QUANTITATIVE CORPORATE FINANCE

Transcription

1 QUANTITATIVE CORPORATE FINANCE

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3 QUANTITATIVE CORPORATE FINANCE John B. Guerard, Jr. McKinley Capital Management, Inc. and Eli Schwartz College of Business and Economics Lehigh University

4 John B. Guerard, Jr. Eli Schwartz McKinley Capital Management, Inc. Department of Economics 3301 C. Street Lehigh University Anchorage 621Taylor Street Alaska Bethlehem, PA ISBN-13: e-isbn-13: Library of Congress Control Number: Springer Science+Business Media, LLC All rights reserved. This work may not be translated or copied in whole or in part without the written permission of the publisher (Springer Science+Business Media, Inc., 233 Spring Street, New York, NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in connection with any form of information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed is forbidden. The use in this publication of trade names, trademarks, service marks, and similar terms, even if they are not identified as such, is not to be taken as an expression of opinion as to whether or not they are subject to proprietary rights. Printed on acid-free paper springer.com

5 ACKNOWLEDGMENTS The authors would like to thank their wives, Renee Schwartz and Julie Guerard, for their support while this project was being completed. Additionally, we thank people who took the time to read and comment on the chapters. Mr. Dan Deeney read the entire manuscript and provided many helpful corrections and suggestions. Professors James Vander Weide, of Duke University, and Bernell Stone, of Brigham Young University, were among our manuscript reviewers and read several chapters. Dr. Harry Markowitz and Professor Tao Wang, of Queens College, read the portfolio risk and return on equity and multi factor risk model chapters. Professor Ralph Steuer, of the University of Georgia, commented extensively on the forecasting and time series chapters. Professor Steve Buell, a former colleague at Lehigh University, read several chapters. We thank these gentlemen for their time and thoughts. Mrs. Alex Slivka and Sundaram Chettiappan of McKinley Capital Management read several chapters and provided very useful comments. Any errors remaining are the sole responsibility of the authors. The manuscript was written (99.5%) while John Guerard taught Advanced Corporate Finance in The Graduate School of Management at Rutgers University, the University of Pennsylvania Executive Masters in Technology Management (EMTM), and the International University of Monaco (IUM). I thank my students who corrected typographical errors. We covered the entire manuscript in a four-day session (8 AM 6 PM) in Monaco, adjourning to Stars N Bars for refreshments after class. John Blin and Steve Bender, of APT, provided their software for classroom use at Rutgers and IUM. The APT software is used in the multi factor risk model chapter. John Guerard has published with Mr. Blin and Mr. Bender and is grateful for their friendship and support. The APT software enhances student knowledge of practical multi factor risk models. Rene Hollinger, of Lehigh University, typed and prepared the manuscript and we are indebted to her able assistance.

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7 CONTENTS 1 INTRODUCTION: CAPITAL FORMATION, RISK, AND THE CORPORATION Financial Mathematics and Theory Growth and Survival of the Firm Risk and Uncertainty Inherent in Finance Types of Business Risk Financial Risk Division of Risk, Income, and Control Profitability Return, and Risk Areas Covered in this Book THE CORPORATION AND OTHER FORMS OF BUSINESS ORGANIZATION The Sole or Single Proprietorship The Partnership The Limited Partnership The Corporation, its Basic Characteristics Chartering the Corporation Administrative Organization Major Rights of the Shareholders The Advantages of the Corporate Form THE CORPORATION BALANCE SHEET The Balance Sheet Assets Liabilities and Stockholder Equity Current Liabilities Long-Term Debt Deferred Credits Common Equity Book Value of Common Stock...43

