Rates come down

America’s Federal Reserve made a surprise cut in interest rates, trimming the fed funds rate half a point to 6%. The Fed also said it would cut rates again if that were necessary to ward off recession. Recent bad news included a sharp fall in the National Association of Purchasing Management’s index of manufacturing activity in December: it hit its lowest level since April 1991. The Conference Board’s index of consumer confidence also fell, for the third month running, reaching a two-year low.

See article: Greenspan’s big surprise On the first day of trading in the new year, America’s high-tech Nasdaq Composite index fell 7.2% as investors worried about falling profits and the state of the economy. But it rebounded almost twice as far on news that the Fed had cut interest rates. See article: After the Fed’s rate-cut

America’s travails gave a boost to the euro, which reached a five-month high against the dollar, of just below 95 cents. And it rose above ¥108—a level not seen since last February. The euro-zone also welcomed a new member: Greece became the 12th country to adopt the single currency.

Saudi Arabia responded to sliding oil prices by calling for OPEC to cut production at its meeting on January 17th by 1.5m barrels a day. It convinced oil markets that quotas would be cut and briefly caused the oil price to rally.

Credit where due
A sharp fall in the prices of investment-grade and junk bonds looks likely to continue in America, according to Standard & Poor’s, a credit-rating agency. It added that defaults would probably increase as America’s economy slowed. S&P also said that the number of credit downgrades had exceeded upgrades for the tenth quarter in succession.

As part of last year’s messy divorce settlement with Arthur Andersen, Andersen Consulting adopted a new name, accenture. Despite hoping to emphasise an “accent on the future”, the logo will adopt what is now a rather old-fashioned look: lower-case lettering throughout. Corporate freebies with the old name could become collectors’ items.

Edson Mitchell, a top executive at Deutsche Bank and a leading figure in its investment-banking arm’s push for elite “bulge bracket” status, died in a plane crash. Mr Mitchell had been tipped as the next head of Deutsche’s investment-banking unit.

Chase Manhattan completed a takeover of J.P. Morgan to become J.P. Morgan Chase, but lost a senior executive. Joe MacHale—J.P. Morgan’s chief executive for Europe, the Middle East and Africa—announced that he would quit the enlarged investment bank. Other departures are expected soon.

Trouble brewing
Britain’s government told Belgium’s Interbrew that it must sell the brewing interests that it acquired from Britain’s Bass for £2.3 billion ($3.5 billion) last year. Interbrew, the world’s second-largest brewer, had not expected such tough regulatory intervention; its shares fell sharply.

Wal-Mart, the world’s biggest retailer, said that the December shopping season had been disappointing and that sales would be below its projections. But it also announced plans to follow Carrefour, the world’s number two retailer, into Japan. The French company opened a store in Japan late last year and plans another dozen. Wal-Mart is hoping to open its first store next year.

Glaxo Wellcome and SmithKline Beecham completed their merger to form the world’s second-largest drug company. GlaxoSmithKline’s birth had been delayed by American regulatory concerns over market dominance in some product lines.

Tyson Foods, the world’s biggest chicken company, is to buy IBP, America’s largest beef-processing operation, for a meaty $3.2 billion in cash and shares. A rival all-share bid from Smithfield Foods, an American pork company, got the chop.

Aventis, a Franco-German drug company, announced that it would sell its 66% stake in Messer Griesheim, an industrial-gas firm, to Allianz Capital Partners and Goldman Sachs at a price thought to exceed euro1.5 billion ($1.4 billion). Aventis, like other drug firms, is moving away from the broad life-sciences business to concentrate on drug making.

Endesa, a Spanish power firm, expanded its pan-European activity with the acquisition of Remu, the fourth-largest gas and electricity distribution company in the Netherlands. The euro1.1 billion ($1 billion) purchase will give Endesa a 9% share of the Dutch market.

Online off-load

Letsbuyit.com, a European online group-buying concern, won temporary bankruptcy protection. It also announced that it would take no new orders as it hunts around for a cash injection to keep it solvent. When market trading resumed, its shares fell by over 50% in one day. See article: Another Internet star falls

Intershop Communications, Europe’s foremost supplier of e-commerce software, issued a profits warning. The German company blamed cutbacks in Internet spending by big companies as gains promised by e-commerce remained an ever distant prospect. Its shares plummeted.

EToys, a struggling American online toy shop, is to close all its European operations later this month after disappointing sales over Christmas.

