen elsewhere in the text, such as ¥ The particular new product or serviceÕs costs and revenues. ¥ The likely impact that the new service or product will have on the firmÕs existing productsÕ costs and revenues. ¥ The impact of using existing assets or employees already employed elsewhere in the firm. ¥ How to handle charges such as the research and development costs incurred to develop the new product.One of the keys to this chapter will be making sure that we have a system-atic approach to handling and arrang-ing details. In the next few sections, © Antenna/Getty Images RFweÕre going to construct a process which, if we follow it faithfully, will guide us in considering factors such as those listed.The exact process that weÕre going to use is more formally referred to as pro forma analysis, which esti-mates expected future cash flows of a project using only the necessary parts of the balance sheet and income statements; if a part of either financial statement doesnÕt change because of the new project, weÕll ignore it. This approach will allow us to focus on the question, ÒWhat will be this projectÕs impact on the firmÕs total cash flows if we go forward?ÓLG12-1pro forma analysisProcess of estimating expected future cash flows of a project using only the relevant parts of the bal-ance sheet and income statements.Final PDF to printer

394 part six Capital Budgetingcor91411_ch12_392-425.indd 394 01/27/17 06:44 PMTABLE 12.1 Sample Project Projected Unit SalesYearUnit Sales115,000227,00035,00012.1 ∙ Sample Project DescriptionLetÕs suppose that we are working for a game development company, First Strike Soft-ware (FSS). FSS is considering leasing a new plant in Gatlinburg, Tennessee, which it will use to produce copies of its new console game ÒFinProf,Ó a role-playing game where the player battles aliens invading a local collegeÕs finance department.FSS will price this game at $39.99, and the firm estimates sales for each of the next three years as shown in Table 12.1. Given buyersÕ rapidly changing tastes in console games, FSS does not expect to be able to sell any more copies after year 3.Variable costs per game are low ($4.25), and FSS expects fixed costs to total $150,000 per year, including rent. Start-up costs include $75,000 for the purchase of a software-duplicating machine, plus an additional $2,000 in shipping and installation costs. For our first stab at analyzing this project, we will assume that the duplicating machine will be straight-line depreciated to an estimated ending salvage value of $5,000 over the life of the project. However, due to the rapidly declining market for such machines (many of FSSÕs competitors are switching to download-only games), we are also estimating that weÕll only be able to sell the machine for $2,000 after weÕre done using it.FinProf is an updated version of an older game sold by FSS, MktProf. FSS intends to keep selling MktProf but anticipates that FinProf will decrease sales of MktProf by 2,000 units per year throughout the life of the new game. MktProf sells for $19.99 and has variable costs of $3.50 per unit. The decrease in MktProf sales will not affect either NWC or fixed assets.Development costs totaled $150,000 throughout the creation of the game, and First Strike estimates its NWC requirements at the beginning of each year will be approxi-mately 10  percent of the projected sales during the coming year. First Strike is in the 34  percent tax bracket and uses a discount rate of 15  percent on projects with risk profiles such as this. The relevant question: Should FSS put FinProf into production or not?12.2 ∙ Guiding Principles for Cash Flow EstimationWhen we calculate a projectÕs expected cash flows, we must ensure that we cover all incremental cash flows; that is, the cash flow changes that we would expect throughout the entire firm, for both this project and for everything else the firm is already doing, because of the new project coming on board. Some incremental cash flow effects are fairly obvious. For example, suppose a firm has to buy a new asset to support a new proj-ect but would not be buying the asset if the project were not adopted. Clearly, the cash associated with buying the asset is due to the project, and we should therefore count it when we calculate the cash flows associated with that project. But we can hardly expect all incremental cash flows to be so obvious. Other incremental cash flows, as discussed in the following sections, are more subtle, and weÕll have to watch for them very carefully.Opportunity CostsAs you likely remember from your microeconomics classes, an opportunity cost exists whenever a firm has to choose how to allocate scarce resources. If those resources go into project A, the firm must forgo using them in any other way. Those forgone choices LG12-1salvage valueThe estimated amount for tax purposes that a company will receive when it disposes of an asset at the end of the assetÕs usable life.LG12-2incremental cash flowsCash flows directly attribut-able to the adoption of a new project.opportunity costThe dollar cost or forgone opportunity of using an asset already owned by the firm, or a person already employed by the firm, in a new project.Final PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 395cor91411_ch12_392-425.indd 395 01/25/17 08:29 PMrepresent lost opportunities, and we have to account for them when calculating cash flows attributable to project A.For example, suppose that FSS already owned the piece of software-duplicating machinery discussed previously. If the machinery was already being fully utilized by another project within the company, then obviously switching it over to the FinProf game would require that other project to find another source of software duplication. Therefore, to be fair, the FinProf project should be charged for the use of the machinery.Even if the machinery was not currently being used in any other projects, it could still possibly have an opportunity cost associated with using it in the FinProf project. If FSS could potentially sell the machinery on the open market for $75,000, the company would have to give up receiving that $75,000 in order to use the piece of machinery for the FinProf game. In the end, it would not really matter whether the firm had to buy the asset from outside sources or not; either way, the project will be tying up $75,000 worth of capital, and it should be charged for doing so.The underlying concept behind charging the project for the opportunity cost of using an asset also applies to expenses other than those associated with capital assets such as machinery: Overall, we should charge any new project for any assets used by that project as well as any wages and benefits paid to employees working on it. Even if the firm was already employing those people prior to starting work on the new project, they are no longer available to work on any existing projects; and if the firm did not have any new projects, it could have laid those employees off, saving their wages and benefits.In the FSS project, wages and benefits to employees would constitute part of the variable costs we were quoted earlier. Just as with the software-duplicating machinery, whether these employees were previously working for FSS on another project would be irrelevant; if FSS is going to use these employees on this project, the project should be charged for them.Sunk CostsIf a firm has already paid an expense in the past or is obligated to pay one in the future (i.e., thereÕs no way out of paying it), regardless of whether a particular project is under-taken, that expense is a sunk cost. A firm should never count sunk costs in project cash flows. Intuitively, if you have to pay the expense regardless of your decision concerning the project, it doesnÕt meet the definition of being Òincremental.ÓFor example, we are told that FSS incurred $150,000 in development costs as they developed the game. Development costs would presumably include items such as the salaries of the gameÕs programmers, market research costs, and so forth. Since we are not told otherwise, we can sensibly assume that this money is gone, and that FSS will never recoup the money, even if it decides not to go ahead with publishing the game. Thus those costs are sunk, and FSS should not even consider them as part of its decision about whether to move forward with putting the FinProf game into production.Substitutionary and Complementary EffectsIf a new product or service will either reduce or increase sales, costs, or necessary assets for other, already existing products or services, then those changes to the cash flows of the other projects are incremental to the new project and should rightfully be included in the new projectÕs cash flows.For example, consider how FSSÕs FinProf game may affect the existing MktProf game. The gross sales and variable cost figures for the new game might be as shown in Table 12.2.However, FSS also expects the MktProf game to lose yearly sales of 2,000 × $19.99 = $39,980 when the FinProf game starts selling. Partially offsetting this, the decrease in sales of MktProf will also result in a decrease in yearly variable costs for MktProf of sunk costA cost that has already been incurred and cannot be recovered.Final PDF to printer

396 part six Capital Budgetingcor91411_ch12_392-425.indd 396 01/25/17 08:29 PM2,000 × $3.50 = $7,000 in savings (i.e., forgone costs) per year. So the net incremental sales and variable cost figures for the project will be as shown in Table 12.3.As we see, we have to reduce FinProfÕs sales each year by the $39,980 reduction in MktProf sales attributable to the Finprof game existing, but we also get to reduce FinProfÕs costs by $7,000 each year due to the cost savings of not having to make so many copies of MktProf. Technically speaking, we are seeing a reduction in both sales and variable costs because FinProf is a partial substitute for MktProf. If the new game had been a complement (i.e., if we had sold more of the MktProf game due to the roll-out of FinProf), then both sales and variable costs of the existing product would have increased instead.Stock Dividends and Bond InterestOne final, important note concerning incremental project cash flows: We will never count any financing costs, including dividends paid on stock or interest paid on debt, as expenses of the project. The costs of capital are already included as component costs in the weighted-average cost of capital (WACC) that we will be using to discount these cash flows in the next chapter. If we were to include them in the cash flow figures as well, we would be double-counting them.substitute and complementEffects that arise from a new product or service either decreasing or increasing sales, respec-tively, of the firmÕs existing products and services.financing costsInterest paid to debt hold-ers or dividends paid to stockholders.TIME OUT 12-1 Suppose that your manager will be devoting half of her time to a new project, with the other half devoted to currently existing projects. How would you reflect this in your cal-culation of the incremental cash flows of the project?  12-2 Could a new product have both substitutionary and complementary effects on existing products?  YearSalesVariable Costs115,000 × $39.99 = $599,85015,000 × $4.25 = $63,750227,000 × $39.99 = $1,079,73027,000 × $4.25 = $114,75035,000 × $39.99 = $199,9505,000 × $4.25 = $21.250TABLE 12.2 Gross Sales and Variable Costs for FinProfYearSalesVariable Costs1$599,850 − $39,980 = $559,870$63,750 − $7,000 = $56,7502$1,079,730 − $39,980 = $1,039,750$114,750 − $7,000 = $107,7503$199,950 − $39,980 = $159,970$21,250 − $7,000 = $14,250TABLE 12.3 Net Incremental and Variable Costs for FinProf12.3 ∙ Total Project Cash FlowIn Chapter 2, we discussed the concept of free cash flow (FCF), which we defined as FCF = Operating cash flow − Investment in operating capital (12-1) = [EBIT (1 − Tax rate) + Depreciation] − [Δ Gross fixed assets + Δ Net operating working capital] LG12-3Final PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 397cor91411_ch12_392-425.indd 397 01/25/17 08:29 PMIn this chapter, we are going to use this variable again as a measure of the total amount of available cash flow from a project. However, we will observe two important differ-ences from how we used it in Chapter 2. First, since we will be considering potential projects rather than a particular firmÕs actual, historic activities, the FCF numbers we calculate will be, frankly, guessesÑinformed guesses, surely, but still guesses. Since we will be ÒcalculatingÓ guesses, we will introduce possible estimation error into our capital budgeting decision statistics, but we will hold off on discussing that until the next chapter.Second, we will now calculate FCF on potential projects individually, rather than across the firm as a whole as we did in Chapter 2. In some ways, calculating FCF on individual projects will make our job much easier, since we donÕt have to worry about estimating an entire set of balance sheets for the firm. Instead, we will only have to be concerned with the limited subset of pro forma statements necessary to keep track of the assets, expense categories, and so on, that a new project will affect. Unfortunately, the elements of that limited set will vary from situation to situation, and the hard part will be identifying which parts of the balance sheets are necessary and which are not.Calculating DepreciationExpected depreciation on equipment used during the life of the project will affect both the operating cash flows and the change in gross fixed assets that will occur at the end of the project when we sell or abandon them, so letÕs start our organizing there.For First StrikeÕs proposed FinProf project, the firm will depreciate capital assets such as the software-duplicating machine using the straight-line method to an ending book value of $5,000. To calculate the annual depreciation amount, First Strike will first need to compute the machineryÕs depreciable basis. According to the Internal Revenue Ser-viceÕs (IRS) Publication 946, the depreciable basis for real property is the sum of: ¥ Its cost. ¥ Amounts paid for items such as sales tax. ¥ Freight charges. ¥ Installation and testing fees.We arenÕt told anything about sales tax on the machinery, so the depreciable basis for the new projectÕs software-duplicating machine will be the $75,000 purchase price plus the $2,000 shipping and installation cost, for a total depreciable basis of $77,000.Under straight-line depreciation, the annual depreciation for each year will be equal to the depreciable basis minus the projected ending book value, all over the number of years in the life of the asset: Depreciation = Depreciable basis − Ending book value _______________________________ Life of asset (12-2) = $77,000 − $5,000 ______________ 3 years = $24,000 per year WeÕll discuss later in the chapter why this depreciation assumption is far too simple, and why other, more complicated depreciation methods can be much more advantageous to the company. For now, though, this straight-line depreciation approach will suffice for our initial go at calculating the projectÕs cash flows.Calculating Operating Cash FlowWe defined operating cash flow (OCF) in Chapter 2 as EBIT (1 − Tax rate) + Deprecia-tion. We will still calculate OCF as being mathematically equal to EBIT (1 − Tax rate) + Depreciation. But remember that we will be constructing the FCF components ourselves depreciable basisAn assetÕs cost plus the amounts you paid for items such as sales tax, freight charges, and installation and testing fees.Final PDF to printer

398 part six Capital Budgetingcor91411_ch12_392-425.indd 398 01/25/17 08:29 PMinstead of taking them off an income statement that someone else has already produced. So we will usually find it most helpful to conduct this calculation by using what we will call a Òquasi-income statementÓ that leaves out some components that donÕt matter for project cash flows, such as interest deductions. (Note that the process of leaving out any interest deduction is exactly in line with our discussion of not counting interest on debt as an expense of the project, but the resulting financial statement would not make an accountant happy).Such a statement is shown in Table 12.4 for First StrikeÕs proposed project. The pri-mary benefit of calculating OCF this way instead of as an algebraic formula is that with this format, we have space to expand subcalculations, such as the impact of FinProf being a partial substitute for the MktProf product.Before we move on, notice that not only is EBIT negative in year 3 of OCF calcula-tions, but we also assume that this negative EBIT, in turn, generates a Ònegative tax billÓ (i.e., a tax credit, when we subtract the negative tax amount of −$9,615 from the negative EBIT). How, and when, can we get away with making this assumption?Well, the rule for handling negative EBIT is that when calculating the cash flows for a single project for a firm, we assume that any loss by this project in a particular period can be applied against assumed before-tax profits made by the rest of the firm in that period. So, while our project is expected to have a loss of $28,280 before taxes during year 3, the assumed ability of the firm to use that loss to shelter $28,280 in before-tax profits elsewhere in the firm means that the incremental after-tax net income for this project during year 3 is expected to be −$28,280 − (−$9,615) = −$18,665. This is still negative, but less negative than the EBIT because of this tax-sheltering effect.What would we do if we expected a negative EBIT during a particular year and this was the only project the firm was undertaking, or if this project was so big that a negative EBIT would overshadow any potential profits elsewhere in the firm? Long story short, we would not get to take the tax credit during that year . . . but we will leave the discussion of just exactly when we would get to take it to a more advanced text.Calculating Changes in Gross Fixed AssetsGross fixed assets will change in almost every project at both the beginning (when assets are usually purchased) and at the end (when assets are usually sold). First StrikeÕs pro-posed project is no exception.Year 1Year 2Year 3 Sales of FinProf$ 599,850$ 1,079,730$1,079,730 Less: Reduced sales of MktProf 39,980 39,980 39,980Net incremental sales$ 559,870$ 1,039,750$159,970 Variable costs of FinProf$ 63,750$ 114,750$ 21,250 Less: Reduced costs of MktProf 7,000 7,000 7,000Less: Incremental variable costs56,750107,75014,250Less: Fixed costs150,000150,000150,000Less: Depreciation 24,000 24,000 24,000Earnings before interest and taxes$ 329,120$ 758,000−$ 28,280Less: Taxes 111,901 257,720 −9,615Net income$ 217,219$ 500,280−$ 18,665Plus: Depreciation 24,000 24,000 24,000Operating cash flow$ 241,219$ 524,280 $ 5,335TABLE 12.4 Calculation of OCFFinal PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 399cor91411_ch12_392-425.indd 399 01/25/17 08:29 PMCalculating the change in gross fixed assets at the beginning of the project is fairly straightforwardÑit will simply equal the assetÕs depreciable basis. So, for FSSÕs project, we will increase gross fixed assets by $77,000 at time zero.At the end of a project, the change in gross fixed assets is a little more complicated, because whenever a firm sells any asset, it has to consider the tax consequences of that sale. The IRS treats any sale of assets for more than depreciated book value as a taxable gain and any sale for less than book value as a taxable loss. In either event, we can calcu-late the after-tax cash flow (ATCF) from the sale of an asset using the following formula, where TC is the same appropriate corporate tax rate discussed in the previous chapter. ATCF = Market value − (Market value − Book value) × TC (12-3)Since the machinery for FSSÕs project will be depreciated down to $5,000 but is expected to sell for only $2,000, the ATCF for that assetÕs sale will equal ATCF = $5,000 + ($2,000 − $5,000) × (1 − 0.34) = $3,020 Although it may be a little difficult to wrap your brain around the idea of reducing the $5,000 we were Òsupposed to getÓ (at least, according to the IRS) from the sale of the machinery at the end of the project by only 66  percent of the shortfall from that amount we actually expect to happen (i.e., $5,000 − $2,000 = $3,000), thatÕs exactly what weÕre doing. ÒLosingÓ $3,000 of the $5,000 expected book value when we sell the machinery will let us hide $3,000 in revenues elsewhere from the tax man, so we get credit for shielding $3,000 from our 34 percent tax rate loss (i.e., $3,000 × 34% = $1,020) in addi-tion to estimating that weÕll be able to sell the machinery for $2,000 cash. If this really is making your brain hurt, just realize that, as long as you faithfully and precisely apply the formula for ATCF, it will give you the net cash flow from the sale of the asset. In particular, note that this formula would work equally well on an asset sold at a gain.EXAMPLE 12-1ATCF for an Asset Sold at a GainSuppose that a firm facing a marginal tax rate of 25  percent sells an asset for $4,000 when its depreciated book value is $2,000. What will be the ATCF from the sale of this asset?SOLUTION: The ATCF will equal ATCF = $2,000 + ($4,000 − $2,000) × (1 − 0.25) = $3,500 Similar to Problems 12-1, 12-8For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG12-3 Calculating Changes in Net Working CapitalWe can make several different assumptions concerning the NWC level necessary to sup-port a project. The most straightforward of these would be to simply assume that we add NWC at the beginning of the project and subtract it at the end. This assumption would be valid if the project is expected to have steady sales throughout its life, or if variations in NWC do not affect the project much.FSSÕs proposed project, however, features a more typical product life cycle. Its unit sales will follow an approximate bell-shaped curve, starting out low at the beginning, peaking in the middle of the project, and then dropping off again at the end. When sales are timed in this way, FSS needs to give a little more thought to exactly when the firm Final PDF to printer

400 part six Capital Budgetingcor91411_ch12_392-425.indd 400 01/25/17 08:29 PMneeds to set aside net working capital to support high sales volumes and when it can reduce NWC as sales drop off.The assumption that First StrikeÕs NWC at any particular time will be a function of the next yearÕs sales might seem odd at first glance. But a little thought about how we mea-sure balance sheet numbers (such as NWC) and income statement items (such as sales) will show that, really, this assumption makes a lot of sense.Since income statements (and our quasi-income statement discussed previously) mea-sure what happens during a period, the sales show up on the statement at the end of the year, even though they actually start accumulating at the beginning of the year. The balance sheet Òsnapshots,Ó on the other hand, capture how much capital sits in NWC accounts at a particular point in time. So, for example, the sales figures from our quasi-income statement for year 1 that are used in the OCF calculation for year 1 must be supported when they start occurring, which would be at the start of year 1. But remem-ber, timelines are funny things: The start of year 1 is actually year 0, so we have to plan to have the NWC shown on the year 0 balance sheet reflect capital earmarked for NWC that will be supporting year 1 sales.Of course, this same line of reasoning can be generalized for all other time periods, too: Any sales figure that appears in a time N OCF calculation needs NWC support at the beginning of year N, which is actually time N − 1. So NWC at time N − 1 should vary with time N sales. Therefore, the assumption that First StrikeÕs NWC at any particular time will be a function of the next yearÕs sales isnÕt as crazy as we first thought.Also, note that it is just the changes in the level of NWC, not the levels themselves, that will affect our cash flows. To explain why, we need to throw a little more intuition into the pot here.First, we have to admit that we do not really care about the changes in NWC, either, at least not for their own sake; instead, what we are actually measuring is the investment in capital necessary to make those changes happen. (And thatÕs why there is a negative sign in front of NWC in our formula for free cash flow: It costs us money to make NWC bigger, and vice versa).Second, we need to think a little about exactly what we are measuring when we talk about using NWC to support sales. Since NWC equals current assets minus current lia-bilities, itÕs probably easier to think of it as being composed of cash, accounts receivable, and inventory, net of current liabilities. Do these types of assets get used up? Sure, when cash is used to make change, or when someone pays off an account receivable, or when we sell finished goods out of inventory, the respective asset account will go down. But those accounts go down because we are bringing in money, and some of that money can be used to Òrestock the shelves,Ó so to speak; that is, when someone buys one of our prod-ucts out of inventory, we assume that part of the purchase price goes toward replenishing the inventory we just sold, and when someone pays off an account receivable, we assume that allows us to turn around and lend that money to someone else and so forth.The basic point here is that cash, once invested in NWC, pretty much replenishes itself until we manually take it back out. So when we are looking at the levels of NWC throughout the life of a project, it is the changes in those levels that we have to finance, not the levels themselves. Once we put a million dollars into inventory, it sort of stays there because of this idea of replenishment, even when we sell some of the inventory. And if we are keeping track of the amount of money that we have to invest in inventory or some other type of NWC account, we will find investment necessary only when we need to grow NWC by adding to that million dollars (or when we decide to take some of it back out).So, we can use the given information for the First Strike project to compute the NWC necessary to support sales throughout the projectÕs life, and then in turn use NWC lev-els to compute the necessary changes in NWC, as shown in Table 12.5. Notice that the NWC level at each time is simply 10  percent of the following yearÕs sales figures from Table 12.4.Final PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 401cor91411_ch12_392-425.indd 401 01/25/17 08:29 PMThis method for computing changes in NWC levels has several appealing features: ¥ The changes in NWC at the beginning of a project will always equal the level at time 0, as NWC will be going from a presumed zero level before the project starts up to that new, non-zero level. ¥ Allowing NWC to vary as a  percentage of coming sales like this allows FSS to add NWC during periods when it expects sales to increase (e.g., years 0 and 1 in this example) and to decrease NWC when it expects sales to fall off (e.g., years 2 and 3 in this example). NWC levels fall off the last two years of this project precisely because FSS expects sales to fall off and is adjusting NWC to compensate. ¥ Finally, one especially nice feature of this approach is that it will always automati-cally bring NWC back down to a zero level when the project ends. Since sales in the year after the project ends are always zero, 10  percent of zero will also be zero. This corresponds to what we would expect to see in the real world: when a proj-ect ends, the firm sells off inventory, collects from customers, pays off accounts receivable, and so forth.Bringing It All TogetherUsing the numbers that we calculated for OCF, change in gross fixed assets, and change in NWC, First StrikeÕs expected total cash flows from the new project would be as shown in Table 12.6.Note, in particular, that correct use of the after-tax cash flow from selling the machin-ery at the end of the project requires that we change the cash flowsÕ sign to negative when we enter it for year 3. Why? Because the ATCF formula shown in equation 12-3 does a little too much work for us. It computes cash flow effects of selling the asset, while the formula we are using for FCF wants us to enter the change in fixed assets. Or, to put it another way, cash flow at the end of the project should go up because fixed assets decrease. We subtract that decrease in our FCF = OCF − (ΔFA + ΔNWC) calculation, which has the effect of Òsubtracting a minus.Ó Eventually, then, we increase the final yearÕs FCF above that which we would have generated by just combining OCF with the cash freed up from decreasing NWC.Year:0123Level of NWC$59,985$107,973$19,995$0NWCt − NWCT−1 = ΔNWCt$59,985 − $0 = $59,985$107,973 − $59,985 = $47,988$19,995 − $107,973 = −$87,978$0 − $19,995 = −$19,995TABLE 12.5 Change in NWCYear:0123OCF $ 0$241,219$524,280$ 5,335 FA$77,000$ 0$ 0−$3,020 NWC 59,985 47,988−87,978−19,995Less: IOC 136,985 47,988 −87,978−23,015FCF−$136,985$193,231$612,258$28,350TABLE 12.6 Total Cash FlowsTIME OUT 12-3 Explain why an increase in NWC is treated as a cash outflow rather than as an inflow. 12-4 Will OCF typically be larger or smaller than net income? Why?  Final PDF to printer

402 part six Capital Budgetingcor91411_ch12_392-425.indd 402 01/25/17 08:29 PM12.4 ∙ Accelerated Depreciation and the Half-Year ConventionOur FCF calculation in the previous section was complete, but we used a rather simplistic assumption concerning depreciation in the calculations. In reality, the IRS requires that depreciation must be calculated using the half-year convention, which basically says that all property placed in service during a given period is assumed to be placed in service at the midpoint of that period.1 By implication, three years of asset life, such as the machin-ery in the First Strike example, will extend over four calendar years of the firm, starting a half-year before the project starts and ending a half-year after it ends.Just to make things a little more confusing, the IRS names an assetÕs class life in its depreciation tables according to how long the asset will live, not according to how many of the firmÕs calendar years the depreciation will stretch across. For example, Table 12.7 shows an excerpt from the IRS depreciation table for straight-line depreciation using the half-year convention.Note that assets falling in, for example, the three-year class life (denoted by the col-umn headings along the top) get depreciation taken during the first four calendar years after purchase, with the  percentage figures in the relevant column denoting how much of the assetÕs depreciable basis may be deducted in each respective firm calendar year. For example, an asset with a depreciable basis of $100,000 falling into the three-year class life would be depreciated $100,000 × 0.1667 = $16,670 during the first calendar year the firm owned it, $33,330 during the second and third years of ownership, and another $16,670 during the fourth year of ownership.The IRS provides guidance on which categories various assets fall into, so itÕs usually pretty easy to figure out which column to use. For this text, we will assume that we are always told which column to use.Note that the IRSÕs interpretation of the half-year convention is not as direct as simply taking one-half of the first yearÕs depreciation and moving it to the end of the assetÕs life. For example, the column for 3.5-year depreciation shows that such an asset would have 14.29  percent of its value depreciated during the first year and 28.57  percent during each of the second, third, and fourth years. So, rather than using a formula to compute the depreciation  percentage, itÕs preferable to look the  percentages up from the appropriate IRS table. A copy of the entire table for straight-line depreciation using the half-year con-vention appears as Appendix 12A at the end of this chapter.MACRS Depreciation CalculationThough the IRS allows firms to use the straight-line method with the half-year convention to depreciate assets, most businesses probably benefit from using some form of acceler-ated depreciation. Accelerated depreciation allows firms to expense more of an assetÕs LG12-4class lifeThe number of years of assumed usage for an asset to be used in the cal-culation of depreciation.1There are also midmonth and midquarter conventions, which apply in special circumstances. Please refer to IRS Publication 946 for details.Normal Recovery PeriodYear2.533.545120.00%16.67%14.29%12.50%10.00%244.00 33.33 28.57 25.00 20.00 340.00  33.33 28.57 25.00 20.00 40.00 16.67 28.57 25.00 20.00 50.00 0.000.0012.50 20.00 60.000.000.000.0010.00TABLE 12.7 Excerpt of Straight-Line Depreciation Table with Half-Year ConventionFinal PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 403cor91411_ch12_392-425.indd 403 01/25/17 08:29 PMcost earlier in the assetÕs life. An example of this is the double-declining-balance (DDB or 200  percent declining balance) depreciation method, under which the depreciation rate is double that used in the straight-line method.To make all of this completely confusing, the IRS also uses the half-year convention with DDB depreciation and tends to switch back and forth between DDB and SL depre-ciation methods in the same table, depending upon which method is more advantageous to the taxpayer.For example, MACRS (modified accelerated cost recovery system) depreciation tables use DDB for 3- to 10-year property, the 150  percent declining balance method for 15- to 20-year property, and straight-line depreciation whenever it becomes more advantageous to the taxpayer. But for real estate, MACRS uses straight-line depreciation and the mid-month convention for all asset classes.This all can be more than enough to make you want to cry, but the good news is that the applicable depreciation  percentages are provided for you in the MACRS depreciation tables compiled by the IRS. We have provided this for you in Appendix 12A. An excerpt of the DDB section of the MACRS table appears as Table 12.8. MACRS is generally the depreciation method of choice for firms since it provides the most advantageous method of depreciation.Section 179 DeductionsIn certain circumstances, we can accelerate asset expensing even further by expensing assets immediately in the year of purchase rather than having to depreciate them over time. The IRS allows most businesses to immediately expense up to $500,000 of property placed in service each year under what is referred to as a Section 179 deduction. The Section 179 deduction is obviously targeted at helping small businesses, so it places an annual limit on the amount of deductible property. If the cost of qualifying Section 179 property you put into service in a single tax year exceeds the current statutory base of $2 million (as of the 2015 tax year), then you cannot take the full deduction. The maxi-mum deduction is also limited to the annual taxable income from the active conduct of the business.Section 179 deductionA deduction targeted at small businesses that allows them to immediately expense asset purchases up to a certain limit rather than depreciating them over the assetsÕ useful lives.Normal Recovery PeriodYear35710133.33%20.00%14.29%10.00%244.45 32.00 24.49 18.00 314.81 19.20 17.49 14.40 47.4111.52 12.49 11.52 50.0011.52 8.939.2260.005.768.927.3770.000.008.936.5580.000.004.466.5590.000.000.006.56100.000.000.006.55110.000.000.003.28120.000.000.000.00130.000.000.000.00140.000.000.000.00150.000.000.000.00160.000.000.000.00170.000.000.000.00180.000.000.000.00190.000.000.000.00200.000.000.000.00210.000.000.000.00TABLE 12.8 DDB Depreciation with Half-Year ConventionFinal PDF to printer

