Pushing Back the Boundaries

1. Introduction
§ Debt markets → the most important developments have been continued deregulation and regulatory harmonization
§ Eurobond, Euro-medium ten note (EMTN) and Euro-commercial paper (ECP) markets
§ Access to the Eurobond market → be made less cumbersome by the rapidly growing acceptance of EMTNs by investors who traditionally purchased Eurobonds
§ Access to the Euromarkets → has always been determined less by overt regulation than by unofficial or investor-driven market practice
§ Current economic climate → regulatory developments which have facilitated access to the securities markets have been partially offset by investors' concerns over credit risk
§ Ratings have become increasingly important → unrated entities will find it more difficult than before to borrow via a Eurobond offering
§ Financial covenants for corporate issuers → more restrictive → as investors try to protect themselves against downgrading and defaults
§ Domestic markets have also continued to benefit from deregulation and regulatory harmonization:
i. Standards of prospectus and listing requirements converge → issuers find it less expensive and time consuming to issue outside their home market
ii. Deregulation often permits the issuance of a more sophisticated range of instruments than was previously allowed
iii. The distinction between international and domestic securities markets has become increasingly blurred → it has become correspondingly easier for issuers to find an appropriate investor base for their securities
§ The international equity markets → have traditionally been far smaller in issuance volume terms than their debt counterpart → because of regulatory differences and equities tend to be denominated in the currency of the issuer and settled in its home market

2. Europe
§ The international bond market has traditionally had its headquarters in London
§ Eurobond market → can be accessed by institutions ranging from small, unrated corporations to large supranational institutions
§ The liberalization → has increased the pressure on other regulatory authorities to bring their regulations into line
i. The strongest candidates for change are the French, Dutch and Swiss markets
§ Banking industry is pressing for the securities industry to be forced to comply with bank-style capital adequacy requirements
i. Large corporations and state and sovereign entities might find it more difficult to access the markets
§ Continental European equity markets still differ considerably in structure, liquidity and regulation
§ Supply of equity is increasing → as family-run businesses are sold off by a generation that does not wish to continue running these businesses
§ The European investor base is becoming more institutionalized
§ Admission Directive → coordinates the conditions for the admission of securities to official stock exchange listing → by setting minimum requirements which have to be met by any company seeking a listing
§ European Commission (EC) Directives → should mean greater efficiency and transparency in the markets for public securities → both debt and equity

3. United States
§ The US authorities still operate a separate environment
§ All public offerings of securities in the US → must be registered under the Securities Act of 1933
§ The appeal of the US public markets for foreign issuers → has traditionally been limited to larger borrowers with the time
§ By limiting the extraterritorial impact of the existing regulations and extending the exemption for private placements → the Securities and Exchange Commission (SEC) has made it easier and cheaper for foreign borrowers to access the US debt and equity markets

4. Emerging Markets
§ One of the most significant trends → has been the increase in companies and financial institutions from emerging markets seeking to raise capital outside their home markets
§ The size of predicted capital flows from these countries → has serious implications for the international securities markets
§ The economic and political background of the companies whose shares are being offered → involve particular challenges when the shares are being offered internationally

5. New Products
§ Most encouraging for potential issuers of securities → is the increased range of instruments and currencies available
§ Development in derivatives as well as a proliferation of hybrid debt / equity instruments → have allowed issuers far greater flexibility in choosing securities
§ These new instruments → require a far greater understanding of the legal and accounting environments of:
i. the jurisdiction from which the securities are issued
ii. Of those into which they may be sold
§ Some of the most powerful instruments and structures → have developed simply as a response to the increased internationalization of world securities markets
§ Global offerings → allow issuers to gain access to a more diverse investor base than was available to them previously → enabling them to lower their cost of funds and to increase name recognition
§ Debt markets → global bond issues are becoming an increasingly popular tool for certain of the larger borrowers
§ Development of the Global Depository Receipt (GDR) → another indication of the increasing internationalization of the international securities markets
§ GDR → a capital raising structure that provides issuers with a means to tap international capital markets through the simultaneous issuance of a single, fungible security in the US and other markets
§ The GDR → is offered simultaneously in several jurisdictions
§ GDRs → have facilitated offerings of securities from Korea, Malaysia, the Philippines, India, China, Taiwan, Thailand and Singapore → without obliging investors to operate within the confines of the local trading and settlement systems
§ The general trend is clear and it is a positive one for issuers of debt and equity securities
§ By giving issuers access to a greater diversity of markets and so a greater number of potential investors → these trends should also lower borrowers' costs of borrowing

Foreign Ownership and Investment: Evidence from Korea

1. Introduction
§ Korean equity market → opened to foreign investors in January 1992
§ Maximum foreign investment limits → eliminated in May 1998
§ Effects of increase in foreign ownership → attract many attentions
§ Researches found → firm’s investment depends on the availability of internal funds
§ The importance of financial factors → is attributed to higher costs of external finance arising from information asymmetry and agency costs in an imperfect capital market
§ This study → focuses on the level of foreign ownership as a segmenting criterion
§ If financial intermediaries consider that foreigners favour firms with low information asymmetry → firms with high foreign ownership are able to raise external funds at low cost
§ If foreign investors have better monitoring skills than domestic investors in developing countries → foreign firms have less managerial agency problems
§ Test whether firms owned by foreigners face less credit constraint than domestically owned firms → main empirical findings:
i. Cash flow sensitivity of investment ↓ as foreign ownership ↑
ii. After 1998 → effect on foreign ownership on financial constraints became stronger

2. Relevant Literature and Hypothesis Formulation
§ Modigliani and Miller → Firms investment depend on the profit opportunity
§ Empirical literature → found that firms’ investment decision depend on financial factors → availability of internal funds
§ Why investment is sensitive to internal funds in imperfect financial markets → two streams:
i. Focus on lemon premium → firms must pay on external finance → firms tend to rely internal funds to carry out performance
ii. Studies attribute the importance of internal funds to managerial agency problems
§ Managers → not the owners → may pursue their own interest → not the stakeholders’ interest
§ Managers tend to spend all available funds on investment projects at their own discretion
§ Both stream of literature predict → the availability of internal funds does affect investment
§ Investment of more financially constrained firms respond more sensitively to changes in cash flow
§ Concentrated ownership → leads to less liquidity-constraint
§ Managers’ ownership stakes in their firms increase → investment-cash flow sensitivity increase
§ Cash flow sensitivity decrease → after a certain level of insider holding
§ Most developing countries →have recently experienced an increase in the equity share of foreigners
§ FDI → eases credit constraints by bringing in capital
§ Ivory Coast → foreign firms were less credit-constrained than domestic firms
i. FDI → reduces firm-level financing constraints
§ Present study → examine whether financial constraints are mitigated as a result of a favorable financing position in market
§ Foreign investors prefer → equity shares in firms with low information asymmetry to those with higher information asymmetry
§ Japanese market → Foreigners prefer large firms, firms with good performance, low risk, and low leverage
§ Swedish firms → foreigners prefer large firms, firms paying low dividends, and firms with large cash position
§ Czech firms → foreign investors seek safe and profitable firms where they can exert influence on corporate governance
§ Financial constraints model and managerial discretion model → one expect cash floe sensitivity of investment to be lower in foreign owned firms than in domestically owned firms

