Thursday, October 31, 2013

Capital Budgeting And WACC In Practice

The Association of Financial Professionals recently released its 2013 AFP Estimating and Applying Cost of Capital Survey. The report is rather lengthy, but we would like to discuss some of the findings.

Eighty-five percent of the companies surveyed used discounted cash flow analysis for capital budgeting projects. For those of you who are worried about projecting cash flows far into the future, 51 percent of the companies used an explicit 5-year cash flow projection and 26 percent used an explicit 10-year cash flow projection. After that estimation period, a terminal valuation is used to account for cash flows beyond that period. Additionally, 72 percent of companies used scenario analysis when evaluating a new project.

When estimating the cost of equity, 85 percent of companies use the CAPM. The choice of the risk-free rate is varied, with 39 percent using the 10-year Treasury, which is not consistent with our choice. There is also a disparity in practice whether to apply the current, historical, or forward risk-free rate. The choice of beta is also widely varied, with companies choosing different sources, estimation periods, return frequency, adjustment of the estimated beta toward one, and delevering and relevering beta.

As we discussed in the textbook, many argue that the market risk premium since 1926 is unsustainable going forward. The survey results show the variation in the market risk premium used. Seventeen percent of companies use a market risk premium of 3 percent or less, while 19 percent use a market risk premium of 6 percent or more. One thing we should mention about the market risk premium relates back to the choice of the Treasury used to proxy the risk-free rate. The choice of a longer term Treasury over a shorter term Treasury would result in a lower market risk premium, assuming an upward sloping yield curve. Because the choice of which Treasury maturity should proxy the risk-free rate is directly related to the market risk premium, interpreting the results of this question in isolation is problematic.  

Finally, for those students who feel that they are struggling with finance, rest assured that you are not alone. We would fail the 36 percent of the companies in this survey who use the current book value debt/equity ratio. As we mentioned numerous times, book values are not useful in most instances, but rather market values should be used. However, the 17 percent of companies that use the current book debt/current market equity ratio for the capital structure weights would pass our classes since the book value and market value of debt are generally close.

Wednesday, October 30, 2013

Britain Issues Sukuk

The British government will become the first non-Muslim country to issue sukuk, a form of debt that complies with Islamic law, which prohibits the payment of interest. Instead, sukuk pays a share of the returns from an underlying asset such as property. The size of the issue, which is expected in 2014, will be about £200 million ($322 million). There are currently 49 sukuk listings on the London Stock exchange, valued at $34 billion. Overall, investments compliant with Islamic law are expected to grow to about £1.3 trillion ($2.08 trillion) in 2014. By way of contrast, the U.S Treasury bond market is about $11.3 trillion and U.S. corporate debt is about $9.2 trillion.

Tuesday, October 29, 2013

Read Carefully, Think Critically

The Economist recently published an article debunking the already well-debunked myth that U.S. Treasury bonds are risk-free (see Problem 22 in Chapter 10). While we expect that many people are not aware that Treasury bonds have inflation, or purchasing power risk, we hope that by now you do. It is well-known that there is no true risk-free asset, but Treasuries are used as a proxy for the risk-free rate. What is really disappointing is the time value of money skills displayed by the author. The article notes that the real return in Treasury bonds was a loss of about 2 percent per year, for a cumulative purchasing power loss of 91 percent for the period 1946-1981. And of course, this got us fact checking. Based on the returns reported by Ibbotson, an investor in long-term Treasury bonds would have earned a nominal return of 2.35 percent over this 35-year period, while inflation averaged 4.90 percent per year. This gives a real return of -2.43 percent per year, which results in a cumulative real loss of 57.76 percent. Pretty bad, but not even close to the 91 percent reported.

We would also like to point out dangers in any article that chooses a specific period from a longer dataset. If the investor has stayed in the market for the period 1982-1991, the average real return on Treasuries was 12 percent per year for this period. So, over the entire 45-year period, the real return for Treasury bond investors was .78 percent per year.

Wednesday, October 23, 2013

Investing In Athletes

Fantex recently announced its first pro athlete IPO. The company will issue 1 million shares of tracking stock at $10 each, with the proceeds to be paid to Houston Texans running back Arian Foster. In return, Foster, or the "brand" as he is called in the prospectus, will give Fantex 20 percent of his future earnings. Right now, you likely believe that the stock price will depend on Foster's future earnings, and it will to a degree. But further reading unlocks a host of other risks. For example, the company may never pay dividends to stockholders, but instead reallocate the cash for company expenses. Or, the company can convert the Foster stock into shares of Fantex stock at the discretion of company management. If Fantex fails, investors in Foster stock are left with one percent (or less) of the bankrupt company. All in all, Arian Foster stock appears to be a very risky investment, which brings us to our main point: Many believe that SEC approval of a prospectus means that the SEC feels the security is a good investment. In reality, the SEC merely reads the propesctus to ensure that all required information and risks are disclosed in the prospectus. The SEC does not certify that the security is a good investment. It is up to the individual to determine if the investment is appropriate for their risk tolerance.