404 part six Capital Budgetingcor91411_ch12_392-425.indd 404 01/25/17 08:29 PMFor example, consider a manufacturer who completely re-equips his facility in 2015, at a cost of $2.1 million. This is $100,000 more than allowed, so he must reduce his eligible deductible limit to $400,000, which is the current $500,000 expensing limit minus the $100,000 excess over the current statutory base limit. To take this deduction, the firm must have at least $400,000 of taxable income for the year. A company that spent $2.5 million (= $2 million + $500,000) or more on qualifying Section 179 property would not be able to take the deduction at all, regardless of its taxable income. Property that does not qualify for a Section 179 deduction can be depreciated using MACRS.Property eligible for a Section 179 deduction includes ¥ Machinery and equipment. ¥ Furniture and fixtures. ¥ Most storage facilities. ¥ Single-purpose agricultural or horticultural structures. ¥ Off-the-shelf computer software. ¥ Certain qualified real property (limited to $250,000 of the $500,000 expensing limit).Ineligible property includes ¥ Buildings and their structural components (unless specifically qualified). ¥ Income-producing property (investment or rental property). ¥ Property held by an estate or trust. ¥ Property acquired by gift or inheritance. ¥ Property used in a passive activity. ¥ Property purchased from related parties. ¥ Property used outside of the United States.Like many IRS deductions, there are several terms and conditions that apply, so be sure to get all the facts if you intend to use this method of depreciation.Impact of Accelerated DepreciationSo, letÕs return to our FSS example and FinProf. Remember that our initial, simplistic view of depreciation had us taking $24,000 per year in depreciation for each of the three years of the projectÕs life. If the software reproduction machinery fell into the three-year life class, we could instead have taken the following depreciation amounts by using either the straight-line or DDB approaches, as shown in Table 12.9.If First Strike could take advantage of the Section 179 deduction that would probably be the most advantageous way to deduct the cost of the new machineryÑit could deduct the entire $77,000 in year 1. If FSS could not use a Section 179 deduction, the DDB depreciation available under MACRS would result in the next quickest recovery of the tax breaks associated with the machinery purchase.And why is it better to depreciate the cost of an asset as quickly as possible? Well, tak-ing the depreciation over a longer time span doesnÕt get you more dollars of depreciation tax shield; it just stretches the same total amount of dollars over that longer time span. So, think about it in the context of time value of money: The present value of $X of total income tax shield will be highest when we get the $X as soon as possible.Year 1Year 2Year 3Ending BVStraight-line$77,000 − 16.67% = $12,835.90$77,000 − 33.33% = $25,664.10$77,000 − 33.33% = $25,664.10$12,835.90DDB$77,000 − 33.33% = $25,664.10$77,000 − 44.45% = $34,226.50$77,000 − 14.81% = $11,403.70$5,705.70TABLE 12.9 FSSÕs Yearly Depreciation and Ending Book Values under Alternative DepreciationFinal PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 405cor91411_ch12_392-425.indd 405 01/27/17 07:27 PM12.5 ∙ ÒSpecialÓ Cases ArenÕt Really That SpecialAs long as we are consistent in using incremental FCF to calculate total project cash flows, we can handle many project types that are habitually viewed as ÒspecialÓ cases requiring extraordinary treatment with some relatively simple revisions to the methods we used for valuing First StrikeÕs proposed new project.LG12-5TIME OUT 12-5 Explain why, under MACRS, Òfive-yearÓ depreciation is actually spread over six years, six-year depreciation spreads into seven years, and so forth. 12-6 If the IRS wanted to encourage businesses to invest in certain types of assets, would it put them into shorter or longer MACRS life-class categories?Replacement ProblemSuppose that Just-in-Time Donuts is considering replacing one of its existing ovens. The original oven cost $100,000 when purchased five years ago and has been depreciated by $9,000 per year since then. Just-in-Time thinks that it can sell the old machine for $65,000 if it sells today, and for $10,000 by waiting another five years until the ovenÕs anticipated life is over. Just-in-Time is considering replacing this oven with a new one, which costs $150,000, partly because the new oven will save $50,000 in costs per year relative to the old oven. The new oven will be subject to three-year class life DDB depreciation under MACRS, with an anticipated useful life of five years. At the end of the five years, Just-in-Time will abandon the oven as worthless. If Just-in-Time faces a marginal tax rate of 35  percent, what will be the total project cash flows if it replaces the oven?SOLUTION: If Just-in-Time sells the old oven today for $65,000 when it has a remaining book value of $55,000 ($100,000 purchase price − 5 years of $9,000 per year deprecia-tion), then the ATCF from its sale will equal ATCF = Book value + (Market value − Book value) × (1 − TC) = $55,000 + ($65,000 − $55,000) × (1 − 0.35) = $61,500 In return for selling the old oven today, however, Just-in-Time will have to forgo both the yearly depreciation that the company would have received for it over the next five years and the EXAMPLE 12-2For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG12-5 YearYear 0Year 1Year 2Year 3Year 4Year 5Net incremental sales$ 0$ 0$ 0$ 0$ 0Less: Net incremental variable costs−50,000−50,000−50,000−50,000−50,000 Depreciation on new oven$49,995$66,675$22,215$11,115$ 0 Forgone depreciation on old oven −9,000 −9,000 −9,000 −9,000 −9,000Less: Incremental depreciation 40,995 57,675 13,215 2,115 −9,000EBIT $ 9,005−$ 7,675$36,785$47,885$59,000Less: Taxes 3,152 −2,686 12,875 16,760 20,650ÒNet incomeÓ$ 5,853−$ 4,989$23,910$31,125$38,350Plus: Depreciation 40,995 57,675 13,215 2,115 −9,000OCF$46,848$52,686$37,125$33,240$29,350 ΔFA for new oven$150,000$ 0 ΔFA for old oven −61,500 10,000 ΔFA$ 88,500$10,000 ΔNWC 0 0Less: Investment in operating capital $88,500 0 0 0 0 10,000FCF = OCF − IOC−$88,500 $46,848 $52,686 $37,125 $33,240 $19,350Final PDF to printer

406 part six Capital Budgetingcor91411_ch12_392-425.indd 406 01/25/17 08:29 PM$10,000 that it could get for selling it at the end of the five years. We must reflect both of these factors in our calculation of incremental FCFs so that we are reckoning the true costs of the proj-ect. In addition, switching from the old oven to the new one would apparently alter neither sales nor NWC requirements across the five-year life of the new oven (see table on the previous page).We usually think that a positive value for ΔFA is associated with the purchase of FA. But note that in this circumstance, the $10,000 for the forgone sale of the old oven at time 5 is not an investment in fixed assets, but rather the opportunity cost of not getting to sell the old oven at that time.Similar to Problem 12-13Cost-Cutting ProblemYour company is considering a new computer system that will initially cost $1 million. It will save your firm $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated using three-year MACRS. The firm expects that the system will have a salvage value of $50,000 at the end of year 5. This purchase does not affect net working capital; the marginal tax rate is 34  percent, and the required return is 8  percent. What will be the total project cash flows if this cost-cutting proposal is implemented?SOLUTION: Since the new computer falls into the three-year MACRS category, it will be fully depreciated when the project ends five years from now. As a result, the ATCF from the sale of the computer will be ATCF = BV + (MV − BV ) × (1 − T c ) = $0 + ($50,000 − $0) × (1 − 0.34) = $33,000 And the FCFs for the cost-cutting proposal will be equal toSimilar to Problem 12-9YearYear 0Year 1Year 2Year 3Year 4Year 5Net incremental sales$ 0$ 0$ 0$ 0$ 0Less: Incremental variable costs−300,000−300,000−300,000−300,000$ 0−300,000Less: Incremental depreciation 333,300 444,500 148,100 74,100 0EBIT−$ 33,300−$144,500$151,900$225,900$300,000Less: Taxes −11,322 −49,130 51,646 76,806102,000Less: Taxes−$ 21,978−$ 95,370$100,254$149,094$198,000ÒNet incomeÓ 333,300 444,500 148,100 74,100 0Plus: Depreciation$311,322$349,130$248,354$223,194$198,000OCF ΔFA$1,000,000−$33,000 ΔNWC 0 0Less: Investment in operating capital $1,000,000 0 0 0 0 −33,000FCF = OCF − IOC −$1,000,000 $311,322 $349,130 $248,354 $223,194 $231,000EXAMPLE 12-3For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG12-6 TIME OUT 12-7 Explain why, in Example 12-2, the investment in operating capital in the last year of the project was positive instead of negative.   12-8 Would it ever be possible to have a project that generated net positive cash flows across all years of a projectÕs life just by buying and depreciating assets?  Final PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 407cor91411_ch12_392-425.indd 407 01/25/17 08:29 PM12.6 ∙ Choosing between Alternative Assets with Differing Lives: EACOne type of problem that also deserves special mention involves situations where weÕre asked to choose between two different assets that can be used for the same purpose. Such a problem does not usually require the computation of incremental FCF, but instead will require you to take the two alternatives sets of incremental cash flows associated with the two assets and restructure them so that they can be compared to each other.For example, suppose a company has decided to go ahead with a project but needs to choose between two alternative assets, where ¥ Both assets will result in the same sales. ¥ Both assets may have different costs and recurring expenses. ¥ Assets will last different lengths of time. ¥ When the chosen asset wears out, it will be replaced with an identical machine.In such a situation, the firm cannot really compare one iteration of each machine to the other, since they last different lengths of time. The key here is to use the fact that, since the firm will replace each machine with another identical machine when it wears out, it is really being asked to choose between two sets of infinite, but systematically varying, cash flows. To handle such a situation, we need to Òsmooth outÓ the variation in each set of cash flows so that each becomes a perpetuity. Then the company can choose between the two machines based on which will generate the highest present value of cash flows.Since the decision will involve only a subset of a projectÕs cash flowsÑthe purchase of one of a choice of assetsÑthat present value will probably be negative. If the firm were to look at all the benefits deriving from the choice of which asset to use, including expected sales and so forth, the present value of all cash flows would need to be positive for the entire project to be attractive. We will discuss this in much greater depth in the next chapter when we cover the net present value (NPV) rule for capital budgeting decisions.The basic concept behind the EAC approach is to use TVM to turn each iteration of each project into an annuity. Once we have done that, then we can think of the stream of iterations of doing that project again and again as a stream of annuities, all with equal paymentsÑor, to put it another way, as a perpetuity.To compute and use the EACs of two or more alternative assets 1. Find the sum of the present values of the cash flows (the net present value, or NPV, which we will cover in great detail in the next chapter) for one iteration of A and one iteration of B. 2. Treat each sum as the present value of an annuity with life equal to the life of the respective asset, and solve for each assetÕs EAC (i.e., payment). 3. Choose the asset with the highest (i.e., least negative) EAC.It may seem that we have just done exactly what we said we should not do: compare the cash flows from one machine A to those from one machine B. In fact, the comparison we just did is actually much broader than that, though it will take a little explanation to see.Visualize the cash flows to the infinitely repeated purchases of machine B (chosen simply because it has a short life, so it will be easier to see multiple iterations on a time line in the following discussion) as shown in Figure 12.1.LG12-7FIGURE 12.1Cash Flows of Repeated Purchases of Machine BYear 0 1 2 3 4 5 6B −$12,000 −$3,500 −$3,500 −$3,500 −$12,000 −$3,500 −$3,500 −$3,500 −$12,000B Total −$12,000 −$3,500 −$3,500 −$15,500 −$3,500 −$3,500 −$15,500Final PDF to printer

408 part six Capital Budgetingcor91411_ch12_392-425.indd 408 01/25/17 08:29 PMNotice that, after the initial purchase of the first machine B, the cash flows exhibit a systematic cycle: −$3,500 for two years, followed by −$15,500 for one year (when the next machine B is purchased), repeating this way forever. This systematic cycle, which we donÕt have a formula for valuing, makes it necessary to convert these cash flows into a perpetuity, which we can value.When we computed the NPV of one iteration of machine B, we basically ÒsquishedÓ that machineÕs cash flows down to a single lump sum at one point in time (i.e., the pur-chase point for that particular machine), and when we treated that as the present value of an annuity and solved for the payments we were effectively taking that same value and spreading it evenly across the life of the first machine B. Furthermore, since subsequent machine B purchases will be identical to this first one, we can visualize doing the exact EAC ApproachSuppose that your company has won a bid for a new projectÑpainting highway signs for the local highway department. Based on past experience, you are pretty sure that your company will have the contract for the foreseeable future, and now you have to decide whether to use machine A or machine B to paint the signs: Machine A costs $20,000, lasts five years, and will generate annual after-tax net expenses of $2,500. Machine B costs $12,000, lasts three years, and will have after-tax net expenses of $3,500 per year. Assume that, in either case, each machine will simply be junked at the end of its useful life, and the firm faces a cost of capital of 12  percent. Which machine should you choose?SOLUTION: One iteration of each machine will consist of the sets of cash flows shown below:Year012345Machine A CFs−$20,000−$2,500−$2,500−$2,500−$2,500−$2,500Machine B CFs  −12,000  −3,500  −3,500  −3,500The sum of the present values of machine AÕs cash flows will be ∑ t=0 5 C F t ______ (1 + i) t = C F 0 ______ (1 + i) 0 + C F 1 ______ (1 + i) 1 + C F 2 ______ (1 + i) 2 + C F 3 ______ (1 + i) 3 + C F 4 ______ (1 + i) 4 + C F 5 ______ (1 + i) 5 = −$20,000 ________ (1.12) 0 + −$2,500 _______ (1.12) 1 + −$2,500 _______ (1.12) 2 + −$2,500 _______ (1.12) 3 + −$2,500 _______ (1.12) 4 + −$2,500 _______ (1.12) 5 = −$29,012 Treating this as the present value of a five-period annuity, setting i to 12  percent, and solving for payment will yield a payment of −$8,048, which is machine AÕs EAC.The sum of the present values of machine BÕs cash flows will be ∑ t=0 3 C F t ______ (1 + i) t = C F 0 ______ (1 + i) 0 + C F 1 ______ (1 + i) 1 + C F 2 ______ (1 + i) 2 + C F 3 ______ (1 + i) 3 = −$12,000 ________ (1.12) 0 + −$3,500 _______ (1.12) 1 + −$3,500 _______ (1.12) 2 + −$3,500 _______ (1.12) 3 = −$20,406 Treating this as the present value of a 3-period annuity, setting i to 12  percent, and solving for payment will yield a payment of −$8,496, which is machine BÕs EAC.Since machine AÕs EAC is less negative than machine BÕs, your firm should choose machine A.Similar to Problems 12-3 to 12-5, Self-Test Problem 3EXAMPLE 12-4For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG12-7 CALCULATOR HINTSN = 5I = 12PV = 29,012FV = 0CPT PMT = −8,048CALCULATOR HINTSN = 3I = 12PV = 20,406FV = 0CPT PMT = 8,496Final PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 409cor91411_ch12_392-425.indd 409 01/27/17 06:44 PMsame thing to every machine BÕs cash flow. Turning each machine BÕs cash flow into an annuity in this manner has the net effect of turning all the machine BÕs cash flows into a perpetuity, as shown in Figure 12.2.In the process, we also turn the repeated purchase of machine A into a perpetuity. We could calculate the present values of these two perpetuities and then compare them, which is what weÕre really interested in doing: P V Perpetuity of Infinitely Repeated As vs. P V Perpetuity of Infinitely Repeated Bs −$8,048 _______ 0.12 vs. −$8,496 _______ 0.12 But do we really need to? No. The relationship between these two present values of the respective perpetuities is really the same as the relationship between their payment amounts2Ñeach machineÕs respective EAC.FIGURE 12.2Converted Cash Flows of Repeated Purchases of Machine BYear 0 1 2 3 4 5 6New B $0 −$8,496 −$8,496 −$8,496 $0 −$8,496 −$8,496 −$8,496 $0 New B Total $0 −$8,496 −$8,496 −$8,496 −$8,496 −$8,496 −$8,496 TIME OUT 12-9 Explain how the EAC approach turns uneven cash flows for infinitely repeated asset purchases into perpetuities.   12-10 What if two alternative assets lasted the same length of time: Would the EAC approach still work?  2Because the two perpetuities have the same interest rate and the same periodicity (i.e., length between pay-ments), the only possible source of difference in their present values would be the respective payment amounts.12.7 ∙ Flotation Costs RevisitedIn the previous chapter, we talked about how to take flotation costs into account by adjust-ing the WACC upwards, incorporating flotation costs directly into the issue prices of the securities used to fund projects. Another way that we can account for flotation costs is to adjust the projectÕs initial cash flow so that it will reflect the flotation costs of raising capital for the project as well as the necessary investment in assets.In this approach, we will 1. Compute the weighted-average flotation cost, fA, using the firmÕs target capital weights (because the firm will issue securities in these  percentages over the long term): f A = E _______ E + P + D f E + P _______ E + P + D f P + D _______ E + P + D f D (12-4)where fE, fP, and fD are the  percentage flotation costs for new equity, preferred stock, and debt, respectively.LG12-8Final PDF to printer

410 part six Capital Budgetingcor91411_ch12_392-425.indd 410 01/25/17 08:29 PM 2. Compute the flotation-adjusted initial investment, CF0, using Adjusted C F 0 = C F 0 ____ 1 − f A (12-5)Adjusting CF0 for Flotation CostYour company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $375,000 per year for five years. The WACC is 15  percent and the firmÕs target D/A ratio is 0.375. The flotation cost for equity is 5  percent, the flotation cost for debt is 3  percent, and your firm does not plan on issuing any preferred stock within its capital struc-ture. If your firm follows the practice of incorporating flotation costs into the projectÕs initial investment, what will the flotation-adjusted cash flows for this project be?SOLUTION: Since the D/A is 0.375, the E/A ratio will be equal to 1 − 0.375 = 0.625, and the weighted- average flotation cost for the firm will be f A = E _______ E + P + D f E + P _______ E + P + D f P + D _______ E + P + D f D = (0.625 × 0.05) + (0.375 × 0.03) = 0.0425, or 4.25% Using this, the adjusted CF0 for the project will be Adjusted C F 0 = C F 0 ____ 1 − f A = −$1,000,000 ___________ 1 − 0.0425 = −$1,044,386 So the flotation-adjusted cash flows for the project will beYear012345Cash Flow−$1,044,386$375,000$375,000$375,000$375,000$375,000EXAMPLE 12-5For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG12-8 As we discussed in the previous chapter, this approach to adjusting for flotation costs violates the spirit of the separation principle of capital budgeting, which states that the calculations of cash flows should remain independent of the choice of financing. On the other hand, the approach we used in the last chapter, increasing the projectÕs WACC to incorporate the flotation costsÕ impact, tends to understate the component cost of new equity. So, which approach is better? Well, even though most practitioners have historically taken the approach of adjusting the WACC upward, it is intuitively a little Ò distastefulÓ; it burdens the capital raised to finance a project with a higher required rate of return from then on, even though those flotation costs are actually a one-time thing. So, ideally, we would handle flotation costs as weÕve done in this chapter, by adjusting the projectÕs initial cash flow to account for them. Pragmatically, however, it is not unusual for firms to use either approach based on what they find the most intuitively appealing.TIME OUT 12-11 How would you compute the equity flotation cost if a firm were going to use a mixture of retained earnings and new equity to finance a project? 12-12 Why do we divide the initial cash flow by (1 − fA) instead of multiplying it by (1 + fA)?Final PDF to printer

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 411cor91411_ch12_392-425.indd 411 01/25/17 08:29 PMviewpoints REVISITEDBusiness Application SolutionBased on the given information, the yearly sales, levels of NWC, and resulting changes in NWC for McDonaldÕs will be:YearYearly SalesYearly Levels of NWCChanges in NWC0$ 0$364,000$364,00012,800,000 937,300573,30027,210,000 965,90028,60037,430,000 994,50028,60047,650,000 512,200−482,30053,940,0000−512,200OCF calculations, ΔNWC, and ΔFA for each year are shown as follows:(in millions)Year 0Year 1Year 2Year 3Year 4Year 5Sales$2.80$7.21$7.43$7.65$3.94Less: Variable costs1.343.523.70 3.892.04Less: Fixed costs0.000.000.000.000.00Less: Depreciation 0.00 0.00 0.00 0.00 0.00Earnings before interest and taxes$1.46$3.69$3.73$3.76$1.90Less: Taxes 0.00 0.00 0.00 0.00 0.00Net income$1.46$3.69$3.73$3.76$1.90Plus: Depreciation 0.00 0.00 0.00 0.00 0.00Operating cash flow$1.46$3.69$3.73$3.76$1.90 Δ Fixed assets$7.00$0.00$0.00$0.00$0.00$0.00 Δ Net working capital 0.00 0.00 0.00 0.00 0.00 0.00Less: Investment in operating capital $7.00 0.00 0.00 0.00 0.00 0.00Free cash flow−$7.00$1.46$3.69$3.73$3.76$1.90Personal Application SolutionAchmedÕs purchase of a new computer should not be counted as an incremental cash flow to getting an MBA, as he has indicated that he would be getting one anyway. Likewise, the $250 that he paid to take the GMAT is a sunk cost and should not be counted, either. His tuition payments constitute an annuity due, so his incremental cash flows will equalYears0Ð34Ð23FCF−$15,000$10,000Final PDF to printer

412cor91411_ch12_392-425.indd 412 01/25/17 08:29 PMsummary of learning goalsIn this chapter, we discussed how to apply the concept of free cash flow to measure expected cash flows from pro-posed new projects. The key concept is that only factors that affect a firmÕs cash flows that are incrementally attribut-able to the project should be included, and we must also be comprehensive in finding these incrementally attributable cash flows.Explain why we use pro forma statements to analyze project cash flows. Calculating expected future cash flows for a project is a complex undertaking. Using a systematic approach involving quasi-income statements and other pro forma financial statements ensures that our calculations will be careful and methodical.Identify which cash flows we can incrementally apply to a project and which ones we cannot. If a particular cash flow effect will take place if the project is undertaken but wonÕt occur if the project is not accepted, then it should be included in the projectÕs cash flows.Calculate a projectÕs expected cash flows using the free cash flow approach. Free cash flow measures the operating cash flow a project produces minus the necessary investment in operating capital. This concept is as valid for proposed new projects as it is for the firmÕs current operations.Explain how accelerated depreciation affects project cash flows. The IRS allows firms to take the same total depreciation amount on an asset regardless of how quickly the firms take it. Since no one gives you any interest or credit for delaying depreciation, time value of money concepts tell us that sooner is always better.Calculate free cash flows for replacement equipment. New projects and replacement projects LG12-1LG12-2LG12-3LG12-4LG12-5differ only in that with replacement projects, we must consider not only the incremental cash flows of purchasing a new asset, but also any cash flows that arise in the process of surrendering old equipment before the end of its usable life.Calculate cash flows associated with cost-cutting proposals. For cost-cutting proposals, the main benefit comes from cost reductions; often we see no actual change in sales revenues in response to a cost-cutting proposal.Demonstrate the EAC approach to choosing among alternative cash streams for recurring projects. The EAC approach basically involves taking one iteration of an asset purchase, Òsquishing it downÓ to find the present value of all the assetÕs cash flows at a single point in time, and then spreading them back out ÒflatÓ; that is, in the form of an annuity. By conceptualizing doing this for all iterations of an infinitely repeated asset purchase, we can turn that infinite series of cash flows into a perpetuity, which we know how to value.Adjust initial project investments to account for flotation costs. To adjust an initial investment for flotation costs, we simply divide it by one minus the average  percentage flotation cost, which gives us the sum of financial securities we must sell in order to raise enough capital to both fund the project and pay underwriting fees.LG12-6LG12-7LG12-8chapter equations 12-1 FCF = Operating cash flow − Investment in operating capital = [EBIT (1 − Tax rate) + Depreciation] − [ΔGross fixed assets + ΔNet operating working capital] 12-2 Depreciation = Depreciable basis − Ending book value _______________________________ Life of asset 12-3 ATCF = Market value − (Market value − Book value) × TC Final PDF to printer

413cor91411_ch12_392-425.indd 413 01/27/17 07:29 PM 12-4 f A = E _______ E + P + D f E + P _______ E + P + D f P + D _______ E + P + D f D 12-5 Adjusted C F 0 = C F 0 ____ 1 − f A key termsclass life The number of years of assumed usage for an asset to be used in the calculation of depreciation. p. 402depreciable basis An assetÕs cost plus the amounts you paid for items such as sales tax, freight charges, and installation and testing fees. p. 397financing costs Interest paid to debt holders or dividends paid to stockholders. p. 396incremental cash flows Cash flows directly attributable to the adoption of a new project. p. 394opportunity cost The dollar cost or forgone opportunity of using an asset already owned by the firm, or a person already employed by the firm, in a new project. p. 394pro forma analysis Process of estimating expected future cash flows of a project using only the relevant parts of the balance sheet and income statements. p. 393salvage value The estimated amount for tax purposes that a company will receive when it disposes of an asset at the end of the assetÕs usable life. p. 394Section 179 deduction A deduction targeted at small businesses that allows them to immediately expense asset purchases up to a certain limit rather than depreciating them over the assetsÕ useful lives. p. 403substitute and complement Effects that arise from a new product or service either decreasing or increasing sales, respectively, of the firmÕs existing products and services. p. 396sunk cost A cost that has already been incurred and can-not be recovered. p. 395self-test problems with solutions1 Computing FCF for Expansion Project The SCFE Co. wants to add a production line. To do this, the company must spend $200,000 to expand its current building and purchase $1 million in new equipment. The company anticipates moving locations in five years, and it expects to sell its current building and the new equipment at that time. SCFE estimates that the building expansion will add $80,000 to the price the building can be sold for, and that the equipment will have a market value of $290,000 at that time. The new equipment falls into the MACRS five-year class, and the building improvements fall into the ÒNonresidential Real EstateÓ 31.5 years MACRS category.The new production line is expected to produce 100,000 units per year of a new product, which has a projected sales price of $7.75 per unit and a variable cost of $3.90 a unit. Introducing the new product is expected to cause sales of existing products to decline by $89,000 per year and existing costs to decline by $49,000 per year. Fixed costs of the new line will be $142,000 annually, and the company expects NWC to increase by $1,800,000 when the new line is added.If the company faces a marginal tax rate of 34  percent, what will be the total expected cash flows for the project?  Solution:The equipment and the building improvements have to be depreciated separately. The depreciation  percentages and the annual dollar depreciation amounts for each LG12-3, 12-4Final PDF to printer

414cor91411_ch12_392-425.indd 414 01/25/17 08:29 PMYear12345Remaining Book ValueEquipment MACRS %20.00% 32.00% 19.20%11.52%11.52%Depreciation$200,000$320,000$192,000$115,200$115,200$ 57,600Improvement MACRS %3.042%  3.175%  3.175%  3.175%  3.175%Depreciation$ 6,084$ 6,350 $ 6,350$ 6,350$ 6,350$168,516year are shown below, along with the remaining book value of both at the end of the project life:Calculations of OCF for the five years of the project will be equal to:Year 0Year 1Year 2Year 3Year 4Year 5Sales$775,000$ 775,000$ 775,000$ 775,000$ 775,000Less: Lost sales89,00089,00089,00089,00089,000Less: Variable costs390,000390,000390,000390,000390,000Less: Fixed costs142,000142,000142,000142,000142,000Plus: Lost costs49,00049,00049,00049,00049,000Less: Depreciation 206,084 326,350 198,350 121,550 121,550Earnings before interest and taxesÐ$ 3,084Ð$123,350$ 4,650$ 81,450$ 81,450Less: Taxes Ð1,049 Ð41,939 1,581 27,693 27,693Net incomeÐ$ 2,035Ð$ 81,411$ 3,069$ 53,757$ 53,757Plus: Depreciation 206,084 326,350 198,350 121,550 121,550Operating cash flow $204,049 $244,939$ 201,419$175,307$ 175,307The ATCF from the sale of the two assets will be equal to ATCF Equipment = $57,600 + ($290,000 − $57,600)(1 − 0.34) = $210,984 ATCF Improvements = $168,516 + ($80,000 − $168,516)(1 − 0.34) = $110,095 The levels and changes in NWC will be equal toLevel of NWC$1,800,000$1,800,000$1,800,000$1,800,000$1,800,000$0Change in NWC 1,800,00000001,800,000So the free flows for the project will be equal toYear 0Year 1Year 2Year 3Year 4Year 5Operating cash flow$204,049$244,939$201,419$175,307$ 175,307Less: Δ Fixed Assets$1,000,000Ð210,984Less: Δ Fixed Assets200,000Ð2110,095Less: Δ Net working capital 1,800,000Ð1,800,000Free cash flowÐ$3,000,000$204,049$244,939$201,419$175,307$2,296,3862 Computing FCF for Cost-Cutting Proposal Your firm is considering the purchase of a new air conditioning unit at a cost of $50,000. It will be straight-line depreciated to zero using a five-year life with the half-year convention. After five years, you expect that the unit can be sold for a salvage value of $20,000. This air conditioner is more energy efficient than the one itÕs replacing, so you anticipate saving $2,000 annually in electricity costs. You also anticipate that your workers will be more productive in a cool environment, and you expect to be able to reduce overtime costs by $20,000 per year. If all applicable tax rates are 35  percent, what will be the expected cash flows associated with the purchase of the new air conditioner?LG12-5Final PDF to printer

415cor91411_ch12_392-425.indd 415 01/25/17 08:29 PMYear 0Year 1Year 2Year 3Year 4Year 5Sales$ 0$ 0$ 0$ 0$ 0Less: Variable costsÐ22,000Ð22,000Ð22,000Ð22,000Ð22,000Less: Fixed costs00000Less: Depreciation 5,000 10,000 10,000 10,000 10,000Earnings before interest and taxes$ 17,000$ 12,000$ 12,000$ 12,000$ 12,000Less: Taxes 5,950 4,200 4,200 4,200 4,200Net income$ 11,050$7,800$ 7,800$ 7,800$ 7,800Plus: Depreciation 5,000 10,000 10,000 10,000 10,000Operating cash flow$ 16,050$ 17,800$ 17,800$ 17,800$ 17,800Less: Δ Fixed Assets$50,0000000Ð14,750Less: Δ Net working capital 0 0 0 0 0 0Free cash flow Ð$50,000$ 16,050$ 17,800$ 17,800$ 17,800$ 32,550Solution:3 Using EAC Dumb & Dumber Development Company has two mutually exclusive investment projects to evaluate. Assume both projects can be repeated indefinitely. The following cash flows are associated with each project:LG12-3, 12-4YearProject A Cash FlowProject B Cash Flow0−$100,000−$70,000120,00030,000250,00030,000350,00030,000470,00045,0005Ñ10,000The project types are equally risky and the firmÕs cost of capital is 10  percent. Which project should the firm choose?  Solution:Using the EAC approach: NPV A = $44,880.81 Solving for the EAC PMT for A: Calculator: N = 4 I/Y = 10 PV = 44,880.81CPT PMT = 14,158.59 NPVB = $41,550.38Solving for the EAC PMT for B: Calculator: N = 5 I/Y = 10 PV = 41,550.38CPT PMT = 10,960.89Which do you choose? Project A, because $14,158.59 > $10,960.89.Final PDF to printer