3. Model and Method
§ Model
i. q is the only determinant of investment and no other financial variable should matter
ii. A test for existence of financing constraints amounts to a test for null hypothesis
iii. Test → whether cash flow sensitivity of investment differs across foreign ownership structure
iv. Test → whether the complete opening of the Korean equity market has effected the degree of financial constraints
v. q model has many limitation → difficult to measure q → because average q is equal to marginal q under strict condition
vi. Forbes → derived an Euler equation
a. From the model of maximization of the firm value → under the assumption that dividend must be non-negative
b. Implying that external financing is costly due to information asymmetry
§ Method
i. OLS for dynamic investment models → result in biased estimates → because of endogeneity and heterogeneity problems
ii. Sales and cash flow depends on technological shock
iii. The presence of lagged investment-to-capital ratio as an explanatory variable → bias the coefficient estimates from the OLS
iv. The generalized method of moments (GMM) estimation → widely used for dynamic panel model → depends:
a. On the adoption of appropriate instruments
b. On the efficient elimination of unobserved firm effect
v. Arellano and Bond → two specification tests:
a. A Sargan test for over identifying restriction → used to test for the validity of instruments
b. A test of serial correlation of errors terms → used to detect the presence of unobserved individual effect
§ Data and definition of variables
i. A firm-level panel data set → constructed from the Korea Investors Service-Financial Analysis System
ii. Data set → consist of 5084 observations of 371 firms used → period 1992-2002
iii. High foreign ownership → based on two criteria:
a. More than 5.88% foreign ownership
b. More than upper quartile foreign ownership
iv. The dummy variable High → has a value of one for firms with high foreign ownership and zero

4. Empirical Result
§ Sargan test result for over-identifying restrictions → indicate that the instruments used are valid
§ q-model and Euler equation → suggest that:
i. The availability of internal funds does effect investment levels
ii. Persistence is found in a firm’s investment from significant estimates in the lagged investment-to-capital ratio
§ q-model and Euler equation → the cash flow sensitivity for firms with high foreign ownership is statistically insignificant
i. It suggest → financial constraints faced by firm decrease as foreign ownership increases
§ Managers of a firm with high foreign ownership → less likely to use cash flow at their discretion due to improving corporate governance system
§ In the Korean Stock Market → found that estimates in cash flow are lower after 1998
§ It is conjectured → the opening of the stock market is surely one of the factors in the mitigation of financial constraints
§ Found → liquidity constraints are reduced in firms with low foreign ownership
§ Cash-flow sensitivity in firms with high foreign ownership → statistically insignificant regardless of time period
§ Liquidity constraints → not statistically significant in firms with high foreign ownership
§ With non-linear relationship between foreign ownership structure and the value of the firm → foreign ownership seems to have a linear relationship to financial constraints

How Corrupt is Wall Street?

§ Kanjinal → a Queens pediatrician → claimed he lost $500,000 investing in INSP
§ The Securities and Exchange Commission → launched a probe into practices at 10 firms → while the Justice Dept. is pondering an enquiry or its own
§ The widening scandal → plunged Wall Street into crisis
o Because many more individuals lost money in the recent market collapse
§ Relationship between analyst and their investment banking colleagues → grow
o Because it comes on the heels of several other scandals → raise big questions about how Wall Street operates
§ Enron Corp.’s collapse
o Many firms may have made a bundle investing in the partnership
o Those same firms advised clients to hold Enron stock virtually → until it went bankrupt
o Makes Wall Street seem rigged for the benefit of insiders as never before
§ Entire economy depends on the financial system → to raise and allocate capital
o Financial system → is built on the integrity on its information
§ Investors hesitate to put money into stocks
o It could easily put a damper on the economy → if companies are less willing or less able to raise capital on Wall Street
§ Wall Street → was always struggled with conflict of interest
§ An investment bank → is a business built on the conflict of interest → the same institution serve two masters:
o The companies → sells stocks, issued bonds, or executes mergers → want high price and low interest rates on their bonds
o The investors → it advised → low price and high interest rates
§ The bank gets fee from both → trades stocks and bonds on its own behalf
§ Mega banks → are allowed to do everything from trading stocks to lending money and managing pension funds
§ Chinese walls → were supposed to keep the bankers honest and free from corruption
§ The final blow → was the tide of money that flooded over Wall Street during the great tech bubble
§ The bubble burst in the spring 2000 → wiping out more than $4 trillion in investor wealth
§ The fact → bubble market allowed the creation of bubble companies, entities designed more with an eye to making money off investors
§ A feeding frenzy set in as rivals fought to grab a big share of the market to bring companies public
§ Investors took everything at face value → understandable
§ Analyst disparage stocks as “crap” and “junk”
o They threaten to thrust Wall Street into the sort of public relations nightmare
o All the ingredients are present:
· Publicity-hungry attorneys general, packs of plaintiffs’ lawyers, and potential congressional hearings
§ More explosive documents may be on the way
§ Spitzer and the SEC → seek the analyst’ recommendation and their potential conflicts of interest
§ Analyst were being paid to help the firms’ banking clients
§ If the analyst covering other industries at the firm harbored similar doubts about the companies they hawked → the number of claimants will expand exponentially
§ If the prosecutors conclude that firms are guilty of systemic fraud → research directors and other high-ranking execs could be vulnerable
§ New rules forcing analyst to limit and disclose contracts with investment banker colleagues
§ Analyst who work at investment banks often work against investors
§ Analysts are under pressure from the companies they cover → as well as from big institutional clients who may own the stock → to give positive ratings
§ Analysts also need to shine in surveys → in which money managers vote for their favorite stock pickers → they spend too much time lobbying clients rather that crunching numbers
§ The biggest factor contaminating the system is COMPENSATION
§ Analyst’ pay → tied to how much investment banking business they bring in
§ Experts say → a lot of the corruption oozing from Wall Street has to do with an erosion in investment banking ethics and practices
§ Slashed commission → meant the firms were forced to derive more revenues from investment banking business
§ Investment bankers generated mega profits from secretly investing in Enron’s hidden partnership
§ Wall Street itself → used to have much more of an interest initial public offerings is way of its 200 high
§ It’s unlikely that Wall Street → can sustain its profitability
§ Firms has already taken some steps → such as eliminating direct reporting by analyst to investment bankers
§ Focusing on increased disclosure will do little to end the abuse
§ The Street should take great pains to monitor itself in an effort to restore investors’ confidence

Dividend policy and firm performance: Hotel REITs vs. Non-REIT hotel companies

1. Introduction
§ Mid-1990s → Real Estate Investment Trusts (REITs) à experienced rapid growth fueled by readily available external equity and debt financing
§ The authors → Economies of scale are the driving force behind recent mergers and acquisitions in the industry
§ REITs → over invest → must distribute 95% of their taxable income to shareholders in order to maintain their preferential tax status
i. Reits → less likely to suffer from agency problems associated with free cash flow
§ REITs have less internally generated equity financing and are more likely to seek external financing for acquisitions
§ Nobel and Tarhan (1998) → demonstrate improved operating performance for over-investing firms making larger distribution of cash to stockholders

