Annuities

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.

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).

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.

#IPOpop

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.

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.

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.

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.