416cor91411_ch12_392-425.indd 416 01/25/17 08:29 PMquestions 1. How is the pro forma statement we used in this chapter for computing OCF different from an accountantÕs income statement? (LG12-1) 2. Suppose you paid your old college finance professor to evaluate a project for you. If you would pay him regardless of your decision concerning whether to proceed with the project, should his fee for evaluat-ing the project be included in the projectÕs incremen-tal cash flows? (LG12-2) 3. Why does a decrease in NWC result in a cash inflow to the firm? (LG12-3) 4. Everything else held constant, would you rather depreciate a project with straight-line depreciation or with DDB? (LG12-3) 5. Everything else held constant, would you rather depreciate a project with DDB depreciation or deduct it under a Section 179 deduction? (LG12-4) 6. In a replacement problem, would we ever see changes in NWC? (LG12-5) 7. In a replacement problem, will incremental net depreciation always be less than the gross depre-ciation on the new piece of equipment? (LG12-5) 8. In a cost-cutting proposal, what might cause you to sometimes have negative EBIT? (LG12-6) 9. How many TVM formulas do you use every time you calculate EAC for a project? (LG12-7) 10. Will an increase in flotation costs increase or decrease the initial cash flow for a project? (LG12-8)problems 12-1 After-Tax Cash Flow from Sale of Assets Suppose you sell a fixed asset for $109,000 when its book value is $129,000. If your companyÕs marginal tax rate is 39  percent, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)? (LG12-3) 12-2 PV of Depreciation Tax Benefits Your company is considering a new project that will require $1 million of new equipment at the start of the project. The equipment will have a depreciable life of 10 years and will be depreciated to a book value of $150,000 using straight-line depreciation. The cost of capital is 13  percent, and the firmÕs tax rate is 34  percent. Estimate the present value of the tax benefits from depreciation. (LG12-4) 12-3 EAC Approach You are trying to pick the least-expensive car for your new delivery service. You have two choices: the Scion xA, which will cost $14,000 to purchase and which will have OCF of −$1,200 annually throughout the vehicleÕs expected life of three years as a delivery vehicle; and the Toyota Prius, which will cost $20,000 to purchase and which will have OCF of −$650 annu-ally throughout that vehicleÕs expected four-year life. Both cars will be worthless at the end of their life. If you intend to replace whichever type of car you choose with the same thing when its life runs out, again and again out into the foresee-able future, and if your business has a cost of capital of 12  percent, which one should you choose? (LG12-7) 12-4 EAC Approach You are evaluating two different cookie-baking ovens. The Pillsbury 707 costs $57,000, has a five-year life, and has an annual OCF (after tax) of −$10,000 per year. The Keebler CookieMunster costs $90,000, has a seven-year life, and has an annual OCF (after tax) of −$8,000 per year. If your discount rate is 12  percent, what is each machineÕs EAC? (LG12-8) 12-5 EAC Approach You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $80 initially, and then $125 per year in maintenance costs. Machine B costs basic problemsFinal PDF to printer

417cor91411_ch12_392-425.indd 417 01/25/17 08:29 PM$150 initially, has a life of three years, and requires $100 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Which is the better machine for the firm? The discount rate is 12  percent and the tax rate is zero. (LG12-8)advanced problems 12-10 Change in NWC You are evaluating a project for The Tiff-any golf club, guar-anteed to correct that nasty slice. You estimate the sales price of The Tiff-any to be $400 per unit and sales volume to be 1,000 units in year 1; 1,500 units in year 2; and 1,325 units in year 3. The project has a three-year life. Variable costs amount to $225 per unit and fixed costs are $100,000 per year. The project requires an initial investment of $165,000 in assets, which will be depreciated straight-line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $35,000. NWC requirements at the beginning of each year will be approximately 20  percent of the projected sales during the coming year. The tax rate is 34  percent and the required return on the project is 10  percent. What change in NWC occurs at the end of year 1? (LG12-3) 12-11 Operating Cash Flow Continuing the previous problem, what is the operating cash flow for the project in year 2? (LG12-3) 12-12 Project Cash Flows Your highly successful software company is considering adding a new software title to your list. If you add the new product, it will use the full capacity of your disk duplicating machines that you had planned on using for intermediate problems 12-6 Project Cash Flows KADS, Inc., has spent $400,000 on research to develop a new computer game. The firm is planning to spend $200,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $50,000. The machine has an expected life of three years, a $75,000 estimated resale value, and falls under the MACRS seven-year class life. Revenue from the new game is expected to be $600,000 per year, with costs of $250,000 per year. The firm has a tax rate of 35  percent, an opportunity cost of capital of 15  percent, and it expects net working capital to increase by $100,000 at the beginning of the project. What will the cash flows for this project be? (LG12-3) 12-7 Depreciation Tax Shield Your firm needs a computerized machine tool lathe that costs $50,000 and requires $12,000 in maintenance for each year of its three-year life. After three years, this machine will be replaced. The machine falls into the MACRS three-year class life category. Assume a tax rate of 35  percent and a discount rate of 12  percent. Calculate the depreciation tax shield for this project in year 3. (LG12-4) 12-8 After-Tax Cash Flow from Sale of Assets If the lathe in the previous problem can be sold for $5,000 at the end of year 3, what is the after-tax salvage value? (LG12-4) 12-9 Project Cash Flows You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck for $60,000. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in NWC (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firmÕs marginal tax rate is 40  percent. What will the cash flows for this project be? (LG12-6)Final PDF to printer

418cor91411_ch12_392-425.indd 418 01/25/17 08:29 PMyour flagship product, ÒBattlinÕ Bobby.Ó You had previously planned on using the unused capacity to start selling ÒBBÓ on the west coast in two years. Eventu-ally, you would have had to purchase additional duplicating machines 10 years from today, but since your new product will use up the extra capacity, this will require moving this purchase up to 2 years from today. If the new machines will cost $100,000 and will be depreciated straight-line over a five-year period to a zero salvage value, your marginal tax rate is 32  percent, and your cost of capi-tal is 12  percent, what is the opportunity cost associated with using the unused capacity for the new product? (LG12-3) 12-13 Project Cash Flows You are evaluating a project for The Ultimate recreational tennis racket, guaranteed to correct that wimpy backhand. You estimate the sales price of The Ultimate to be $400 per unit and sales volume to be 1,000 units in year 1; 1,250 units in year 2; and 1,325 units in year 3. The project has a three- year life. Variable costs amount to $225 per unit and fixed costs are $100,000 per year. The project requires an initial investment of $165,000 in assets, which will be depreciated straight- line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $35,000. NWC requirements at the beginning of each year will be approximately 20  percent of the projected sales during the coming year. The tax rate is 34  percent and the required return on the project is 10  percent. What will the cash flows for this project be? (LG12-3) 12-14 Project Cash Flows MomÕs Cookies, Inc., is considering the purchase of a new cookie oven. The original cost of the old oven was $30,000; it is now five years old, and it has a current market value of $13,333.33. The old oven is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $15,000 and an annual depreciation expense of $3,000. The old oven can be used for six more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is $25,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new oven are $4,000 a year over its full MACRS depreciable life. Deprecia-tion is computed using MACRS over a five-year life, and the cost of capital is 10  percent. Assume a 40  percent tax rate. What will the cash flows for this project be? (LG12-5) 12-15 Project Cash Flows Your company is contemplating replacing its current fleet of delivery vehicles with Nissan NV vans. You will be replacing five fully-depreciated vans, which you think you can sell for $3,000 each and which you could probably use for another two years if you chose not to replace them. The NV vans will cost $29,850 each in the configuration you want them and can be depreciated using MACRS over a five-year life. Expected yearly before-tax cash savings due to acquiring the new vans amounts to about $3,700 each. If your cost of capital is 8  percent and your firm faces a 34  percent tax rate, what will the cash flows for this project be? (LG12-5)research it! Looking Up Information on Section 179 DeductionGo to the IRSÕs website at www.irs.gov and search for information on Section 179 deductions for the current tax year.What is the maximum Section 179 deduction for the current tax year?Final PDF to printer

419cor91411_ch12_392-425.indd 419 01/25/17 08:29 PMintegrated mini-case: Project Cash FlowsYour company, Dawgs ÒRÓ Us, is evaluating a new project involving the purchase of a new oven to bake your hotdog buns. If purchased, the new oven will replace your existing oven, which was purchased seven years ago for a total installed price of $1 million.You have been depreciating the old oven on a straight-line basis over its expected life of 15 years to an ending book value of $250,000, even though you expect it to be worthless at the end of that 15-year period. The new oven will cost $2 million and will fall into the MACRS five-year depreciation class life. If you purchase the new oven, you expect it to last for eight years. At the end of those eight years, you expect to be able to sell it for $100,000. (Note that both of the ovens, old and new, therefore have an effective remaining life of eight years at the time of your analysis.) If you do purchase the new oven, you estimate that you can sell the old one for its current book value at the same time.The advantages of the new oven are twofold: Not only do you expect it to reduce the before-tax costs on your current baking operations by $75,000 per year, but you will also be able to produce new types of buns. The sales of the new buns are expected to bring your company $200,000 per year throughout the eight-year life of the new oven, while associated costs of the new buns are only expected to be $80,000 per year.Since the new oven will allow you to sell these new products, you anticipate that NWC will have to increase immediately by $20,000 upon purchase of the new oven. It will then remain at that increased level throughout the life of the new oven to sustain the new, higher level of operations.Your company uses a required rate of return of 12  percent for such projects, and your incremental tax rate is 34  percent. What will be the total cash flows for this project?ANSWERS TO TIME OUT 12-1 You should charge half of her salary and benefits to the new project and the other half to the existing projects. 12-2 Sure. For example, think about a restaurant chain adding a new item to its menu: say, gourmet coffee. To the extent that some customers who would have bought their cur-rent drinks will replace that selection with the new coffee, the coffee is a substitute for those drinks; but assuming that the coffee will attract some ÒnewÓ customers, ones who would not have come into the restaurant otherwise, and that those new custom-ers will also buy some of the existing pastry products, then the new coffee is a com-plement for the pastries. 12-3 Even though we are explicitly keeping track of the level of NWC, what we are really concerned with is the inflow or outflow of cash arising from changes to that level. When we increase NWC, we have to buy inventory, make sales on credit, or tie up cash flow in the form of physical cash, all of which use up cash flow. 12-4 As long as we have any depreciation, OCF will be larger than net income because it reflects the fact that depreciation is not a cash expense. 12-5 Because of the half-year convention, the IRS allows us to take only one-half of the first yearÕs life of the asset during the first calendar year we own it. This, in turn, implies that we will still have the last half of the fifth year of the assetÕs five-year life to take during the sixth year that we own it, and so forth. 12-6 They would encourage investment in certain types of assets by putting them into shorter life-class categories. Since the IRS gives you the same total amount of depre-ciation regardless of the length of depreciable life allowed, the present value of the total tax shields from the depreciation of an asset will be higher if you get to take the depreciation quicker.Final PDF to printer

420cor91411_ch12_392-425.indd 420 01/25/17 08:29 PM 12-7 Although a positive investment in operating capital would normally be associated with a purchase of fixed assets, here the positive value was generated by the forgone sale of the old assets: since we sold them at the beginning of the replacement project, we had to give up selling them at the end. 12-8 No. As long as the tax rate is less than 100  percent, the present value of the deprecia-tion tax shields will always be less than the present value of the costs of those assets, implying that net cash flows for such a project would have to be, on average across the life of the project, negative. 12-9 It does so by turning each individual asset purchase not only into an annuity, but into an annuity that is perfectly aligned with the annuities of the identical assets purchased before and after it so as to form a perpetuity. 12-10 Sure. Since the EAC is calculated as the equivalent cost per year, it does not matter if both projects have the same or differing lives. 12-11 Since retained earnings do not have a flotation cost, the average equity flotation cost would simply be a weighted average (where the weights are the relative proportions of retained earnings and new equity) of the flotation cost of the new equity and zero. For example, if a firm was going to use one-third retained earnings and two-thirds new equity, and new equity had a flotation cost of 5  percent, then the weighted-average flotation cost of equity would be 1/3 × 0 + 2/3 × 0.05 = 0.033, or 3.33%. 12-12 Multiplying by (1 + fA) would give us the flotation expense on the initial cash flow itself, but it would not give us the Òflotation cost on the flotation cost.Ó If we want to raise both the money needed for a project and the money needed to cover the flotation costs, both entirely from the sale of new securities, we will have to keep in mind that the underwriter will charge us a fee on all of the money. Dividing by (1 − fA) handles this. For example, if we wanted to raise $1 million to buy new assets, and the under-writer was going to charge us a weighted-average flotation cost of 5  percent, then we would actually have to sell $1,000,000/(1 − 0.05) = $1,052,631.58 worth of securities, giving $52,631.58 of the proceeds to the underwriter as a fee in order to be able to keep the $1 million we needed.Final PDF to printer

cor91411_ch12_392-425.indd 421 01/25/17 08:29 PM421appendix 12A MACRS Depreciation TablesMACRS DepreciationReal EstateNormal Recovery PeriodResidentialNonresidentialYear35710152027.531.539133.33%20.00%14.29%10.00%5.00%3.750%3.485%3.042%2.461%244.4532.0024.4918.009.507.2193.6363.1752.564314.8119.2017.4914.408.556.6773.6363.1752.56447.4111.5212.4911.527.706.1773.6363.1752.56450.0011.528.939.226.935.7133.6363.1752.56460.005.768.927.376.235.2853.6363.1752.56470.000.008.936.555.904.8883.6363.1752.56480.000.004.466.555.904.5223.6363.1752.56490.000.000.006.565.914.4623.6363.1742.564100.000.000.006.555.904.4613.6373.1752.564110.000.000.003.285.914.4623.6363.1742.564120.000.000.000.005.904.4613.6373.1752.564130.000.000.000.005.914.4623.6363.1742.564140.000.000.000.005.904.4613.6373.1752.564150.000.000.000.005.914.4623.6363.1742.564160.000.000.000.002.954.4613.6373.1752.564170.000.000.000.000.004.4623.6363.1742.564180.000.000.000.000.004.4613.6373.1752.564190.000.000.000.000.004.4623.6363.1742.564200.000.000.000.000.004.4613.6373.1752.564210.000.000.000.000.002.2313.6363.1742.564220.000.000.000.000.000.003.6373.1752.564230.000.000.000.000.000.003.6363.1742.564240.000.000.000.000.000.003.6373.1752.564250.000.000.000.000.000.003.6363.1742.564260.000.000.000.000.000.003.6373.1752.564270.000.000.000.000.000.003.6363.1742.564280.000.000.000.000.000.001.9703.1752.564290.000.000.000.000.000.000.003.1742.564300.000.000.000.000.000.000.003.1752.564310.000.000.000.000.000.000.003.1742.564320.000.000.000.000.000.000.001.7202.564330.000.000.000.000.000.000.000.002.564340.000.000.000.000.000.000.000.002.564350.000.000.000.000.000.000.000.002.564360.000.000.000.000.000.000.000.002.564370.000.000.000.000.000.000.000.002.564380.000.000.000.000.000.000.000.002.564390.000.000.000.000.000.000.000.002.564400.000.000.000.000.000.000.000.000.10741 0.000.000.000.000.000.000.000.000.000Final PDF to printer

422cor91411_ch12_392-425.indd 422 01/25/17 08:29 PMSL DepreciationNormal Recovery PeriodYear2.533.54566.577.588.59120.00%16.67%14.29%12.50%10.00%8.33%7.69%7.14%6.67%6.25%5.88%5.56%240.0033.3328.5725.0020.0016.6715.3914.2913.3312.5011.7711.11340.0033.3328.5725.0020.0016.6715.3814.2913.3312.5011.7611.1140.0016.6728.5725.0020.0016.6715.3914.2813.3312.5011.7711.1150.000.000.0012.5020.0016.6615.3814.2913.3412.5011.7611.1160.000.000.000.0010.0016.6715.3914.2813.3312.5011.7711.1170.000.000.000.000.008.3315.3814.2913.3412.5011.7611.1180.000.000.000.000.000.000.007.1413.3312.5011.7711.1190.000.000.000.000.000.000.000.000.006.2511.7611.11100.000.000.000.000.000.000.000.000.000.000.005.56110.000.000.000.000.000.000.000.000.000.000.000.00120.000.000.000.000.000.000.000.000.000.000.000.00130.000.000.000.000.000.000.000.000.000.000.000.00140.000.000.000.000.000.000.000.000.000.000.000.00150.000.000.000.000.000.000.000.000.000.000.000.00160.000.000.000.000.000.000.000.000.000.000.000.00170.000.000.000.000.000.000.000.000.000.000.000.00180.000.000.000.000.000.000.000.000.000.000.000.00190.000.000.000.000.000.000.000.000.000.000.000.00200.000.000.000.000.000.000.000.000.000.000.000.00210.000.000.000.000.000.000.000.000.000.000.000.00220.000.000.000.000.000.000.000.000.000.000.000.00230.000.000.000.000.000.000.000.000.000.000.000.00240.000.000.000.000.000.000.000.000.000.000.000.00250.000.000.000.000.000.000.000.000.000.000.000.00260.000.000.000.000.000.000.000.000.000.000.000.00270.000.000.000.000.000.000.000.000.000.000.000.00280.000.000.000.000.000.000.000.000.000.000.000.00290.000.000.000.000.000.000.000.000.000.000.000.00300.000.000.000.000.000.000.000.000.000.000.000.00310.000.000.000.000.000.000.000.000.000.000.000.00320.000.000.000.000.000.000.000.000.000.000.000.00330.000.000.000.000.000.000.000.000.000.000.000.00340.000.000.000.000.000.000.000.000.000.000.000.00350.000.000.000.000.000.000.000.000.000.000.000.00360.000.000.000.000.000.000.000.000.000.000.000.00370.000.000.000.000.000.000.000.000.000.000.000.00380.000.000.000.000.000.000.000.000.000.000.000.00390.000.000.000.000.000.000.000.000.000.000.000.00400.000.000.000.000.000.000.000.000.000.000.000.00410.000.000.000.000.000.000.000.000.000.000.000.00420.000.000.000.000.000.000.000.000.000.000.000.00430.000.000.000.000.000.000.000.000.000.000.000.00440.000.000.000.000.000.000.000.000.000.000.000.00450.000.000.000.000.000.000.000.000.000.000.000.00460.000.000.000.000.000.000.000.000.000.000.000.00470.000.000.000.000.000.000.000.000.000.000.000.00480.000.000.000.000.000.000.000.000.000.000.000.00490.000.000.000.000.000.000.000.000.000.000.000.00500.000.000.000.000.000.000.000.000.000.000.000.00510.000.000.000.000.000.000.000.000.000.000.000.00520.000.000.000.000.000.000.000.000.000.000.000.00Final PDF to printer

423cor91411_ch12_392-425.indd 423 01/25/17 08:29 PMSL DepreciationNormal Recovery PeriodYear9.51010.51111.51212.51313.514151616.515.26%5.00%4.76%4.55%4.35%4.17%4.00%3.85%3.70%3.57%3.33%3.13%3.03%210.5310.009.529.098.708.338.007.697.417.146.676.256.06310.5310.009.529.098.708.338.007.697.417.146.676.256.06410.5310.009.539.098.698.338.007.697.417.146.676.256.06510.5210.009.529.098.708.338.007.697.417.146.676.256.06610.5310.009.539.098.698.338.007.697.417.146.676.256.06710.5210.009.529.098.708.348.007.697.417.146.676.256.06810.5310.009.539.098.698.338.007.697.417.156.666.256.06910.5210.009.529.098.708.348.007.697.417.146.676.256.061010.5310.009.539.098.698.338.007.707.407.156.666.256.06110.005.009.529.098.708.348.007.697.417.146.676.256.06120.000.000.004.558.698.338.007.707.407.156.666.256.06130.000.000.000.000.004.178.007.697.417.146.676.256.06140.000.000.000.000.000.000.003.857.407.156.666.256.06150.000.000.000.000.000.000.000.000.003.576.676.256.06160.000.000.000.000.000.000.000.000.000.003.336.256.06170.000.000.000.000.000.000.000.000.000.000.003.126.07180.000.000.000.000.000.000.000.000.000.000.000.000.00190.000.000.000.000.000.000.000.000.000.000.000.000.00200.000.000.000.000.000.000.000.000.000.000.000.000.00210.000.000.000.000.000.000.000.000.000.000.000.000.00220.000.000.000.000.000.000.000.000.000.000.000.000.00230.000.000.000.000.000.000.000.000.000.000.000.000.00240.000.000.000.000.000.000.000.000.000.000.000.000.00250.000.000.000.000.000.000.000.000.000.000.000.000.00260.000.000.000.000.000.000.000.000.000.000.000.000.00270.000.000.000.000.000.000.000.000.000.000.000.000.00280.000.000.000.000.000.000.000.000.000.000.000.000.00290.000.000.000.000.000.000.000.000.000.000.000.000.00300.000.000.000.000.000.000.000.000.000.000.000.000.00310.000.000.000.000.000.000.000.000.000.000.000.000.00320.000.000.000.000.000.000.000.000.000.000.000.000.00330.000.000.000.000.000.000.000.000.000.000.000.000.00340.000.000.000.000.000.000.000.000.000.000.000.000.00350.000.000.000.000.000.000.000.000.000.000.000.000.00360.000.000.000.000.000.000.000.000.000.000.000.000.00370.000.000.000.000.000.000.000.000.000.000.000.000.00380.000.000.000.000.000.000.000.000.000.000.000.000.00390.000.000.000.000.000.000.000.000.000.000.000.000.00400.000.000.000.000.000.000.000.000.000.000.000.000.00410.000.000.000.000.000.000.000.000.000.000.000.000.00420.000.000.000.000.000.000.000.000.000.000.000.000.00430.000.000.000.000.000.000.000.000.000.000.000.000.00440.000.000.000.000.000.000.000.000.000.000.000.000.00450.000.000.000.000.000.000.000.000.000.000.000.000.00460.000.000.000.000.000.000.000.000.000.000.000.000.00470.000.000.000.000.000.000.000.000.000.000.000.000.00480.000.000.000.000.000.000.000.000.000.000.000.000.00490.000.000.000.000.000.000.000.000.000.000.000.000.00500.000.000.000.000.000.000.000.000.000.000.000.000.00510.000.000.000.000.000.000.000.000.000.000.000.000.00520.000.000.000.000.000.000.000.000.000.000.000.000.00Final PDF to printer

424cor91411_ch12_392-425.indd 424 01/25/17 08:29 PMSL DepreciationNormal Recovery PeriodYear1718192022242526.528303540455012.94%2.78%2.63%2.50%2.273%2.083%2.00%1.887%1.786%1.667%1.429%1.25%1.111%1.00%25.885.565.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.0035.885.565.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.0045.885.555.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.0055.885.565.265.004.5464.1674.003.7743.5713.3332.8572.502.2222.0065.885.555.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.0075.885.565.265.004.5464.1674.003.7733.5723.3332.8572.502.2222.0085.885.555.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.0095.885.565.275.004.5464.1674.003.7733.5723.3332.8572.502.2222.00105.885.555.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.00115.895.565.275.004.5464.1664.003.7733.5723.3332.8572.502.2222.00125.885.555.265.004.5454.1674.003.7743.5713.3332.8572.502.2222.00135.895.565.275.004.5464.1664.003.7733.5723.3342.8572.502.2222.00145.885.555.265.004.5454.1674.003.7733.5713.3332.8572.502.2222.00155.895.565.275.004.5464.1664.003.7743.5723.3342.8572.502.2222.00165.885.555.265.004.5454.1674.003.7733.5713.3332.8572.502.2222.00175.895.565.275.004.5464.1664.003.7743.5723.3342.8572.502.2222.00182.945.555.265.004.5454.1674.003.7733.5713.3332.8572.502.2222.00190.002.785.275.004.5464.1664.003.7743.5723.3342.8572.502.2222.00200.000.002.635.004.5454.1674.003.7733.5713.3332.8572.502.2222.00210.000.000.002.504.5464.1664.003.7743.5723.3342.8572.502.2222.00220.000.000.000.004.5454.1674.003.7733.5713.3332.8572.502.2222.00230.000.000.000.002.2734.1664.003.7743.5723.3342.8572.502.2222.00240.000.000.000.000.0004.1674.003.7733.5713.3332.8572.502.2222.00250.000.000.000.000.0002.0834.003.7743.5723.3342.8572.502.2222.00260.000.000.000.000.0000.0002.003.7733.5713.3332.8572.502.2222.00270.000.000.000.000.0000.0000.003.7743.5723.3342.8572.502.2222.00280.000.000.000.000.0000.0000.000.0003.5713.3332.8582.502.2222.00290.000.000.000.000.0000.0000.000.0001.7863.3342.8572.502.2232.00300.000.000.000.000.0000.0000.000.0000.0003.3332.8582.502.2222.00310.000.000.000.000.0000.0000.000.0000.0001.6672.8572.502.2232.00320.000.000.000.000.0000.0000.000.0000.0000.0002.8582.502.2222.00330.000.000.000.000.0000.0000.000.0000.0000.0002.8572.502.2232.00340.000.000.000.000.0000.0000.000.0000.0000.0002.8582.502.2222.00350.000.000.000.000.0000.0000.000.0000.0000.0002.8572.502.2232.00360.000.000.000.000.0000.0000.000.0000.0000.0001.4292.502.2222.00370.000.000.000.000.0000.0000.000.0000.0000.0000.0002.502.2232.00380.000.000.000.000.0000.0000.000.0000.0000.0000.0002.502.2222.00390.000.000.000.000.0000.0000.000.0000.0000.0000.0002.502.2232.00400.000.000.000.000.0000.0000.000.0000.0000.0000.0002.502.2222.00410.000.000.000.000.0000.0000.000.0000.0000.0000.0001.252.2232.00420.000.000.000.000.0000.0000.000.0000.0000.0000.0000.002.2222.00430.000.000.000.000.0000.0000.000.0000.0000.0000.0000.002.2232.00440.000.000.000.000.0000.0000.000.0000.0000.0000.0000.002.2222.00450.000.000.000.000.0000.0000.000.0000.0000.0000.0000.002.2232.00460.000.000.000.000.0000.0000.000.0000.0000.0000.0000.001.1112.00470.000.000.000.000.0000.0000.000.0000.0000.0000.0000.000.0002.00480.000.000.000.000.0000.0000.000.0000.0000.0000.0000.000.0002.00490.000.000.000.000.0000.0000.000.0000.0000.0000.0000.000.0002.00500.000.000.000.000.0000.0000.000.0000.0000.0000.0000.000.0002.00510.000.000.000.000.0000.0000.000.0000.0000.0000.0000.000.0001.00520.000.000.000.000.0000.0000.000.0000.0000.0000.0000.000.0000.00Final PDF to printer

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462cor91411_ch14_462-497.indd 462 01/25/17 08:32 PMviewpointsPART SEVENBusiness ApplicationChewbacca Manufacturing expects sales of $32 million next year. CMÕs cost of goods sold normally runs at 55 percent of sales; inventory requirements are usually 10 percent of annual sales; the average accounts receivable balance is one-sixth of annual sales; and the average accounts payable balance is 5 percent of sales. If all sales are on credit, what will ChewbaccaÕs level of net working capital and its cash cycle be? (See the solution at the end of the chapter.)Personal ApplicationWanda has saved enough money to go back to grad school. She is planning to put the money in a money market account where it will earn 3.5 percent. If she anticipates slowly drawing the money out over the course of her time in grad school at a constant rate of $25,000 per year but is charged a commission of $9.95 every time she sells shares, how much should she take out of the mutual fund at a time? (See the solution at the end of the chapter.)Where else can you park your money . . . for less?Working Capital Management and Policies14Final PDF to printer

463cor91411_ch14_462-497.indd 463 01/25/17 08:32 PM© Stockbyte/Getty Images RFIn this chapter, we focus on the major trade-off implicit in fund-ing net working capital. By and large, the trade-off involves compar-ing the explicit costs of funding an investment in current assets with the shortage costs associated with the firm not having enough cash, inven-tory, or accounts receivable.As weÕll see, the firmÕs ideal solu-tion to providing net working capital would be to get someone else to foot the bill. Though this may be a valid approach to fund some of the firmÕs current assets, itÕs usually difficult to get someone else to cover the entire amount of net working capital neces-sary to run the firm efficiently. We will, however, discuss how to shift those costs elsewhere as much as possible in this chapter by covering the following topics: 1. How to determine the optimal amount of investment in cur-rent assets. 2. How to measure the portion of current assets that the firm is responsible for funding. 3. How to choose the source of funding for that portion of cur-rent assets.Depending on the firmÕs line of busi-ness and the extent to which it pro-vides physical goods versus services, the management of portions of the current assets may come under a spe-cialized department responsible for the firmÕs operations management. Though beyond the scope of this book, if you ever get a chance to read about the models used in opera-tions management, youÕll notice that many of the concepts weÕll discuss here are directly related to the inven-tory management models used exten-sively in operations management. For example, our discussion below of flexible, restrictive, and com-promise financing of current assets would fit right in with the concept LG14-1 Set overall objectives of a good working capital policy. LG14-2 Discuss how net working capital serves the firm. LG14-3 Analyze the firmÕs operating and cash cycles to deter-mine what funding for cur-rent assets the firm needs. LG14-4 Model the optimal trade-off between carrying costs and shortage costs that dictates the firmÕs current asset investment. LG14-5 Compare the flexible and restrictive approaches to financing current assets. LG14-6 Differentiate among sources of short-term financing avail-able for funding current assets. LG14-7 Justify the firmÕs need to hold cash. LG14-8 Use the Baumol and Miller-Orr models for determining cash policy. LG14-9 Identify sources of float and show how to control float for the firmÕs disbursement and collection functions. LG14-10 Identify firmsÕ choices for using excess cash. LG14-11 Connect the firmÕs credit terms and collection policy and the amount of capital the firm has invested in accounts receivable. LG14-12 Be able to create and interpret a cash budget.LG14-1, 14-2 Learning GoalsFinal PDF to printer