2. Data and Methodology
§ Sample:
i. Sixteen hotel REITs and fifty-one non-REIT corporations from 1993 to 1999
ii. Examine whether differences in internally generated equity financing can explain differences in performance
§ The control group → consists of firms identified from COMPUSTAT as non-REIT corporations → whose primary business involves investment in hotels and motels
§ More than thirty variables of both types of companies have been collected
§ Examine the free cash flow hypothesis → create two sets of variables to capture the free cash flow for a company:
i. FCF1 → measures the total amount of post-tax free cash flow that is discretionary for mangers before they determine the amount of either interest or dividend payments
ii. FCF2 = EBITDA - TAX - INTEXP – TOTDIV
a. TOTDIV is the total dollar of dividends declared on common and preferred stock
iii. This definition → based on the assumption → depreciation and amortization expenses are at managers' discretions in both types of companies

3. Empirical Results
§ Structural differences
i. T-tests → conducted on collected variables → to examine the differences between the two types of firms
ii. Non-REIT hotel firms are about the same size as the hotel REITs
iii. Non-REIT companies produce higher income adjusted by firm size than REITs
iv. On annual returns of common stock (Stock Return) → non-REIT companies:
a. Perform marginally better than REITs
b. Riskier investments measured by Beta although the t-Statistic is insignificant
v. Return on assets (ROA) → REITs have significantly higher means than the non-REIT companies
vi. Mean of the market-to-book ratio → statistically higher for non-REITs than for REITs
vii. Non-REIT companies are more highly leveraged
a. Non-REIT companies have higher means than REITs on total liability, total debt and total interest expenses
viii. Non-REIT companies → higher means than REITs in total capital expenditure and total acquisition
ix. Non-REIT companies → higher depreciation and amortization expenses → which is typically considered an additional source of free cash flow
x. The means of dividend per share, common dividends and total dividends → higher for REITs than for non-REITs → maintaining high dividend payouts

§ The impact of free cash flow
i. Examine:
a. The relationship between a firm's market-to-book ratio and free cash flow controlling for whether the firm is a REIT
b. A firm's assets (size), leverage, debt coverage ratio, change in assets (growth) and profitability
ii. The asset growth variable → RASSET → proxies for opportunities for profitable reinvestment of cash flow
iii. Free cash flow has a negative impact on firm performance
iv. Market-to-book ratio is significantly greater for:
a. Larger firms (where size is measured by assets)
b. More heavily leveraged firms and more profitable firms
v. Market-to-book ratio → negatively related to free cash flow net of common dividends
vi. Market-to-book ratio decreases with the free cash flow measured at both before and after common dividend distribution levels
vii. Examine further → the relationship of the excess market value of the company and free cash flow
viii. Market-to-book ratio → positively dependent on the leverage level, the asset growth rate, the asset-adjusted operating income and the debt coverage ratio

4. Conclusion
§ Two types of companies statistically significant differences → in means across asset-adjusted earnings, leverage level, dividend policy, and most importantly, free cash flow levels
§ Non-REIT companies → more heavily leveraged and pay lower dividends than the REIT
§ Larger amount of free cash flow is retained by non-REIT firms than their REIT
§ Market-to-book ratio is negatively related to free cash flow

Share Repurchase:To Buy or Not to Buy

1. Introduction
§ Stock buybacks have leap-frogged corporate stock issues by ever-increasing amounts
§ Total number of shares repurchased in the last six years → far outstripped the total number of new shares issued
§ FEI members → Key findings:
i. 39% of the respondents instituted a share repurchase program → to improve their earnings per share numbers
ii. 28% → to distribute excess cash to shareholders
iii. 27% → their companies were trying to reduce the cost of employee stock option plans
iv. 12% → main reason → adjusting capital structure
§ Financial Executives Research Foundation → mission:
i. Determine the long-term effects of stock buyback programs on a company’s stock price
ii. Assess which companies benefit most from this programs
§ Data → 200 firms that announced, conducted and completed share purchase programs from 1991 to 1996
§ Completed Repurchase Plans → The firm announced and later purchase at least 50% of the shares authorized for the program
§ Firms that announced buyback program → usually just buy very little stock

2. Why Repurchase Shares?
§ Five commonly reasons:
i. To increase share price
ii. To rationalized the company capital structure
iii. To substitute share repurchases for cash dividend payouts → tax advantages
iv. To prevent dilution of earnings
v. To deploy excess cash flow → become alternative investment
§ Firm repurchases shares has different options:
i. Open market repurchases
ii. Tender offers
iii. Privately negotiated repurchases
§ Sample → Firms were consent in a range of industry and market capitalization:
i. 48% → have market caps below %200 million
ii. 10% → have market caps in excess of $10 billions
iii. 42% → along the continuum

3. Four Key Findings
§ Shares Outstanding
i. Proportion of share repurchases →5%
ii. This proportion → repurchases were measured in terms of numbers of shares or in terms of dollar value
§ No substitute for dividend payouts
i. Dividend payouts ratio → increase once the stock buyback program is over
ii. Large-cap and small-cap companies → reported the same increase in dividend payout ratios
§ Effect on earnings per share
i. The repurchasing firms → effectively closing gap → between their EPS growth rates and those of industry peers that aren’t buying back stock
§ Effect on debt
i. 27% of the fund used to finance the stock repurchases → stem from excess operational cash flow

4. Guidelines for Getting Going
§ A stock buyback program signaling:
i. Management won’t be funneling anymore money into markets or product lines that are dead ends
ii. The company isn’t hunting around for an acquisition
§ Companies repurchase equity only under these circumstances:
i. When they have excess debt capacity, and the supply of funds exceed the demand
ii. When they’re under-performing → profitability and sales growth rates→ relative to their industry’s averages
§ Companies should avoid stock buybacks under these circumstances:
i. When they’re over-leveraged and sales growth rates exceed industry averages
ii. When both their profitability and sales growth rates exceed industry average
§ A share repurchase program → must be conducted in strict accordance with federal securities laws to avoid liability for market manipulation or insider trading
§ Company’s board of directors → must determine that any purposed buyback program is a sound course of action and that it’s in the best interests of shareholders

5. The Value Connection
§ Shareholder Value Based Management → demonstrates that long-term shareholder value is created buy the firm’s growth and profitability prospects from its product market positions
§ The company’s decision to conduct a repurchase program could be misinterpreted by investors as a negative signal
§ But also can be a positive sign → because investors interpret the repurchases as the welcome return of capital and an indication that management is turning the business around
§ Conducting a successful stock buybacks → he or she must figure out how to bring the two major aspect – strategy and finance – together in the most effective way possible

The Effect of Asymmetric Information on Dividend Policy

1. Introduction
§ Several theories exist on why firms pay dividends
§ The various explanations of dividend policy → classified into at least three categories:
i. Agency cost
ii. Asymmetric information
iii. Transaction Cost
§ Alternative explanation on dividend policy is based on pecking order theory
§ The underinvestment → when the firm has inadequate funds for investment purposes → does not want to bear the lemons-premium associated with new capital issues
§ Firms find it optimal not to pay dividend → their exclusion from any empirical analysis may create a selection bias in the sample → resulting in biased and inconsistent estimates of the underlying parameters