Napster, a free service for downloading music from the Internet, struck a deal with Edel Music, a European music company, to make Edel’s music available on the web. Napster, which is developing the new service with Bertelsmann, a German media giant, hopes that other record companies will follow suit.

Issuing Securities to the Public

This chapter looks at how corporations issue securities to the investing public. Thegeneral procedures for debt and equity are quite similar. This chapter focuses on eq-uity, but the procedures for debt and equity are basically the same.

Before securities can be traded on a securities market, they must be issued to the pub-lic. A firm making an issue to the public must satisfy requirements set out in various federallegislation and statutes and enforced by the Securities and Exchange Commission (SEC). Ingeneral, investors must be given all material information in the form of a registration state-ment and prospectus. In the first part of this chapter we discuss what this entails.

A public issue of equity can be sold directly to the public with the help of underwrit-ers. This is called a general cash offer. Alternatively, a public equity issue can be sold to thefirm’s existing stockholders by what is called a rights offer. This chapter examines the dif-ference between a general cash offer and a rights offer.

Stock of companies going public for the first time is typically underpriced. We describethis unusual phenomenon and provide a possible explanation.

THE PUBLIC ISSUE

The basic steps in a public offering are depicted in Table 19.1. The Securities Act of 1933sets forth the federal regulation for all new interstate securities issues. The Securities Ex-change Act of 1934 is the basis for regulating securities already outstanding. The SEC ad-ministers both acts.

The Basic Procedure for a New Issue
1. Management’s first step in any issue of securities to the public is to obtain approvalfrom the board of directors.
2. Next, the firm must prepare and file a registration statement with the SEC. This state-ment contains a great deal of financial information, including a financial history, details of theexisting business, proposed financing, and plans for the future. It can easily run to 50 or morepages. The document is required for all public issues of securities with two principal exceptions:
a. Loans that mature within nine months.
b. Issues that involve less than $5.0 million.The second exception is known as the small-issues exemption. Issues of less than $5.0million are governed by Regulation A, for which only a brief offering statement—ratherthan the above registration statement—is needed. For Regulation A to be operative, no morethan $1.5 million may be sold by insiders.
3. The SEC studies the registration statement during a waiting period. During thistime, the firm may distribute copies of a preliminary prospectus. The preliminary prospec-tus is called a red herring because bold red letters are printed on the cover. A prospectus contains much of the information put into the registration statement, and it is given to po-tential investors by the firm. The company cannot sell the securities during the waiting pe-riod. However, oral offers can be made.
A registration statement will become effective on the 20th day after its filing unless theSEC sends a letter of comment suggesting changes. After the changes are made, the 20-daywaiting period starts anew.
4. The registration statement does not initially contain the price of the new issue. Onthe effective date of the registration statement, a price is determined and a full-fledged sell-ing effort gets under way. A final prospectus must accompany the delivery of securities orconfirmation of sale, whichever comes first.
5. Tombstone advertisements are used during and after the waiting period. An exam-ple is reproduced in Figure 19.1.

Why Does It Dividend Policy？

In recent years, U.S. corporations have paid out about 50 percent of their net income ascash dividends. However, a significant number of corporations pay no cash dividendsand many pay more dividends than their net income.

Corporations view the dividend decision as quite important because it determines whatfunds flow to investors and what funds are retained by the firm for reinvestment. Dividendpolicy can also provide information to the stockholder concerning the firm’s performance.The bulk of this chapter considers the rationale both for a policy of high dividend payoutand for a policy of low dividend payout.

In part, all discussions of dividends are plagued by the “two-handed lawyer” problem.President Truman, while discussing the legal implications of a possible presidential deci-sion, asked his staff to set up a meeting with a lawyer. Supposedly Mr. Truman said, “ButI don’t want one of those two-handed lawyers.”When asked what a two-handed lawyer was,he replied, “You know, a lawyer who says, ‘On the one hand I recommend you do so-and-so because of the following reasons, but on the other hand I recommend that you don’t doit because of these other reasons.’ ” Unfortunately, any sensible treatment of dividend pol-icy will appear to be written by a two-handed lawyer. On the one hand there are many goodreasons for corporations to pay high dividends, but on the other hand there are many goodreasons to pay low dividends.