464 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 464 01/25/17 08:32 PMof Òjust in timeÓ (JIT) inventory management, while the Baumol model weÕll be dis-cussing for determining the target cash balance is a simple extension of the Barabas Economic Order Quantity (EOQ) model for minimizing total inventory holding and ordering costs.14.1 ∙ Revisiting the Balance-Sheet Model of the FirmRecall our discussion of the balance sheet in Chapter 2. At a glance, the balance sheet brings together the firmÕs assets or sources of financing and its liabilities, or investments, as Table 14.1 shows. Net working capital reflects the need for the firm to generate funds to stay in business and maximize profit.Earlier in the text, we discussed the fact that current assets, while the most liquid, are also usually less profitable than fixed assets. Because of that, many managers view net working capital as a Ònecessary evil,Ó that is, as something they have to fund, but would really rather not. And they do have to fund it: Most firms canÕt sell finished goods without inventory to display, or without offering to sell to customers on credit, and so forth.But just because a firm has to fund some current assets does not mean that it has to fund too much of it. Ideally, the firm should invest in each type of current assets only up to the point where the marginal benefit of each dollar tied up by doing so just equals the marginal opportunity cost of not having that dollar invested in fixed assets with positive net present value (NPV).Also, the firm normally is able to shift part of the burden of funding current assets through the judicious use of current liabilities. While we normally think of liabilities as the ÒbadÓ entries (compared to assets) on a balance sheet, from a cash flow perspective they actually act as sources of capital, while assets represent, in a sense, Òmoney pitsÓ that require us to use capital to fund them.  To the extent that the firm can partially offset the capital they have tied up in necessary current assets by buying from suppli-ers on credit, or by getting employees to work for them in advance of getting paid, such accounts payable or accrued wages are actually good things.This line of reasoning helps explain why some managers like to think of net working capital as Òthe net amount of current assets that the firm has to fund, above and beyond those that someone else funds for us.ÓTIME OUT 14-1 Why might a firmÕs creditors not think of net working capital as a necessary evil, but rather as a good thing?   14-2 If demand for a firmÕs products suddenly slows down so that inventory increases while sales decrease, how will the firmÕs needs for net working capital react?  LG14-1, 14-2just in time (JIT)A production strategy that attempts to improve a firmÕs return on investment by reducing in-process inventory and associated carrying costs as much as possible.opportunity costThe dollar cost or forgone opportunity of using an asset already owned by the firm, or a person already employed by the firm, in a new project.Barabas Economic Order Quantity (EOQ)The inventory order quan-tity that minimizes total holding and ordering costs.shortage costsCosts associated with not having sufficient cash, inventory, or accounts receivable.operations managementThe area of management concerned with designing and overseeing the pro-cess of production.TABLE 14.1 The Basic Balance SheetTotal AssetsTotal Liabilities and EquityCurrent assets:Net working capitalCurrent liabilities: Cash and marketable securities Accrued wages and taxes Accounts receivable Accounts payable Inventory Notes payableFixed assets:Long-term debt Gross plant and equipmentStockholdersÕ equity: Less: Depreciation Preferred stockNet plant and equipment Common stock and paid-in surplusOther long-term assetsRetained earningsFinal PDF to printer

chapter 14 Working Capital Management and Policies 465cor91411_ch14_462-497.indd 465 01/25/17 08:32 PM14.2 ∙ Tracing Cash and Net Working CapitalTo trace cash flows through the firmÕs operations, we must measure the operating cycleÑ the time necessary to acquire raw materials, turn them into finished goods, sell them, and receive payment for themÑas well as the firmÕs cash cycle.If we continue in the vein of thinking of net working capital as the portion of current assets that the firm must fund (above and beyond those assets funded by current liabili-ties), then we can similarly think of the firmÕs cash cycle as the portion of the operating cycle that the firm must finance.The Operating CycleTo measure the firmÕs operating cycle, we need to turn to some of the ratios that we dis-cussed in Chapter 3: Operating cycle = DaysÕ sales in inventory + Average collection period = Inventory × 365 ________________ Cost of goods sold  +  Accounts receivable × 365 _______________________ Credit sales (14-1)LG14-3operating cycleThe time required to acquire raw materials and to produce, sell, and receive payment for the finished goods.cash cycleThe operating cycle minus the average payment period.EXAMPLE 14-1Calculation of Operating CycleSuppose that MMK Industries has annual sales of $1 million, cost of goods sold of $650,000, average inventories of $116,000, and average accounts receivable of $150,000. Assuming that all MMKÕs sales are on credit, what will be the firmÕs operating cycle?SOLUTION: The operating cycle will be equal to Operating cycle = Inventory × 365 ________________ Cost of goods sold  +  Accounts receivable × 365 _______________________ Credit sales = $116,000 × 365 _______________ $650,000  +  $150,000 × 365 _______________ $1,000,000 = 65.14 days + 54.75 days = 119.89 days So it will take MMK almost 120 days from the time it receives raw materials to produce, market, sell, and collect the cash for the finished goods.Similar to Problems 14-13, 14-14For interactive versions of this example, log in to Connector go to mhhe.com/Cornett4e.LG14-3 The Cash CycleThe firmÕs cash cycle will simply be the operating cycle minus the average payment period as shown in Figure 14.1.Translating this into a formula yields Cash cycle = Operating cycle − Average payment period = Operating cycle −  Accounts payable × 365 _____________________ Cost of goods sold (14-2)Note that even though it will take MMK almost 120 days to turn the raw materials into cash, the cash cycle indicates that the firm will have to foot the bill for its production cycle Final PDF to printer

466 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 466 01/25/17 08:32 PMfor only 52.50 days of that time. This is the crux of managing the firmÕs operating and cash cycles: Minimize the number of days that the firm has to pay for its production cycle.Calculation of Cash CycleExtending the previous example, assume that MMKÕs average accounts payable balance is $120,000. What will be the firmÕs cash cycle?SOLUTION: The cash cycle will be equal to Cash cycle =  Operating cycle −  Accounts payable × 365 _____________________ Cost of goods sold = 119.89 days −  $120,000 × 365 _______________ $650,000 = 119.89 days − 67.38 days = 52.50 days Similar to Problems 14-15, 14-16EXAMPLE 14-2For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG14-3 DaysÕ Sales in InventoryOperating CycleAverage Payment PeriodCash CycleAverage Collection PeriodFIGURE 14.1 Relationship between Operating and Cash CyclesThe firmÕs cash cycle will simply be the operating cycle minus the average payment period.TIME OUT 14-3 How will a firm affect its operating cycle if it can reduce inventory on hand?   14-4 When we compare two firms, will the one with the longer cash cycle tend to have more or less net working capital requirements than the one with a shorter cash cycle, every-thing held equal? Why?  14.3 ∙ Some Aspects of Short-Term Financial PolicyIn the last section, we derived the cash cycle by first determining the operating cycle and then subtracting the payment cycle. This derivation suggests two obvious ways that firms can reduce their net working capital needs. 1. They can reduce their cash cycle by managing their need for current assets. 2. They can extend the payment cycle by seeking to obtain as many current liabilities as economically feasible to fund the current assets that they do need.LG14-4Final PDF to printer

chapter 14 Working Capital Management and Policies 467cor91411_ch14_462-497.indd 467 01/25/17 08:32 PMThe Size of the Current Assets InvestmentChoosing the optimal level of investment in each current asset type involves a trade-off between carrying costs and shortage costs.Carrying costs are associated with having current assets and fall into two general categories: 1. The opportunity costs associated with having capital tied up in current assets instead of more productive fixed assets. 2. Explicit costs necessary to maintain the value of the current assets.For example, a car dealer who purchases used vehicles and keeps them in inventory would incur not only the opportunity cost of not being able to invest the money paid for the used vehicles in a more lucrative opportunity, such as new hybrid vehicles, but would also incur explicit costs consisting of rental or lease payments on the piece of property where the used cars are on display and any maintenance costs necessary to keep the cars ready to sell.Shortage costs are the costs associated with not having enough current assets and can include opportunity costs such as sales lost due to not having enough inventory on hand, as well as any explicit transaction fees paid to replenish the particular type of current asset. For example, consider a camera shop that has a policy to reorder par-ticular lenses from its supplier only if a customer comes in asking for them, and, even then, to order only one lens at a time. In todayÕs business environment, most custom-ers who are seeking an item want it now. If that item is out of stock at one store, the customer will probably buy it either at another store or online, resulting in lost sales to the store. If, in addition, we assume that stores pay a shipping fee for every order placedÑor that they get quantity discounts if they order in bulkÑthen the camera shopÕs current policy will probably result in higher shipping fees and missed volume discounts.Carrying costs will increase, and shortage costs will decrease, as a firm buys more of any particular asset. Therefore, firms should ideally try to choose the point of an assetÕs lowest total cost, which occurs where marginal carrying and shortage costs are equal. This level is identified as CA* in Figure 14.2.carrying costsThe opportunity costs asso-ciated with having capital tied up in current assets instead of more productive fixed assets and explicit costs necessary to maintain the value of the current assets.!want to know more?Key Words to Search for Updates: The article ÒOff the shelf: Low inven-tories drove down working capital last year. But will that continue as the economy improves?Ó (www.cfo.com)Kaizen is a Japanese approach to productivity improvement that aims to eliminate waste through just-in-time delivery, standardized work and equipment, and so on. The five basic elements of kaizen are 1. Teamwork 2. Personal discipline 3. Improved moraleKAIZEN ()finance at work investments 4. Quality circles 5. Suggestions for improvementStudies show that the kaizen approach can reduce (some-times dramatically) net working capital requirements, with businesses adopting the approach reporting reductions in finished-goods and in-process inventory of anywhere from 10 to 30 percent.Final PDF to printer

468 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 468 01/25/17 08:32 PMAlternative Financing Policies for Current AssetsIn a perfect world, a firm would use long-term debt and equity to finance long-term (i.e., fixed) assets and short-term debt to finance current assets. Such an approach would allow the firm to maturity-match assets with their corresponding liabilities, resulting in a low or nonexistent level for net working capital. As we have previously discussed, in the real world, net working capital is usually positive for most firms. The implication: At least some portion of current assets must be financed with long-term debt, equity, or a mixture of both.Assuming that most firms can expect to have some steady, stable need for current assets throughout their calendar year and additional demand for current assets that fluc-tuates on some seasonal cycle, a growing firmÕs total demand for assets would resemble that shown in Figure 14.3.So, a firm in such a situation faces the basic question of whether it should finance the peaks or the valleys of total asset demand (or somewhere in between) using long-term financing. Figures 14.4, 14.5, and 14.6 illustrate some of these choices.We usually refer to the decision to finance the peaks of asset demand with long-term debt and equity, shown in Figure 14.4, as a flexible financing policy. It provides the firm with a surplus of cash and marketable securities most of the timeÑexcept during peak asset demand.LG14-5 Amount of Current AssetsCostsCarrying costsShortage costsTotal costsCA*FIGURE 14.2 Carrying and Shortage CostsThe point at which marginal carrying and shortage costs are equal (CA) is the optimal level of investment for each current asset category.TimeAssetsGrowth in Þxed assets and permanent current assets over timeSeasonalßuctuation incurrent assetsTotalassetsof ÞrmCurrent assetsFixed assetsFIGURE 14.3 Components of Current AssetsA firm makes long- or short-term financing decisions by examining the peaks and valleys of total asset demand.Final PDF to printer

chapter 14 Working Capital Management and Policies 469cor91411_ch14_462-497.indd 469 01/27/17 06:47 PMTimeAssetsLong-termdebtandequityAssetrequirementsInvesting inmarketable securitiesFIGURE 14.4 Flexible Financing of Current AssetsFlexible financing policy reflects the decision to finance the peaks of asset demand with long-term debt and equity.Long-termdebtandequityAssetrequirementsShort-termÞnancingTimeAssetsFIGURE 14.5 Restrictive Financing of Current AssetsRestrictive financing policy reflects the decision to finance the troughs of asset demand with long-term debt and equity.Long-termdebtandequityAssetrequirementsInvesting inmarketable securitiesShort-termÞnancingTimeAssetsFIGURE 14.6 Compromise Financing of Current AssetsCompromise financing policy reflects the decision to finance the seasonally adjusted average level of asset demand with long-term debt and equity.Final PDF to printer

470 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 470 01/25/17 08:32 PMOn the opposite side of the continuum, we refer to a decision to finance the troughs or valleys of asset demand with long-term debt and equity, shown in Figure 14.5, as a restrictive financing policy. Under this policy, the firm will have to seek short-term financing for all peak demand fluctuations for current assets, as well as for in-between demand situations. In some ways, this policy is the most ÒconservativeÓ; on the other hand, itÕs also the least convenient for the firm, as it involves seeking some level of short-term financing almost all of the time.A third choice is to follow a compromise financing policy, wherein the firm finances the seasonally adjusted average level of asset demand with long-term debt and equity. The firm uses both short-term financing and short-term investing as needed. Figure 14.6 illustrates such a policy. Which approach works best? As is the case with almost all working capital decisions, it depends on several factors: ¥ Current and future expected interest rate levels. If we expect rates to rise in the future, the firm may want to lock in fixed rates for a longer time by shifting toward a flexible financing policy. With falling rates, the opposite would of course hold true. ¥ The spread between short-and long-term rates. Long-term borrowing usually costs more than short-term financing, but the ÒgapÓ (called the spread) between the two terms may be historically small or large, encouraging firms to shift to a more flex-ible or restrictive policy, respectively. ¥ Alternative financing availability and costs, discussed in the following sections. Firms with easy and sustained access to alternative sources will want to shift toward more restrictive policies.TIME OUT 14-5 Suppose that the gap between short-term rates and long-term rates increases. Would firms tend to shift more toward flexible current asset financing policies or toward more restrictive policies?   14-6 If a firm offers longer credit terms to its customers, what will happen to its carrying costs?  14.4 ∙ The Short-Term Financial PlanFirms that follow any financing policy other than a flexible financing plan will find themselves forced to seek short-term financing at times. Depending on their industry, they may find themselves using unsecured loans, secured loans, or other sources of short-term financing.Unsecured LoansFor most businessesÑparticularly smaller onesÑthe most common way to cover a short-term financing need is to apply at a bank for a commercial loan. The company may expect to need such short-term loans repeatedly in the futureÑperhaps because it is following a restrictive financing policy but faces seasonal fluctuations in asset demand, as discussed previously. If the bank deems the firm creditworthy enough, the bank will usually grant the firm a line of credit, upon which the firm can draw and then pay off repeatedly as the firm goes through those seasonal fluctuations.Fees for lines of credit can be both explicit (usually taking the form of an interest rate equal to the bankÕs prime lending rate plus a small premium) and implicit (as a compen-sating balance requirement and/or a bankÕs up-front commitment fee). A compensating balance is a percentage of the borrowed money (usually 5 to 10 percent) that the bank LG14-6compensating balanceAmount of money required to be kept in a firmÕs deposit accounts with a lender according to a lend-ing arrangement.Final PDF to printer

chapter 14 Working Capital Management and Policies 471cor91411_ch14_462-497.indd 471 01/25/17 08:32 PMrequires the firm to keep on deposit in the firmÕs bank accounts. In return, the bank agrees to lend money to the firm.1Commitment fees, if charged, are usually calculated as a flat percentage of the credit line. But banks also charge commitment fees based on the portion of the line of credit Òtaken downÓ (i.e., used by the firm) or even of the portion not taken down. The amount of fees the bank charges for a line of credit and their type will depend on whether the bank is trying to encourage the use of the line of credit or not.Secured LoansAsset-based loans are short-term loans secured by a companyÕs assets. Secured loans carry lower interest rates than unsecured loans, so it is usually in the firmÕs best interest to provide security (or collateral) when it can. Though real estate, accounts receivable, inventory, and equipment are all sometimes used to back asset-based loans, most firms seeking such a loan to finance seasonal fluctuations in current assets will typically prefer to use inventory or accounts receivable as security for the loan, as they wonÕt wish to encumber long-term assets such as real estate or equipment.Accounts receivable can either be sold outright to a factor or assigned. A factor is an entity who will buy accounts receivable on a discounted basis before they are due, with the spread between the discounted price and the receivableÕs face value provid-ing the factor with expected compensation for both the time value of money and the expected level of defaults among the accounts receivable. Assignment is a process whereby the firm borrows money from another entity, providing in return a lien on the accounts receivable as well as the right of recourse (i.e., the legal right to hold the firm responsible for payment of the debt if the accounts receivable debtors do not repay as promised).Firms can also use their inventory as collateral for an inventory loan, a secured short-term loan used to purchase that inventory. Inventory loans include blanket inventory liens, trust receipts, and field warehousing financing. The major difference between the three lies with the question of who owns and keeps the inventory in question: ¥ Under a blanket inventory lien, the lender gets a lien against all the firmÕs inven-tory, but the firm retains ownership and possession. ¥ When the borrower holds the inventory in trust for the lender, with any proceed from the sale of the inventory being the property of that lender, the document acknowledging this loan commitment is referred to as the trust receipt. ¥ In field warehousing financing, a public warehouse company takes possession and supervises the inventory for the lender.Other SourcesTwo other primary sources of short-term financing are commercial paper issues and financing through bankerÕs acceptances. Commercial paper, which we explore in depth in Chapter 18, is a money-market security, issued by large banks and medium-to-large corporations, that matures in nine months or less. Since these issues have such short durations, and since firms use the proceeds only for current transactions, commercial paper (or simply paper) is exempt from registering as a security with 1If you are sitting there wondering why the bank doesnÕt just lend only 95 percent or 90 percent of the money, instead of lending it all and then asking for part of it back, the answer has to do with bank regula-tions. Though itÕs too complicated to go into great detail, the simple answer is that bank regulators see a difference between a $900,000 loan and a $1,000,000 loan with a 10 percent compensating balance require-ment, though they may sound the same to us.asset-based loansShort-term loans secured by a companyÕs assets.factorAn entity that will buy accounts receivable from a firm before they are due on a discounted basis.assignmentA voluntary liquidation proceeding that passes the liquidation of the firmÕs assets to a third party that is designated as the assignee or trustee.recourseThe legal right to hold a firm responsible for payment of a debt if the debtors do not repay as promised.commercial paperAn unsecured short-term promissory note issued by a public firm to raise short-term cash, often to finance working capital requirements.Final PDF to printer

472 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 472 01/25/17 08:32 PMthe SEC. The corresponding lack of paperwork and regulations to issue short-term debt, along with the fact that commercial paper is usually issued only by firms with very high credit rankings, makes commercial paper cheaper than using a bank line of credit.A bankerÕs acceptance (BA) is a short-term promissory note issued by a corporation, bearing the unconditional guarantee (acceptance) of a major bank. The bank guarantee makes them very safe, and the rates are usually roughly equivalent to those charged on commercial paper.TIME OUT 14-7 If its bank started charging fees to a firm based upon the portion of a line of credit not taken down, how would the firmÕs financing policy for current assets likely change? Why would a bank take such a stance?   14-8 If a firm starts selling its accounts receivable to a factor, how will the firmÕs cash cycle change?  14.5 ∙ Cash ManagementOne common source of confusion when weÕre discussing net working capital is the dif-ference between a cash flow and a cash account. Cash flows, which we have discussed in a number of contexts within this book (such as estimating cash flows for proposed new projects in Chapter 12) are a good thing. A cash account, on the other hand, is a current asset account just like all the other current asset accounts we have been discussing, and it has exactly the same attributes of high liquidity and low profitability that inventory and accounts receivable accounts have: i.e., it is, relatively speaking, a bad thing from a cash flow perspective.Reasons for Holding CashA firm may keep part of its capital tied up in cash for three primary reasons: 1. Transaction facilitation: Firms need cash to pay employeesÕ wages, taxes, sup-pliersÕ bills, interest on debts, and stock dividends. Though the firm will have cash coming in from day-to-day operations and any financing activities, the inflows and outflows are not usually perfectly synchronized, so the firm will need to keep enough cash on hand to meet reasonable transaction demands. 2. Compensating balances: As we previously discussed, firms must often keep a cer-tain percentage of borrowed funds in their checking accounts with their lending institution. Since lenders are exempt from paying interest on corporate checking accounts, compensating balances become a cheap source of funds for the lender and represent opportunity costs for borrowing firms. 3. Investment opportunities: In some industries, investment opportunities come and go very quickly. Sometimes, this happens even too quickly for the firm to arrange a loan or seek other financing, so having excess cash on hand may allow the firm to take advantage of investment opportunities that would otherwise be impossible to transact.To determine how much cash to keep on hand, firms must trade off the opportunity costs associated with holding too much cash against the shortage costs of not holding enough. The two standard models for calculating the trade-offs are the Baumol Model and the Miller-Orr Model.bankerÕs acceptance (BA)A short-term promissory note issued by a corporation, bearing the unconditional guarantee (acceptance) of a major bank.LG14-7 transaction facilitationThe use of cash to pay employeesÕ wages, taxes, suppliersÕ bills, interest on debts, and dividends on stock.Final PDF to printer

chapter 14 Working Capital Management and Policies 473cor91411_ch14_462-497.indd 473 01/25/17 08:32 PMTIME OUT 14-9 In what types of industries would firms need more cash on hand for transaction facilita-tion? In what industries might firms need less?   14-10 If a firm is going to take a loan with a bank that has a compensating balance require-ment, how does that affect the amount of money the firm must borrow?  Determining the Target Cash Balance: The Baumol ModelAn economist named William Baumol developed the first model designed to minimize the sum of the opportunity costs associated with holding cash and the trading costs associated with converting other assets to cash.2 BaumolÕs model is intuitively appeal-ing, and analysts still use it in industries for which cash outflows are fairly predictable. For other industries, its use is more problematic due to the modelÕs rather unrealistic assumptions: ¥ The model assumes that the firm has a constant, perfectly predictable disburse-ment rate for cash. In reality, disbursement rates are much more variable and unpredictable. ¥ The model assumes that no cash will come in during the period in question. Since most firms hope to make more money than they pay out, and usually have cash inflows at all times, this assumption is obviously at odds with what we usually see. ¥ The model does not allow for any safety stock of extra cash to buffer the firm against an unexpectedly high demand for cash.In BaumolÕs model, cash is assumed to start from a replenishment level, C, and then decline smoothly to a value of zero. When cash declines to zero, it can be immediately replenished by selling another C worth of marketable securities, for which the firm has to pay a trading cost of F.Thus the model implies that cash levels will follow a cyclical pattern throughout the year. For example, if a firm sells $20,000 worth of marketable securities each time it needs to replenish cash and disburses $5,000 in cash each week, then the cash balance would cycle every four weeks, as shown in Figure 14.7.Notice another implication of the cash being disbursed at a constant rate. The average cash level should equal one-half of the replenishment level, C/2. If the firm can earn an interest rate i on marketable securities, then keeping an average cash balance of C/2 will impose an opportunity cost on the firm of Opportunity cost = C __ 2  × i (14-3) If we also assume that a particular firm faces an annual demand for cash of T, then the firm will need to sell marketable securities T/C times during the year, incurring in the process annual trading costs of Trading cost = T __ C  × F (14-4) LG14-82See W. S. Baumol, ÒThe Transactions Demand for Cash: An Inventory Theoretic Approach,Ó Quarterly Journal of Economics 66, no. 4 (November 1952), pp. 545Ð556.safety stockExcess amounts of a cur-rent asset kept on hand to meet unexpected shocks in demand.replenishment levelThe level to which the cash account is ÒrefilledÓ when marketable securities are sold to recapitalize it.Final PDF to printer

474 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 474 01/25/17 08:32 PMThe firmÕs total annual costs associated with its cash management policy will therefore be Total cost = C __ 2  × i +  T __ C  × F (14-5) Solving this for the value of C that minimizes annual costs, C*, yields C* = √ _____ 2TF / i (14-6) Optimal Cash Replenishment under Baumol ModelsSuppose that AFS Industries faces an annual demand for cash of $2 million, incurs transaction costs of $150 every time it sells marketable securities, and can earn 6 percent on its market-able securities. What will be the firmÕs optimal cash replenishment level?SOLUTION: The optimal cash replenishment level will be C* =  √ _____ 2TF / i =  √ _______________________ 2 ( $2,000,000 ) ( $150 ) / 0.06   = $100,000 Similar to Problems 14-19, 14-20, Self-Test Problem 4EXAMPLE 14-3For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG14-8 Determining the Target Cash Balance: The Miller-Orr ModelThe Miller-Orr model takes a different approach to calculating the optimal cash manage-ment strategy.3 It assumes that daily net cash flows are random but normally distributed, 3See M. H. Miller and D. Orr, ÒA Model of the Demand for Money by Firms,Ó Quarterly Journal of Economics 80, no. 3 (August 1966), pp. 413Ð435.$0$2,000$4,000$6,000$8,000$10,000$12,000$14,000$16,000$18,000$20,00002468101214161820WeeksCash balanceAverage cashFIGURE 14.7 Cash Flow Patterns of the Baumol ModelIn this model, when cash declines to zero, it can be immediately replenished by selling marketable securities.Final PDF to printer

chapter 14 Working Capital Management and Policies 475cor91411_ch14_462-497.indd 475 01/25/17 08:32 PMand allows for both cash inflows and outflows. This model bases its computations on information about ¥ The lower control limit, L. ¥ The trading cost for marketable securities per transaction, F. ¥ The standard deviation in net daily cash flows, σ. ¥ The daily interest rate on marketable securities, iday.Using their model, Miller and Orr show that the optimal cash return point, Z*, and upper limit for cash balances, H*, are equal toZ*  =    3 √ _____________ 3F σ 2 / 4iday + L (14-7)H* = 3Z* − 2L (14-8) Note that the firm determines L, and that the firm can set it to a non-zero number to rec-ognize the use of safety stock.The optimal cash return point, Z*, is analogous to the replenishment level, C*, in BaumolÕs model, but with one key difference. Since BaumolÕs model only allowed for cash disbursements, C* was always Òreplenished toÓ from a level of zero. In the Miller-Orr model, Z* will be the replenishment level to which cash is replenished when the cash level hits L, but it will also be the return level that cash is brought back down to when cash hits H*.EXAMPLE 14-4Calculation of Optimal Return Point and Upper Limit for the Miller-Orr ModelSuppose that Dandy Candy, Inc., would like to maintain its cash account at a minimum level of $100,000 but expects the standard deviation in net daily cash flows to be $5,000; the effective annual rate on marketable securities will be 8 percent per year, and the trading cost per sale or purchase of marketable securities will be $200 per transaction. What will be Dandy CandyÕs optimal cash return point and upper limit?SOLUTION: The daily interest rate on marketable securities will equal i day  =  365 √ _______ 1.08 − 1  = 0.000211 And the optimal cash return point and upper limit will equal Z* = 3 √ _________ 3F σ 2 / 4 i day  + L = 0.000211 = 3 √ __________________________ 3 ( $200 ) ( $5,000 ) 2 / ( 4 × 0.000211 )  + $100,000 = $126,101.72 H*  = 3Z* − 2L = $178,305.16 LG14-8 For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.Final PDF to printer

476 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 476 01/27/17 06:48 PMAs Figure 14.8 shows, the firm will reduce cash to $126,101.72 by buying market-able securities when the cash balance gets up to $178,305.16, and it will increase cash to $126,101.72 by selling marketable securities when the cash balance gets down to $100,000.Assuming the random cash balances shown below, Dandy Candy would buy or sell securities to make adjustments as indicated:DayCash Balance before AdjustmentAdjustmentCash after Adjustment1$177,025.21$177,025.212$158,965.54$158,965.543$162,488.16$162,488.164$183,466.74−$57,365.02$126,101.725$132,548.06$132,548.066$129,816.11$129,816.117$103,709.38$103,709.388$77,229.23 $48,872.49$126,101.729$121,483.60$121,483.6010$109,309.78$109,309.7811$81,609.28 $44,492.44$126,101.7212$128,636.69$128,636.6913$102,121.84$102,121.8414$125,376.66$125,376.6615$145,025.00$145,025.0016$142,320.22$142,320.2217$166,501.15$166,501.1518$191,226.65−$65,124.93$126,101.7219$119,127.54$119,127.5420$109,377.65$109,377.6521$80,841.15 $45,260.57$126,101.7222$125,476.90$125,476.9023$114,416.24$114,416.24Similar to Problems 14-21, 14-22, 14-23, 14-24, Self-Test Problem 5$Ð$20,000$40,000$60,000$80,000$100,000$120,000$140,000$160,000$180,000$200,000TimeCashZ*H*LZ*Cash balance before adjustmentCash after adjustmentH*LFIGURE 14.8 Cash Flow Patterns of the Miller-Orr ModelThe model assumes that the distribution of daily net cash flows is normally distributed and allows for both cash inflows and outflows.Final PDF to printer

chapter 14 Working Capital Management and Policies 477cor91411_ch14_462-497.indd 477 01/25/17 08:32 PMOther Factors Influencing the Target Cash BalanceEven the Miller-Orr model, the more realistic of the two models because it deals with both cash inflows and outflows, still ignores fundamental factors that influence firmsÕ cash management practices. First, firms also have the option of borrowing short term to meet unexpected demands for cash. Though the short-term borrowing rate faced by the firm is likely to be more expensive than the opportunity cost incurred by selling market-able securities,4 this isnÕt necessarily the comparison that matters. If the probability of an unexpected demand for cash causing a firm to borrow in the short term is low enough, or if the amount of interest to be earned by investing in longer-term securities is sufficiently higher than that to be earned on marketable securities, then it might be worth it for the firm to risk occasionally paying a relatively high interest rate on short-term borrowing if it can earn a substantially higher return by investing the funds that would have been tied up in marketable securities in something more lucrative.Second, the authors of both models developed their ideas when buying and selling marketable securities was a relatively expensive and time-consuming proposition. The costs and delays of trading securities have fallen dramatically since the advent of the Internet. The cost has fallen so much since then that many large firms now habitually use all or the majority of their available cash to purchase overnight securities. If trading costs are low enough that it makes sense for the firm to incur at least two sets of trading costs each dayÑone for selling enough marketable securities in the morning to make it through the day, and another for purchasing marketable securities at the end of the busi-ness dayÑthen itÕs also probable that any unforeseen demand for cash during the day can probably be met fairly cheaply by selling marketable securities as needed. Or, put another way, the transactions costs associated with trading securities have fallen so dramatically relative to the opportunity costs of not having cash invested in marketable securities that keeping any ÒextraÓ money idle in cash just doesnÕt make sense.Finally, both models ignore the fact that many firms must keep compensating bal-ances in their deposit accounts as part of borrowing agreements with their banks. If the compensating balance requirement was a constant amount or percentage, then we could adjust the Miller-Orr model so that L included the compensating balance, but many firms must only keep a certain minimum compensating balance on average. This implies that an unforeseen demand for cash that causes a firmÕs deposit account to temporarily dip below the minimum compensating balance can be offset by keeping a corresponding amount of excess cash in the account in a later period. Even the more modern Miller-Orr model does not allow for that.TIME OUT 14-11 What effect does increasing the standard deviation in daily cash flows have on the cash return point in the Miller-Orr model?   14-12 If you were asked to adjust the Baumol model to reflect the need to keep a minimum cash balance, how would you go about doing so?  14.6 ∙ Float Control: Managing the Collection and Disbursement of CashThe economic definition of cash includes undeposited checks, but as we all know, an undeposited check is not as liquid as the same amount of cash sitting inside your checking account. So another component of a good cash management policy involves making sure that checks clear in a timely manner.4To see why, go down to your local bank or savings and loan and see which is higher: The rate it pays on sav-ings accounts or the rate it charges on short-term borrowing.LG14-9 Final PDF to printer