The JOBS Act Explained

The Jumpstart Our Business Startups (JOBS) Act has received press recently since Twitter filed its registration documents with the SEC under this Act. An important part of the JOBS Act, which will allow crowdfunding, is not in place yet, although the SEC is meeting today to propose crowdfunding rules. Since the JOBS Act is only a year and a half old, many are unclear of what the Act actually covers. CFO posted a JOBS Act tutorial that answers many questions about the Act.

Wednesday, October 16, 2013

Reasons For Holding Cash

John Maynard Keynes identified three theories as to why firms hold cash: the speculative motive, the precautionary motive, and the transaction motive. In 1980, firms had about 12 percent of total assets in cash. By 2011, this number had jumped to 22 percent. There are several factors that have lead to this increase. For example, low inflation has lowered the opportunity cost of cash. Additionally, much of the cash horde is held overseas. Bringing the cash back to the U.S. would result in large tax liabilities. However, recent evidence suggests that the previous experience of managers may be the key factor. CEOs who have experienced financial difficulties are likely to hold more cash than CEOs who have not experienced financial difficulties, a nod to the Keynes' precautionary motive.

Tuesday, October 15, 2013

Finance And Retirement Planning

We have had a number of students claim that they will never use anything they have learned in this class in the future. We hope you are not one of those students. If you are, we could tell you countless stories like a former student who is Director of Marketing at his company, but also responsible for capital budgeting decisions, but we won't do that. One thing we are sure you will use the knowledge you have gained is for retirement planning. A recent poll indicates that 82 percent of workers 50 and over say that it is at least somewhat likely that they will have to work in retirement. And while the recent market downturn affected some of these potential retirees, we would guess that most simply did not prepare early and often enough for retirement.

To help you prepare for your retirement (and it is never as far away as you would like to think), we would like to direct you to Professor Joshua Rauh's free MOOC at Stanford University. The course is the Finance of Retirement and Pensions, and although you do not get a grade, it may help better prepare you for your own retirement planning. Notice, you will get the most out of the course if you understand the value of diversified portfolios, interest rates, inflation, perpetuities, and annuities, which we hope you  already have learned.

Monday, October 14, 2013

The Market Is Efficient, Or It Isn't, Wins Nobel Prize

The Nobel Prize in Economic Sciences was awarded today to Eugene Fama, Robert Shiller and Lars Peter Hansen. By now you are aware of Eugene Fama, one of the earliest and most vocal proponents of stock market efficiency. Fama's research centered around testing for market efficiency and attacks on market efficiency. What is interesting about this year's Nobel Prize is that Robert Shiller is a proponent of behavioral finance, arguing that markets are often inefficient. He is known for predicting the housing bubble and has argued that while the stock market may exhibit random price fluctuations in the short term, it is predictable over three to five year periods. As is noted by Nobel Laureate Robert Solow, the award this year is a little like an award to both the Yankees and Red Sox.

Thursday, October 10, 2013

Economic Profit

McKinsey Quarterly recently published an article on the results of its study of economic profit for 3,000 large companies. If you prefer, a narrated slideshow discussing the results is also available. As a quick review, economic profit is also known as Economic Value Added (EVA) and is similar to an NPV calculation for the company as a whole. The results of the study show the disparities between the top and bottom performers from middle-of-the-pack companies. Surprisingly, bottom performers tend to have higher revenues than middling performers, have the highest tangible-capital ratio, but the lowest asset turnover. They are likely to be in a capital intensive industry such as airlines, electric utilities, and railroads. Top performers tend to have high margins and a low tangible-capital ratio.

Interestingly, top performers were likely to remain as such, in part due to more fresh capital. In other words, they stay on top because they get bigger and seem to invest in profitable projects. Of course, a company can improve its performance, but much of the improvement lies in the industry. In fact, companies that do improve (or experience a decline) in economic profit tend to be driven by industry performance. The results of the study indicate that as much as 54 percent of a company's economic profit is due to its industry. Interestingly though, top quintile companies rely the least on industry effects.

Monday, October 7, 2013

Trade-Credit Insurance

If you export goods to another country, one potential problem with credit is a swift devaluation of that country's currency. For example, in 1994, the Mexican peso fell from 4 pesos per dollar to 7.2 pesos per dollar in one week. The devaluation can make it difficult, if not impossible, for the importing company to pay its bills. To cover the risk there is trade-credit insurance. In fact, the recent decline in the Indian rupee is expected to generate a 10 percent increase in trade-credit insurance for imports to that country. With trade-credit insurance, if an importer has difficulty paying the counterparty, the trade-credit insurer will step in and pay the exporter. At the same time, the trade-credit insurer will make an agreement with the importer to pay the debt in installments, often over a three to five year period.

