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Cost of Equity As discussed earlier in this chapter, investors have many choices to invest their funds, and a rational investor expects to receive a higher rate of return when an investment is riskier than alternatives. In estimating Acme‟s cost of equity capital, Victoria uses the modified capital asset pricing model (CAPM), which is defined as: Cost of Equity = Risk-Free Rate + (Equity Risk Premium × Beta) + Premium for Size Risk + Premium for Risks Unique to Firm Investments in private firms are widely considered to be long-term rather than short-term investments. Accordingly, the risk-free rate, the first part of the modified CAPM, is based on the 20- year U.S. Treasury bond yield. U.S. Treasuries are considered risk-free investments because they have virtually no default risk. Victoria finds the yield on the 20-year Treasury bonds is 6.4%, which is a proxy for the risk-free rate in the modified CAPM. Exhibit 16.7 Acme Manufacturing, Inc.: Forecasted balance sheets, 2009-2013.
Victoria explains that the second part of the modified CAPM is the equity risk premium . This is the extra return investors require above a risk-free rate to invest in risky stocks. A common benchmark for the equity risk premium is the returns of the S&P 500 stock index. Several researchers and commercial data providers have analyzed historical equity risk premiums. For instance, Morningstar‟s Ibbotson Associates performs annual empirical studies of the historical equity risk premium going back to 1926. Since investors in private firms have long investment horizons, business valuation theory uses an equity risk premium with a long-term perspective. Based on her research, Victoria believes a reasonable estimate of Acme‟s equity risk premium is 8.1% above the risk-free rate. The modified CAPM uses the sensitivity of a firm‟s stock price to swings in the broader market. Beta is a measure of the relationship between the returns on an individual stock to returns of the overall market. A proxy for the market is often a stock index such as the S&P 500 index. Moreover, the prices of some stocks tend to rise and fall faster than the overall market. When a stock‟s beta is greater than 1.0, its returns tend to be more volatile than those of the market. Alternatively, a stock with a beta below 1.0 tends to be less volatile than overall market returns. In summary, beta measures a stock‟s volatility relative to the overall market. If a stock has a beta greater than 1.0, its returns are more volatile and, therefore, it is riskier than the overall market. If beta is less than 1.0, its returns are less volatile, and it is less risky than the market. One can obtain beta measurements of public stocks from free Web sites like Yahoo! Finance or MSN Money and from proprietary financial sources like Bloomberg. But how does one get the beta of a private firm to apply the modified CAPM? One way is to use the average beta of public firms that are in the same industry as a proxy. Victoria‟s analysis finds that the average beta of public firms in Acme‟s industry is 0.99. She believes this average is a reasonable proxy for Acme‟s beta for use in the modified CAPM.
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Table of Contents Title Page Copyri
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Chapter 6 - Planning Capital Expend
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For Further Reading Part IV - Manag
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Successful Postmerger Implementatio
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This book is printed on acid-free p
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Syllabus How Chapter Topics in This
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Some of these experts are full-time
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About the Contributors Richard T. B
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Advances in Quantitative Analysis o
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enterprise development. Dr. Zachara
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The left side shows Nutrimin‟s in
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Gail, let‟s go over this balance
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Gail, do you have any questions abo
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11. Not all expenses are cash outfl
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Financial Statements: Who Uses Them
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profitability to keep investing for
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Financial Accounting Standards It i
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Downloadable Resources for this cha
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Next, we explain each of these thre
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liquidity. Or, more simply, achievi
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If these ratios are seriously defic
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The debt-to-equity ratio is evaluat
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year 1 to year 3. The net effect wa
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to rate of return on the equity. Th
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Other types of comparisons of finan
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income/sales), asset turnover (sale
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successful businesspeople should ha
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More than a decade ago, a special c
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companies is used for illustration.