2. Asymmetric Information, Testable Hypotheses, and Control Variables
§ Pecking Order Theory
i. Myers and Majluf → the precense of asymmetric information → a firm may underinvest in certain states of mature
ii. Firm can reduce underinvestment → by accumulating slack through retention
iii. Higher the control of asymmetric information → lower the dividend to control the underinvestment problem

§ Signaling Theory
i. Higher dividends → higher current earnings
ii. Dividend convey information about current earnings → trough the source and uses identity (time)
iii. Firms with higher current earnings → pay high enough dividend
iv. Firms with higher level asymmetric information → have to pay more dividend → to signal the same level of earnings as firm with a lower level of asymmetric information

§ Control Variable
i. The potential importance of asymmetric information in determining dividend policy does not rule out other factors affecting dividend policy

§ Agency Cost of (External) Equity
i. Dividend payments → reduce agency cost of external equity
ii. Two Forms of agency cost
a. From the monitoring of managers
b. From risk -aversion
iii. Value of dividend in controlling agency cost → is likely to be lower in the presence of some other control mechanism → such as managerial ownership of shares
iv. Higher managerial or insider ownership → lower agency cost

§ Growth or Investment Opportunities
i. Size of the investment increase → the ex-ante loss resulting from underinvestment also increase
ii. Firm that expect rapid growth should lower its dividend payout
iii. Pecking-order and residual theories → Higher growth opportunities of the firm → Lower the dividend

§ Cash Flow
i. Residual theory, pecking-order theory, signaling argument → higher current earnings → pay higher dividend

§ Agency Cost of Debt and Financial distress
i. Firms may face binding debt covenants when they are in financial distress
ii. Firms reduce dividends early during period of financial distress
iii. Firms with higher likelihood of financial distress may pay lower dividend

3. Empirical Specification, Methodology and Measures for the Dependent Variable
i. The optimal dividend policy is determined by the firm-specific attributes
ii. Non-dividend paying firms find it optimal not to pay dividends → should not be ignored in any analysis of corporate dividend policy

§ Dependent Variables Measures
i. Dependent variables → conventional dividend yields → equals the ratio of dividend per share to price per share
ii. Dependent variable → equals the measure dividend yields for dividend-paying firms → equals zero for non-dividend-paying firms

§ Data
i. Date were obtained from the industrial annual COMPUSAT database for period 1988-1992
ii. Sample consist of manufacturing firms that trade on either NYSE or the AMEX
iii. Five year period were chosen
iv. Firms that had no data and firms initiating or omitting dividends in the sample period → dropped from sample
v. The final sample → 446 firms, 158 of which are non-dividend-paying firms

4. Empirical Results
i. Independent variables → insider ownership variables, analyst following, growth opportunities, the cash flow measure, dummy variables
ii. Analyst following and cash flow → positive and significant at 1 percent level
iii. The coefficient on growth opportunities → negative and significant at 1 percent
iv. The coefficient on distress variables → positive and significant at 10 percent
v. Positive coefficient on analyst following → firms with less asymmetric information pay higher dividend → consistent with pecking order theory, inconsistent with signaling theory
vi. Negative coefficient on the growth measure → consistent with pecking order theory
vii. Positive coefficient on DIST → firms with low cash flow and low growth opportunities → pay higher dividends

§ Dividend Policy and Insider Ownership
i. Analyst following is negatively related to insider ownership
a. The demand for analyst services → stems from outsider to the firm
ii. Lower analyst follower → higher asymmetric information
iii. Dividends → negative relationship with insider ownership

5. Dividend Policy and Equity Issues: A further Test of the Pecking Order Theory
i. Pecking order theory
a. Firms should exhaust their internal funds first before resorting to external funds
b. Firms that issue equity should pay lower dividend
ii. Result → Firms that resort external sources for funds attempt to first exhaust their internal funds by paying lower dividend

§ Dividend Policy and Firm Size
i. Positive relationship between dividend yields and size
ii. Firm size → calculated as the logarithm of the book value of assets
iii. Larger firms → have less asymmetric information → pay higher dividend
a. Consistent with pecking order theory
iv. While size is positive and significant → analyst following is significant

§ Dividend Policy, Asymmetric Information, and Issue Cost
i. Pecking order theory → asymmetric information problems exacerbate the under pricing associated with new capital issues
ii. Firms may be reluctant to issue equity → when their stock is undervalued
iii. A higher analyst following → less asymmetric information
iv. Issue cost increase with the level of asymmetric information between the firms and its investors

The Financing of Private Enterprise in China

1. Introduction
a. China’s economy → undergone fundamental change:
i. From complete reliance on state-owned and collective enterprise → mixed economy where private enterprises play strong role
b. The discrepancy between the dynamism of the private sector and its limited use of intermediated financing → private sector may not be able to sustain its current rate of growth unless it can increase its access to financing

2. Financing Patterns
a. Survey of private firms in Beijing, Chengdu, Shunde, and Wenzhou → the private sector arm of the World Bank Group → 80% considered the lack of access to finance to be a serious constraint
i. More than 90% of their initial capital came from the principal owners, the start-up teams, and their families
b. The relative importance of different sources of financing among surveyed firms → depend on firms size
i. Smallest firms → external sources are mainly informal channels
ii. Larger Firms → internal sources become less important
c. Commercial banks → the second most important source of funds for the largest firms after retained earnings
d. Banks provide more support for larger and relatively successful private firms
e. Chinese firms rely more on internal sources of financing than do firms in transition and developed economies

3. Factors Affecting Access to Financing
a. Difficulty private Chinese firms face in obtaining financing is due partly to factors within the financial system and partly to the nature of Chinese private enterprise
i. Bank incentives
§ China has made significant progress in reducing government interference in bank lending
§ Bank still do not consider a bad loan to a state-owned enterprise to be as serious as bad loan to a private enterprise
§ Expectation → State-owned enterprise is helped by government → private enterprise does not
§ Banks will discriminate against private sector firms
§ Banks need added incentives to lend to private enterprises
§ Banks concentrate to avoiding losses and show little interest in sharing the rewards of projects that might be riskier but have higher expected return
§ There are controls on interest rates and transaction fee
§ Banks are taking advantage of this more flexible interest rate regime, but interest rates need to be liberalized further to encourage more lending to private firms
§ State banks charge effective interest rates that are comparable to those in the informal market
ii. Bank procedures
§ The procedures rely on collateral and personal relationship rather than on project appraisal
§ Collateral requirements, the cost of the application process, and relationship banking tend to make it harder for smaller firms to gain access to financing
iii. Collateral requirement
§ Inability to meet collateral requirements → the most frequent reason for not being able to obtain a bank loan
§ In practice → real estate assets appear to the most common kind of collateral accepted
iv. Information problems
§ Information problem → especially severe for state firms in China
§ The resulting of clear ownership management in structures imposes obvious constraint of borrowing