We begin this chapter with a discussion of some practical aspects of dividend pay-ments. Next we treat dividend policy. Before delineating the pros and cons of different div-idend levels, we examine a benchmark case in which the choice of the level of dividends isnot important. Surprisingly, we will see that this conceptual setup is not merely an academiccuriosity but, instead, quite applicable to the real world. Next we consider personal taxes,an imperfection generally inducing a low level of dividends. This is followed by reasonsjustifying a high dividend level. Finally, we study the history of dividends of the AppleComputer Company. The case provides some clues as to why firms pay dividends.

DIFFERENT TYPES OF DIVIDENDS

The term dividend usually refers to a cash distribution of earnings. If a distribution is madefrom sources other than current or accumulated retained earnings, the term distribution ratherthan dividend is used. However, it is acceptable to refer to a distribution from earnings as adividend and a distribution from capital as a liquidating dividend. More generally, any directpayment by the corporation to the shareholders may be considered part of dividend policy.
The most common type of dividend is in the form of cash. Public companies usuallypay regular cash dividends four times a year. Sometimes firms will pay a regular cash div-idend and an extra cash dividend. Paying a cash dividend reduces the corporate cash andretained earnings shown in the balance sheet—except in the case of a liquidating dividend(where paid-in capital may be reduced).

Another type of dividend is paid out in shares of stock. This dividend is referred to asa stock dividend. It is not a true dividend, because no cash leaves the firm. Rather, a stockdividend increases the number of shares outstanding, thereby reducing the value of eachshare. A stock dividend is commonly expressed as a ratio; for example, with a 2-percentstock dividend a shareholder receives one new share for every 50 currently owned.
When a firm declares a stock split, it increases the number of shares outstanding.Because each share is now entitled to a smaller percentage of the firm’s cash flow, the stockprice should fall. For example, if the managers of a firm whose stock is selling at $90 de-clare a 3:1 stock split, the price of a share of stock should fall to about $30. A stock splitstrongly resembles a stock dividend except it is usually much larger.

STANDARD METHOD OF CASH DIVIDEND PAYMENT

The decision whether or not to pay a dividend rests in the hands of the board of directors ofthe corporation. A dividend is distributable to shareholders of record on a specific date.When a dividend has been declared, it becomes a liability of the firm and cannot be easilyrescinded by the corporation. The amount of the dividend is expressed as dollars per share(dividend per share), as a percentage of the market price (dividend yield), or as a percent-age of earnings per share (dividend payout).

The mechanics of a dividend payment can be illustrated by the example in Figure 18.1and the following chronology.

1. Declaration date. On January 15 (the declaration date), the board of directorspasses a resolution to pay a dividend of $1 per share on February 16 to all holders of recordon January 30.
2. Date of record. The corporation prepares a list on January 30 of all individuals be-lieved to be stockholders as of this date. The word believed is important here, because thedividend will not be paid to those individuals whose notification of purchase is received bythe company after January 30.
3. Ex-dividend date. The procedure on the date of record would be unfair if efficientbrokerage houses could notify the corporation by January 30 of a trade occurring onJanuary 29, whereas the same trade might not reach the corporation until February 2 if ex-ecuted by a less efficient house. To eliminate this problem, all brokerage firms entitlestockholders to receive the dividend if they purchased the stock three business days before the date of record. The second day before the date of record, which is Wednesday, January28, in our example, is called the ex-dividend date. Before this date the stock is said to tradecum dividend.
4. Date of payment. The dividend checks are mailed to the stockholders on February 16.

Obviously, the ex-dividend date is important, because an individual purchasing the se-curity before the ex-dividend date will receive the current dividend, whereas another indi-vidual purchasing the security on or after this date will not receive the dividend. The stockprice should fall on the ex-dividend date.1It is worthwhile to note that this drop is an indi-cation of efficiency, not inefficiency, because the market rationally attaches value to a cashdividend. In a world with neither taxes nor transaction costs, the stock price would be ex-pected to fall by the amount of the dividend:
Before ex-dividend date Price = $(P + 1)
On or after ex-dividend date Price = $P

This is illustrated in Figure 18.2.
The amount of the price drop is a matter for empirical investigation. Elton and Gruberhave argued that, due to personal taxes, the stock price should fall by less than the dividend.2For example, consider the case with no capital gains taxes. On the day before a stock goesex-dividend, shareholders must decide either (1) to buy the stock immediately and pay taxon the forthcoming dividend, or (2) to buy the stock tomorrow, thereby missing the dividend.If all investors are in the 28-percent bracket and the quarterly dividend is $1, the stock priceshould fall by $0.72 on the ex-dividend date. That is, if the stock price falls by this amounton the ex-dividend date, purchasers will receive the same return from either strategy.3