478 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 478 01/25/17 08:32 PMAccelerating CollectionsThe period of time between when a check is written and when it clears and the funds are available for use is referred to as float. The checks sent to a firm experience three differ-ent types of collection float, illustrated in Figure 14.9: 1. Mail float is the length of time that checks are en route to the firm, either through the postal system or through some sort of electronic transfer. 2. In-house processing float is the length of time needed for the firm to process and deposit check payments from its customers once they have been received. 3. Availability float is the length of time necessary for a check to clear through the banking system once it has been deposited.Together, these three types of float span the entire length of time between the customer sending a payment and the firm receiving cash in its account. Several different techniques can help firms reduce collection float: ¥ A lockbox system is a collection of geographically dispersed post office boxes, each maintained for the firm by a bank local to the respective box. For firms with hundreds or thousands of customers spread across a large region, the ideal situ-ation is to have enough locations so that no customer is more than a couple of hundred miles from one of the firmÕs post office boxes. By having customers send their payments to the closest post office box, and then having the local bank pick up and handle the payment processing several times a day, the firm can reduce both mail float and in-house processing float. ¥ Concentration banking accelerates cash collections from customers by having funds sent to several geographically situated regional banks and then transferred to a main concentration account in another bank. The funds can be transferred through depository transfer checks and electronic transfers. ¥ Wire transfers are the fastest way of transmitting money from a local bank into the concentration bank. Banks within the United States utilize the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system to make payments to banks in countries outside of the United States. Bank-to-bank transfers conducted within the United States take place over the Fedwire sys-tem, which uses the Federal Reserve System and its assignment of bank routing numbers.Delaying DisbursementsDisbursement float is the delay between the firm sending out a payment and the money being taken out of the firmÕs bank account. Two legal ways to increase disbursement float involve keeping the cash available to the firm until the very last moment: ¥ A zero-balance account is a checking account that the firm sets up so that the bank agrees to automatically transfer funds from an interest-bearing account to pay off any checks presented. Since zero-balance accounts never contain excess cash, floatThe period of time between when a payment is sent out and when the money is actually received by the collecting firm.zero-balance accountA corporate checking account which keeps a zero balance, automatically transferring in just enough funds to cover any checks received on the account from another interest- bearing account.Mail FloatIn-House Processing FloatCollection FloatAvailability FloatFIGURE 14.9 Components of Collection FloatCash is not always liquid due to collection float.Final PDF to printer

chapter 14 Working Capital Management and Policies 479cor91411_ch14_462-497.indd 479 01/25/17 08:32 PMthey represent one way that firms can get around regulations against corporations having interest-bearing checking accounts. ¥ Drafts resemble checks, but differ in that they are payable by the firm issuing them rather than payable by a bank. When a draft is sent to the firmÕs bank for payment, the bank must present the draft to the firm before disbursing the funds.Ethical and Legal QuestionsUsing collected cash before actually receiving it, or continuing to use disbursed cash after you have sent a check out, can earn your firm higher returns, but this practice is illegal. The most extreme form of taking illegal advantage of disbursement float is a practice called check kiting, which is any sort of fraud that involves drawing out money from a bank account with insufficient funds to cover the check.The Check Clearing for the 21st Century Act, which allows for transmitting electronic images of checks rather than the physical paper checks themselves, has greatly reduced the incidence of check kiting by substantially shortening the time required for a check to be cleared from one bank to another.TIME OUT 14-13 In Japan, many consumers pay their bills by electronic deduction from their checking accounts instead of using paper checks. What effect do you think this has on the col-lection float of Japanese firms versus that of American firms?   14-14 WhatÕs the difference between a lockbox system and concentration banking?  draftSimilar to a check, but pay-able by the issuing firm rather than by its bank.!want to know more?Key Words to Search for Updates: ÒMarketing Tip: Payment MethodsÓ (see the Japan Marketing News blog at www.japanmarketingnews.com)JapanÕs Postal Savings Bank, the worldÕs largest bank, has long been used as an example of the efficiencies available to both individuals and businesses of electronic transactions. Electronic transactions are instantaneous transactions that use security authentication rather than conventional check-clearing processes to transfer funds from a buyer to the seller.However, in 2006, one of the Nikkei trade papers summa-rized the results of a survey among Japanese women regarding payment methods used for Internet shopping. Not surpris-ingly, the vast majority (56 percent) of respondents purchasing goods over the Internet reported that they used credit cards for their transactions. However, the distribution of the rest of the responses illustrates a vast difference between alternative pay-ment pipelines that American and Japanese consumers use.For example, 17.6 percent of Japanese respondents ordered online, then paid in cash at their local convenience CULTURAL DIFFERENCES IN PREFERENCES FOR PAYING BILLSfinance at work globalstore; 13.1 percent paid COD when the mailman delivered the goods; and 4.3 percent paid using electronic transfers from their post office savings accounts.Though there is some anecdotal evidence that the usage of credits cards has increased slightly since 2006, the use of such alternative methods of payment in Japan is still much higher than we see elsewhere in the world.What implications does this have for the money man-agement policies of firms doing business in Japan? Well, given that a far larger percentage of Americans probably pay for their online purchases with credit cards, and that the alternative methods of payment listed previously could be expected to have different clearing times than do pay-ments received through a merchantÕs credit card account, itÕs something that firms seeking to do business in Japan should consider.Final PDF to printer

480 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 480 01/25/17 08:32 PM14.7 ∙ Investing Idle CashAs both the Baumol and Miller-Orr models imply, firms habitually move cash into and out of marketable securities in order to partially offset the opportunity costs of having capital tied up in current assets. Most large firms will manage their marketable securi-ties investments themselves. Smaller firms will typically invest through an independently managed money-market fund or by letting their bank transfer all available excess funds at the end of each business day into a sweep account, which will then be invested on their behalf.Why Firms Have Surplus CashFirms tend to have surplus cash available either due to seasonal fluctuations in their cash flow patterns, or in preparation for planned expenditures. Seasonal fluctuations in the amount of cash on hand can occur as a result of either cyclical sales or cyclical purchases of raw materials. For example, a firm that produces swimming pool accessories will obviously experience higher sales from spring through late fall, and a firm that distributes fresh vegetables purchased on the spot market will have higher cash outflows during the harvest season.FirmsÕ cash balances may also temporarily increase immediately prior to a planned expenditure, either because they have been Òsaving upÓ for the expenditure, or because they issued stocks or bonds in advance of the expenditure but need someplace to ÒparkÓ the funds until they are needed.What to Do with Surplus CashAs mentioned, firms usually put surplus cash into money-market securities. As discussed in Chapter 18, these include Treasury bills, federal funds and repurchase agreements, commercial paper, negotiable certificates of deposit, and bankerÕs acceptances.TIME OUT 14-15 Should a firm with nonseasonal cash flows that lacks any good prospective invest-ments keep excess cash on hand? Why or why not?   14-16 Suppose a firm has a temporary surplus of cash meant to fund an upcoming expansion project. Why might it not wish to invest these funds in capital-market (as opposed to money-market) securities?  14.8 ∙ Credit ManagementAs is the case with the firmÕs cash management policy, the firmÕs optimal credit policy will trade off the opportunity cost of lost sales (if the firm does not grant credit or is too conservative in terms of the credit it does grant) against the carrying costs associated with funding the accounts receivable plus the expected costs of default on the accounts receivable.Credit Policy: Terms of the SaleAs a minimum, the credit terms of sale usually contain at least the credit period, the cash discount, and a description of the type of credit instrument. The credit period is the matu-rity of the credit that the firm is willing to extend, which varies based on attributes of the LG14-10 LG14-11 credit termsA listing of the credit period, the cash discount, and the type of credit instrument to be used.Final PDF to printer

chapter 14 Working Capital Management and Policies 481cor91411_ch14_462-497.indd 481 01/25/17 08:32 PMgoods being sold and the customer purchasing the goods.For example, perishable goods will usually carry a lower credit period, regardless of who is purchasing them. Creditwor-thy, established customers will probably be given better credit terms than customers the firm has not dealt with before.To encourage early repayment, firms will often offer a percentage discount if the bill is paid within a certain time period. For example, a firm that quotes customers terms of Ò2/10, net 30Ó is offering them the choice between paying the entire bill within 30 days or taking a 2 percent discount off the invoiced price if they pay within 10 days.For most trade credit, the invoice is the only type of credit instrument involved.When the customer signs a copy upon receipt of the goods, the customer makes an implicit promise to pay under the terms listed on the invoice. If a firm wishes for a customer to make a more explicit acknowledgment of its ability and obligation to pay, a firm can ask the customer to sign a promissory note upon delivery of the goods or to furnish a commercial draft or bankerÕs acceptance in advance of the delivery of the goods.Credit AnalysisBefore granting a customer credit, the firm may wish to engage in credit analysis. Such analysis involves a systematic determination of the potential borrowerÕs ability and will-ingness to pay for the goods being provided on credit.A thorough credit analysis will look at the potential borrowerÕs past record and its present and forecasted future financial condition, which generally involves examining the Òfive CÕsÓ: 1. Capacity: Does the borrower have the legal and economic ability to pay? 2. Character: Does the borrowerÕs reputation indicate a willingness to settle debt obligations? 3. Capital: Having assets at risk makes it more likely that the borrower will repay as promised. 4. Collateral: Goods that can be seized and sold, with the proceeds being used to pay the firm in the event of bankruptcy by the borrower, also makes it more likely that the customer will repay as promised. 5. Conditions: Any economic conditions that may affect the borrowerÕs ability to repay the loan should also be taken into account.Collection PolicyThe firmÕs collection policy is aimed at collecting past-due debts from customers.The usual procedure for collecting follows a typical path of 1. Sending one or more delinquency letters informing the customer of the past-due status of the account, asking the customer to contact the firm to discuss alternative means of repayment and pointing out what legal recourse the firm has. 2. Initiating telephone calls conveying the same information as above. 3. Employing a collection agency. 4. Taking legal action against the customer if all else fails.To monitor and control this process, firms use a tool called an aging schedule, which stratifies a firmÕs accounts receivable by the age of each account. For example, a firm that offers terms of 2/10, net 60 to its customers might want to measure the age of accounts receivable using the categories shown in Table 14.2.credit analysisA systematic determina-tion of a borrowerÕs ability and willingness to repay a potential loan.Final PDF to printer

482 part seven Working Capital Management and Financial Planningcor91411_ch14_462-497.indd 482 01/25/17 08:32 PMSuch an aging schedule would allow the firm to see what percentage of its customers are still eligible to take the discount (i.e., those in the Ò0Ð10 daysÓ category), how many are past due by less than 30 days (i.e., those in the Ò61Ð90 daysÓ category), and how many are over 30 days past due (i.e., those in the ÒOver 90 daysÓ category).Firms often link their collection policies to their aging schedules. For example, the customers in Table 14.2 that fall into the Ò61Ð90 daysÓ category might be sent a delin-quency letter, while those in the ÒOver 90 daysÓ category might be phoned.TIME OUT 14-17 Why do firms offer customers discounts for paying early?   14-18 Should a firm always turn far-overdue bills from customers over to a collection agency or sue the customers? Why or why not?  viewpoints REVISITEDBusiness Application SolutionChewbaccaÕs operating cycle will be equal to Operating cycle =   0.1 × 365 ________ 0.55  +  0.1667 + 365 ___________ 1 Their cash cycle will be equal to Cash cycle = 127.20 −  0.05 + 365 _________ 0.55 = 94.02 days Absent any other information about current assets or current liabilities, ChewbaccaÕs net working capital will be ( 0.10 + 0.1667 − 0.05 )  × $32 million = $6.93 million Personal Application SolutionSince Wanda will be drawing out the money smoothly from the account, she can use the Baumol model to determine the optimal replenishment level for her personal stock of cash: C* =  √ ______________________ 2 ( $25,000 ) ( $9.95 ) / 0.035  = $3,770.18 TABLE 14.2 Sample Aging ScheduleAge BracketPercentage of AR in Bracket0Ð10 days 10% 11Ð30 days 35 31Ð60 days 45 61Ð90 days 7 Over 90 days 3 100 Final PDF to printer

483cor91411_ch14_462-497.indd 483 01/25/17 08:32 PMsummary of learning goalsIn this chapter, we discussed the firmÕs working capital policy, focusing on how we can determine the optimal amount to be invested in current assets, the portion of that amount to be provided by the firm, and sources of funding for that portion.Set overall objectives of a good working capital policy. A good working capital policy has the firm providing enough net working capital, but not too much.Discuss how net working capital serves the firm. Net working capital measures the portion of current assets that are not funded by current liabilities, but which must be funded by other sources of capital.Analyze the firmÕs operating and cash cycles to determine what funding for current assets the firm needs. The cash cycle is basically the operating cycle minus the average payment period and represents the funding need.Model the optimal trade-off between carrying costs and shortage costs that dictates the firmÕs current asset investment. Ideally, the firm will have just enough current assets so that the marginal carrying costs and marginal shortage costs are equal, thereby minimizing total cost.Compare the flexible and restrictive approaches to financing current assets. A flexible financing policy has the firm funding short-term fluctuations in the amount of current assets with long-term debt; a restrictive policy has the firm funding those fluctuations with short-term debt.Differentiate among sources of short-term financing available for funding current assets. The firm can use unsecured loans, secure loans, commercial paper, or bankerÕs acceptances.Justify the firmÕs need to hold cash. The three main reasons for holding cash are to facilitate LG14-1LG14-2LG14-3LG14-4LG14-5LG14-6LG14-7transactions, to provide for compensating balances for loan agreements, and to take advantage of short-lived investment opportunities.Use the Baumol and Miller-Orr models for determining cash policy. The Baumol model was designed to help determine a firmÕs cash policy under conditions of certain cash demand, while the Miller-Orr model is designed for conditions of stochastic cash demand.Identify sources of float and show how to control float for the firmÕs disbursement and collection functions. Float stems from delays in physically sending or receiving a payment and from processing delays either by the receiving firm or by the check-clearing process. To the extent that it is legally and ethically possible, firms will attempt to increase disbursement float and reduce collection float so as to reduce the amount of cash they have to keep on hand.Identify firmsÕ choices for using excess cash. Excess cash is generally invested in money-market instruments or marketable securities.Connect the firmÕs credit terms and collection policy and the amount of capital the firm has invested in accounts receivable. The more generously the firm grants credit, the more its customers will take advantage of that generosity and the longer the firm will have to pay for producing and selling its product without collecting any money for it, so generous credit terms will result in the firm requiring a larger investment in net working capital than would otherwise be the case.LG14-8LG14-9LG14-10LG14-11Final PDF to printer

484cor91411_ch14_462-497.indd 484 01/25/17 08:32 PMchapter equations 14-1 Operating cycle = DaysÕ sales in inventory + Average collection period = Inventory × 365 ________________ Cost of goods sold  +  Accounts receivable × 365 _______________________ Credit sales 14-2 Cash cycle = Operating cycle − Average payment period = Operating cycle −  Accounts payable × 365 _____________________ Cost of goods sold 14-3 Opportunity cost  =  C __ 2  × i 14-4 Trading cost  =  T __ C  × F   14-5 Total cost  =  C __ 2  × i +  T __ C  × F 14-6 C* =  √ _____ 2TF / i   14-7 Z* =   3 √ __________ 3F σ 2 / 4 i day  + L   14-8 H* = 3Z* − 2L   key termsasset-based loans Short-term loans secured by a com-panyÕs assets. p. 471assignment A voluntary liquidation proceeding that passes the liquidation of the firmÕs assets to a third party that is designated as the assignee or trustee. p. 471bankerÕs acceptance (BA) A short-term promissory note issued by a corporation, bearing the unconditional guar-antee (acceptance) of a major bank. p. 472Barabas Economic Order Quantity (EOQ) The inven-tory order quantity that minimizes total holding and ordering costs. p. 464carrying costs The opportunity costs associated with having capital tied up in current assets instead of more productive fixed assets and explicit costs necessary to maintain the value of the current assets. p. 467cash cycle The operating cycle minus the average pay-ment period. p. 465commercial paper An unsecured short-term promis-sory note issued by a public firm to raise short-term cash, often to finance working capital requirements. p. 471compensating balance Amount of money required to be kept in a firmÕs deposit accounts with a lender according to a lending arrangement. p. 470credit analysis A systematic determination of a borrow-erÕs ability and willingness to repay a potential loan. p. 481credit terms A listing of the credit period, the cash dis-count, and the type of credit instrument to be used. p. 480draft Similar to a check, but payable by the issuing firm rather than by its bank. p. 479factor An entity that will buy accounts receivable from a firm before they are due on a discounted basis. p. 471float The period of time between when a payment is sent out and when the money is actually received by the col-lecting firm. p. 478Final PDF to printer

485cor91411_ch14_462-497.indd 485 01/25/17 08:32 PMjust in time (JIT) A production strategy that attempts to improve a firmÕs return on investment by reducing in-process inventory and associated carrying costs as much as possible. p. 464operating cycle The time required to acquire raw materi-als and to produce, sell, and receive payment for the fin-ished goods. p. 465operations management The area of management con-cerned with designing and overseeing the process of production. p. 463opportunity cost The dollar cost or forgone opportunity of using an asset already owned by the firm, or a person already employed by the firm, in a new project. p. 464recourse The legal right to hold a firm responsible for pay-ment of a debt if the debtors do not repay as promised. p. 471replenishment level The level to which the cash account is ÒrefilledÓ when marketable securities are sold to recap-italize it. p. 473safety stock Excess amounts of a current asset kept on hand to meet unexpected shocks in demand. p. 473shortage costs Costs associated with not having suffi-cient cash, inventory, or accounts receivable. p. 463transaction facilitation The use of cash to pay employ-eesÕ wages, taxes, suppliersÕ bills, interest on debts, and dividends on stock. p. 472zero-balance account A corporate checking account which keeps a zero balance, automatically transferring in just enough funds to cover any checks received on the account from another interest-bearing account. p. 478self-test problems with solutions1 Computing Operating Cycle and Cash Cycle Your firm currently has an operating cycle of 73 days. You are analyzing some operational changes that are expected to decrease the average collection period by 5 days and decrease the daysÕ sales in inventory by 3 days. The average payment period is expected to decrease by 10 days. If all of these changes are adopted, what will your firmÕs new operating cycle be?  Solution:Since the operating cycle is equal to daysÕ sales in inventory plus the average collection period, the operating cycle of the firm will decrease to 73 Ð 5 Ð 3 = 65 days. The change in the average payment period has no effect on the operating cycle.2 Minimizing Carrying and Shortage Costs Suppose that your firm is seeking a five-year, amortizing $500,000 loan with annual payments and your bank is offering you the choice between a $600,000 loan with a $100,000 compensating balance and a $500,000 loan without a compensating balance. If the interest rate on the $500,000 loan is 9 percent, how low would the interest rate on the loan with the compensating balance have to be in order for you to choose it?  Solution:The payments on the $500,000 loan would be equal to $128,546.23. To pay less on the $600,000 loan, you would have to have an interest rate lower than 2.34 percent.3 Flexible versus Restrictive Financing If your firm faces a long-term borrowing rate of 8 percent, a short-term borrowing rate of 10 percent, can earn 7 percent when investing marketable securities, and needs to fund $3 million in permanent current assets and $1 million in seasonal current assets (for six months out of the year), what would be the cost difference between using a flexible and a restrictive financing policy?  LG14-3LG14-4LG14-5Final PDF to printer

486cor91411_ch14_462-497.indd 486 01/25/17 08:32 PMSolution:Under either policy, you will be funding the $3 million in permanent current assets with long-term debt, so you can ignore this as an incremental difference between the two policies. If you use long-term debt, you will be paying $1 million × 8 percent = $80,000 per year in interest, but earning $1 million × 7 percent × 0.5 = $35,000 in interest for the half year that you get to invest the money in marketable securities, for a net cost of $80,000 Ð $35,000 = $45,000 for the flexible financing policy. With the restrictive financing policy, you will be paying $1 million × 10 percent × 0.5 = $50,000 per year, so your net costs will be lower if you follow the flexible financing policy.4 Baumol Model Suppose that Overton, Inc., faces an annual demand for cash of $17 million, incurs transaction costs of $200 every time it sells marketable securities, and can earn 7.3 percent on its marketable securities. What will be its optimal cash replenishment level?  Solution:The optimal cash replenishment level will be C * = √ _____ 2TF / i = √ ________________________ 2($17,000,000 ) ($200 ) / 0.073 = $305,205.97 5 Miller-Orr Model GenCo would like to maintain its cash account at a minimum level of $250,000, but management expects the standard deviation in net daily cash flows to be $15,000, the effective annual rate on marketable securities to be 5 percent per year, and the trading cost per sale or purchase of marketable securities to be $110 per transaction. What will be GenCoÕs optimal cash return point and upper limit?  Solution:The daily interest rate on marketable securities will be equal to i day  =  365 √ ____ 1.05  − 1 = 0.000134 And the optimal cash return point and upper limit will be equal to Z * = 3 √ __________ 3F σ 2 / 4 i day  + L = 3 √ _____________________________ 3($110) ($15,000) 2 / (4 × 0.000134)  + $250,000 = $301,783.25 H * = 3($301,783.25) − 2($250,000 ) = $405,349.76 6 Float Calculation AFS, Inc., estimates that it takes, on average, three days for customersÕ payments to arrive, two days for the payments to be processed and deposited by AFSÕs bookkeeping department, and three more days for checks to clear once they are deposited. What is AFSÕs collection float?  Solution:The collection float will be 3 + 2 + 3 = 8 days.7 Aging Schedule OTK Sports has constructed the aging schedule shown in the following table. If the company offers terms of 2/10, net 30 to its customers, and if its LG14-8LG14-8LG14-9LG14-11Final PDF to printer

487cor91411_ch14_462-497.indd 487 01/25/17 08:32 PMcollection policy is to send a letter on bills more than 30 days overdue and to call on bills more than 60 days overdue, how many letters will it need to print?  Age BracketNumber of Customers in Bracket0Ð10 days2511Ð30 days7831Ð60 days1761Ð90 days3Over 90 days1Solution:OTK will need to print 17 letters.questions 1. Is it possible for a firm to have negative net working capital? How? (LG14-1) 2. Would it be possible for a decision to deny credit to your customers to be value maximizing? How? (LG14-1) 3. Which of the following will result in an increase in net working capital? (LG14-2) a. An increase in cash. b. A decrease in accounts payable. c. An increase in notes payable. d. A decrease in accounts receivable. e. An increase in inventory. 4. Would it be possible for a firm to have a negative cash cycle? How? (LG14-3) 5. If a firmÕs inventory turnover ratio increases, what will happen to the firmÕs operating cycle? (LG14-3) 6. If a firmÕs inventory turnover ratio increases, what will happen to the firmÕs cash cycle? (LG14-3) 7. Everything else held constant, will an increase in the amount of inventory on hand increase or decrease the firmÕs profitability? (LG14-4) 8. Would a firm ever use short-term debt to finance permanent current assets? Why or why not? (LG14-5) 9. Suppose that short-term borrowing actually becomes more expensive than long-term bor-rowing: How would this affect the firmÕs choice between a flexible financing policy and a restrictive policy? (LG14-5) 10. If asset-backed loans are cheaper than unsecured loans, what is the disadvantage to the firm in using an asset-backed loan? (LG14-6) 11. Is an increase in the cash account a source of funds or a use of funds? (LG14-7) 12. What will be the carrying cost associated with a compensating balance requirement? (LG14-7) 13. What will be the shortage cost associated with a compensating balance requirement? (LG14-7) 14. What would be the shortage costs associated with a restaurant not having enough cash on hand to make change? (LG14-7) 15. If a firm needs to keep a minimum cash balance on hand and faces both cash inflows and outflows, which of the cash management models discussed in this chapter would be more appropriate for the firm to use? (LG14-8) 16. What effect will increasing the trading costs associ-ated with selling marketable securities have on the optimal replenishment level in the Baumol Model? Why? (LG14-8) 17. What effect will an increase in the standard devia-tion of daily cash flows have on the return point in the Miller-Orr model? Why? (LG14-8) 18. Could a firm ever have negative collection float? Why or why not? (LG14-9) 19. Could a firm ever have negative disbursement float? Why or why not? (LG14-9) 20. Would a draft have availability float? Why or why not? (LG14-9) 21. From our discussion of capital markets elsewhere in this book, why would you expect a firm to have Final PDF to printer

488cor91411_ch14_462-497.indd 488 01/25/17 08:32 PMa time delay between raising funds to finance a project and the expenditure of those funds on that project? (LG14-9) 22. What purpose does a discount on credit terms serve? What is the cost of such a discount to the offering firm? (LG14-9)problems 14-1 Net Working Capital Requirements JohnBoy Industries has a cash balance of $45,000, accounts payable of $125,000, inventory of $175,000, accounts receivable of $210,000, notes payable of $120,000, and accrued wages and taxes of $37,000. How much net working capital does the firm need to fund? (LG14-2) 14-2 Net Working Capital Requirements Dandee Lions, Inc., has a cash balance of $105,000, accounts payable of $220,000, inventory of $203,000, accounts receivable of $319,000, notes payable of $65,000, and accrued wages and taxes of $75,000. How much net working capital does the firm need to fund? (LG14-2) 14-3 DaysÕ Sales in Inventory Dabble, Inc., has sales of $980,000 and cost of goods sold of $640,000. The firm had a beginning inventory of $36,000 and an end-ing inventory of $46,000. What is the length of the daysÕ sales in inventory? (LG14-3) 14-4 DaysÕ Sales in Inventory Sow Tire, Inc., has sales of $1,450,000 and cost of goods sold of $980,000. The firm had a beginning inventory of $97,000 and an ending inventory of $82,000. What is the length of the daysÕ sales in inventory? (LG14-3) 14-5 Average Payment Period If a firm has a cash cycle of 67 days and an operating cycle of 104 days, what is its average payment period? (LG14-3) 14-6 Average Payment Period If a firm has a cash cycle of 45 days and an operating cycle of 77 days, what is its average payment period? (LG14-3) 14-7 Payables Turnover If a firm has a cash cycle of 73 days and an operating cycle of 127 days, what is its payables turnover? (LG14-3) 14-8 Payables Turnover If a firm has a cash cycle of 54 days and an operating cycle of 77 days, what is its payables turnover? (LG14-3) 14-9 Compensating Balance Would it be worthwhile to incur a compensating bal-ance of $10,000 in order to get a 1 percent lower interest rate on a one-year, pure discount loan of $225,000? (LG14-7) 14-10 Compensating Balance Would it be worthwhile to incur a compensating bal-ance of $7,500 in order to get a 0.65 percent lower interest rate on a two-year, pure discount loan of $150,000? (LG14-7) 14-11 Collection Float CM Enterprises estimates that it takes, on average, three days for customersÕ payments to arrive, one day for the payments to be pro-cessed and deposited by the bookkeeping department, and two more days for the checks to clear once they are deposited. What is CMÕs collection float? (LG14-9) 14-12 Collection Float Smelpank, Inc., estimates that it takes, on average, four days for customersÕ payments to arrive, three days for the payments to be processed and deposited by the bookkeeping department, and three more days for the checks to clear once they are deposited. What is the firmÕs collection float? (LG14-9)basic problemsFinal PDF to printer

489cor91411_ch14_462-497.indd 489 01/25/17 08:32 PM 14-13 Operating Cycle Suppose that Dunn Industries has annual sales of $2.3 million, cost of goods sold of $1,650,000, average inventories of $1,116,000, and average accounts receivable of $750,000. Assuming that all of DunnÕs sales are on credit, what will be the firmÕs operating cycle? (LG14-3) 14-14 Operating Cycle Suppose that LilyMac Photography has annual sales of $230,000, cost of goods sold of $165,000, average inventories of $4,500, and average accounts receivable of $25,000. Assuming that all of LilyMacÕs sales are on credit, what will be the firmÕs operating cycle? (LG14-3) 14-15 Cash Cycle Suppose that LilyMac Photography has annual sales of $230,000, cost of goods sold of $165,000, average inventories of $4,500, average accounts receivable of $25,000, and an average accounts payable balance of $7,000. Assuming that all of LilyMacÕs sales are on credit, what will be the firmÕs cash cycle? (LG14-3) 14-16 Cash Cycle Suppose that Ken-Z Art Gallery has annual sales of $870,000, cost of goods sold of $560,000, average inventories of $244,500, average accounts receivable of $265,000, and an average accounts payable balance of $79,000. Assuming that all of Ken-ZÕs sales are on credit, what will be the firmÕs cash cycle? (LG14-3) 14-17 Compensating Balance Interest Rate Suppose your firm is seeking an eight-year, amortizing $800,000 loan with annual payments, and your bank is offering you the choice between an $850,000 loan with a $50,000 compensating balance and an $800,000 loan without a compensating balance. If the interest rate on the $800,000 loan is 8.5 percent, how low would the interest rate on the loan with the compensating balance have to be for you to choose it? (LG14-4) 14-18 Compensating Balance Interest Rate Suppose your firm is seeking a four-year, amortizing $200,000 loan with annual payments and your bank is offer-ing you the choice between a $205,000 loan with a $5,000 compensating balance and a $200,000 loan without a compensating balance. If the interest rate on the $200,000 loan is 9.8 percent, how low would the interest rate on the loan with the compensating balance have to be for you to choose it? (LG14-4) 14-19 Optimal Cash Replenishment Level Rose Axels faces a smooth annual demand for cash of $5 million, incurs transaction costs of $275 every time the company sells marketable securities, and can earn 4.3 percent on its marketable securities. What will be its optimal cash replenishment level? (LG14-8) 14-20 Optimal Cash Replenishment Level Watkins Resources faces a smooth annual demand for cash of $1.5 million, incurs transaction costs of $75 every time the firm sells marketable securities, and can earn 3.7 percent on its marketable secu-rities. What will be its optimal cash replenishment level? (LG14-8) 14-21 Optimal Cash Return Point HotFoot Shoes would like to maintain its cash account at a minimum level of $25,000, but expects the standard deviation in net daily cash flows to be $4,000, the effective annual rate on marketable securities to be 6.5 percent per year, and the trading cost per sale or purchase of marketable securities to be $200 per transaction. What will be its optimal cash return point? (LG14-8) 14-22 Optimal Cash Return Point Veggie Burgers, Inc., would like to maintain its cash account at a minimum level of $245,000 but expects the standard deviation in net daily cash flows to be $12,000, the effective annual rate on marketable securities to be 4.7 percent per year, and the trading cost per sale or purchase of marketable securities to be $27.50 per transaction. What will be its optimal cash return point? (LG14-8)intermediate problemsFinal PDF to printer

490cor91411_ch14_462-497.indd 490 01/25/17 08:32 PM 14-23 Optimal Upper Cash Limit Veggie Burgers, Inc., would like to maintain its cash account at a minimum level of $245,000 but expects the standard deviation in net daily cash flows to be $12,000, the effective annual rate on marketable securities to be 3.7 percent per year, and the trading cost per sale or purchase of marketable securities to be $27.50 per transaction. What will be its optimal upper cash limit? (LG14-8) 14-24 Optimal Upper Cash Limit HotFoot Shoes would like to maintain its cash account at a minimum level of $25,000 but expects the standard deviation in net daily cash flows to be $2,000, the effective annual rate on marketable securities to be 3.5 percent per year, and the trading cost per sale or purchase of marketable securities to be $200 per transaction. What will be its optimal upper cash limit? (LG14-8)research it! Looking Up Information on a FirmÕs Cash CycleGo to the SECÕs Edgar site at www.sec.gov/edgar/quickedgar.htm and download the latest annual (10-K) report for the firm of your choice. Use the financial statements in the report to calculate the firmÕs cash cycle.integrated mini-case Line of CreditYour bank offers you a $140,000 line of credit with an interest rate of 2.30 percent per quarter. The loan agreement also requires that 7 percent of the unused portion of the credit line be deposited in a non-interest-bearing account as a compensating balance. Your short-term investments are paying 1.55 percent per quarter. 1. What is your effective annual interest rate if you borrow the whole $140,000 for the entire year? 2. What will be the carrying cost in this problem? 3. What will be the shortage cost in this problem?ANSWERS TO TIME OUT 14-1 A creditor might think of net working capital as a buffer, in that it represents the amount of short-term capital slated to come into the firm above and beyond the amount that the creditor is owed. The larger the amount of the net working capital is, the greater is the chance that the creditor will get paid back. 14-2 Everything else held constant, we would normally expect net working capital to increase in such a situation: Inventory would increase and accounts receivable might also increase if the firm offered better credit terms to try to stimulate sales. 14-3 Reducing inventory on hand would reduce daysÕ sales in inventory, which would cause the operating cycle to decrease. 14-4 The firm with a longer cash cycle will tend to have more net working capital require-ments, as the firm will have to fund current assets for a longer period of time.Final PDF to printer