4. Policy Agenda for Financial Sector
a. Improving private firms’ access to external financing requires:
i. Strengthen banks’ incentives to lend to private enterprises
§ An important step → strengthen profit incentives through private ownership and competition
§ Private financial institutions are less likely to be swayed by political considerations and more likely to be profit oriented
§ The big state owned banks → likely to dominate the domestic financial landscape for the foreseeable future
§ Strengthening the profit incentives of these banks → have a major impact on improving private firm’s access to bank loans
ii. Further liberalize interest rates
§ Further liberalization of interest rates → needed to improve private firm’s access to bank loans
§ Access to financing is more important than the cost of funds
iii. Allow banks to charge transaction fees
§ Bank finds → lending to private companies → carries higher unit transaction cost
§ Transaction fees → encourage banks to consider:
o More proposals from small firms
o Develop a more service-oriented culture
o Promote greater transparency and better accounting standards
iv. Develop alternatives to bank lending (Leasing and Factoring)
§ Leasing and factoring are underdeveloped in China
§ In China, leasing faces obstacles:
o Rent arrears have long been a problem
o Accounting standards are unclear
o The regulatory environment does not provide equal treatment with other sources of capital investment financing
o Funding is a perpetual concern
§ Factoring → the sales of firm’s account receivables to a financial institution
§ Factoring → is a way to improve a company’s liquidity by substituting a cash balance for book debt
v. Create the framework for the development of private equity markets
§ Private equity markets in China are at an embryonic stage of development
§ Industrial investment funds → No regulations cover the organizational structures that can be used to establish private equity funds
§ Structure equity funds → can be developed is:
o Legal instruments are in place
o High ability of investors to use a variety of financial instruments to structure investment
§ Private enterprises → have lack of flexibility in their financial arrangements
vi. Improve access to public equity
§ The availability of exit mechanisms is a key condition for the development of private equity markets
§ Quota system on listing → private firms would have greater opportunity to acquire long-term funding through the equity market
§ Two ways to further improve private firm’s access to public equity:
o Broaden the range of exit mechanism available to investors
o Relax listing requirements

Pecking Order or Trade-Off hypothesis? Evidence on the Capital Structure of Chinese Companies

I. Introduction
a. Determine capital structure of a firm
i. Trade-off theory
§ A value-maximizing firm will pursue an optimal capital structure by considering → the marginal cost and benefits of each additional unit of financing → then choosing the form of financing that equates these marginal cost and benefits
o Benefits of debts → include its tax advantage and the reduced agency costs of FCF
o Cost → include the increase of risk of financial distress and increased monitoring and contracting costs associated with higher debt levels
ii. Pecking order theory
§ Based on the argument → asymmetric information creates a hierarchy of cost in the use of external financing which is broadly common to all firm
b. Distinguish the two theory in practice is not easy
i. Fama and French can only identify two predictions on which either theory performed better than another
§ Trade-off theory → better in “large equity issues of low leverage firms”
§ Pecking order theory → better in “the negative impact of profitability on leverage”
c. It is difficult to distinguish between trade-off and pecking order models because many determining variables are relevant in both models
d. Several reasons why one might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts in the industrial countries
i. Many private firms in DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage
ii. Capital markets are less developed in DTEs → narrower range of financial instruments → wider range of constraints on financing decision
iii. Accounting and auditing standard in DTEs tend to be relatively lax → implementing asymmetric information is more problematic
e. Singh and Hamid (1992) and Singh (1995) → concluded that firms in developing economies rely more heavily on equity than on debt to finance growth than do their counterparts in the industrial economies
f. None of the researchers explicitly set out to discriminate between trade-off and pecking order theories in a manner designed to discriminate between them
g. This paper studies the determinants of capital structure decisions in a sample of listed Chinese companies
i. China is of interest for several reasons → but particularly because it is in the almost unique position of being both a developing economy and a transition economy

II. Hypotheses
Three related aspects of corporate financing where trade-off and pecking order theories give different predictions:
a. Determinants of Leverage: profitability, size, and growth
i. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relationship between leverages and profitability
o Unprofitable firms facing a positive NPV investment opportunity will avoid external finance in general and leverage in particular
§ Pecking orders theory → there will be negative relationships between leverage and profitability
o Firms will use retentions first then debt and equity issues as a last resort
o Less profitable firms facing a positive NPV investment opportunity will be more willing to use external funds if cash flow are weak
ii. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relation between leverage and firm size
o There are economic scale of bankruptcy → agency cost will be lower for larger company
§ Pecking order theory → a negative relation between leverage and size
o Larger the firm → more complex the organization →higher the cost of information asymmetries → more difficult to raise external finance

b. Leverage and Dividends
i. Trade-off theory → negative relationship between dividends and leverage
§ Dividend are high (retention low) → because external financing low
ii. Pecking order theory → Positive relationship between dividends and leverage
§ Firms with higher past dividends will have less financial slack → higher leverage → because they require more external funds

c. Corporate investment and financing
i. Trade-off theory → Leverage should be negatively related to investment → because of funding limitations arising from high leverage
ii. Pecking order theory → larger firms are less transparent than smaller firms

III. Data and Methodology
a. Use base in China
i. China → in transition from a planned economy to a market economy → continues to be characterized by a fragmented capital market, fragile banking system, poorly specified property rights and institutional uncertainty
ii. Chinese firms → have a relatively short operating history → have not accumulated much reputation
iii. Most listed companies→ originally state-owned enterprises → privatization has been incomplete with the state often retaining a controlling share
iv. Banks → often process commercial loans and collect debts in a preferential way → the market is subject to irregular government intervention
v. A well-functioning and fully-enforced accounting and auditing system has developed only gradually in China
vi. Firms could partially disclose, distort, and even forge information for transaction or taxation purposes with low risk of being caught
b. Study attention and methodology
i. China top 50 companies for the period 2001-2003 → data were extracted from the published accounts of non-financial companies listed on the Shanghai and Shenzhen stock exchange
ii. The listing is based on total assets, income from main businesses, net profit and market value
iii. For holding companies → the consolidated data were used
iv. Two datasets:
§ For 2002 and 2001 → using 2002 annual report
§ For 2003 and 2002 → using 2003 annual report
v. Two measure of leverage
§ Wide measure → ratio of total liabilities to total assets
§ Standard ways → two comments:
o In measuring ROA → one should ideally use the ratio of operating income to operating assets rather than total assets
o Dividend → scaled by book equity rather than the market value

IV. Results
a. More than 50% of the cross sectional variation in leverage
b. Profitability → mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression →provide quite robust support for pecking order theory
c. Assets growth → highly significant and has a positive sign contrary to the predictions of trade-off theory
d. Size → signed positive, a finding that is more consistent with trade-off theory
e. Dividend → positively signed as predicted by pecking order theory
f. Dividend and size → signed negative but not significant → consistent with pecking order theory
g. Profitability:
i. Negative but significant in 2002 → consistent with trade-off theory
ii. Positive but significant in 2003 → consistent with pecking order theory
h. There is some degree of stability in the parameters across time periods

ST. LOUIS CHEMICAL: THE INVESTMENT DECISION

A. Abstract
§ St. Louis Chemical is a regional chemical distributor
§ The company reported small losses during it first two years → reported increasing sales and profits
§ The growth has required:
i. acquisition of equipment
ii. expansion of storage capacity
iii. increasing the size of the work force