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The identification of nonrecurring
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The Dow Chemical single-step income
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is a pretax measure, but income fro
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Sources: Companies‟ annual report
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Exhibit 3.11 Examples of discontinu
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amortization purposes, the Company
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Examples of nonrecurring items disc
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During Fiscal 2006, inventory quant
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The nonrecurring items of Boston Sc
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The disclosure presented earlier in
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gains or losses that appear as part
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ecurring as for Kimberly-Clark, the
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Summarizing Nonrecurring Items and
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This example of using the SEB works
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Exhibit 3.27 Other income (expense)
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Source: Pfizer, Inc., annual report
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Exhibit 3.30 Acquisitions note: Pfi
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Source: Pfizer, Inc., annual report
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Exhibit 3.33 Cost-reduction initiat
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Exhibit 3.36 Share-based payment no
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The Pfizer Worksheet Analysis: Down
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Some Further Points on the Pfizer W
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• It is common to treat items as
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FedEx Corporation (2007) First Sola
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1 The American Institute of Certifi
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28 These alternative translation me
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If you need some instruction in Exc
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To solve using Excel, open your Exc
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As you can see from the previous ex
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C6 = 5 • Now enter the “=” si
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Ordinary Annuity An ordinary annuit
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To confirm that the number of payme
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The FV of this first payment into t
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Exhibit 4.15 Finding the future val
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Exhibit 4.18 Finding the present va
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From Exhibit 4.20, we see that as t
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Exhibit 4.22 Amortization schedule
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Exhibit 4.25 Regular cash flows wit
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Internet Links For Further Reading
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Investors who are risk averse will
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considering the risk of a single as
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Portfolio Risk Stand-alone risk is
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In spite of unique or diversifiable
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If a particular stock is highly sus
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The formula tells us that, to begin
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for the entire market of stocks sin
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The dividend per share for preferre
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If you are able to determine the cu
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Debt finance is the lower-cost meth
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We don‟t observe many firms whose
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Capital Structure in Practice Finan
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are able to observe regularities in
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dividends and capital gains. We wil
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where EBIT is earnings before inter
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Since long-term debt holders have a
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accept more investment projects. Re
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A beer company is considering build
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accounts receivable, and tabulates
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profit by the tax rate determines t
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Accounting profit often mixes varia
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The concept that future cash flows
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Like project A, project C also cost
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The after-tax interest rate is the
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equal mix of debt and equity, its d
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The payback period rule stipulates
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The IRR rule is appealing in that i
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complete with its real options is g
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What does it matter that one invest
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Exhibit 7.3 Time line in dollars an
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There are a number of countries in
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eturn of 10% on its investments in
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Exhibit 7.12 Summary of exchange ra
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and so will the value of the liabil
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Source: CIA, World Factbook, availa
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Exhibit 7.18 Net present value of c
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equired interest payments to be pai
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So if the assistant treasurer was r
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This theory is far from perfect, as
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The Consulting Firm Jennifer, Jean,
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part by a statute, the Uniform Limi
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formation in Delaware (or any state
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purpose of requiring qualification.
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Phil‟s death may terminate the bu
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the transfer. This means that if Br
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These rules extend to tort liabilit
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In the absence of a meeting, stockh
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A more detailed discussion on the b
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Partnerships If possible, the resul
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associated with this arrangement ar
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Partnerships are also not separate
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For most start-up businesses, howev
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form, even at the risk of some unli
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likely that our consultants will be
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Thus, the corporation and LLC, with
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It is not possible to fully describ
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usiness corporation for all purpose
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a cash-basis taxpayer to be taxed a
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The Tax Reform Act of 1986 substant
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limit is the product of the value o
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he would have spent anyway. In fact
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protect Brad from the scenario of h
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paying for the privilege. If the st
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The second tax scenario attaches to
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include that nullity in his taxable
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then the capital gain to be taxed h
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Most relevant to Morris is Section
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To begin with, the ESOP will have t
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general partner of a limited partne
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small businesses) is also subject t
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oth Lisa and Brad would be free to
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Assume that a limited liability com
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corporations, and had been audited
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There is plenty of blame from the c
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• An important study about top ma
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• The federal government made at
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$79.7 million for other services, a
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Budgets offer a variety of benefits
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determine the impact of specific pr
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Exhibit 11.2 Budget variance report
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udget, we just add more to it next
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income statement. The financial bud
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For a manufacturing company, cost o
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C&G‟s Gift Shop has a policy to m
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Meeting cash obligations as they co
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was unusually low, say, due to the
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A fixed budget, sometimes called a
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A large part of the budget selling
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• Centralized resource allocation
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Merewitz, Leonard, and Stephen H. S
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This chapter starts with a discussi
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Interestingly the numbers for quart
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Exhibit 12.4 Scenarion analysis.