1、Empirically, the stock price appears to fall within the first few minutes of the ex-dividend day.
2、N. Elton and M. Gruber, “Marginal Stockholder Tax Rates and the Clientele Effect,” Review of Economics andStatistics 52 (February 1970). See also R. Bali and G. L. Hite, “Ex-Dividend Day Stock Price Behavior:Discreteness or Tax-Induced Clienteles?” Journal of Financial Economics (February 1998) and M. Frank and R.Jagannathan, “Why Do Stock Prices Drop by Less than the Value of the Dividend? Evidence from a Countrywithout Taxes,” Journal of Financial Economics (February 1998).
3、The situation is more complex when capital gains are considered. The individual pays capital gains taxes upon asubsequent sale. Because the price drops on the ex-dividend date, the original purchase price is higher if thepurchase is made before the ex-dividend date, and the individual will reap, and pay taxes on, lower capital gains.Elton and Gruber show that the price drop should be somewhat more than 72¢ when capital gains are considered.

Corporate-Financing Decisions and Efficient Capital Markets

The section on value concentrated on the firm’s capital budgeting decisions—theleft-hand side of the balance sheet of the firm. This chapter begins our analysis ofcorporate-financing decisions—the right-hand side of the balance sheet. We takethe firm’s capital budgeting decision as fixed in this section of the text.

The point of this chapter is to introduce the concept of efficient capital markets and itsimplications for corporate finance. Efficient capital markets are those in which current mar-ket prices reflect available information. This means that current market prices reflect theunderlying present value of securities, and there is no way to make unusual or excess prof-its by using the available information.

This concept has profound implications for financial managers, because market effi-ciency eliminates many value-enhancing strategies of firms. In particular, we show that inan efficient market

1. Financial managers cannot time issues of bonds and stocks.
2. The issuance of additional stock should not depress the stock’s market price.
3. Stock and bond prices should not be affected by a firm’s choice of accounting method.

Ultimately, whether or not capital markets are efficient is an empirical question. We will de-scribe several of the important studies that have been carried out to examine efficient markets.

CAN FINANCING DECISIONS CREATE VALUE?

Earlier parts of the book show how to evaluate projects according to the net present valuecriterion. The real world is a competitive one where projects with positive net present valueare not always easy to come by. However, through hard work or through good fortune, afirm can identify winning projects. For example, to create value from capital budgeting de-cisions, the firm is likely to

1. Locate an unsatisfied demand for a particular product or service.
2. Create a barrier to make it more difficult for other firms to compete.
3. Produce products or services at lower cost than the competition.
4. Be the first to develop a new product.

The next five chapters concern financing decisions. Typical financing decisions includehow much debt and equity to sell, what types of debt and equity to sell, and when to selldebt and equity. Just as the net present value criterion was used to evaluate capital budget-ing projects, we now want to use the same criterion to evaluate financing decisions.
Though the procedure for evaluating financing decisions is identical to the procedurefor evaluating projects, the results are different. It turns out that the typical firm has manymore capital-expenditure opportunities with positive net present values than financing opportunities with positive net present values. In fact, we later show that some plausiblefinancial models imply that no valuable financial opportunities exist at all.

Though this dearth of profitable financing opportunities will be examined in detaillater, a few remarks are in order now. We maintain that there are basically three ways to cre-ate valuable financing opportunities:

1. Fool Investors. Assume that a firm can raise capital either by issuing stock or by is-suing a more complex security, say, a combination of stock and warrants. Suppose that, intruth, 100 shares of stock are worth the same as 50 units of our complex security. If investorshave a misguided, overly optimistic view of the complex security, perhaps the 50 units canbe sold for more than the 100 shares of stock can be. Clearly this complex security providesa valuable financing opportunity because the firm is getting more than fair value for it.

Financial managers try to package securities to receive the greatest value. A cynic mightview this as attempting to fool investors. However, empirical evidence suggests that investorscannot easily be fooled. Thus, one must be skeptical that value can easily be created here.

The theory of efficient capital markets expresses this idea. In its extreme form, it saysthat all securities are appropriately priced at all times, implying that the market as a wholeis very shrewd indeed. Thus, corporate managers should not attempt to create value by fool-ing investors. Instead, managers must create value in other ways.