B. Case Overview
§ headquartered in St. Louis → considering the opportunity to increase its packaged goods sales, sales of material in 55 gallon drums
§ to take advantage of this opportunity → additional equipment must be obtained → requiring a major capital investment
§ Williams is considering two alternatives
i. The acquisition and installation of used equipment that will provide the capacity to fill an additional 200,000 fifty-five gallon drums annually → economic life 3 years
ii. The acquisition and installation of new equipment with the capacity to fill 400,000 drums annually → economic life 7 years
a. New equipment is more efficient thus the cost to fill a drum is less than the per drum filling cost of the used equipment
§ Bush feels that Williams may be willing to consider using debt if she can convince him of the advantages of using debt in the firm's capital structure

C. Content
1. Prepare a presentation for Williams regarding the concept of WACC
§ the weighted average cost of capital (WACC) is the cost the company is paying to finance its assets and reflects the riskiness of the firm or the firm's assets
§ it is a weighted average of the costs of the various sources of capital (debt and equity) used in the firm's capital structure
§ WACC is an after-tax cost → calculated using the after-tax cost of each source of capital
§ determine WACC:
i. calculate the cost it must pay for each source of capital
ii. determine the target mix of debt and equity to be used by the firm

2. Calculate St. Louis Chemical's WACC (round to the nearest whole number). arguments should be made to convince Williams of the advantage of using long-term debt in the firm's capital structure
§ WACC = W^sub d^(k^sub d^)(l-t) + W^sub 8^(k^sub 8^)
§ The best argument that can be made to convince Williams to use debt capital in its capital structure is to calculate the firm's WACC with and without debt
§ Without debt, the firm's cost of capital is 16% → with 30% debt, its cost of capital is 13%
§ The use of debt lowers St. Louis Chemical's cost of capital because low cost debt capital is substituted for high cost equity capital
§ Debt has a lower cost than equity because to the holder of debt there is less risk
§ Debt has less risk → the certainty of payments associated with debt (interest and principal) is greater than the payments associated with equity (dividends and stock appreciation)

3. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, the same discount rate should be used to evaluate each alternative
§ The discount rate used to evaluate the project reflects the risk level of the project, not the cost of the financing
§ The cost of capital represents the risk level of the firm's assets

4. An accurate WACC is important to a firm's long-term success.
§ A firm's WACC is used to assess investment decisions
§ An asset's return is less than the WACC → shareholders will not receive their required return
§ If the WACC is underestimated → the firm risks losing equity capital as unsatisfied investors take their funds elsewhere or will have difficulty raising capital in the future
§ If the WACC is overestimated → the firm risks missing profitable growth opportunities
§ Making investment decisions based on informal analysis is an unacceptable process and will not result in an effective allocation of the firm's scarce resources

5. Evaluate the strengths and weaknesses of the NPV, IRR and Cash Payback Period capital expenditure budgeting methods. Prepare a recommendation for Williams regarding the capital budgeting method or methods to use in evaluating the expansion alternatives
§ Cash Payback Period is the number of years it takes a firm to recover the original investment
i. The advantages of the Payback Period
a. easy to calculate and explain
b. focuses on future cash flows
c. places a premium on liquidity
ii. The disadvantages of the payback period
a. ignores time value of money
b. ignores cash flows beyond the payback period
c. does not include an accept/reject feature

§ Net Present Value (NPV) method is determined by:
i. calculating the present value of the future cash flows
ii. deducting the project's cost from the present value of the future cash flows
© If the project's value (the present value of its future cash flows) exceeds its cost → the project is a good investment and should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. includes an accept/reject feature
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. requires knowledge of a firm's WACC

§ Internal Rate of Return (IRR) method is calculated by determining the discount rate that will cause the present value of the future cash flows to equal the project's cost
© If the IRR exceeds the firm's WACC, the project should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. does not require knowledge of a firm's WACC
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. if the project's future cash flows include some years with cash outflows rather than cash inflows, multiple IRRs may result
§ Recommendation should include the use of all evaluation methods because each provides valuable information regarding a potential project
§ Priority should be given to the results of the NPV method because it compares the projects value to the projects cost

6. The projected cash flow benefits of both projects did not include the effects of inflation. Future cash flows were determined using a constant selling price and operating costs (real cash flows). The cash flows were then discounted using a WACC that included the impact of inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when calculating a project's NPV or IRR.
§ If inflation is neutral, impacting revenues and costs equally, the NPV and IRR will be underestimated → Because revenues are usually greater than costs, revenues will increase by a greater dollar amount than costs

Tie Your Capital Budget to Your Strategic Plan

A. Introduction
§ Upgrade the equipment to support a product that was in the mature stage → possibly approaching a point where it would be phased out
§ Capital assets decisions → the most irrevocable long-range activities because:
i. Involve significant corporate funding
ii. The least flexible in terms of changing the strategic direction of the business
iii. The least flexible for conversion into more liquid assets
iv. May geographically impact the long-term raw material supply capabilities of the business
v. May geographically impact the business’s long-term customer access
vi. Involve decisions about assets that are unique to the company
§ Unique features of capital assets → represent the source of a company’s product individuality and position in the market place

B. Defining the Strategic Plan
§ Strategic plan must be a living document that:
i. Managers keep it
ii. Easily updated → depend on events
iii. Requires management explanation when the projection aren’t met → can be adjusted
iv. Represent management’s philosophy of managing with a planning process →the product is the plan; the process is the interaction → employees and management → that takes to develop the plan
v. Reflect the corporate leadership’s visions of the company’s future
vi. Supported with individual functional plans
vii. Contains objectives → specific measurable results that outline exactly what should be accomplished in a given time frame
viii. Identifies the strategies → How, where, and when of resource commitment to achieve objectives
§ Strategic plan → focus on customers needs then business capabilities to meet those needs with its products and services

C. Building the Plan
The strategic plans contains
§ Corporate mission → company purpose
§ Where the business wants to be in the future
§ How it plans to get there
§ It identifies guidelines for targeting the corporate market
§ It identifies the corporate organizational features

D. Managing the Assets
§ Develop the strategic plans → need to look at the fixed assets
§ Stages of asset management:
i. Companies acquire new physical assets → operating management determines the plant facilities are inadequate → for growth or corporate citizenship → acquisition include:
a. Equipment replacement expenditures
b. Expansion investment
c. Investment to support strategic improvements → existing or new product
ii. Maintenance → management should be concerned about the potential for piecemeal maintenance programs for older facilities
iii. Disposition of assets → get rid of assets when it still has value → both company (acquired or sell) can get benefit
a. The goal → to ensure the assets will fully utilized and support management’s strategic vision

E. Some Common Evaluation Techniques
§ Payback period
i. Its strengths
a. Simplicity
b. Identifying the time required to return the money
ii. Its weakness
a. It ignores the time value of money
b. The cash outflows after the payback period
§ Average Annual Rate on Investment
i. Its advantages
a. The consideration of the full income of the project
b. The ease of locating comparable data later in the accounting records
ii. Its Disadvantages
a. Failure to consider time value of money
b. Influence of inflation
§ Present Value method
i. Its Disadvantages
a. Difficult to compute
b. Management must select the discount rate
c. Result may be misleading when comparing projects
§ Discounted Cash Flow method
i. Its advantages
a. Consideration of time value of money
b. Consideration of all project’s cash flow
c. Results are easily understood
d. Compensates of unequal lives and cash flow
ii. Its Disadvantages
a. Difficult to compute
b. Implication that the cash can be reinvested at the internal rate of interest
§ Purchase vs. Lease