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Pitfalls Although this analytic tec
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Exhibit 12.6 Variable cost element
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Variable Cost as a Function of Outp
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If scenario 2 yields a lower profit
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Microsoft certainly does not price
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If it is determined that dumping ha
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Leaving government agencies and not
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transaction processing. Each proces
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Exhibit 13.3 E-commerce transaction
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To summarize the analysis, the busi
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Capacity costs are probably the mos
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which it was, but for the inventory
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They called this strategic cost man
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A closer study, however, revealed s
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the benefits of business planning.
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The last type of plan is called a d
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The Business Plan We will progress
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Hook the Reader That means having t
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Industry The goal of this section i
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upscale suburban client who wants p
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Company and Product Description Com
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Exhibit 14.8 shows the competitive
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Exhibit 14.9a Advertising schedule.
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Scope of Operations What is the pro
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Development Time Line A development
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By law, most organization types req
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As mentioned in the development pla
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that can be depreciated, you should
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1 Special thanks to Matt Feczko, Mi
Page 405 and 406: For better or worse, the business e
Page 407 and 408: Leeson bet and lost. Japanese stock
Page 409 and 410: Between February and April 1994, Da
Page 411 and 412: LTCM could be picky when it came to
Page 413 and 414: An investor who wished to invest in
Page 415 and 416: Similarly, the swaps market has rev
Page 417 and 418: speculator would suffer losses equa
Page 419 and 420: American manufacturer will suffer l
Page 421 and 422: The ease with which futures facilit
Page 423 and 424: Exhibit 15.1 Call option payoff dia
Page 425 and 426: Exhibit 15.2 Payoff diagram for a w
Page 427 and 428: Notice that the put option payoff r
Page 429 and 430: Bank, owns a large block of NASDAQ
Page 431 and 432: can be tailored so that the money r
Page 433 and 434: Finally, the last step is to choose
Page 435: 3 Fischer Black, who co-invented th
Page 439 and 440: not include assets that the firm ha
Page 441 and 442: Thus, a business valuation will usu
Page 443 and 444: Negative • Acme is highly depende
Page 445 and 446: Exhibit 16.3 Acme Manufacturing, In
Page 447 and 448: Profitability ratios reflect the re
Page 449 and 450: When we talk about the value of a b
Page 451 and 452: This example illustrates that with
Page 453 and 454: Income Approach: Discounted Cash Fl
Page 455: Exhibit 16.5 Acme Manufacturing, In
Page 459 and 460: Victoria analyzes Acme‟s audited
Page 461 and 462: In summary, the discounted cash flo
Page 463 and 464: Adjustment for Illiquidity As previ
Page 465 and 466: 51% position sells for a higher pri
Page 467 and 468: examples. The proper application of
Page 471 and 472: The subject of this chapter is grow
Page 473 and 474: Finally, an acquisition can be effe
Page 475 and 476: M&A activity has been the focus of
Page 477 and 478: companies continue to make the same
Page 479 and 480: equals was taking on a distinctive
Page 481 and 482: Anatomy of a Successful Acquirer: T
Page 483 and 484: employees kept their original jobs
Page 485 and 486: where ΔCF t is the incremental cas
Page 487 and 488: where it‟s ultimately buried. Suc
Page 489 and 490: The following example summarizes th
Page 491 and 492: make sure that you are at least awa
Page 493 and 494: acquisition, there is no immediate
Page 495 and 496: its vascular business, which was so
Page 497 and 498: While all employees should be part
Page 499 and 500: makes strategic and financial sense
Page 501 and 502: Bhagat, Sanjai, Ming Dong, David Hi
Page 505 and 506: The 2008 financial crisis underscor
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Source: Plunkett’s Outsourcing &
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To summarize: Trends • Large numb
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Companies are becoming increasingly
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What steps should a company follow
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• Results of meetings with vendor
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• Breach of contract and remedies
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Assuming the project or service rev
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The answer is: profits. The company
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19 Information Technology and You D
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People‟s lives have been turned u
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its self-contained rechargeable bat
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Random-Access Memory (RAM) Random-a
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On laptop computers and PDAs, the s
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Operating System An operating syste
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the spreadsheet software together w
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Exhibit 19.5 Pro forma sales and in
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Database Software A database is a c
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Internet e-mail addresses often con
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Personal Finance Software There are