491cor91411_ch14_462-497.indd 491 01/25/17 08:32 PM 14-5 As the relative cost of long-term debt increased, firms would tend to shift toward more restrictive policies. 14-6 Carrying costs will increase, because the firm will have to fund a longer collection cycle. 14-7 The firm would be less likely to ask for an excessive amount when it requested a line of credit, implying that the firmÕs use of such a line of credit would tend to decrease slightly. A bank might adopt such a policy if it wanted to encourage firms to ask for only as much credit as they intended to use. 14-8 Since the firm would not have to wait on collection of the accounts receivable, the cash cycle would decrease. 14-9 Retail firms, which involve a lot of customer transactions, would probably need more cash on hand; industries where direct customer interaction is rare, such as utilities, would need less. 14-10 The firm will need to borrow more money than it really needs, so that both its needs and the compensating balance requirement are met. 14-11 It will cause the cash return point to increase. 14-12 Add the minimum cash balance to C*. 14-13 Since mail float will be eliminated, collection float should decrease. 14-14 In a lockbox system, customersÕ payments are physically collected close to them, but not necessarily processed close to them; in concentration banking, both the physical collection and much of the processing takes place close to the customer, speeding up the firmÕs receipt of funds. 14-15 No, they should not keep excess cash on hand, as it is costing the firm interest to raise the money but the firm is not earning any interest on spare cash that is just sitting around. 14-16 Investing money in long-term capital-market funds could expose the firm to the risk that the invested principal might be worth less when the firm needs the money. For example, if a firm bought bonds that were longer term than its time horizon for invest-ing in an expansion project, it could see its investment value go down if interest rates went up. 14-17 If customers pay early, the firmÕs cash cycle is shortened. 14-18 Not necessarily. If the amount due is small enough, it probably is not worth pursuing the overdue bill. However, if a collection agency is willing to work for a percentage of the amount recovered, the firm might as well turn collection over to the agency regardless of the size involved because the firm incurs no out-of-pocket cost.Final PDF to printer

492cor91411_ch14_462-497.indd 492 01/25/17 08:32 PMappendix 14A The Cash BudgetThe production and sales in many firms vary over the year. For example, a toy retailer will have many more sales in November and December than in March and April. On the other hand, consider the manufacturer of toys. That company would have to manufacture most of the toys it will sell to the retail stores before November. For the most part, all businesses have some seasonality in their sales and/or production cycle. This seasonality creates periods during the year in which the firm will generate large cash surpluses and other periods in which it will generate large cash deficits. Financial managers must plan ahead for such times so that the firm always has adequate cash to pay its liabilities. The cash budget is the instrument they use.Consider the example of Yellow Jacket, Inc., a manufacturer of coats and jackets that has decided to operate its factory at a constant pace all year. Thus, inventory builds up until early fall, when it ships large amounts of its product to retailers. The coats are mostly sold in the fall, depleting inventory. This strategy allows the company to keep a few full-time workers instead of hiring many seasonal employees and then laying them off during the slow times of the year. However, incurring costs during most of the year with few sales and then selling the coats in the fall creates a serious cash flow problem that the financial manager is responsible for resolving.Cash budgets can be created for daily, monthly, or quarterly time periods. Given the severe seasonality of Yellow JacketÕs sales, its cash budget is done monthly. The cash budget begins with a projection of sales for the year. In this case, Yellow Jacket is projecting a 10 percent increase in sales each month from the same month of the previous year. The top of Table 14A.1 shows these monthly projected sales, which are quite seasonal. Many companies have sales terms like 2/10 net 45, which means that customers must pay within 45 days of the saleÑbut if they pay within 10 days they can take a 2 percent discount. Even with terms like this, Yellow Jacket has found that its customers take the 2 percent discount if they pay in the same month of the sale, which 30 percent do. Then 50 percent pay in the month after the sale, leaving the final 20 percent to pay in the following month. This is illustrated in the cash collection row of the table. Note that the firm collects only $1 million in cash payments in July while it collects as much as $26.4 million in November.The total sales for the year are $125 million. If the company pursues the level production strategy, then it needs to produce the coats at a sale value rate of $10.42 million per month (= $125 million/12). Table 14A.2 shows the cash disbursements per month. The manufacturing costs are assumed to be materials at 50 percent of sales, while wages are 15 percent of sales. Thus, material cost payments are $5.2 million per month (= $10.42 million × 50%) and wage payments are $1.6 million per month (= $10.42 million × 15%). Other payments predicted throughout the year are those for capital investments, interest payments, and dividend payments. Yellow Jacket plans to invest in some factory upgrades for which it will pay $15 million in June. Interest payments on its bonds are cash budgetA calculation of the esti-mated cash flow from receipts and disbursements over a specific time period. LG14-12 Be able to create and interpret a cash budget.Learning GoalFinal PDF to printer

493cor91411_ch14_462-497.indd 493 01/30/17 09:21 PMsemiannual (March and September), while quarterly dividends are paid in February, May, August, and November. Notice that the total cash disbursements have a high degree of variability over time. In addition, the payments do not align well with the cash collection. For example in June, the firm receives only $1.2 million in cash and expects to pay $24.5 million. On the other hand, it expects to collect $26.4 million in November and pay only $7.8 million.The cash budget can now be completed. Table 14A.3 shows that the next step is to compute the net cash flow generated each month. This is simply the cash collection for that month minus that monthÕs disbursement. Note that Yellow Jacket has seven months in a row (March through September) in which it generates a negative cash flow. TABLE 14A.2 Cash Disbursement ($ millions) Sales Cash collection Disbursements Materials Wages, salaries & other Taxes Capital projects Long-term Þnancing (interest & dividends) Total cash disbursementDec1522.95.21.62.7009.5Nov2526.45.21.6001.07.8Jan1014.35.21.60006.8Feb1010.75.21.6001.07.8Mar58.55.21.62.705.014.5Apr25.15.21.60006.812.35.21.6001.07.8MayJun11.25.21.62.715.0024.5Jul11.05.21.60006.852.25.21.6001.07.8Sep208.65.21.62.705.014.5Oct3019.85.21.60006.8 AssumptionsDisbursement:Material is 50% of salesWages, etc. are 15% of sales$15 million factory upgrade in June $5 million in interest, twice per year$1 million in dividends, quarterly$2.7 million in taxes, quarterly A B C D E F G H I J K L M12345678910111213141516171819202122232425November cash disbursement comes from: $5.2 million in materials purchased + $1.6 million in wages + $2.7 million in quarterly taxes paid + $5.0 million in semiannual interest payment on debt—————- $14.5 millionAugTABLE 14A.1 Cash Collection AssumptionsCollection:Month 0, 30% pay with 2% discountMonth 1, 50% payMonth 2, 20% pay10% increase in sales from previous year ($ millions) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecSales 10 10 5 2 1 1 1 5 20 30 25 15Cash collection 14.3 10.7 8.5 5.1 2.3 1.2 1.0 2.2 8.6 19.8 26.4 22.9October cash collection comes from:30% × October sales after 2% discount = 0.3 × 0.98 × $30 plus 50% × September sales = 0.5 × $20 plus 20% × August sales = 0.2 × $5 —————- Total = $19.8123456789101112131415 A B C D E F G H I J K L MFinal PDF to printer

494cor91411_ch14_462-497.indd 494 01/25/17 08:32 PMThe cumulative net cash flow row shows that the surplus of cash generated in January and February helps with the deficits from March and April. However, by May, Yellow Jacket enters a cash deficit situation that lasts the rest of the year. The deficit is increased by the fact that the firm likes to have a cash balance minimum of $2 million at all times. Finally, the cash budget shows the cash account surplus or deficit during the year. It is apparent that Yellow Jacket will need to obtain a bank loan or line of revolving credit that can handle a maximum of $45.4 million (SeptemberÕs deficit is the highest).Note that Yellow Jacket is a profitable firm. Yet, the seasonality in the sales of coats and jackets causes severe cash deficit problems during the year. If financial managers do not plan ahead for this situation, then the firm will experience significant financial stresses that can damage its reputation and relationship with suppliers and customers. The value of building the cash budget on a spreadsheet (as shown in these tables) is that sensitivity analysis and what-if scenarios can easily be implemented.TIME OUT 14A-1 Should all cash payments and receipts made by the firm be included in the cash budget?  14A-2 Due to the nature of Yellow JacketÕs business, they are likely to experience significant cash deficits each year. How is their bank likely to view this situation?  TABLE 14A.3 Cash Budget AssumptionsMinimum cash balance of $2 millionNet cash ßow = Cash collection Ð Total cash disbursement123456789101112131415161718192021222324252627282930 A B C D E F G H I J K L M ($ millions) Sales Cash collection Disbursements Materials Wages, salaries & other Taxes Capital projects Long-term Þnancing (interest & dividends) Total cash disbursement Net cash ßow Cumulative net cash ßow Minimum cash balance Cash surplus or deÞcitDec‒1522.95.21.62.7009.513.41.62.00.4Nov‒2526.45.21.6001.07.818.6‒11.82.013.8Jan1014.35.21.60006.87.57.52.05.5Feb1010.75.21.6001.07.82.910.42.08.4Mar58.55.21.62.705.014.5‒6.04.42.02.4Apr25.15.21.60006.8‒1.72.72.00.7May12.35.21.6001.07.8‒5.5‒2.82.0‒4.8Jun‒‒11.25.21.62.715.0024.5‒23.326.12.028.1Jul‒11.05.21.60006.8‒5.8‒31.92.033.9‒52.25.21.6001.07.8‒5.6‒37.52.039.5Sep‒208.65.21.62.705.014.5‒5.9‒43.42.045.4Oct‒3019.85.21.60006.813.0‒30.42.032.4Cash surplus or deÞcit = Cumulative net cash ßow Ð Minimum cash balanceCumulative net cash ßow = Last monthÕs cumulative cash ßow + This monthÕs net cash ßowAugFinal PDF to printer

495cor91411_ch14_462-497.indd 495 01/25/17 08:32 PMsummary of learning goalBe able to create and interpret a cash budget. Creating a cash budget involves recording estimates of the cash collected and cash disbursed during each period (e.g., daily, monthly, or quarterly). These LG14-12estimates are then used to determine the net cash surplus or deficit each period. Over the year, large cash deficits may accumulate. Planning ahead for these situations allows the firm to operate smoothly through them.key termcash budget A calculation of the estimated cash flow from receipts and disbursements over a specific time period. p. 492self-test problem with solution1 Sensitivity Analysis The cash budget for Yellow Jacket was created starting with the assumption that sales would grow by 10 percent in the coming months compared to that month the previous year. What would the accumulated deficits look like with just 5 percent growth? Assume the disbursements on interest payments, dividends, and capital spending are not changed. Also assume tax payments are reduced by $0.1 million per quarter.  Solution:First adjust each sales estimate by multiplying by (1.05/1.10) to remove the 10 percent growth and create 5 percent growth. In this scenario, the total sales for the year will be $119.3 million. The reduced sales will decrease the cash collection, but they will also reduce the disbursement for materials, wages, and other costs directly related to the production of coats. The new cash budget is:LG14-12 A B C D E F G H I J K L M12345678910111213141516171819202122Dec14.321.95.01.52.6009.112.81.12.0‒1.123.925.25.01.5001.07.517.7‒11.92.0‒13.9Jan9.514.25.01.50006.57.77.72.05.7Feb9.510.35.01.5001.07.52.810.62.08.6Mar4.88.15.01.52.605.014.1‒6.04.62.02.6Apr1.94.95.01.50006.5‒1.63.02.01.0May1.02.25.01.5001.07.5‒5.3‒2.32.0‒4.31.01.15.01.52.615.0024.1‒22.9‒25.22.0‒27.2JunJulNovOct1.00.95.01.50006.5‒5.5‒30.72.0‒32.7Aug4.82.15.01.5001.07.5‒5.4‒36.12.0‒38.1Sep19.18.25.01.52.605.014.1‒5.9‒42.02.0‒44.028.618.95.01.50006.512.5‒29.62.0‒31.6 ($ millions) Sales Cash collection Disbursements Materials Wages, salaries & other Taxes Capital projects Long-term Þnancing (interest & dividends) Total cash disbursement Net cash ßow Cumulative net cash ßow Minimum cash balance Cash surplus or deÞcitFinal PDF to printer

496cor91411_ch14_462-497.indd 496 01/25/17 08:32 PMNotice the change to a 5 percent growth rate does not impact this cash budget much. For example, the cash account deficit still starts in May and lasts throughout the year. In addition, the worst deficit (in September) is actually $1.3 million smaller than before.problems 14A-1 Cumulative Net Cash Flow The net cash flow for a firm in January, February, and March is −$2.5 million, −$3.0 million, and $2.4 million, respectively. What is the cumulative net cash flow for March? (LG14-12) 14A-2 Cumulative Net Cash Flow The net cash flow for a firm in January, February, and March is $3.5 million, −$1.0 million, and $1.4 million, respectively. What is the cumulative net cash flow for March? (LG14-12) 14A-3 Cash Disbursement The Hug-a-Bear company makes its teddy bears the month before they are sold and pays for all materials in the month of purchase. If sales of $2.5 million are expected in November and the firm pays 50 percent of sales in material costs, then what is the materials cash disbursement in October? (LG14-12) 14A-4 Cash Disbursement The Snow Adventures company makes its snowboards the month before they are sold and pays for all materials in the month of purchase. If sales of $7.8 million are expected in November and the firm pays 65 percent of sales in material costs, then what is the materials cash disbursement in October? (LG14-12) 14A-5 Cash Collection Consider a company that has sales in May, June, and July of $10 million, $12 million, and $9 million, respectively. The firm is paid by 35 percent of its customers in the month of the sale, 40 percent in the following month, and 22 percent in the next month (3 percent are bad sales and never pay). What is the cash collected in July? (LG14-12) 14A-6 Cash Collection Consider a company that has sales in May, June, and July of $11 million, $10 million, and $12 million, respectively. The firm is paid by 25 percent of its customers in the month of the sale, 50 percent in the follow-ing month, and 23 percent in the next month (2 percent are bad sales and never pay). What is the cash collected in July? (LG14-12) 14A-7 Cash Surplus or Deficit A firm has estimated the two-month cash budget below. What is the cash surplus or deficit for these two months? (LG14-12)($ in millions)MARAPRSales120.0130.0Cash collection 84.0 90.0Total cash disbursement 90.0 85.0Net cash flow −6.0  5.0Cumulative net cash flow−15.0  ?Minimum cash balance 10.0 10.0Cash surplus or deficit ? ?basic problemsintermediate problemsFinal PDF to printer

497cor91411_ch14_462-497.indd 497 01/25/17 08:32 PM 14A-8 Cash Surplus or Deficit A firm has estimated the two-month cash budget below. What is the cash surplus or deficit for these two months? (LG14-12)($ in millions)MARAPRSales75.068.0Cash collection63.065.0Total cash disbursement60.057.0Net cash flow 3.0 8.0Cumulative net cash flow11.0 ?Minimum cash balance 3.0 3.0Cash surplus or deficit ? ? 14A-9 Cash Budget Spreadsheet Problem The company from the text, Yellow Jacket, has decided to change its production strategy. Instead of a steady production throughout the year, they will produce the coats they estimate to sell in the month prior. This will impact the materials and wage disbursements of the cash budget. (For the December computation, assume that the following January sales will increase by 10 percent from the prior year.) Build this cash budget. How does this impact the cash surplus/deficit of the firm? (LG14-12)ANSWERS TO TIME OUT 14A-1 All cash flows that can be estimated or predicted ahead of time should be included. For example, if the firm expects to make a payment from a legal judgment on a certain date, that cash disbursement should be included so that it can be planned for. 14A-2 Banks understand the seasonality of some businesses. As long as the firm can show that it will be able to pay back the loan at the end of the cycle, banks are happy to loan money and collect fees and interest payments. The cash budget can be used not only to plan ahead by the financial manager, but it can also be used when negotiating with the bank to show the dynamics of the cash flow cycle.advanced problemsFinal PDF to printer

498cor91411_ch15_498-529.indd 498 01/25/17 09:03 PMviewpointsPART SEVENBusiness ApplicationRiada Industries has had sales of $1 million, $1.3 million, and $1.7 million in the last three years and expects this trend to continue into the future. The company currently has the capacity in its $1.5 million of fixed assets to handle sales of $2 million per year and has $500,000 in current assets supporting the latest yearÕs sales. If current liabilities are $300,000 and the firm has a profit margin of 5 percent and a retention ratio of 70 percent, how much external funding will Riada need to raise to support next yearÕs sales? (See the solution at the end of the chapter.)Personal ApplicationKamala starts college next month. She will be working a part-time job where she will earn $300 a month, and she has a partial scholarship, which will reduce her out-of-pocket expenses associated with going back to school (including room and board) to $10,000 per year. Assuming that Kamala has $5,000 saved up for college, how much will she need to borrow this year? (See the solution at the end of the chapter.)What will KamalaÕs future cash flows look like and when will she need the loan?Financial Planning and Forecasting15Final PDF to printer

499cor91411_ch15_498-529.indd 499 01/25/17 09:03 PM© Blend Images/Jetta Productions/Getty Images RFWhat key elements does a firm need to analyze in order to plan its future? A list of such key elements will invari-ably include sales. Sales are cru-cial, both in projected volume and in resources for support. In previous chapters, weÕve shown you how to do quite a lot of analysis, but thereÕs always been an underlying assumption that external guidance is available. In other words, youÕve known where to find how many units you expect to sell, the prices at which you expect to sell, what types of assets you would need to support those sales, how much assistance you would get from sup-pliers and employees (in the form of accounts payable and accrued wages, respectively), and how much capital you would need to raise from external sources. When you answer these ques-tions, you are able to form a financial plan for the firm. To form a plan, we will start with the idea of forecast-ing expected future sales. Then we will cover the use of those forecasted sales to estimate what level of assets will be needed to support them. We will find the ÒspontaneousÓ sources of funds that can be expected to help fund the necessary assets, determine how much of the net required assets can be funded internally through retained earnings, and then see how much will need to be funded through external sources.Learning Goals LG15-1 Describe the process of financial planning in the context of the firm and how base case projections are used in the strategic plan-ning process. LG15-2 Identify how forecasting sales supports the process of financial planning. LG15-3 Compare and contrast the na•ve, average, and seasonality- and trend-adjusted approaches to forecasting sales and how they are implemented. LG15-4 Explain and demonstrate the additional funds needed (AFN) approach to estimating a firmÕs need to seek external financing. LG15-5 Use pro forma financial state-ments to estimate additional funds needed.Final PDF to printer

500 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 500 01/25/17 09:03 PM15.1 ∙ Financial PlanningWhen most of us hear the term financial planning, we think of its meaning in the context of investments, where financial planners help individuals set and achieve their long-term financial goals. Your personal financial planner can provide advice on investments, tax planning, asset allocation, risk management, retirement planning, and estate planning. The financial planning process of a firm pretty much involves the same types of activi-ties, although in a slightly more complex environment. In this process, each operating division of a firm normally creates a pro forma set of financial statements depicting its expected financial situation in the foreseeable future. Managers use the most reasonable set of assumptions concerning relevant factors such as demand and prices for their prod-ucts, costs of raw materials and labor, and expected future tax rates. The pro forma finan-cial statements from all of the firmÕs divisions are then combined in a set of master pro forma statements for the entire firm, which form the basis for the firmÕs financial plan.The financial plan is an important element in the process of strategic planning, which involves formulating, implementing, and evaluating cross-functional decisions that will enable a firm to achieve its long-term objectives. Put more simply, strategic planning is the process of determining where a firm is going over the next year or more, how it is going to get there, and how it will know if it gets there or not.The set of assumptions underlying the firmÕs financial plan is normally referred to as the base case and the resulting projected financial statements are referred to as base case projections. These projections are useful in the strategic planning process for setting internal goals, for providing information to shareholders and other external stakeholders concerning the firmÕs future expectations, and for estimating the firmÕs future needs for internal and external financing.In order to construct the pro forma statements in the financial plan, we need a meth-odology for consistently estimating values for the financial statements. The most logical way to proceed is to assume that every balance sheet and income statement item will be a function of the firmÕs sales. So if we can predict future sales, that will give us a starting point for predicting everything else.As we will see, predicting future sales can be as simple as assuming they will be equal to current sales (appropriate when the firmÕs sales are stable over time), or as complicated as adjusting for seasonality and time trends. However, once we have calculated a forecast for sales that we are comfortable with, we can then use that forecast to determine how much external financing the firm will need to raise.15.2 ∙ Forecasting SalesThe Na•ve ApproachThe simplest approach to estimating a future periodÕs sales is to assume that they will be equal to those of the latest observed period. In statistics, this is often simply referred to as the na•ve approach, as it would have us use the latest observed sales figure as the expected value for the sales at any future period: E(Sale s t+j ) = Sales t  for all j > 0 (15-1)How well does the na•ve approach work? To find out, we need to examine how much error may be in its forecasts. There are several commonly used statistics for measuring the amount of forecast error produced by a particular estimation strategy. One of the most popular, and the one we will use in this chapter, is the mean absolute percentage error, or MAPE, which is calculated across the n forecasts of a testing period as MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | ____________________ n (15-2)MAPE measures the efficiency of a forecast developed using one set of historic, observed data on another set that is held Òout-of-sampleÓ during the formulation of the forecast. Or, LG15-1financial planningThe process of mapping out the future cash inflows and outflows of the firm.strategic planningThe process of determining where a firm is going over the next year or more, how it is going to get there, and how it will know if it gets there or not.base caseThe set of assumptions underlying the firmÕs finan-cial plan.base case projectionsThe projected financial statements associated with the base case.LG15-2LG15-2, 15-3na•ve approachAssuming that future sales will be equal to the latest periodÕs sales.MAPEMean absolute percentage error, a measurement of a forecastÕs accuracy.Final PDF to printer

chapter 15 Financial Planning and Forecasting 501cor91411_ch15_498-529.indd 501 01/27/17 06:52 PMput another way, MAPE measures how well a forecasting technique works when using one set of historic data to forecast another later (but still historic) set of Òtesting data.Ó As such, it measures how well your forecasting technique would have worked in the past, but that does not necessarily mean that it will work equally as well going into the future.As long as sales remain fairly stable over time for a company, the na•ve approach may actually be an appropriate estimation method. However, if there is reason to expect that sales either will systematically change over time or will exhibit large period-to-period variation, we may wish to use a more sophisticated estimation method.EXAMPLE 15-1Estimation of Future Sales Using the Na•ve ApproachUp until the early part of 2013, Target Corporation provided monthly sales information on the companyÕs Investor Information page of its website. A change in policy in 2013 appar-ently resulted in Target stopping additional monthly releases, but the historic data set, available up through January of 2013, is still available at http://investors.target.com/phoe-nix.zhtml?c=65828&p=irol-salesSummary. The sales figures provided for January 2010 through December 2012 are shown in Table 15.1.For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-3 Assuming you were at the beginning of January 2012 and were going to use the na•ve approach, what would be your best estimates of the anticipated sales for each month of 2012? Using those estimates and the actual realized monthly sales figures for 2012, what would be the MAPE of the na•ve forecasts for 2012?SOLUTION: Using the na•ve approach, the expected sales for each month of 2012 will be equal to the December 2011 sales figure, $10,138 million, resulting in a MAPE of MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | _____________________ n = ⎛ ⎜ ⎝ | 4,608 − 10,138 _____________ 4,608 | + | 5,132 − 10,138 _____________ 5,132 | + | 6,427 − 10,138 _____________ 6,427 | + | 4,978 − 10,138 _____________ 4,978 | +  | 5,038 − 10,138 _____________ 5,038 | + | 6,419 − 10,138 _____________ 6,419 | + | 4,995 − 10,138 _____________ 4,995 | + | 5,543 − 10,138 _____________ 5,543 | +  | 6,075 − 10,138 _____________ 6,075 | + | 4,982 − 10,138 _____________ 4,982 | + | 6,183 − 10,138 _____________ 6,183 | + | 10,214 − 10,138 ______________ 10,214 | ⎞ ⎟ ⎠ __________________________________________________________________________ 12 = 0.7992, or 79.92%          This is a very high forecast error.Similar to Problems 15-1, 15-2, Self-Test Problem 1TABLE 15.1 Target Corporation Monthly Sales (in millions) for January 2010ÐDecember 2012Month201020112012January$4,289$4,383$4,608February4,6374,7505,132March6,2335,9556,427April4,2884,8744,978May4,6224,7995,038June5,9186,2566,419July4,5854,8404,995August5,0235,2925,543September5,5625,9236,075October4,6414,8394,982November6,0126,1916,183December9,88210,13810,214Final PDF to printer

502 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 502 01/25/17 09:03 PMThe Average ApproachOne of the basic principles of statistics is that when you are using a sample to estimate something about the population it is taken from, more observations are always bet-ter. This principle is based on the idea that observation-specific, idiosyncratic errors (errors that apply only to a single sample) are likely to cancel out as a sample gets larger and larger. This idea holds true when using historic sales figures to predict future sales estimates, as well. The na•ve approach that we discussed above can be thought of as using a sample size of one to predict future sales, with the associated risk that any particular error in the last observed periodÕs sales will be included in the prediction of future sales. We can improve the accuracy of this prediction in the face of assumed idiosyncratic errors by taking the mean of multiple historic observations as our predictor: E( Sales n+j ) = Σ i=1 n Sales t _________ n  for all j > 0 (15-3)The question here, though, is, ÒHow far back do we go when computing the aver-age?Ó Well, it basically depends upon how stable you think the sales figures have been and will be going forward in time: More observations are better if the sample is representative of the population. However, to the extent that sales may be expected to occasionally shift to a new level, historic sales figures from before the point in time where such a shift occurs may be Òstale,Ó or not truly representative of the new level of sales. If we knew for sure that such a shift had not happened, then the best esti-mator for future expected sales would simply be an average of all available historic sales figures.However, if we were to take a look at the historic sales figures for 2010 and 2011 as shown in Figure 15.1, we might notice that average sales seemed to be consistently higher during 2011 than they were during 2010, implying that perhaps just such a shift had occurred.Note two important facts here. First, using an average as our predictor greatly reduced the MAPE compared to the na•ve forecasts, regardless of which average was chosen. This average approachAssuming that future sales will be equal to the aver-age historical value across some relevant period.LG15-3$10,000Sales ($1,000,000)$0Dec – 2011Jan – 2010Feb – 2010Mar – 2010Apr – 2010May – 2010Jun – 2010Jul – 2010Aug – 2010Sep – 2010Oct – 2010Nov – 2010Dec – 2010Jan – 2011Feb – 2011Mar – 2011Apr – 2011May – 2011Jun – 2011Jul – 2011Aug – 2011Sep – 2011Oct – 2011Nov – 2011Sales – actualSales – yearly average$9,000$12,000$11,000$8,000$7,000$6,000$5,000$4,000$3,000$2,000$1,000FIGURE 15.1Target Historic Sales versus Average Annual Sales, 2010 and 2011Focus on the yearly average line in the graph. What can you conclude?Final PDF to printer

chapter 15 Financial Planning and Forecasting 503cor91411_ch15_498-529.indd 503 01/25/17 09:03 PMimplies that there apparently was a great deal of idiosyncratic ÒincorrectnessÓ induced when we simply used the December 2011 monthly sales figure as our na•ve forecast for all of the 2012 monthly sales figures; this incorrectness was greatly reduced when we used an average of multiple monthly sales figures instead.Second, note that the MAPE was actually a little bit better (i.e., lower) when we used all available historic data rather than just the last historic yearÕs average monthly sales figure. This may be an artifact of our MAPE statistic1 or it might imply that what we thought was a systematic shift in monthly sales between 2010 and 2011 either did not persist or was not strong enough to matter to our MAPE sta-tistic in 2011. Or it simply may not have been statistically significant enough to take into account. Either way, we should take this example as a cautionary tale concern-ing the possible risks of discarding a subset of our historic data due to a perceived structural shift.1MAPE has several quirks that are well-documented in statistical literature, but an in-depth discussion of the associated problems is outside the scope of this book.Estimation of Future Sales Using the Historic Average ApproachAssume once again that you were at the beginning of January 2012 and wanted to esti-mate TargetÕs upcoming sales for 2012 using a historic average approach. Compare and contrast the estimates and the associated MAPE figures from using all 24 months of historic data for 2010 and 2011 with those obtained by using only the 12 months of historic data from 2011 to compute your average.SOLUTION: Using all two yearsÕ worth of historic data, the average monthly sales figure would be $5,581 million, and the resulting MAPE for the 2012 forecasts would be: MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | _____________________ n = ⎛ ⎜ ⎝ | 4,608 − 5,581 ____________ 4,608 | + | 5,132 − 5,581 ____________ 5,132 | + | 6,427 − 5,581 ____________ 6,427 | + | 4,978 − 5,581 ____________ 4,978 | +  | 5,038 − 5,581 ____________ 5,038 | + | 6,419 − 5,581 ____________ 6,419 | + | 4,995 − 5,581 ____________ 4,995 | + | 5,543 − 5,581 ____________ 5,543 | +  | 6,075 − 5,581 ____________ 6,075 | + | 4,982 − 5,581 ____________ 4,982 | + | 6,183 − 5,581 ____________ 6,183 | + | 10,214 − 5,581 _____________ 10,214 | ⎞ ⎟ ⎠ ______________________________________________________________________ 12 = 0.1388, or 13.88%  Using just the historic monthly sales data from 2011, the average monthly sales figure would be $5,687 million, and the resulting MAPE for the 2012 forecasts would be: MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | _____________________ n EXAMPLE 15-2For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-3 Final PDF to printer