F. Is the Program Effective?
Key measurements that will keep the program viable and effective
§ Periodically review all capital asset acquisition project to make sure you still need them
§ Review the project to see if the initial planning projections were on target
§ Continuously review all capital acquisition expenditures to make sure that all assets are being acquired according to the strategic plan

G. The Capital Budget
§ Capital budget → portion of strategic plan; select which assets you should acquire; allocates available resources; based on quantitative and qualitative evaluation; determine the best investment
§ Corporate decision-making process:
i. Defining and communicating a firm’s long-range and strategic plans and goals
ii. Developing a system → permits gathering and ranking of company proposals
iii. Determining the accuracy of the estimates that will be used in the estimation of rate of return calculation
iv. Determine and assign levels of risk probabilities to each investment proposals

H. Effective Implementation is Key
§ Driving force of any strategic plan is its effective implementation
§ Develop the corporate strategic plan assumption → next step is to merge this information to the various functional plans and link all short-term and long-term plans
§ The prime decision-making factors of the capital program should be
i. The time value of money
ii. The cost of capital
iii. The inherent risk of each project/proposal
§ Fixed assets → long-term present-dollar commitments that will be used over a long period of time in the normal course of business

The Capital Budgeting Decisions of Small Business

1. Introduction
§ Capital investments in the small business sector → important to both the individual firms and the overall economy
§ Small and large firms → use different criteria to evaluate the project
o Small business owners → balance wealth maximization against other objectives (e.g. independency of business)
o Small firms lack of personal resources → have no time or expertise as deep as the large firm
o Some small firms are capital constraints
§ Result of research:
o Types of investment the firm makes
o Tools to evaluate the project
o Firm’s use of other planning tools
o Owner’s willingness to finance project with debts
o Relation between capital budgeting practice and firm’s characteristics


2. Capital Budgeting Theory and Small Firms
§ Simple rule managers can use to make capital budgeting decisions
o Invest in all positive net present value projects and rejects those which have negative net present value
© Firms will make set of investment decision that will maximize the shareholder’s value
© No need to consider alternative capital budgeting tools → payback period or ARR
§ Problem → small firms often operated in environment that do not satisfy the basic capital budgeting model

A. Capital Budgeting Assumptions and the Small Firm
§ Capital budgeting theory → The primary goals of a firm’s shareholders is to maximize firm value
o Firm is assumed to have access to perfect financial markets
o Allowing it to finance all value enhancing projects
§ Reasons why it cannot be implemented to small firm
o Shareholder wealth maximization may not be the objectives of all small firms
o Many small firm have limited management resources → lack expertise in finance and accounting
o Capital market imperfections → constraint the financing options for small firm (wrong information)

B. Cash Flow Estimation Issues
§ Estimation issues managers must confront when implementing discounted cash flow analysis
§ Discounted cash flow is less valuable when the level of future cash flows is more uncertain
o Discounted cash flow analysis can be applied most directly to projects with cash flow profiles similar to the firm’s current operations
§ Small firms is considering investment in new product lines → future cash flow cannot be estimated directly from the past performance of the firm’s current operations
§ Small firms may not rely exclusively on discounted cash flow analysis when evaluating investments in new product lines
§ Small firms may not use discounted cash flow analysis to evaluate replacement decisions
o Small firm may have limited replacement options and differences in future maintenance costs of the various option can be difficult to forecast


3. Description of Data
§ Survey provide information that cannot be readily gleaned from financial statements
§ Survey can shed light on how firms make investment and financing decisions and why they use these approach
§ 72% of samples → construction, manufacturing, retail, all industries requiring substantial capital investment
o 20% is services industries


4. Survey Results
§ Three questions concerning the capital budgeting activities of small firms
o We consider whether the investment and financing activities of small firms conform to the assumptions underlying capital budgeting theory
o We look at the overall planning → identify firm’s characteristics
o We provide evidence about the specific project evaluation techniques small firms use

A. Investment Activity
§ The most important type of investment is replacement for 46% of the sample firms
o Firms in service industry are more likely select this response → firms in manufacturing industry were less likely
o Firms with highest growth rates and those who in business less than six years were less likely than the firm which report replacement activities as the primary investment type
o The importance of replacement activity increases with the age of the business owner
§ Project to extend existing product lines are shown as the primary investment activity for 21 % of the sample firms
o Construction and manufacturing firms, firms with highest growth, young firms → more likely to expand the existing project
o Low growth rates firms, oldest firms → less likely to expand the existing project
§ Many small firms face real capital constraints → wait for cash
o Youngest firms, the smallest firms, firms with older owners, and those whose owners does not have a college degree → wait for cash
§ Reasons why small firms might not follow the prescriptions of capital budgeting theory
o Replacement is not the most important type of activities
i. Maintaining the viability of the firm is going concern might be the owner’s objectives
o Many small firms place internal limits on the amount they will borrow
o Personal financial planning considerations of business owners may effect the investment and financing decisions of small firms

B. Planning Activity
§ 31 % of the sample firms have written business plan
§ Over 30 % of the sample firm do not estimate future cash flows
§ 26 % of the firms do not consider the tax implications of investment decisions
o Firms with highest growth rates, firms that extend business project, newer firms and younger owners, firms which the owners have college degree → more likely to have formal and complete business plan

C. Project Evaluation Methods
§ Primary tools firm use to assess a project’s financial viability → payback period, accounting rate of return, discounted cash flow analysis, “gut feel”, or combination
§ Use of Gut Feel → related to owner’s background → inverse with firm’s planning tools
o It is widely used by firms that make primarily replacement investments
o Small business owners use relatively unsophisticated methods of analysis to evaluate replacement options
o Gut Feel → Service industry
i. Firm’s primary considerations when evaluating the purchasing decision → cost, reliability, product features → structuring discounted cash flow is difficult
§ Payback period → used by firms that will use wait for cash
o Use of payback period → increase → related to educational level of owners
o Payback period can be a rational project evaluation tool for small firms facing capital constraints
§ Accounting Rate of Return → the use increase → with firm’s growth rates
o ARR → important → if firm must provide with periodic financial statements or is required to comply with loan covenants based on financial statement ratios
§ Discounted cash flow → primary evaluation method of only 12 % of the firms
o Firms with written business plan, those who consider taxes of investment, less than six years firms, and also firms extending existing product lines → more likely use this method

D. Multivariate Analysis
§ Using multinomial logit → jointly identify factors influencing the choice of a project evaluation tools
§ This technique → appropriate → when unordered response has more than two outcomes
§ Result
o Firms using any formal investment evaluation tools → more likely to make cash flow projection
o Firms using ARR, DCF, or a combination → more likely consider tax implications
o Capital constraints and the type of investment can influence how firms evaluate projects
o Wait for cash coefficient → positive and significant to both payback period and DCF
o Firms committed to funding projects internally are not necessarily irrational or unsophisticated
o ARR → the choice of firms pursuing either growth strategy, expand product lines or new product line
o The importance of DCF analysis → depend on the type of growth the firm is pursuing