2. Reduce Costs or Increase Subsidies.We show later in the book that certain forms offinancing have greater tax advantages than other forms. Clearly, a firm packaging securitiesto minimize taxes can increase firm value. In addition, any financing technique involvesother costs. For example, investment bankers, lawyers, and accountants must be paid. A firmpackaging securities to minimize these costs can also increase its value. Finally, any financ-ing vehicle that provides subsidies is valuable. This last possibility is illustrated below.

Suppose Vermont Electronics Company is thinking about relocating its plant toMexico where labor costs are lower. In the hope that it can stay in Vermont, thecompany has submitted an application to the State of Vermont to issue $2 millionin five-year, tax-exempt industrial bonds. The coupon rate on industrial revenuebonds in Vermont is currently 5 percent. This is an attractive rate because the nor-mal cost of debt capital for Vermont Electronics Company is 10 percent. What isthe NPV of this potential financing transaction?

This transaction has a positive NPV. The Vermont Electronics Company obtainssubsidized financing where the amount of the subsidy is $379,079.

3. Create a New Security. There has been a surge in financial innovation in recent years.For example, in a speech on financial innovation, Nobel laureate Merton Miller asked therhetorical question, “Can any twenty-year period in recorded history have witnessed evena tenth as much new development? Where corporations once issued only straight debt andstraight common stock, they now issue zero-coupon bonds, adjustable-rate notes, floating-rate notes, putable bonds, credit-enhanced debt securities, receivable-backed securities,adjusted-rate preferred stock, convertible adjustable preferred stock, auction-rate pre-ferred stock, single-point adjustable-rate stock, convertible exchangeable preferredstock, adjustable-rate convertible debt, zero-coupon convertible debt, debt with manda-tory common-stock-purchase contracts—to name just a few!”1And, financial innovationhas occurred even more rapidly in the years following Miller’s speech.

Though the advantage of each instrument is different, one general theme is that thesenew securities cannot easily be duplicated by combinations of existing securities. Thus, apreviously unsatisfied clientele may pay extra for a specialized security catering to itsneeds. For example, putable bonds let the purchaser sell the bond at a fixed price back tothe firm. This innovation creates a price floor, allowing the investor to reduce his or herdownside risk. Perhaps risk-averse investors or investors with little knowledge of the bondmarket would find this feature particularly attractive.

Corporations gain from developing unique securities by issuing these securities at highprices. However, we believe that the value captured by the innovator is small in the long runbecause the innovator usually cannot patent or copyright his idea. Soon many firms are is-suing securities of the same kind, forcing prices down as a result.2

This brief introduction sets the stage for the next five chapters of the book. The rest ofthis chapter examines the efficient-capital-markets hypothesis. We show that if capital mar-kets are efficient, corporate managers cannot create value by fooling investors. This is quiteimportant, because managers must create value in other, perhaps more difficult, ways. Thefollowing four chapters concern the costs and subsidies of various forms of financing. Adiscussion of new financing instruments is postponed until later chapters of the text.

Strategy and Analysis in Using Net Present Value

CORPORATE STRATEGY AND POSITIVE NPV
The intuition behind discounted cash flow analysis is that a project must generate a higherrate of return than the one that can be earned in the capital markets. Only if this is true willa project’s NPV be positive. A significant part of corporate strategy analysis is seeking in-vestment opportunities that can produce positive NPV.

Simple “number crunching” in a discounted cash flow analysis can sometimes erro-neously lead to a positive NPV calculation. In calculating discounted cash flows, it is al-ways useful to ask: What is it about this project that produces a positive NPV? or Wheredoes the positive NPV in capital budgeting come from? In other words, we must be able topoint to the specific sources of positive increments to present value in doing discountedcash flow analysis. In general, it is sensible to assume that positive NPV projects are hardto find and that most project proposals are “guilty until proven innocent.”

Here are some ways that firms create positive NPV:
1. Be the first to introduce a new product.
2. Further develop a core competency to produce goods or services at lower cost thancompetitors.
3. Create a barrier that makes it difficult for other firms to compete effectively.
4. Introduce variations on existing products to take advantage of unsatisfied demand.
5. Create product differentiation by aggressive advertising and marketing networks.
6. Use innovation in organizational processes to do all of the above.

This is undoubtedly a partial list of potential sources of positive NPV. However, it isimportant to keep in mind the fact that positive NPV projects are probably not common.Our basic economic intuition should tell us that it will be harder to find positive NPV proj-ects in a competitive industry than a noncompetitive industry.
Now we ask another question: How can someone find out whether a firm is obtainingpositive NPV from its operating and investment activities? First we talk about how share prices are related to long-term and short-term decision making. Next we explain how man-agers can find clues in share price behavior on whether they are making good decisions.