504 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 504 01/27/17 06:56 PMEstimating Sales with Systematic Variations: Adjusting for Trends and SeasonalityA close examination of the sales data in Table 15.1 shows us that several strong patterns emerge that would be evident even if we were just looking at the 2010 and 2011 monthly sales figures: 1. There definitely seems to be a quarterly pattern, with sales figures being highest during the third month of each quarter. 2. This pattern is greatly exaggerated in the fourth quarter of each year, when the company experiences holiday sales. 3. There does seem to be a slight upward trend in sales across time.To more accurately predict future sales, you must make adjustments for such patterns in sales. One common method for doing so, and the one that we will use, is to deseasonalize the historic sales figures by dividing each monthÕs actual sales by a seasonal index, cal-culated by dividing the monthÕs sales by a moving average around that month of annual sales. Then, calculate the trend using linear regression on the deseasonalized figures. Finally, use the seasonal indexes and regression parameters we have developed to predict future sales.deseasonalizeTo remove the effects of seasonality from historic data.Estimation of Future Sales by Adjusting for Seasonality and TrendUsing Target CorporationÕs historic monthly sales figures for 2010 and 2011 (see Table 15.1) to compute monthly seasonal and trend adjustments, estimate the monthly sales figures for 2012 and then compute the MAPE for these forecasts across 2012.SOLUTION: To compute the monthly seasonal indexes, we need to compute a centered moving average for the yearÕs worth of monthly sales surrounding each historic monthly sales figure. If we had an odd number of months in a year, this would be pretty straightforward: We would simply have to average the monthÕs sales with an equal amount of monthly sales from before and after that month to construct a centered moving average. However, since a year has an even number of months, the year ÒcenteredÓ around a particular month must either include five months before and six months after the month in question, or six months before and five months after; obviously, neither of these averages will be exactly centered around centered moving averageA moving average created to put a specific observa-tion exactly in the center of the period over which the moving average is calculated.EXAMPLE 15-3For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-3  = ⎛ ⎜ ⎝ | 4,608 − 5,687 ____________ 4,608 | + | 5,132 − 5,687 ____________ 5,132 | + | 6,427 − 5,687 ____________ 6,427 | + | 4,978 − 5,687 ____________ 4,978 | +  | 5,038 − 5,687 ____________ 5,038 | + | 6,419 − 5,687 ____________ 6,419 | + | 4,995 − 5,687 ____________ 4,995 | + | 5,543 − 5,687 ____________ 5,543 | +  | 6,075 − 5,687 ____________ 6,075 | + | 4,982 − 5,687 ____________ 4,982 | + | 6,183 − 5,687 ____________ 6,183 | + | 10,214 − 5,687 _____________ 10,214 | ⎞ ⎟ ⎠ ______________________________________________________________________ 12 = 0.1447, or 14.47%  Similar to Problems 15-3, 15-4, Self-Test Problem 2Final PDF to printer

chapter 15 Financial Planning and Forecasting 505cor91411_ch15_498-529.indd 505 01/25/17 09:03 PMthe month in question. The easiest way to handle this is to compute both of these ÒcenteredÓ averages and then take an average of them, in turn. This approach is illustrated below: 1. The column Ò12-CMAÓ is a 12-month centered moving average where the sales figure it will be associated with (which, as we will discuss, is the actual sales figure from the next row) is the seventh of 12 months used in the computation of the average. This means that the next 12-CMA figure treats the associated monthly sales figure as the sixth of 12 monthly sales figures included in its average, and so forth. For example, the first figure in the 12-CMA column, $5,474, is a 12-month average where the July 2010 actual sales figure of $4,585 is the seventh of 12 included in the average (meaning that it has 6 other months before it and 5 months after it in that aver-age). The second figure in the 12-CMA column, $5,482, includes the July 2010 actual sales figure of $4,585 as the sixth of 12 (meaning that it has 5 before it and 6 after it). The first figure in the 2-CMA column is therefore an average of these two 12-CMA figures, $5,474 and $5,482, which together ÒbracketÓ the month of July. By taking an average like this, we wind up with an average that is centered smack-dab over the month of July. 2. The July 2010 actual sales figure, $4,585, is then divided by this 2-CMA to get a sea-sonal index for the month of July of approximately 0.8369, meaning that this monthÕs actual sales figures are 83.69 percent of the average sales figure for the year exactly surrounding it. This process is then repeated for all of the other months of the calendar, resulting in the (raw) seasonal indexes shown in the table. 3. As a final step before using the seasonal indexes to deseasonalize the historic monthly sales figures, note that the seasonal indexes are summed directly below their calcula-tion. Theoretically, this sum should be 12, but rounding and other statistical artifacts have caused it to actually be approximately 11.99. To keep this Òstatistical driftÓ from unduly influencing the rest of our problem, we renormalize all of the seasonal indexes by multiplying each value by 12 and dividing by their sum, so that the new sum (shown at the bottom of the ÒAdj. Seas. IndexÓ column in the table) sums to exactly 12. 4. Finally, to deseasonalize the monthly historic sales figures, we divide the actual sales figure for each month by the appropriate seasonal index calculated for that month of the year, which are shown in the table as ÒDeseas. Sales.ÓSimilar to Problems 15-7, 15-8, 15-11, 15-12, Self-Test Problem 3DateJan – 2010Feb – 2010Mar – 2010Apr – 2010May – 2010Jun – 2010Jul – 2010Aug – 2010Sep – 2010Oct – 2010Nov – 2010Dec – 2010Jan – 2011Feb – 2011Mar – 2011Apr – 2011May – 2011Jun – 2011Jul – 2011Aug – 2011Sep – 2011Oct – 2011Nov – 2011Dec – 2011Deseas. Sales0.8374713420.9160318491.0156004570.8454493771.0889015831.7829161570.7872760050.8498658371.0604857980.8643946610.8487306061.102876328120.8369461050.9154573411.0149635040.8449191371.0882186571.7817979660.786782250.8493328271.0598206940.8638525390.8481983081.10218463711.992473960.8369460.9154571.0149640.8449191.0882191.7817980.7867820.8493331.0598210.8638530.8481981.102185$ 5,474$ 5,482$ 5,492$ 5,468$ 5,517$ 5,532$ 5,560$ 5,581$ 5,604$ 5,634$ 5,650$ 5,665$ 5,687$ 4,289$ 4,637$ 6,233$ 4,288$ 4,622$ 5,918$ 4,585$ 5,023$ 5,562$ 4,641$ 6,012$ 9,882$ 4,383$ 4,750$ 5,955$ 4,874$ 4,799$ 6,256$ 4,840$ 5,292$ 5,923$ 4,839$ 6,191$ 10,138Month123456789101112123456789101112Observation123456789101112131415161718192021222324$ 4,374.08$ 5,651.56$ 5,644.73$ 5,595.59$ 5,498.25$ 5,595.87$ 5,544.66$ 5,755.24$ 5,559.52$ 5,624.69$ 5,786.27$ 5,295.89$ 4,469.94$ 5,789.28$ 5,392.97$ 6,360,28$ 5,708.81$ 5,915.47$ 5,853.04$ 5,063.45$ 5,920.35$ 5,864.66$ 5,958.55$ 5,433.08Seas. IndexAdj. Seas. IndexSeas.-Irreg.2-CMA12-CMA$ 5,478$ 5,487$ 5,480$ 5,493$ 5,525$ 5,546$ 5,571$ 5,593$ 5,619$ 5,642$ 5,658$ 5,676Sales – ActualFinal PDF to printer

506 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 506 01/25/17 09:03 PMSummary OutputRegression StatisticsMultiple R0.624095866R Square0.38949565Adjusted R Square0.361745452Standard Error150.470127Observations24Now that we have the deseasonalized sales figures, we can regress them against the time period (the column titled ÒObservationÓ) to get parameters for estimating the his-toric trend. The results of this regression are shown in the tables below, with the intercept and slope coefficients that we will need for estimating future sales highlighted.AnovaDFSSMSFSignificance FRegression1317787.7149317787.714.035780.001117156Residual22498107.700522641.26Total23815895.4153CoefficientsStandard ErrorT-StatP-ValueLower 95%Upper 95%Intercept5365.65975963.400661184.630973.74E-295234.1748365497.14468X Variable 116.623391454.4371219733.7464360.0011177.42136369325.8254192Finally, we reverse the process, using the parameters of the regression to estimate still-seasonally-adjusted monthly sales figures for 2012 and then Òde-adjustingÓ them by multiplying them by the respective monthly seasonal index. For example, the sea-sonally adjusted forecast for January of 2012 (month 25 in our time series) would be computed as $5,365.659759 + ($16.62339145 × 25) = $5,781.244546, which would then in turn be multiplied by the seasonal index for January to yield $5,781.244546 × 0.787276005 = $4,551.44. Forecasted values for all months of 2012 would be as shown below:DateObservationMonthDeseas. SalesForecast (S. Adj.)Sales ForecastJan-2012251$5,853.09$5,781.244546$ 4,551.44Feb-2012262$6,038.605,797.867937$ 4,927.41Mar-2012273$6,060.435,814.491329$ 6,166.19Apr-2012284$5,758.945,831.11472 $ 5,040.38May-2012295$5,935.925,847.738111$ 4,963.15Jun-2012306$5,820.245,864.361503$ 6,467.67Jul-2012317$5,964.385,880.984894$ 4,925.16Aug-2012328$6,051.105,897.608286$ 5,402.40Sep-2012339$5,981.685,914.231677$ 6,006.50Oct-20123410$5,892.725,930.855069$ 5,014.24Nov-20123511$5,678.205,947.47846 $ 6,476.22Dec-20123612$5,728.825,964.101852$10,633.49These forecasts, when compared to the actual monthly sales results for 2012, yield a MAPE of only 0.0228, or 2.28 percent. Apparently, deseasonalizing and adjusting for Final PDF to printer

chapter 15 Financial Planning and Forecasting 507cor91411_ch15_498-529.indd 507 01/25/17 09:03 PMTIME OUT 15-1 What would be an appropriate way to forecast sales for a firm that has stable year-to-year sales, but seasonally fluctuating month-to-month sales?   15-2 Suppose you were forecasting sales for a firm that exhibited a cyclical pattern within each week. How would you go about forecasting sales for this firm?  15.3 ∙ External FinancingThe Simple Approach to Estimating Necessary External Financing: Additional Funds NeededIf sales are expected to increase in the future, that increase must be supported by an accompanying increase in assets. Of the funds necessary to finance an increase in assets, some will be provided by increases in liabilities that will occur as direct reactions to the increase in sales. For example, if a company sells more product, it will have to order more raw materials. Assuming that the companyÕs supplier offers it trade credit, then ordering more materials means that the amount of accounts payable increases, too. Such corresponding increases in liabilities are referred to as spontaneous increases.In most lines of business, the spontaneous increases in liabilities will not be enough, by themselves, to fund the necessary increases in assets. Even if we make the logical assumption that as sales increase the firm will also experience a corresponding increase in retained earnings, most firms will still have a portion of the necessary increase in assets that will need to be funded from external capital. We call this portion the additional funds needed (AFN), and it can be computed as: AFN = Necessary increase in assets − Spontaneous increase in liabilities − Projected increase in retained earnings (15-4)The necessary increase in assets can usually be computed by dividing the amount of assets tied directly to sales (A*) by the amount of current sales (S0) to get the capital intensity ratio, and then multiplying the capital intensity ratio by the projected increase in sales (ΔS): Necessary increase in assets = A * ____ S 0 × ΔS (15-5)The spontaneous increase in liabilities can be computed by dividing the amount of liabilities tied directly to sales (L*) by the amount of current sales to get the spontaneous liabilities ratio, and then multiplying the spontaneous liabilities ratio by the projected increase in sales: Spontaneous increase in liabilities = L * ____ S 0 × ΔS (15-5)And the projected increase in retained earnings can be calculated by multiplying the profit margin (M) by the projected sales in the coming period (S1), and then in turn mul-tiplying this by the retention ratio (RR): Projected increase in retained earnings = M × S 1 × RR (15-7)LG15-4trade creditThe practice of one firm selling to another on credit terms.additional funds needed (AFN)The amount of external financing a firm must seek in order to change the asset base as necessary to support a different level of sales.capital intensity ratioRelevant assets divided by current sales.spontaneous liabilities ratioRelevant liabilities divided by current sales.the trend in this manner greatly increases the forecast accuracy over the use of either the na•ve or average approach.Final PDF to printer

508 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 508 01/25/17 09:03 PMCalculation of AFNSuppose that Dandy Candy, Inc., currently has the following balance sheet and that sales for the year just ended were $8 million. The firm also has a profit margin of 20 percent, a reten-tion ratio of 40 percent, and expectations of $10 million in sales next year. If all assets and current liabilities are expected to grow with sales, how much in additional funds will Dandy Candy need from external sources to fund the expected growth?SOLUTION: Since it is stated that all assets are expected to grow with sales, A* is $6,000,000, and the necessary increase in assets will be Necessary increase in assets = A * ___ S 0 × ΔS = $6,000,000 ___________ $8,000,000 × ($10,000,000 − $8,000,000) = 0.75 × $2,000,000 = $1,500,000 The spontaneous increase in liabilities will be expected to be Spontaneous increase in liabilities = L * ___ S 0 × ΔS = $500,000 ___________ $8,000,000 × ($10,000,000 − $8,000,000) = $125,000 And the projected increase in retained earnings will be: Projected increase in retained earnings = M × S 1 × RR = 0.20 × $10,000,000 × 0.40 = $800,000 So the amount of AFN will be equal to $1,500,000 − $125,000 − $800,000 = $575,000 Similar to Problems 15-5, 15-6, Self-Test Problem 4AssetsLiabilities and EquityCurrent assets$1,000,000Current liabilities$ 500,000Fixed assets 5,000,000Long-term debt2,500,000Equity 3,000,000Total assets $6,000,000Total liabilities and equity$ 6,000,000EXAMPLE 15-4For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-4 AFN WITH UNUSED CAPACITY ASSETS In the previous example, we assumed that all assets would need to grow proportionately with sales. While this may be the case if a firm is currently fully utilizing its fixed assets, most firms will probably have some unused capacity that could be used to support the increase in sales. In such a situation, A* would not be equal to total assets, but instead would be equal to the portion of assets that would need to change to support the anticipated growth in sales. In most cases, and for most firms, this would make A* equal to current assets (CA); remember that CA are those assets that are most liquid, implying both that they can be easily acquired when needed, and that a firm probably wonÕt keep ÒspareÓ CA on hand until they are needed to support the increase in sales.Final PDF to printer

chapter 15 Financial Planning and Forecasting 509cor91411_ch15_498-529.indd 509 01/25/17 09:03 PMAFN WITH ÒLUMPYÓ ASSETS The previous example begs the question of exactly why a firm would be sitting around with unused fixed-asset capacity. While there are several possible reasons for this, the most common is that fixed assets usually are not infinitely divisible; that is, you cannot buy just one-fourth of a nuclear power plant or three-fourths of a bridge now and then buy the rest when demand grows to the point where you need it. For most fixed assets, when demand starts to outstrip the capacity of any machines already in use, the company adds another machine to cover the incremental amount of demand, even though the change in demand may not be large enough to use the new machineÕs entire capacity.So, when Dandy Candy is expecting an increase in sales in the coming year, itÕs very likely that the reason the company has unused fixed-asset capacity available to help sup-port the new sales is because a previous increase in sales caused it to go from X − 1 machines to X machines, and the available unused capacity is all from that last machine. A company that is currently fully utilizing its fixed assets and expecting an increase in sales will have to consider buying one more machineÑand that one more machine may actually have more capacity than is needed for the increase in sales expected next year. You will often hear this situation referred to as fixed assets being ÒchunkyÓ or Òlumpy,Ó since they have to be bought in discrete, nondivisible, integer-based quanti-ties. Obviously, the decision to go ahead and purchase this not-soon-to-be-used excess infinitely divisibleThe ability to divide a given amount into as small a por-tion as needed.EXAMPLE 15-5Calculation of AFN with Excess CapacityAmending the previous example, suppose that Dandy Candy, Inc., expects only current assets and current liabilities to grow with sales because the firm has enough unused fixed asset capacity to support the new, high level of expected sales. In this situation, how much in additional funds will Dandy Candy need from external sources to fund the expected growth?SOLUTION: In this case, A* will be equal to CA, $1,000,000, and the necessary increase in assets will be Necessary increase in assets = A * ___ S 0 × ΔS = $1,000,000 ___________ $8,000,000 × ($10,000,000 − $8,000,000) = 0.125 × $2,000,000 = $250,000 The spontaneous increase in liabilities will still be expected to be Spontaneous increase in liabilities = L * ___ S 0 × ΔS = $500,000 ___________ $8,000,000 × ($10,000,000 − $8,000,000) = $125,000 And the projected increase in retained earnings will still be Projected increase in retained earnings = M × S 1 × RR = 0.20 × $10,000,000 × 0.40 = $800,000 So the amount of AFN will be equal to $250,000 − $125,000 − $800,000 = −$675,000. This negative AFN implies that the firm can actually expect to generate more money inter-nally from the increase in sales than it needs to support the higher level of sales.Similar to Problem 15-9For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-4 Final PDF to printer

510 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 510 01/25/17 09:03 PMfixed-asset capacity will depend upon a number of factors: How much of the machineÕs capacity will Ògo to wasteÓ in the near term, what kind of profit margin the firm will make on the portion of the new machineÕs capacity that is used, whether further increases in sales are expected in subsequent years, and so on. But letÕs suppose that a careful anal-ysis of all the relevant factors causes the firm to proceed with such a purchase of excess fixed-asset capacity: Then the necessary increase in assets to support the new level of sales must include not only the capital intensity ratio based on current assets, but also the entirety of the fixed assets purchased.Calculation of AFN with Lumpy AssetsOnce again continuing with our Dandy Candy example, suppose that, instead of having excess fixed-asset capacity available, the firm will have to purchase an additional $2.5  million in fixed assets to support the expected increase in sales, in addition to having to finance a proportionate increase in current assets. In this situation, how much in additional funds will Dandy Candy need from external sources to fund the expected growth?SOLUTION: In this case, A* will still be equal to CA, $1,000,000, but the necessary increase in assets will also have to include the required $2,500,000 increase in fixed assets, and so will be Necessary increase in assets = $2,500,000 + A * ___ S 0 × ΔS = $2,500,000 + $1,000,000 ___________ $8,000,000 × ($10,000,000 − $8,000,000) = $2,500,000 + 0.125 × $2,000,000 = $2,750,000 The spontaneous increase in liabilities will still be expected to be Spontaneous increase in liabilities  =   L * ___ S 0 × ΔS = $500,000 ___________ $8,000,000 × ($10,000,000 − $8,000,000) = $125,000 And the projected increase in retained earnings will still be Projected increase in retained earnings  = M × S 1 × RR =  0.20 × $10,000,000 × 0.40 = $800,000 So the amount of AFN will be equal to $2,750,000 − $125,000 − $800,000 = $1,825,000. Note that this amount of AFN is almost as large as the expected increase in sales and is driven largely by the need to increase fixed assets so much.Similar to Problem 15-10EXAMPLE 15-6For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-4 TIME OUT 15-3 Which liabilities would tend to spontaneously increase with sales, and why?   15-4 Some firms can sometimes lease a portion of an asset (e.g., think about firms that share a lease on a corporate jet). How would the ability to lease portions of assets affect the problem with lumpy assets discussed in this section?  Final PDF to printer

chapter 15 Financial Planning and Forecasting 511cor91411_ch15_498-529.indd 511 01/25/17 09:03 PMForecasting Financial StatementsCalculating AFN using the formula in equation 15-4 has a couple of problems: First, this approach involves an inherent assumption that any balance sheet or income statement items that change in response to a change in sales will do so as a linear function of sales. In other words, it assumes that everything that changes with sales does so by remain-ing a fixed percentage of (changing) sales. While this assumption will probably make sense for many of the balance sheet and income statement items, there is no reason that it should hold true for all of them; and even if a particular balance sheet or income state-ment entry does change with sales, that change will not necessarily be a linear function of the change in sales. For example, many formulas used in production management for determining the optimal amount of inventory to keep on hand in response to an antici-pated doubling of sales would have inventory go up at only the square root of the rate of change in sales.The second problem with the way that we have been calculating AFN so far is that it only accounts for what we might call the first order effects to the income statement and balance sheet. That is, this approach ignores the fact that interest on debt, and there-fore taxes, net income, dividends, and retained earnings, will be a function of how the AFN is raised. And, since AFN is itself partially a function of the amount of retained earnings. . . . You see the problem? A more complete calculation of AFN should involve circular references, where AFN is a function of retained earnings, but where retained earnings is also a function of AFN.To come up with a more realistic estimate for AFN, therefore, we are going to need to construct a more flexible depiction of what is happening to each of the balance sheet and income statement items in response to both the anticipated change in sales and in response to the resulting changes in all of the other balance sheet and income statement items, as well. To do so, we will once again make use of pro forma statements, as intro-duced in Chapter 12. Given the necessity for including the circular references discussed above, the only feasible way to construct these pro forma statements will be by using a spreadsheet program such as Microsoft Excel.AFN USING PRO FORMA STATEMENTS In order to compute AFN using pro forma statements, we need to 1. Identify and compute the balance sheet and income statement items that would logically change either directly proportionately with sales or indirectly as a func-tion of those items. (For most firms, this will normally include all balance sheet and income statement items except notes payable, long-term debt, ownersÕ equity, and, depending upon the relative divisibility of the firmÕs fixed assets as discussed previously, possibly some portion of the fixed assets.) 2. Use amounts for these items adjusted for the impact of the change in sales to cal-culate a first pass at AFN. 3. Determine a strategy for changing the items that do not vary proportionately with sales. For example, if we assume that externally obtained notes payable, long-term debt, and equity will be used to cover the AFN, we need to specify what relation-ship should exist between the additions to these accounts. Should we keep the debt-to-equity and short-term to long-term-debt ratios constant at their current val-ues, or is there some other strategy that should be pursued? Also, what will be our plug variable, the balance sheet or income statement item that will ultimately bear the responsibility for balancing the balance sheet? 4. Allow our spreadsheet program to solve for the value for our plug variable that allows the balance sheet to balance.Notice that although Example 15-7 keeps notes payable constant when forecasting into the future, other strategies may include changing it, too, in order to fund the AFN.LG15-5first order effectsThe immediately observ-able effects of changing one item on another. Usu-ally contrasted with higher order effects, which are the subsequent, less observ-able effects of the change.Final PDF to printer

512 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 512 01/25/17 09:03 PMCalculation of AFN Using Pro Forma Financial StatementsSuppose that the 2013 actual and 2014 projected financial statements for Dandy Candy are initially as shown in Tables 15.2 and 15.3. In these tables, sales are projected to rise by 25 percent in the coming year, and the components of the income statement and balance sheet that are expected to increase at the same 25 percent rate as sales are indicated in green type. Assuming that Dandy Candy wants to cover the AFN by selling equal amounts of common stock and long-term debt while keeping notes payable fixed at $75,000, how much in additional funds will Dandy Candy need to raise by selling new debt and shares of equity if debt carries a 10 percent interest rate?EXAMPLE 15-7For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-5 TABLE 15.2 Dandy Candy Income Statements ABC1Annuity Cash Flow2013 Actual2014 Forecast2Sales$8,000,000$10,000,0003Less: Costs except depreciation6,000,0007,500,0004Less: Depreciation1,000,0001,250,0005EBIT$1,000,000$ 1,250,0006Less: Interest257,500257,5007EBT$ 742,500$ 992,5008Less: Taxes (40%)297,000397,0009Net income$ 445,500$ 595,50010Common dividends$ 267,300$ 267,30011Addition to retained earnings$ 178,200$ 328,200TABLE 15.3 Dandy Candy Balance Sheets ABC1Annuity Cash Flow2013 Actual2014 Forecast2Assets3Cash$ 250,000$ 312,5004Accounts receivable250,000312,5005Inventories500,000625,0006Total current assets$1,000,000$1,250,0007Net plant and equipment5,000,0006,250,0008Total assets$6,000,000$7,500,0009Liabilities and Equity10Accounts payable$ 125,000$ 156,25011Notes payable75,00075,00012Accruals50,00062,50013Total current liabilities$ 250,000$ 293,75014Long-term debt 2,500,0002,500,00015Total debt$2,750,000$2,793,75016Common stock$3,000,000$3,000,00017Retained earnings   250,000578,20018Total common equity$3,250,000$3,578,20019Total liabilities and equity$6,000,000$6,371,95020Necessary increase in assets$1,500,00021Spontaneous increase in liabilities43,75022Projected increase in retained earnings328,20023Additional funds needed Change in (NP + LTD + Common stock)$1,128,050Final PDF to printer

chapter 15 Financial Planning and Forecasting 513cor91411_ch15_498-529.indd 513 01/25/17 09:03 PMSOLUTION: In Table 15.3, the usual items used to cover AFN are indicated in red type. We are told that notes payable will remain at $75,000, which means that only the other two red items, long-term debt and common stock, will be adjusted to cover the AFN. One additional point to note is that weÕre also told that debt carries a 10 percent interest rate, meaning that the interest charges of $257,500 shown in Table 15.2 are calculated as 0.10 × ($75,000 + $2,500,000) = $257,000.The first pass at calculating AFN has therefore already been done for us: Table 15.3 shows that, at this point, we need to cover an AFN of $1,128,050. Using the strategy of raising the money to cover AFN equally from long-term debt and common stock described in the problem, the next logical step would seem to be to split the $1,128,050 in two and add each half to the 2014 forecasted long-term debt and common stock accounts as shown in Table 15.4. The relevant formulas used for doing so are associ-ated with the cell that the formula is actually in by enclosing both in a light blue box. For example, notice that both the forecasted long-term debt and common stock accounts for 2014 are calculated by taking the corresponding value from 2013 and adding one-half of $1,128,050.TABLE 15.4 First Stab at Covering AFN Using Pro Forma Financial Statements21345678910111213141516171819202122232524ABCD= 0.1* (F12 + F15)8,000,0006,000,0001,000,000$ 1,000,000742,500257,500297,000445,500267,300178,20010,000,0001,250,0007,500,0001,250,000936,098313,903374,439561,659267,300294,359= E15 + 1,128,050/2= E17 + 1,128,050/2250,000250,000500,0005,000,000$ 1,000,0006,000,000125,00075,00050,000250,0002,500,0002,750,0003,000,000250,0003,250,0006,000,000312,500312,500625,0006,250,000$ 1,250,000$ 7,500,000156,25075,00062,500293,7503,064,025$ 3,357,7753,564,025544,359$ 4,108,384$ 7,466,159$ 1,500,00043,750294,359$ 1,161,892$ 1,128,05025%Percentage salesgrowth2014 Forecast2013 ActualEF2013 Actual2014 ForecastSalesCosts exceptdepreciationDepreciationEBITInterestEBTTaxes (40%)Net incomeCommon dividendsAddition toretained earningsCashAssetsAccountsreceivableInventoriesTotal currentassetsNet plant andequipmentTotal assetsLiabilities andEquityAccounts payableNotes payableAccrualsTotal currentliabilitiesLong-term debtTotal debtCommon stockRetained earningsTotal liabilitiesand equityNecessary increasein assetsSpontaneousincrease in liabilitiesProjected increasein retained earningsAdditional fundsneededChange in(NP + LTD +Common Stock)Total commonequity$$$$$$$$$$$$$$$$$$$$$$$Final PDF to printer

514 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 514 01/25/17 09:03 PMThis should cause the 2014 forecasted balance sheet to balance, right? Well, not quite: Notice that the AFN shown near the bottom of Table 15.4 has increased. Why? Because, since we increased the amount of forecasted debt, the amount of forecasted interest (the for-mula for which is highlighted in the 2014 forecasted income statement) went up, too, causing the amount of retained earnings to go down, and the amount of AFN to increase. So, weÕre trying to hit what is effectively a moving target here.If we change the formulas for long-term debt and common stock to get the amount of AFN from the bottom of the worksheet (instead of passing each Ò$1,128,050/2Ó) as shown in Table 15.5, then we get a warning from Excel about a circular reference error, and are offered guidance on ÒMake a circular reference work by changing the number of times that Excel iter-ates formulas.ÓTABLE 15.5 Making AFN Using Pro Forma Financial Statements Self-Referential21345678910111213141516171819202122232524ABCD= 0.1* (F12 + F15)8,000,0006,000,0001,000,000$ 1,000,000742,500257,500297,000445,500267,300178,20010,000,0001,250,0007,500,0001,250,000936,098313,903374,439561,659267,300294,359= E15 + F25/2= E17 + F25/2250,000250,000500,0005,000,000$ 1,000,0006,000,000125,00075,00050,000250,0002,500,0002,750,0003,000,000250,0003,250,0006,000,000312,500312,500625,0006,250,000$ 1,250,000$ 7,500,000156,25075,00062,500293,750$ 3,357,775544,359$ 4,108,384$ 7,466,159$ 1,500,00043,750294,359$ 1,161,892$ 1,128,05025%Percentage salesgrowth2014 Forecast2013 ActualEF2013 Actual2014 ForecastSalesCosts exceptdepreciationDepreciationEBITInterestEBTTaxes (40%)Net incomeCommon dividendsAddition toretained earningsCashAssetsAccountsreceivableInventoriesTotal currentassetsNet plant andequipmentTotal assetsLiabilities andEquityAccounts payableNotes payableAccrualsTotal currentliabilitiesLong-term debtTotal debtCommon stockRetained earningsTotal liabilitiesand equityNecessary increasein assetsSpontaneousincrease in liabilitiesProjected increasein retained earningsAdditional fundsneededChange in(NP + LTD +Common Stock)Total commonequity$$$$$$$$$$$$$$$$$$$$$$Final PDF to printer

chapter 15 Financial Planning and Forecasting 515cor91411_ch15_498-529.indd 515 01/30/17 09:21 PMTo fix this, we are directed ÒEnable iterative calculation,Ó as Figure 15.2 shows. Upon doing so, Excel iteratively adjusts down to an AFN $1,162,938, as shown in Table 15.6, at which value the effects of both the sources of funding chosen and the resulting amount of interest/retained earnings are included.iterative calculationThe practice of letting a spreadsheet program or calculator repeatedly com-pute an answer so as to take into account circular dependency in a system of equations.TABLE 15.6 AFN Calculation Using Pro Forma Financial Statements That Are Iteratively Self-Referential21345678910111213141516171819202122232524ABCD= 0.1* (F12 + F15)8,000,0006,000,0001,000,000$ 1,000,000742,500257,500297,000445,500267,300178,20010,000,0001,250,0007,500,0001,250,000934,353315,647373,741560,612267,300293,312= E15 + F28/2= E17 + F28/2250,000250,000500,0005,000,000$ 1,000,0006,000,000125,00075,00050,000250,0002,500,0002,750,0003,000,000250,0003,250,0006,000,000312,500312,500625,0006,250,000$ 1,250,000$ 7,500,000156,25075,00062,500293,7503,081,4693,581,4693,375,219543,312$ 4,124,781$ 7,500,000$ 1,500,00043,750293,312$ 1,162,938$ 1,162,9382013 Actual25%Percentage salesgrowth2014 ForecastEF2013 Actual2014 ForecastSalesCosts exceptdepreciationDepreciationEBITInterestEBTTaxes (40%)Net incomeCommon dividendsAddition toretained earningsCashAssetsAccountsreceivableInventoriesTotal currentassetsNet plant andequipmentTotal assetsLiabilities andEquityAccounts payableNotes payableAccrualsTotal currentliabilitiesLong-term debtTotal debtCommon stockRetained earningsTotal liabilitiesand equityNecessary increasein assetsSpontaneousincrease in liabilitiesProjected increasein retained earningsAdditional fundsneededChange in(NP + LTD +Common Stock)Total commonequity$$$$$$$$$$$$$$$$$$$$$$$$Final PDF to printer