8 viii Contents 4 THE OPERATING STATEMENTS: THE INCOME STATEMENT AND ANNUAL CASH FLOW STATEMENT Form and Content of the Income Statement Retained Earnings vs. Dividends Annual Cash Flow Statement FINANCING CURRENT OPERATIONS, RATIO AND CREDIT ANALYSIS Working Capital Concepts Quantitative Working Capital Models Cash Management Sources of Net Working Capital Ratio Analysis and Working Capital Current Analysis Ratios General Analysis Ratios Operating Ratios Financial Ratios and the Perceived Financial Health of Firms The Time Series of Ratios in the US, Limitations of Ratio Analysis Working Capital Analysis and Granting Credit A Summary of Ratio Analysis FINANCING CURRENT OPERATIONS AND THE CASH BUDGET Sources of Short-Term Financing Trade Credit Bank Credit Other Forms of Short-Term Financing The Cash Budget CAPITAL AND NEW ISSUE MARKETS The Secondary Markets The Primary Market Investment Banking and New Issues Department The Originating House The Underwriting Group The Selling Group...128

9 Contents ix 3. Other Aspects of Investment Banking Best Effort vs. Firm Commitment or Underwriting Basis Initial Public Offerings (IPOs) Expansion of a Privately Held Firm into a Public Corporation The Problem of Control Promotion of a Subsidiary by Parent Corporations Formation of a Joint Subsidiary by Two or More Parent Companies The Sec and the Flotation of New Issues Secondary Floatations Issuing Securities through Rights Stock Tenders Costs of Floating an Issue Regulation of the Capital Markets Securities Act of The Securities Exchange Act of Banking Act (Glass Steagle Act) of Glass Steagall Act Amended Retail Brokerage Houses Public Utility Act of The Maloney Amendment, The Investment Company Act of Sarbannes-Oxley Act of The Capital Market as a Source of Funds The Debate on the Optimal Organization of the Capital Market Capital Markets and Long Term Economic Growth THE EQUITY OF THE CORPORATION: COMMON AND PREFERRED STOCK Common Stock Common Stock as Risk Capital Rewards of Common Shareholders The Corporate Sector: A Net Exporter of Funds Definitions of the Value of Common Shares Stock Prices and Dividends: An Example Non-Cash Paying Growth Shares Valuing a Dividend Paying Growth Stock...171

10 x Contents 8. Super-Growth Cannot be Infinite The Paradox of the Low Current Return on Growth Options Risk and Returns to Growth Investments The Cost of Capital to a Growth Firm The Cost of Common Stock Financing: The Norm Preferred Stock Features of Preferred Stock Rationale for Preferred Stock Financing Convertible Preferred Protective Features on Preferred Shares Floating New Common Equity Issues Advantage of New Share Financing LONG-TERM DEBT Bonds Other Types of Long-Term Debt Long-Term Lease The Cost of Debt Capital Level and Structure of the Interest Rates The Liquidity Preference Theory of the Term Structure The Pure Expectations Theory of the Term Structure The Market Segmentation Theory of the Term Structure Structure of Rates and Financial Strategy The Call Feature on Bonds Convertible Bonds and Bonds with Warrants Attached The Advantages and Disadvantages of Long-Term Debt Malkiel s Bond Theorems Retirement of Debt DEBT, EQUITY, THE OPTIMAL FINANCIAL STRUCTURE AND THE COST OF FUNDS A Most Misleading Relationship Definition of Leverage Profits and Financial Risk Illustrations of Leverage Return and Risk Surrogate Evidence on the Development of Optimum Financial Structure The Pure Theory of the Optimal Financial Structure Modigliani and Miller Constant Capital Costs...232

11 Contents xi 7. The Optimal Capital Structure and the M&M Hypothesis Empirical Factors Influencing Financial Structures Measures for Approximating Financial Risk INVESTING IN ASSETS: THEORY OF INVESTMENT DECISION MAKING Net Present Value and the Internal Rate of Return Mutually Exclusive Projects Difference in Project Size Differing Duration of the Inflows Lowest Annualized Total Costs The Irrational Fixed Capital Budget Operating Practice and the Internal Rate of Return Account for Working Capital Real Investments and the Cost of Funds Applying Investment Theory CFO Practice Current Costs of the Optimum Financial Mix Adjusting the Capital Mix and Costs for Individual Project Closing or Continuing Operations Stability of Forecasts-Risk of the Investment The Theory of Dealing with Risk Risk-Adjusted Discount Rate Risk/Return Distribution Certainty Equivalence Maximum Loss and Reversibility Gross Uncertainty Market Risk The Effect of Taxes on the Financial Structure Costing the Components of the Financial Mix Cost of Trade Credit Cost of Bank Credit Cost of Long-Term Debt Cost of Preferred Stock Cost of Common Stock Internal Funds The Cost of Retained Earnings Other Internal Funds-Depreciation, Depletion, etc Summary...273