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There are several different approac
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One of the major attractions of the
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While not a new version of the Web
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industrial revolution, and has occu
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Dummies Inc. has a series of books
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organization. This chapter is desig
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As technology has evolved, the term
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While the software mentioned earlie
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Most of the focus of the investor c
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Data Access and OLAP Before the lat
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Exhibit 20.5 illustrates a differen
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Productivity Tools Workers expect t
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Client-server technology is based o
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Today, most programmers write in C+
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Exhibit 20.6 is a model of a typica
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No treatment of relational database
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Online analytical processing (OLAP)
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server) and the rest on the users
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the other operational departments w
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The world of business has changed d
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Chaffey, Dave, E-Commerce and E-Com
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According to the results of the sur
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understand the financial situation
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MBA graduates who are hoping to ent
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Summary Financial services opportun
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Let‟s begin with the “I left it
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MBA student: “Well, I go to [Grea
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Aiming for Your Goals For career ch
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Networking is generally regarded as
Page 611 and 612:
Let‟s begin with some key assumpt
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like, or moving ahead in the compan
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Accrual accounting: An accounting m
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Cash flow: Cash that is spent or re
Page 622 and 623:
Distribution channel: A chain of in
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Goodwill: As it relates to valuatio
Page 626 and 627:
Management’s discussion and analy
Page 628 and 629:
Ordinary annuity: An annuity that p
Page 630 and 631:
Securities and Exchange Commission
Page 632 and 633:
Vertical merger: A merger in which
Page 634 and 635:
about activity-based costing progre
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Application systems ARPAnet Arthur
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Bell Labs Benefit measurement Beta
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goal orientation legal and contract
Page 642 and 643:
segment information note share-base
Page 644 and 645:
process of purpose of real world us
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uy/build decision capital budget in
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written resume Careers in corporate
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Cell Center for Research in Securit
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Compensation and ownership Competit
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Corporate culture Corporate debt in
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profit planning from an internal pe
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Data Data access and OLAP Database
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Askin Capital Management Barings Ba
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market approach publicly traded gui
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Electronic data interchange (EDI) E
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Extensible markup language (XML) Ex
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short term liquidity users and uses
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Fourth generation programming (4GL)
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Going private Going private transac
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Hypertext links Hypertext markup la
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Information technology and the firm
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International Accounting Standards
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Last-in-first out (LIFO) vs. curren
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Long call option payoff Longer-term
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Market risks Market size and struct
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Motivation to outsource Multiple IR
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Nonrecurring items defined disclosu
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Operational complexity Operational
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Outsourcing metrics Overhead Over-t
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Personal end game Personal expense
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Price competition Price decreases P
Page 698 and 699:
Projected cash flow statements Proj
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Relevant range Relevant range assum
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Risk sharing Risk transfer Risk vs.
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Short call option payoff Short part
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Spot price Spreadsheet software Spr
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Summarizing nonrecurring items and
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acquisition the business dividends
Page 712 and 713:
Timmon‟s Model of Opportunity Rec
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U.S. immigration quotas U.S. Intern
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discounting with discount rate form
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