Sunday, October 6, 2013

A Hot IPO Market

As we mentioned in the textbook, the timing of IPOs appear to follow a "hot market" phenomenon, meaning that that are a larger number of IPOs when the market is doing well. In the first nine months of 2013, there have been 63 IPOs, a 110 percent increase from same period last year. At the beginning of October, there were 116 IPOs in the pipeline that are expected to raise a total of $37 billion. During the third quarter, 92 percent of the IPOs were filed under the JOBS Act, which permits a confidential initial filing for emerging growth companies. The third quarter also continued IPO underpricing, with global IPO underpricing averaging 24.4 percent.

Saturday, October 5, 2013

What Is A Name Worth?

For many companies, the brand name may be one of the most important assets. According to Interbrand, a leader in the valuation of brand names, the Apple brand is worth about $98 billion and Google's brand is worth about $93 billion. If you look at the methodology, you will see the financial analysis Interbrand uses for the valuation. The valuation method is economic profit, or economic value added (EVA), which was popularized by Stern-Stewart. Economic profit is the aftertax operating profit of the company minus a charge for the capital used. When discounting the projected aftertax operating profit, Interbrand references the industry WACC. You should note that the brand valuation is not just the name, but closer to the company value. Would you really buy the Apple name for $98 billion without the ability to sell iPhones, iPads, and iTunes? Probably not. One last question: Does the economic profit concept look familiar to you? We would hope so since it is basically an NPV analysis of the company as a whole, not just the NPV of an individual project.

Friday, October 4, 2013

Twitter And Efficient Markets

We like to think that the stock market is always efficient, but there are events that prove our belief wrong. Twitter's IPO will likely be hot, with huge investor demand. The company already announced that the stock would trade under the ticker TWTR, but it seems that many investors can't wait for the IPO. Today, the stock of Tweeter Home Entertainment Group (TWTRQ) exploded, rising by more than 1,500 percent before falling back to a gain of only about 670 percent. TWTRQ filed for Chapter 11 bankruptcy about 6 years ago, and although the stock is still listed on the OTC market, the company has very little upside. The explanation for the jump in price today is investor confusion about the ticker symbol. We hope that the twits trading TWTRQ didn't tweet to their friends about the great investment that they had just made.

Thursday, October 3, 2013


About three weeks ago, Twitter announced that it had filed for an IPO, although the filing was confidential at the time. Today, Twitter made its S-1 filing public, an indication that the company hopes to go public sooner rather than later. The disclosures reveal that the company's revenue for 2012 was $317 million, with a net loss of $79 million. There are 250 million active users on the service, with 100 million daily users. One million shares are expected to be sold in the IPO. With a valuation of $10 billion, the company will have a P/S ratio of about 31 and, of course, no reportable P/E.

A Bond Pricing Mistake

Everyone makes mistakes, even finance professionals. It was recently revealed that Goldman Sachs mispriced a Ford bond issue. Bond issuers usually price (set the coupon rate) by adding a risk premium to the YTM of a similar maturity Treasury bond. In this case, Goldman Sachs used a Treasury bond that was just issued the same week. This is called the "on-the-run" Treasury issue and will have a slightly different price, in part because it is the most actively traded Treasury near that maturity. As a result of using the on-the-run Treasury instead of the Treasury that was previously issued, it costs Ford $1.5 million in additional interest payments over the life of the bond. As a result, Goldman Sachs lowered its fee from the 35 basis points it charged on Ford's previous bond issue to 25 basis points, a savings in underwriting expenses of $1 million.

Wednesday, October 2, 2013

Cash Management And Transfer Pricing

Now that you know all about cash management, you are ready to pool the cash from the divisions of your company, even if they operate in different countries. One thing you must consider first is transfer pricing. Transfer pricing is the cost charged by one division of a company to another division of the company for goods or services. The transfer price is the price that would be charged by an outside, or arms length, entity. If the transfer is between divisions in the same country, the tax implications (other than state and/or local taxes) are minimal. However, if the divisions are in different countries, transfer pricing becomes important with regards to taxes. A recent article in Treasury & Risk  highlights some potential pitfalls in cash pooling for divisions in different countries. Cash management transfer pricing presents problems because cash pooling generally results in a higher interest rate earned on the combined deposits than the rate that would be received on on individual deposits. Similarly, any borrowing is generally less expensive. Additionally, there is the fact that the parent company should receive compensation for the time, effort, and expenses put into pooling the cash. As you will read, a number of factors affect transfer pricing when pooling cash from divisions in different tax jurisdictions.