Free Cash Flow (FCF), Economic Value Added (EVATM), and Net Present Value (NPV):A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation

1. Abstract
§ The paper assist the user of DCF methods by clearly setting forth the relationship of free-cash-flow (FCF) and economic value added (EVATM) concept to each other and to the more traditional applications of DCF thinking such as NPV
§ The equivalence between EVA and NPV, approaches:
i. Links the problems of security valuation, enterprise valuation, and investment project selection
ii. Relates to more directly use of standard financial accounting information
§ FCF approach → focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow
§ EVA(TM) approach → requires defining the periodic total investment in the firm
§ FCF and EVA(TM) are equivalent to NPV

2. Introduction
§ The use of DCF method for investment decision making and valuation is well entrenched in finance theory and practices
§ Modern literature has broadened application of DCF techniques → capital budgeting and security valuation problems
§ Free cash flow → security valuation
§ Economic value added → managerial performance evaluation

3. Cash Flow
a. The cash budget identity
i. Consider the single period cash budget identity
ii. The components are operating revenues and cost, net security issuance, interest payments, dividend payments, taxes paid, and net investment.
iii. Investment maybe divided into working capital and long-term investment
iv. In practice, use of accounting information for economic analysis requires a number of adjustments to bring the accounting numbers into conformity with economic reality
v. Sources = Uses
Rt + ∆Bt = Ot + Intt + Divt + Taxest + ∆It + ∆WCt

b. Dividends
i. Divt = (Net profit after tax + depreciation) – total net investment + net debt issuance

c. Divisions of cash flow among investors
i. Cash flow to equity (CFE is equivalent to our expression for dividend
ii. Proponents of the FCFE method emphasize that FCFE is dividends that could be paid to shareholders
iii. The difference between FCFE and dividends paid in given year maybe characterized as investment in “excess marketable securities” and its omission from consideration is moot so long as such investments have zero NPV
iv. Cash flow to debt holders in period t, CFDt:
CFDt = Intt - ∆Bt = interest paymentst – net debt issuance

d. Taxes
i. Consider the total-taxes-paid component of cash flow to equity
ii. It is being equal to the tax on operating income before interest – the tax-shield benefits provided by interest payments
iii. Taxest = tax with no debt financing – interst-tax-shield benefits

e. Free cash flow to the firm
i. Free cash flow to the firm → cash flow to equity + cash flow to debt holders – interest-tax-shield benefits from the cash flow to debt holders
ii. We can express that
© CFFt = after tax operating profit from equivalent unlevered firm + depreciation – totaol net investment

4. Valuation
i. Three basic business contexts:
© Project valuation (capital budgeting)
© Security valuation
© Firm valuation
ii. Purpose → demonstrate the conceptual consistency in valuation methodology among the various computational techniques employed in the three valuation contexts

a. Equity valuation by the dividend discount approach
i.

b. Equity valuation by the free-cash-flow-to-equity approach
i.

c. Debt valuation
i.

d. Total firm valuation
i. Total firm value:
ii. To express free cash flow to the firm, firm value can be described in terms of NOPAT, depreciation, and total net investment

e. Project valuation
i.

f. Economic profit (EP) and economic value added (EVATM)
i. The concept of EP boils down to a simple restatement of total firm valuation that “reallocates” investment expenditures from the periods in which they are made to periods over which their resulting benefits occur.
ii. In the EVA(TM) approach to EP →the reallocation assigns to each period an “EVA(TM) depreciation” component representing the “usage” of a portion of the cost of the firm, plus a “capital charge” representing the opportunity cost of the remaining net investment in the firm
iii. The computation of EP:
EPt = (NOPATt + difference between tax depreciation and EVA(TM) depreciation – capital charges on EVA(TM) operating assets / economic profitt

5. Measurement Issues
§ Another important use of valuation concepts requiring use of accounting information is determination of managerial compensation
§ Spirit of managerial compensation arrangement → to reward manager to increase shareholders value → measurement of changes in firm value is critical
§ With the free cash flow model, income must be adjusted for the fact that GAAP involve reliance on both the realization and matching principles

a. Derivation of operating cash flow from accounting profit
i. The dividend discount and free cash flow to equity models adjust accounting profits by starting with NPAT, then adding depreciation and net debt issuance, and subtracting total net investment

b. Derivation of economic profit from accounting profit
i. It is not only concerned with reconciliation of accounting profit and cash flow, but also focuses on issues defining the capital investment in the firm

6. Conclusions
a. Free cash flow, economic value added, and net present value approaches to valuation and decision-making are equivalent
b. Linkage among the problems of security valuation, enterprise valuation, and investment project selection, and by doing so in a manner that relates directly to the use of standard financial accounting information
c. Net operating profit after tax (NOPAT) → adding after tax interest payments to net profit after taxes
d. FCF approach → focuses in periodic total cash flow obtained by deducting total net investment and adding net debt issuance to net operating cash flow
e. EVA(TM) approach → requires defining the periodic total investment in the firm

Outperform with Expectations-Based Management: A State-of-the-Art Approach to Creating and Enhancing Shareholder Value

1. Content
§ How to incorporate expectations into the corporation’s decision processes to enhance shareholder value
§ EBM → A revolutionary new performance metric that links performance standards, performance measurement, and the achievement of performance
§ The literature on investment management pays little attention to shareholder value → from the perspective of the relationship between corporate managers' behavior and investors' expectations
§ Corporate finance research → sidesteps the issue of how management actions affect investor expectations and stock price discovery
§ Beating expectations drives shareholder value
§ expectations into fundamental management behavior
i. Difficult → because it requires corporate managers to adopt an unaccustomed mindset and focus
§ The Author:
i. Tom Copeland is a distinguished financial scholar who has moved to consulting
ii. Aaron Dolgoff is an associate principal of consulting firm CRA International
§ Managing based on beating expectations through a systematic decision process is the best way to increase shareholder value

2. Sections
a. Measuring performance with expectations
i. Expectations-based management (EBM) → determining which management approach is most correlated with increases in shareholder value → EBM
ii. EBM's underlying intuition is almost too simple:
© Managers must beat the expectations embedded in stock prices → create value
© Achieving what analysts already predict about the company will not create value
b. Managerial implications of expectations-based performance
i. the authors argue that expectations count
ii. The corporate manager's job is to identify investors' most important expectations and systematically include them in all aspects of company behavior
iii. EBM is not a simple lesson but a way of thinking that must be translated into action throughout the company
iv. Example:
© how a company should evaluate a new investment proposal
o The projected return on investment must exceed not only the cost of capital but also investors' expectations for returns on existing projects
v. Copeland and Dolgoff argue that managers need to reverse-engineer the value of the company to determine what the market thinks returns should be
vi. Market's expected return is the hurdle rate that must be met, not for a given quarter but over multiple periods
vii. Clarifying a company's actions to exceed market expectations is the key role of management
viii. Top management has to be driven to beat expectations, rather than rewarded for rising stock prices that merely reflect a general market increase
c. The expectations-based model from viewpoints other than management's