12 xii Contents 12 REGRESSION ANALYSIS AND FORECASTING MODELS Autocorrelation Multiple Regression Analysis The Conference Board Composite Index of Leading Economic Indicators and Real US GDP Growth: A Regression Example TIME SERIES MODELING AND THE FORECASTING EFFECTIVENESS OF THE U.S. LEADING ECONOMIC INDICATORS Basic Statistical Properties of Economic Series The Autoregressive and Moving Average Processes ARMA Model Identification in Practice Leading Economic Indicators (LEI) and Real GDP Analysis: The Statistical Evidence, Leading U.S. and G7 Post-Sample Real GDP Forecasting Analysis Quarterly Earnings per Share Modeling SUEs Pro Forma Analysis Forecasting with an Average Annual Growth Rate Regression Forecasting of Sales Summary RISK AND RETURN OF EQUITY AND THE CAPITAL ASSET PRICING MODEL Calculating Holding Period Returns Minimizing Risk The Three Asset Case An Introduction to Modern Portfolio Theory Expected Returns vs. Historic Mean Returns Fundamental Analysis and Stock Selection Modern Portfolio Theory and GPRD: An Example of Markowitz Analysis Further Estimations of a Composite Equity Valuation Model...356

13 Contents xiii 15 MULTI-FACTOR RISK MODELS BARRA Model Mathematics Risk Prediction with MFMS The BARRA Multi Factor Model and Analysts Forecasts, Revisions, and Breadth Alternative Multi-Beta Risk Models Summary and Conclusions OPTIONS The Malkiel-Quandt Notation The Binominal Option Pricing Model The More Traditional Black and Scholes Option Pricing Model Derivation Black and Scholes Model Calculation The OPM and Corporate Liabilities REAL OPTIONS The Option to Delay a Project Implications of Viewing the Right to Delay a Project as an Option Abandonment Value Options in Investment Analysis / Capital Budgeting MERGERS AND ACQUISITIONS Noneconomic Motives for Combinations Holding Companies A Merger History of the US Using an Accounting Basis The Economic Basis for Acquisitions Theories of Conglomerate Mergers Combinations Correcting Economic or Financial Imbalances Combinations Increasing Market Dominance Combinations for Tax Advantages The Larson-Gonedes Exchange Ratio Model Valuation of a Merger Candidate Testing For Synergism...447

14 xiv Contents 11. Do Mergers Enhance Shareholder Wealth? Divestment and Spinoff Summary and Conclusions LIQUIDATION, FAILURE, BANKRUPTCY, AND REORGANIZATION Voluntary Liquidation A Liquidation Example Remaining In Business Failure Informal Remedies Formal Procedure Bankruptcy The WorldCom Case Bankruptcy Procedures Priorities in Liquidation Reorganization Summary CORPORATION GROWTH AND ECONOMIC GROWTH AND STABILITY Factors in Economic Growth Savings and Real Investment Corporation Investment Spending and Economic Stability Monetary Policy, the Cost of Capital, and the Firm Investment Process Economic Growth and Firm Growth Firm Growth and Economic Growth INTERNATIONAL BUSINESS FINANCE Currency Exchange Rates International Diversification International Stock Selection Efficient Portfolio Optimization Results in the Pacific Region Markets International Corporate Finance Decisions...508

15 Contents xv 22 MANAGEMENT-STOCKHOLDER RELATIONS General Agreement and Potential Conflicts in Management and Control Areas of Potential Conflict Managerial and Board of Directors Compensation Executive Compensation Board of Directors Stock Options Bonuses Dividends, Buy Backs, and Retained Earnings Excessively Conservative Financial or Asset Structures Expansion Liquidating or Selling the Firm Risky Acquisitions Turning Agents into Owners The Diseconomics of Financial Scams Insider Trading Conflict of Interests Stockholder Remedies To Whom is Management Responsible? APPENDIX INDEX...537