516 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 516 01/25/17 09:03 PMSimilar to Problems 15-13, 15-14, Self-Test Problem 5FIGURE 15.2Making AFN Using Pro Forma Financial Statements Self-ReferentialWhen you are working in Excel and are warned about a circular reference error, fix the problem by checking the ÒEnable iterative calcula-tions boxÓ under Options, Formulas.Calculation of AFN Using Pro Forma Financial Statements Constructed Using RatiosContinuing our previous example, letÕs suppose that we believed that the anticipated increase in sales was going to be due to a change in Dandy CandyÕs credit policy toward its custom-ers. Specifically, letÕs suppose that all Dandy CandyÕs sales were credit sales, and that the firm was going to offer to lengthen the term of credit it offered to its customers. In 2013, Dandy CandyÕs average collection period (ACP) was ACP = Accounts receivable × 365 days _________________________ Credit sales = $250,000 × 365 days __________________ $8,000,000 = 11.41 days Also assume that Dandy Candy had analyzed the new credit policy and had determined that it could be expected to increase sales by the 25 percent amount we had already dis-cussed, but that it could also be expected to change the ACP to 25 days. What would this do to the AFN for 2014?EXAMPLE 15-8For interactive versions of this example, log in to Connect or go to mhhe.com/Cornett4e.LG15-5 Final PDF to printer

chapter 15 Financial Planning and Forecasting 517cor91411_ch15_498-529.indd 517 01/25/17 09:03 PMSOLUTION: We can Òreverse engineerÓ the ACP formula to determine what the expected new value for accounts receivable will be in 2014: ACP = Accounts receivable × 365 days ____________________________ Credit sales 25 = Accounts receivable × 365 days ____________________________ $10,000,000 $250,000,000 _____________ 365 = Accounts receivable $684,932 = Accounts receivable Substituting this as our expected accounts receivable figure for 2014 causes a change in our AFN to $1,546,888, as shown in Table 15.7. As we would expect, this figure is higher than the one calculated in the previous section because now we are assuming that accounts receivable is increasing at a rate of ($684,932 − $250,000) /$250,000 = 174 percent, which is much faster than the 25 percent growth we were using in the previous section. If we are assuming that one of the portions of current assets is increasing at a faster rate than sales, of course we are going to need more external financing.TABLE 15.7 Dandy Candy Balance Sheets21345678910111213141516171819202122232524ABCD= 0.1* (F12 + F15)8,000,0006,000,0001,000,000$ 1,000,000742,500257,500297,000445,500267,300178,20010,000,0001,250,0007,500,0001,250,000915,156334,844366,062549,093267,300281,793= E15 + F28/2= E17 + F28/2250,000250,000500,0005,000,000$ 1,000,0006,000,000125,00075,00050,000250,0002,500,0002,750,0003,000,000250,0003,250,0006,000,000312,500684,932625,0006,250,000$ 1,622,432$ 7,872,432156,25075,00062,500293,7503,273,4443,773,4443,567,194531,793$ 4,305,237$ 7,872,432$ 1,872,43243,750281,793$ 1,546,888$ 1,546,88825%Percentage salesgrowth2014 Forecast2013 ActualEF2013 Actual2014 ForecastSalesCosts exceptdepreciationDepreciationEBITInterestEBTTaxes (40%)Net incomeCommon dividendsAddition toretained earningsCashAssetsAccountsreceivableInventoriesTotal currentassetsNet plant andequipmentTotal assetsLiabilities andEquityAccounts payableNotes payableAccrualsTotal currentliabilitiesLong-term debtTotal debtCommon stockRetained earningsTotal liabilitiesand equityNecessary increasein assetsSpontaneousincrease in liabilitiesProjected increasein retained earningsAdditional fundsneededChange in(NP + LTD + Common Stock)Total commonequity$$$$$$$$$$$$$$$$$$$$$$$$Similar to Problems 15-13, 15-14Final PDF to printer

518 part seven Working Capital Management and Financial Planningcor91411_ch15_498-529.indd 518 01/25/17 09:03 PMAFN USING PRO FORMA STATEMENTS BASED ON RATIO ANALYSIS Finally, thereÕs often reason to expect that some of the balance sheet and income state-ment items that we have been continuing to treat as linear functions of sales might not grow proportionately with sales. In fact, itÕs pretty easy to imagine that the expected change in sales might even be based on some fundamental underlying change in the companyÕs business policies or in the surrounding macroeconomic environment, and that such a change might be reflected in or signaled by changes to a specific sub-set of the balance sheet and income statement items that have a particular underlying relationship.Such underlying relationships were the focus of our discussion of ratios back in Chapter 3, and just as we impose structure on the combination of external funding sources to be used, we can use those ratios to guide us in changing the relevant balance sheet or income statement items.TIME OUT 15-5 When would iterative calculation not be necessary to find the AFN using pro forma financial statements?   15-6 Suppose a firm was planning to greatly reduce its raw materials inventory next year by introducing just-in-time inventory control procedures. Assuming no other changes to the firmÕs operations, what would this do to AFN?  viewpoints REVISITEDBusiness Application SolutionUsing regression, the intercept and slope for RiadaÕs sales as a function of time are $633,333.33 and $350,000, respectively, implying that RiadaÕs expected sales in year 4 will be $633,333.33 + $350,000 × 4 = $2,033,333. This will be a ΔS of $2,033,333 − $1,700,000 = $333,333. The necessary increase in current assets will be $500,000/$1,700,000 × $333,333 = $98,039. Since we are told that there are enough fixed assets to support $2 million in sales, the necessary increase in fixed assets will be $1,500,000/$2,000,000 × $33,333 (sales in excess of $2 million) = $25,000, for a total necessary increase in assets of $98,039 + $25,000 = $123,039. The spontaneous increase in liabilities will be $300,000/$1,700,000 × $333,333 = $58,824, and the projected increase in retained earnings will be 0.05 × $2,033,333 × 0.7 = $71,167, resulting in an AFN of AFN = $123,039 − $58,824 − $71,167 = −$6,952 Personal Application SolutionSince Kamala earns $300 per month, she will earn $300 × 12 = $3,600 over the course of the year. Since she needs $10,000 to fund college this year, she will need to borrow $10,000 − $3,600 − $5,000 = $1,400.Final PDF to printer

519cor91411_ch15_498-529.indd 519 01/25/17 09:03 PMsummary of learning goalsThis chapter has covered the concepts involved in developing a financial plan for the firm: forecasting sales, translat-ing this into required changes in assets and expected changes in liabilities and retained earnings, and then calculating the iterative solution for the amount of external funding needed.Describe the process of financial planning in the context of the firm and how base case projections are used in the strategic planning process. Financial planning involves estimating projected cash flows, which are useful for setting internal goals, for providing information to shareholders and other external stakeholders concerning the firmÕs future expectations, and for estimating the firmÕs future needs for internal and external financing.Identify how forecasting sales supports the process of financial planning. Forecasted sales drive the amount of assets needed, the liabilities used to help fund those assets, and the amount of external funds needed.Compare and contrast the na•ve, average, and seasonality- and trend-adjusted approaches to forecasting sales and how they are implemented. LG15-1LG15-2LG15-3The na•ve approach is appropriate when sales are stable over time; the average approach is appropriate when there is a possibility of large, random variations over time; and the seasonality and trend-adjusted approaches are appropriate when sales are systematically changing over time.Explain and demonstrate the additional funds needed (AFN) approach to estimating a firmÕs need to seek external financing. The additional funds needed by the firm can be calculated by assuming that much of the firmÕs balance sheet will grow proportionately with projected changes in sales and then extrapolating the amount of additional capital needed.Use pro forma financial statements to estimate additional funds needed. Pro forma statements can be used to iteratively refine the amount of additional funds needed.LG15-4LG15-5chapter equations 15-1 E( Sales t+j ) = Sales t for all j > 0 15-2 MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | ____________________ n 15-3 E( Sales n+j ) = Σ i=1 n Sales t _________ n for all j > 0 15-4 AFN = Necessary increase in assets − Spontaneous increase in liabilities − Projected increase in retained earnings 15-5 Necessary increase in assets = A * ____ S 0 × ΔS 15-6 Spontaneous increase in liabilities = L * ___ S 0 × ΔS 15-7 Projected increase in retained earnings = M × S 1 × RR key termsadditional funds needed (AFN) The amount of external financing a firm must seek in order to change the asset base as necessary to support a different level of sales. p. 507average approach Assuming that future sales will be equal to the average historical value across some relevant period. p. 502Final PDF to printer

520cor91411_ch15_498-529.indd 520 01/25/17 09:03 PMbase case The set of assumptions underlying the firmÕs financial plan. p. 500base case projections The projected financial statements associated with the base case. p. 500capital intensity ratio Relevant assets divided by current sales. p. 507centered moving average A moving average created to put a specific observation exactly in the center of the period over which the moving average is calculated.  p. 504deseasonalize To remove the effects of seasonality from historic data. p. 504financial planning The process of mapping out the future cash inflows and outflows of the firm. p. 500first order effects The immediately observable effects of changing one item on another. Usually contrasted with higher order effects, which are the subsequent, less observable effects of the change. p. 511infinitely divisible The ability to divide a given amount into as small a portion as needed. p. 509iterative calculation The practice of letting a spreadsheet program or calculator repeatedly compute an answer so as to take into account circular dependency in a system of equations. p. 515MAPE Mean absolute percentage error, a measurement of a forecastÕs accuracy. p. 500na•ve approach Assuming that future sales will be equal to the latest periodÕs sales. p. 500spontaneous liabilities ratio Relevant liabilities divided by current sales. p. 507strategic planning The process of determining where a firm is going over the next year or more, how it is going to get there, and how it will know if it gets there or not.  p. 500trade credit The practice of one firm selling to another on credit terms. p. 507self-test problems with solutions1 Na•ve Approach June Bug, Inc., has had sales of $25 million, $28 million, and $23 million for each of the last three years. Using the na•ve approach, what would be the forecast for next yearÕs sales, and what would be the MAPE if the actual sales were $26 million?Solution:The na•ve approach would be to take the last historic periodÕs sales, $23 million, as the forecast for next year. This would result in a MAPE of MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | ____________________ n = | $26,000,000 − $23,000,000 _______________________ $26,000,000 | ________________________ 1 = 0.1154, or 11.54% 2 Average Approach Using the average of the three historic sales figures in the previous problem, what would be the forecast for next year and the MAPE of that forecast?Solution:The average sales figure would be E( Sales n+j ) = Σ i=1 n Sales t _______ n for all j > 0 = $25,000,000 + $28,000,000 + $23,000,000 __________________________________ 3 = 25,333,333 LG15-3LG15-3Final PDF to printer

521cor91411_ch15_498-529.indd 521 01/25/17 09:03 PMAnd the MAPE would be MAPE = Σ t=1 n | Actual t − Forecast t ________________ Actual t | ____________________ n = | $26,000,000 − $25,333,333 _______________________ $26,000,000 | ________________________ 1 = 0.0256, or 2.56% 3 Adjusting for Seasonality American Food Services has detected a strong weekly cyclicality in its food sales, but the firm does not believe that there is any consistent trend across time. Management is attempting to forecast next weekÕs daily sales figures using the historic figures for the last four weeks shown below. If they are somewhat worried about the possibility of large, random variations in their historic data, what should their forecasts be?Solution:The firm should calculate seasonal (i.e., daily) adjustment indexes, deseasonalize the historic sales figures, take their average, and then use the re-seasonalized average to produce forecasts for each day of the week. Please refer to Example 15-3 for a detailed guide to the steps involved. The results will be as shown below:LG15-3Observation12345678910111213141516171819202122232425262728Day12345671234567123456712345671234567Sales – Actual7-CMA*(1)*(2)Adj. Seas. IndexDeseas. Sales*(3)$ 58,359.23 24,385.04 34,337.67 37,928.78 26,354.44 69,177.54 97,782.74$ 34,983.07 48,411.85 50,459.74 42,946.78 61,124.64 50,854.47 46,043.46 49,941.35 58,102.79 42,253.15 44,591.97 45,190.66 51,905.40 46,177.30 49,183.33 44,279.58 52,104.54 63,932.79 40,071.92 43,192.28 54,653.39 47,844.65 44,924.41 54,571.01 45,432.93 72,530.87 55,697.65 51,895.711.1727957840.4900453360.6900550170.7622223850.52962275 1.3902021921.9650565357 1.1672720140.4877372640.6868049150.7586323820.5271282721.3836544561.9558012846.9670305880.7032090.6599061.4214821.8492661.1927570.5944260.6060650.7059530.4984251.5336151.8895431.1506780.4362360.7488910.9670690.4230541.1958672.1285941.1583820.43255 0.7054590.658299$ 46,551 49,057 49,735 48,926 49,106 47,900 48,109 48,146 48,019 47,052 48,023 50,129 49,741 48,011 50,390 50,166 50,211 50,454 48,440 50,896 53,379 52,605$ 41,028 23,724 34,820 32,735 32,373 70,698 90,478 58,571 28,473 29,157 33,989 23,934 72,159 90,741 57,682 21,699 35,955 48,731 21,223 60,046 107,397 56,112 22,015 37,657 34,630 38,414 77,431 101,978*(1) = Actual sales for day j / 7-CMA for day j*(2) = Average of Seas. Irreg. values for day j(Ex: (1.192757 + 1.150678 + 1.158382) / 3 = 1.16727014*(3) = Average of 28 days of Deseas. Sales × Adj. Seas. Index for day j4 Estimating AFN Using Simple Approach Jon Buoys currently has the following balance sheet. Sales for the year just ended were $23 million, and the firm expects sales LG15-4Final PDF to printer

522cor91411_ch15_498-529.indd 522 01/25/17 09:03 PMnext year of $25 million. The firm has a profit margin of 15 percent, a retention ratio of 10 percent, and unused fixed-asset capacity sufficient to cover the projected $25 million in sales. Using the simple approach to calculating AFN, how much in external funds will Jon Buoys require?AssetsLiabilities and EquityCurrent assets$10,000,000Current liabilities$ 3,500,000Fixed assets 35,000,000Long-term debt 11,500,000Equity 30,000,000Total assets $45,000,000Total liabilities and equity $45,000,000Solution:Since it is stated that there is sufficient existing fixed asset capacity to cover the projected sales, A* is $10 million and the necessary increase in assets will be Necessary increase in assets = A* ____ S 0 × ΔS = $10,000,000 ___________ $23,000,000 × ($25,000,000 − $23,000,000) = $869,565 The spontaneous increase in liabilities is expected to be Spontaneous increase in liabilities = L * ___ S 0 × ΔS = $3,500,000 ___________ $23,000,000 × ($25,000,000 − $23,000,000) = $304,348 And the projected increase in retained earnings will be: Projected increase in retained earnings = M × S 1 × RR = 0.15 × $25,000,000 × 0.10 = $375,000 So the amount of AFN will be equal to $869,565 Ð $304,348 Ð $375,000 = $190,217.5 Estimating AFN Using Pro Forma Statements Suppose that the 2013 actual and 2014 projected financial statements for Krazy Krackers are initially as shown in the following table. In these tables, sales are projected to rise by 15 percent in the coming year, and the components of the income statement and balance sheet that are expected to increase at the same 15 percent rate as sales are indicated by green type. Assuming that Krazy Krackers wants to cover the AFN with only long-term debt, how much in additional funds will Krazy Krackers need to raise if debt carries a 10 percent interest rate?Solution:The answer is shown in the following table:LG15-4Final PDF to printer

523cor91411_ch15_498-529.indd 523 01/25/17 09:03 PM1234567891011121314151617181920ABCDAssetsCashAccounts receivableInventoriesTotal current assetsNet plant and equipmentTotal assetsLiabilities and EquityAccounts payableNotes payableAccrualsTotal current liabilitiesLong-term debtTotal debtCommon stockRetained earningsTotal common equityTotal liabilities and equitySalesCosts except depreciationDepreciationEBITInterestEBTTaxes (40%)Net incomeCommon dividends2013 Actual2014 Forecast3,910,000575,000$ 2,415,000200,000$ 2,215,000886,0001,329,000570,0003,400,000500,0002,100,000200,0001,900,000760,000$ 1,140,000570,000Addition to retained earnings759,000570,000$ 6,900,000$ 6,000,000EF2013 Actual2014 Forecast400,000245,0001,200,000$ 1,845,0005,000,0006,845,000179,0001,000,000350,000$ 1,529,0001,000,0002,529,0004,100,000216,000$ 4,316,0006,845,000460,000281,7501,380,000$ 2,121,7505,750,000$ 7,871,750205,8501,000,000402,500$ 1,608,3501,000,000$ 2,608,350$ 4,100,000975,000$ 5,075,000$ 7,683,350$$$$$$$$$$$$$$$123456789101112131415161718192021222422ABCD6,000,0003,400,000500,000$ 2,100,0001,900,000200,000760,0001,140,000570,000570,0006,900,000575,0003,910,0002,415,0002,194,957220,043877,9831,316,974570,000746,974400,000245,0001,200,0005,000,000$ 1,845,0006,845,000179,0001,000,000350,0001,529,0001,000,0002,529,0004,100,000216,0004,316,0006,845,000460,000281,7501,380,0005,750,000$ 2,121,750$ 7,871,750205,8501,000,000402,5001,608,3501,200,4264,100,0002,808,776962,974$ 5,062,974$ 7,871,750$ 1,026,75079,350746,974200,426200,4262013 Actual2014 ForecastEF2013 Actual2014 ForecastSalesCosts except depreciationDepreciationEBITLess interestEBTTaxes (40%)Net incomeCommon dividendsAddition to retained earningsCashAssetsAccounts receivableInventoriesTotal current assetsNet plant andequipmentTotal assetsLiabilities andEquityAccounts payableNotes payableAccrualsTotal currentliabilitiesLong-term debtTotal debtCommon stockRetained earningsTotal liabilitiesand equityNecessary increasein assetsSpontaneousincrease in liabilitiesProjected increasein retained earningsAdditional fundsneededChange in(NP + LTD +Common Stock)Total commonequity$$$$$$$$$$$$$$$$$$$$$$$$$$Final PDF to printer

524cor91411_ch15_498-529.indd 524 01/25/17 09:03 PMquestions 1. Compare and contrast the use of pro forma finan-cial statements in corporate financial planning with their use in accounting. (LG15-1) 2. Why might current liabilities be considered a spon-taneous source of funding for a firm? (LG15-2) 3. What approach should be used to forecast sales if a firm believes that sales will be stable over time? (LG15-3) 4. What approach should be used to forecast sales if a firm believes that sales will increase over time? (LG15-3) 5. What is the optimal length of time over which to take an average of historic sales when using the average approach? (LG15-3) 6. What is the theoretical minimum value for MAPE? (LG15-3) 7. If a firm needs to keep a minimum cash balance on hand and faces both cash inflows and outflows, which of the cash management models discussed in this chapter would be more appropriate for it to use? (LG15-3) 8. Can the procedure described in this chapter for adjusting for seasonality apply to periods longer than a year? How? (LG15-3) 9. Everything else held constant, which will be greater: AFN for a firm with excess fixed-asset capacity, or AFN for a firm with no excess fixed-asset capacity? Why? (LG15-4) 10. What does a negative value for AFN mean? (LG15-4) 11. Which specific item of a pro forma income state-ment should be most expected to vary proportion-ately with sales? Why? (LG15-5) 12. Explain why we need to use the iterative calcula-tion approach described in the text to get a com-plete solution for AFN. (LG15-5)problems 15-1 Na•ve Sales Forecast Suppose a firm has had the following historic sales figures. What would be the forecast for next yearÕs sales using the Na•ve approach? (LG15-3)Year:20122013201420152016Sales$1,500,000$1,750,000$1,400,000$2,000,000$1,600,000 15-2 Na•ve Sales Forecast Suppose a firm has had the following historic sales figures. What would be the forecast for next yearÕs sales using the Na•ve approach? (LG15-3)Year:20122013201420152016Sales$2,500,000$3,750,000$2,400,000$2,000,000$2,600,000 15-3 Average Sales Forecast Suppose a firm has had the following historic sales figures. What would be the forecast for next yearÕs sales using the average approach? (LG15-3)Year:20122013201420152016Sales$1,500,000$1,750,000$1,400,000$2,000,000$1,600,000 15-4 Average Sales Forecast Suppose a firm has had the following historic sales figures. What would be the forecast for next yearÕs sales using the average approach? (LG15-3)basic problemsFinal PDF to printer

525cor91411_ch15_498-529.indd 525 01/25/17 09:03 PMYear:20122013201420152016Sales$2,500,000$3,750,000$2,400,000$2,000,000$2,600,000 15-5 Additional Funds Needed Suppose that Gyp Sum Industries currently has the following balance sheet, and that sales for the year just ended were $10 million. The firm also has a profit margin of 25 percent, a retention ratio of 30 percent, and expects sales of $8 million next year. If all assets and current liabilities are expected to shrink with sales, what amount of additional funds will Gyp Sum need from external sources to fund the expected growth? (LG15-4)AssetsLiabilities and EquityCurrent assets $2,000,000Current liabilities$1,500,000Fixed assets 4,000,000Long-term debt1,500,000Equity 3,000,000Total assets $6,000,000Total liabilities and equity$6,000,000intermediate problems 15-6 Additional Funds Needed Suppose that Wind Em Corp. currently has the following balance sheet, and that sales for the year just ended were $7 million. The firm also has a profit margin of 27 percent, a retention ratio of 20 percent,  and expects sales of $8 million next year. If all assets and current liabilities are expected to grow with sales, what amount of additional funds will Wind Em need from external sources to fund the expected growth? (LG15-4)AssetsLiabilities and EquityCurrent assets $2,000,000Current liabilities$2,500,000Fixed assets 5,000,000Long-term debt1,500,000Equity 3,000,000Total assets $7,000,000Total liabilities and equity$7,000,000 15-7 Regression Sales Forecast Suppose a firm has had the following historic sales figures. What would be the forecast for next yearÕs sales using regression to esti-mate a trend? (LG15-3)Year:20122013201420152016Sales$1,500,000$1,750,000$1,700,000$2,000,000$1,800,000 15-8 Regression Sales Forecast Suppose a firm has had the following historic sales figures. What would be the forecast for next yearÕs sales using regression to esti-mate a trend? (LG15-3)Year:20122013201420152016Sales$2,500,000$3,750,000$4,400,000$5,000,000$5,600,000 15-9 AFN with Excess Capacity Suppose that Psy Ops Industries currently has the following balance sheet, and that sales for the year just ended were $5 million. The firm also has a profit margin of 25 percent, a retention ratio of 30 percent, and expects sales of $8 million next year. If fixed assets have enough capacity to cover the increase in sales and all other assets and current liabilities are expected to increase with sales, what amount of additional funds will Psy Ops need from external sources to fund the expected growth? (LG15-4)Final PDF to printer

526cor91411_ch15_498-529.indd 526 01/25/17 09:03 PMAssetsLiabilities and EquityCurrent assets $2,000,000Current liabilities$1,500,000Fixed assets 4,000,000Long-term debt1,500,000Equity 3,000,000Total assets $6,000,000Total liabilities and equity$6,000,000 15-10 AFN with Lumpy Assets Suppose that Wall-E Corp. currently has the follow-ing balance sheet, and that sales for the year just ended were $7  million. The firm also has a profit margin of 27 percent, a retention ratio of 20  percent, and expects sales of $9 million next year. Fixed assets are currently fully utilized, and the nature of Wall-EÕs fixed assets is such that they must be added in $1 million increments. If current assets and current liabilities are expected to grow with sales, what amount of additional funds will Wall-E need from external sources to fund the expected growth? (LG15-4)AssetsLiabilities and EquityCurrent assets $2,000,000Current liabilities$2,500,000Fixed assets 5,000,000Long-term debt1,500,000Equity 3,000,000Total assets $7,000,000Total liabilities and equity$7,000,000 15-11 Seasonal and Trend Estimated Sales JohnÕs Bait and Fish Shop has had the monthly sales amounts listed below for the last four years. Assuming that there is both seasonality and a trend, estimate monthly sales for each month of the coming year. (LG15-2)Year:2013201420152016January$ 417,812$ 585,558$ 334,336$ 587,080February113,240138,414165,492113,788March139,815177,67686,015137,015April428,157392,734512,061457,425May436,880926,046534,007851,622June743,9471,084,321597,606741,444July1,449,2801,249,4701,564,9391,579,376August1,428,1231,794,5861,849,5851,590,067September1,178,7951,022,538683,038724,279October368,475465,971483,142651,824November257,638389,276261,309309,872December 321,208386,377234,736371,721 15-12 Seasonal and Trend Estimated Sales SaraÕs Ice Cream Shop is closed for six months out of the year but has had the monthly sales amounts listed below for the last four years. Assuming that there is both seasonality and a trend, estimate monthly sales for each month of the coming year. (LG15-3)advanced problemsFinal PDF to printer

527cor91411_ch15_498-529.indd 527 01/25/17 09:03 PMYear:2013201420152016May$ 436,880$ 926,046$ 534,007$ 851,622June743,9471,084,321597,606741,444July1,449,2801,249,4701,564,9391,579,376August1,428,1231,794,5861,849,5851,590,067September1,178,7951,022,538683,038724,279October368,475465,971483,142651,824 15-13 Pro Forma Additional Funds Needed Suppose that the 2016 actual and 2017 projected financial statements for Comfy Corners Catbeds are initially as shown. In these tables, sales are projected to rise by 22 percent in the coming year, and the components of the income statement and balance sheet that are expected to increase at the same 22 percent rate as sales are indicated by green type. Assum-ing that Comfy Corners Catbeds wants to cover the AFN with half equity, 25 per-cent long-term debt, and the remainder from notes payable, what amount of additional funds will be needed if debt carries a 10 percent interest rate? (LG15-3)ABCDEF1Income StatementBalance Sheet22016 Actual2017 Forecast2016 Actual2017 Forecast3Sales$4,000,000$4,880,000Assets4Costs except depreciation2,600,0003,172,000Cash$ 600,000$ 732,0005Depreciation1,000,0001,220,000Accounts receivable137,000167,1406EBIT$ 400,000$ 488,000Inventories1,013,0001,235,8607Interest198,000198,000Total current assets$1,750,000$2,135,0008EBT$ 202,000$ 290,000Net plant and equipment5,000,0006,100,0009Taxes (40%)80,800116,000Total assets$6,750,000$8,235,00010Net income$ 121,200$ 174,00011Liabilities and Equity12Common dividends$ 60,600$ 60,600Accounts payable$ 179,000$ 218,38013Addition to retained earnings$ 60,600$ 113,400Notes payable980,000980,00014Accruals375,000457,50015Total current liabilitiese$1,534,000$1,655,88016Long-term debt1,000,0001,000,00017Total debt$2,534,000$2,655,88018Common stock$4,000,000$4,000,00019Retained earnings216,000329,40020Total common equity$4,216,000$4,329,40021Total liabilities and equity$6,750,000$6,985,280 15-14 Pro Forma Additional Funds Needed Suppose that the 2016 actual and 2017 projected financial statements for AFS are initially as shown. In these tables, sales are projected to rise by 14 percent in the coming year, and the components of the income statement and balance sheet that are expected to increase at the same 14 percent rate as sales are indicated by green type. Assuming that AFS wants to cover the AFN with half equity and half long-term debt, what amount of additional funds will be needed if debt carries a 9 percent interest rate? (LG15-3)Final PDF to printer

528cor91411_ch15_498-529.indd 528 01/25/17 09:03 PMABCDEF1Income StatementBalance Sheet22016 Actual2017 Forecast2016 Actual2017 Forecast3Sales$5,500,000$6,270,000Assets4Costs except depreciation3,000,0003,420,000Cash$ 750,000$ 855,0005Depreciation1,200,0001,368,000Accounts receivable140,000159,6006EBIT$1,300,000$1,482,000Inventories800,000912,0007Interest153,000153,000Total current assets$1,690,000$1,926,6008EBT$1,147,000$1,329,000Net plant and equipment5,000,0005,700,0009Taxes (40%)458,800531,600Total assets$6,690,000$7,626,60010Net income$ 688,200$ 797,40011Liabilities and Equity12Common dividends$ 344,100$ 344,100Accounts payable$ 350,000$ 399,00013Addition to retained earnings$ 344,100$ 453,300Notes payable500,000500,00014Accruals375,000427,50015Total current liabilitiese$1,225,000$1,326,50016Long-term debt1,200,0001,200,00017Total debt$2,425,000$2,526,50018Common stock$4,000,000$4,000,00019Retained earnings265,000718,30020Total common equity$4,265,000$4,718,30021Total liabilities and equity$6,690,000$7,244,800research it! Looking Up Sales InformationGo to the Johnson & JohnsonÕs investor relations sales and earnings page at www .investor.jnj.com/sales-earnings.cfm. The company reports sales on a quarterly basis, so download all available sales reports and set the last four quartersÕ sales figures aside as an Òout-of-sampleÓ test group. Use the rest of the ÒworldwideÓ historical sales figures to forecast what the last four quartersÕ sales figures would have been expected to be, and then perform a MAPE analysis on your forecasts. How accurate was your forecast, and do you think you could have been more accurate if you had calculated forecasts for each component of worldwide sales (ÒU.S. consumer sales,Ó Òinternational pharmaceutical sales,Ó etc.) separately?integrated mini-case Effect of Capital Structure on AFNSuppose that the 2016 actual and 2017 projected financial statements for your firm are initially as shown in the following table. Sales are projected to rise by 18 percent in the coming year, and the components of the income statement and balance sheet that are expected to increase at the same 18 percent rate as sales are indicated by green type. Assuming that your firm has to pay 9 percent interest on debt, what would the AFN be if needed capital was to be raised entirely from equity?How would your answer change if the entire AFN was to be raised from long-term debt? And what does this imply about the relationship between the sources of AFN funding and the amount needed?Final PDF to printer

529cor91411_ch15_498-529.indd 529 01/25/17 09:03 PMABCDEF1Income StatementBalance Sheet22016 Actual2017 Forecast2016 Actual2017 Forecast3Sales$10,000,000$11,800,000Assets4Costs except depreciation5,200,0

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