Monday, November 25, 2013

Negative Interest Rate On Euro

Central banks are in a "race to the bottom", or an effort to lower the domestic currency to improve economic performance. The European Central Bank (ECB) may soon see exactly how low it can go by implementing negative interest rates. When a commercial bank makes a deposit with a central bank, the central bank pays the commercial bank interest on that deposit. The ECB is considering a negative interest rate on those deposits, which means the commercial bank would pay the ECB for all deposits. The result is that commercial banks will deposit fewer euros with the ECB and instead be forced to put those euros in circulation. This would likely lead to a euro devaluation.

Mangerial Idiosyncrasies And Corporate Capital Structure

Coming back for his second appearance, our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

Corporate capital structures generally show a remarkable degree of variation over time.  One under-appreciated source of variation is the unique personal views about appropriate financial policies held by the people running a firm.  There is scope for managers’ idiosyncratic preferences to have a significant influence on the debt-equity mix when taxes and financial distress costs have only a second-order impact on firm value over a reasonably wide range of leverage ratios. 

Coca-Cola’s dramatic shift in capital structure in the 1980s (detailed below) provides a useful illustration of how the idiosyncratic views of top management can radically reshape financial policy.  The Coca-Cola case also highlights how debt can serve as a transitory vehicle for funding investment opportunities.  For more on the latter view, see my previous post.

Coca-Cola’s “levering up” of the 1980s: The appointment of Roberto Goizueta as CEO in 1980 marked a sharp shift in Coca-Cola’s financial policies toward more aggressive use of debt, including a willingness to borrow to make acquisitions (e.g., to acquire Columbia Pictures in 1982).  The CEO’s letter to shareholders in the 1985 annual report spelled out the firm’s new financial principles: “In the financial arena, The Coca-Cola Company is pursuing a more aggressive policy.  We are using greater financial leverage whenever strategic investment opportunities are available.  We are reinvesting a larger portion of our earnings by increasing dividends at a lesser rate than earnings per share growth….And, we are continuing to repurchase our common shares when excess cash or debt capacity exceed near-term investment requirements.”  In a 1984 interview, the firm’s CFO stated “We can go up to $1 billion without hurting our triple-A rating, and we would not hesitate to do so if something unusual comes along….” and “we will not hesitate to be a double-A company.  I want to make that very clear.”  The firm did, in fact, lose its triple-A rating because of its more aggressive use of debt. 

The Coca-Cola case study is from “How Stable Are Corporate Capital Structures?” by Harry DeAngelo and Richard Roll, which is forthcoming in the Journal of Finance.  The case appears in the paper’s Internet Appendix, which also contains case studies of 23 other firms that, like Coca-Cola, were (i) in the Dow Jones Industrial Average at some point, and that were (ii) publicly held from before the Great Depression until at least 2000.

Friday, November 22, 2013

Exxon's Performance

While we don't often discuss an analyst's report, a recent report on Exxon caught our eye. One way to create a positive NPV project is to have economic moats. An economic moat can be a competitive advantage over others in the same industry, or barriers to entry. The article discusses several concepts that we think should interest you after what you have learned in this class so you can see how key concepts are applied in other areas of finance. For example, the article discusses Exxon's low cost of capital (Why would Exxon have a lower cost of capital than its competitors?), as well as economic rents. You can think of economic rents as a positive NPV. The article also discusses Exxon's lower F&D (finding and development) costs in relation to its peers, as well as a lower cost structure, which is the application of ratio analysis.

Wednesday, November 20, 2013

The Check Is Not In The Mail

According to the 2013 AFP Electronic Payments Survey, about seven percent more companies are using electronic payments for business-to-business (B2B) payments than were using electronic payments four years ago. Overall, about 50 percent of companies use electronic payments of some sort for B2B payments. Surprisingly, more companies with sales under $1 billion use electronic payments than companies with sales over $1 billion. The increase in the number of electronic payment users may not reduce overall float since the electronic payment may be made later than it would be with a check, but "The check is in the mail." may no longer be a viable excuse for late payments.

Tuesday, November 19, 2013

PS4 Synergies

As we mentioned, synergies are an important concept in capital budgeting. Take the PS4. Based on a tear down price evaluation, Sony makes about $18 per unit, not including logistical costs, marketing, and other expenses. So how does Sony plan to make a profit on the PS4? Through licensing fees to outside game makers and their own software sales. And while the $18 profit may seem small, Sony actually lost about $300 on each PS3 system it sold.

Lease Accounting Change In The Works

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have decided that leases should be reported on a company's balance sheet. The proposed new standard would require a company to report the present value of lease payments on the balance sheet as a long-term liability. Opponents argue that the change would increase debt-equity ratios and companies will scale back operations to reduce debt-equity ratios back to current levels. Another argument against the new rules is that the increased debt-equity ratio would mean that some companies will exceed the debt-equity ratio written into bond and loan covenants. From a financial perspective, the rule changes will have little or no impact as equity analysts have long treated lease payments as a form of debt. Of course, the change will also result in improved performance for these companies, at least to the untrained eye. Because the rule changes increase debt to balance the balance sheet, there will be a resulting drop in the book value of equity, thus increasing ROE.

Friday, November 15, 2013

A Useful Income Statement

We have heard that the job of an equity analyst is to take what an accountant has produced and fix the mistakes. And while we know that you have been taught basic accounting principles, we should make you aware that there are problems using financial statements when analyzing a company. For example, revenue can be a distorted number. The 25 largest U.S.-based non-financial companies prepare an alternate income statement that they use with investors. A major change is separating revenue into recurring and nonrecurring items. Recurring items are those that regularly occur in the company's business operations. For example, if we are looking at Home Depot, sales of home remodeling supplies are a recurring item. Nonrecurring items are those that are unique and unlikely to be repeated, such as the one-time sale of an asset or an insurance settlement. If we use sales that include nonrecurring items, it will likely give us an incorrect estimate of the company's future sales.


In the textbook, we use the term annuity to describe a periodic payment for a specified number of periods. In practice, annuities are often used as a retirement tool and are purchased from an insurance company. The insurance company will pay you periodic payments, either for a specified period, or until your death. If you want payments until your death, the insurance company calculates the number of payments based on your life expectancy. While you may outlive your life expectancy, the insurance company makes many such contracts and others annuitants will die before expected, reducing the risk to the insurance company. If you think annuities are rare, consider that Social Security payments are an inflation indexed annuity.

We are not giving you any advice on annuities because there are many different types and the purchase of an annuity may not work with your goals. With a deferred annuity, you make a deposit today, which  grows until the annuity payments begin. Payments on an immediate annuity begin immediately. There are fixed annuities that offer a guaranteed rate of return, while variable annuities allow investments in stocks or bonds. Additional options can include basing the payment on one life or multiple lives, guaranteeing the return of principal, and whether or not the payments increase at the inflation rate. The decision to buy an annuity can be complicated, but it becomes much easier if you understand time value of money concepts.

Monday, November 11, 2013

Capital Structure Dynamics And Transitory Debt

Our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

According to the tradeoff theory of capital structure, firms select an optimal leverage ratio by balancing the tax advantages of debt against the potential costs of financial distress.

For simplicity, consider a version of the tradeoff theory in which firms face a corporate tax rate of 35%.  Interest payments are tax deductible, but dividend payments are not. Suppose also that any debt-to-assets ratio over 0.45 is almost certain to result in costly financial distress while those less than or equal to 0.45 imply no chance of distress.  The latter knife-edge structure is, of course, unrealistic. But let’s stick with the assumption in order to illustrate an economically important feature of corporate capital structure decisions that is omitted from the traditional tradeoff arguments about optimal capital structure.

What is the optimal capital structure for our hypothetical firm? According to the traditional tradeoff logic, the optimal leverage ratio is 0.45. The firm gets maximum tax benefits by levering up to 0.45, and it runs no risk of incurring financial distress costs. So, by the usual tradeoff logic, the optimal strategy is to fully exhaust debt capacity (take leverage up 0.45) to capture the tax benefits of debt.

That logic is fine in a simple static setting in which a firm is only concerned with balancing tax benefits and distress costs while holding investment policy fixed.

But things change fundamentally when we look at the problem dynamically and recognize that debt policy is about more than finding the right mix of interest and dividend payouts. Importantly, firms issue debt because it is a low (transaction and asymmetric information) cost vehicle for raising funds for investment.

It is no longer attractive for the firm to lever all the way up to 0.45. Why not? The reason is that the firm would like to have unused borrowing capacity that it can tap in the future if a really attractive investment opportunity arrives.  The rational policy is to keep some “dry powder” – untapped debt capacity – available. The one exception would be if the firm currently had an outstanding investment opportunity and probable future investment opportunities that are much less attractive. In that case, it would be rational to exhaust debt capacity today instead of saving “dry powder” for future use.

What should a firm with untapped debt capacity do when an attractive investment opportunity arrives and it doesn’t have sufficient resources to fund it? In most cases, the right response is to borrow to fund that investment and then use future earnings to pay down debt and restore the option to borrow to meet future funding needs.

The firm’s ideal “target” leverage ratio is less than 0.45 once one takes into account the value of the option to borrow to meet future funding needs.

Traditional tradeoff theories view corporate capital structures as having only “permanent” debt and equity components. The dynamic theory that we have sketched here recognizes that capital structures also have a “transitory” debt component that involves the exercise of the option to borrow and then the restoration of that option by subsequently paying down debt.

You can think of this view of capital structure as the corporate analog of the manner in which a rational individual will manage his or her credit card: Use the borrowing capacity to meet unanticipated funding needs and then repay the debt to free up debt capacity for future use.

The logic here is based on “Capital Structure Dynamics and Transitory Debt” by Harry DeAngelo, Linda DeAngelo, and Toni Whited in the Journal of Financial Economics (2011, pp. 235-261).

Thursday, November 7, 2013

Adding In An Excel Ad

A recent advertisement for Microsoft's Surface tablet highlighting Excel shows how a spreadsheet can be incorrectly constructed. In this case, the marketing company either didn't know how to use Excel, or at least didn't know how to use Excel very well. Excel is a great tool for financial calculations. While the mistakes in this ad are humorous, other Excel mistakes could end up costing you and/or your company money, so take care when you construct spreadsheets.


Twitter jumped about 93 percent from its IPO price shortly after the market opening, although the company's first-day return will likely end up somewhat lower than that based on the closing price. Of course, this IPO pop is nothing like the 1999 experience, with 25 IPOs up by more than 225 percent on the first day. Of course, we hope for Twitter investors that their long-term results are better than the performance of many of these companies. For example, an internet search for Value Software Corp., which experienced the biggest 1-day return of 697.50 percent, returned no results. And Foundry Networks, which had a first-day valuation of about $9 billion, was acquired in 2008 by Brocade Communications for $2.6 billion.

Wednesday, November 6, 2013

Toyota Soars On Weakened Yen

Toyota's profit jumped by 70 percent last quarter, with about 73 percent of the increase due to the weakened yen. A number of Japanese companies, including Nissan, Sony, and Canon, have reported disappointing results recently. Toyota's performance was buoyed by the fact that the company still produces more than 50 percent of its cars in Japan while other Japanese companies have moved production offshore. The yen has lost about 12 percent this year, so Toyota's future currency gains are likely to be muted barring continued weakening in the yen.