Corporate Strategy and the Stock Market

There should be a connection between the stock market and capital budgeting. If a firm in-vests in a project that is worth more than its cost, the project will produce positive NPV, andthe firm’s stock price should go up. However, the popular financial press frequently sug-gests that the best way for a firm to increase its share price is to report high short-term earn-ings (even if by doing so it “cooks the books”). As a consequence, it is often said that U.S.firms tend to reduce capital expenditures and research and development in order to increaseshort-term profits and stock prices.1Moreover, it is claimed that U.S. firms that have validlong-term goals and undertake long-term capital budgeting at the expense of short-termprofits are hurt by shortsighted stock market reactions. Sometimes institutional investorsare blamed for this state of affairs. By contrast, Japanese firms are said to have a long-termperspective and make the necessary investments in research and development to provide acompetitive edge against U.S. firms.

Of course, these claims rest, in part, on the assumption that the U.S. stock market sys-tematically overvalues short-term earnings and undervalues long-term earnings. The avail-able evidence suggests the contrary. McConnell and Muscarella looked closely at the effectof corporate investment on the market value of equity.2They found that, for most industrial firms, announcements of increases in planned capital spending were associated with sig-nificant increases in the market value of the common stock and that announcements of decreases in capital spending had the opposite effect. The McConnell and Muscarella re-search suggests that the stock market does pay close attention to corporate capital spendingand it reacts positively to firms making long-term investments.

In another highly regarded study, Woolridge studied the stock market reaction to thestrategic capital spending programs of several hundred U.S. firms.3He looked at firms an-nouncing joint ventures, research and development spending, new-product strategies, andcapital spending for expansion and modernization. He found a strong positive stock reac-tion to these types of announcements. This finding provides significant support for the no-tion that the stock market encourages managers to make long-term strategic investment de-cisions in order to maximize shareholders’ value. It strongly opposes the viewpoint thatmarkets and managers are myopic.

Some Alternative Investment Rules

WHY USE NET PRESENT VALUE?

Before examining competitors of the NPV approach, we should ask: Why consider usingNPV in the first place? Answering this question will put the rest of this chapter in a properperspective. There are actually a number of arguments justifying the use of NPV, and youmay have already seen the detailed one of Chapter 3. We now present one of the simplestjustifications through an example.

EXAMPLE

The Alpha Corporation is considering investing in a riskless project costing $100.The project pays $107 at date 1 and has no other cash flows. The managers of thefirm might contemplate one of two strategies:
1. Use $100 of corporate cash to invest in the project. The $107 will be paid as adividend in one period.
2. Forgo the project and pay the $100 of corporate cash as a dividend today.If strategy 2 is employed, the stockholder might deposit the dividend in the bankfor one period. Because the project is riskless and lasts for one period, the stock-holder would prefer strategy 1 if the bank interest rate was below 7 percent. Inother words, the stockholder would prefer strategy 1 if strategy 2 produced lessthan $107 by the end of the year.

The comparison can easily be handled by NPV analysis. If the interest rate is 6 percent,the NPV of the project is Because the NPV is positive, the project should be accepted. Of course, a bank interest rateabove 7 percent would cause the project’s NPV to be negative, implying that the projectshould be rejected.

Thus, our basic point is:
Accepting positive NPV projects benefits the stockholders.

Although we used the simplest possible example, the results could easily be applied tomore plausible situations. If the project lasted for many periods, we would calculate theNPV of the project by discounting all the cash flows. If the project were risky, we could de-termine the expected return on a stock whose risk is comparable to that of the project. Thisexpected return would serve as the discount rate.

Having shown that NPV is a sensible approach, how can we tell whether alternative ap-proaches are as good as NPV? The key to NPV is its three attributes:

1. NPV Uses Cash Flows Cash flows from a project can be used for other corporate pur-poses (e.g., dividend payments, other capital-budgeting projects, or payments of corporateinterest). By contrast, earnings are an artificial construct. While earnings are useful to ac-countants, they should not be used in capital budgeting because they do not represent cash.
2. NPV Uses All the Cash Flows of the Project Other approaches ignore cash flows be-yond a particular date; beware of these approaches.
3. NPV Discounts the Cash Flows Properly Other approaches may ignore the time valueof money when handling cash flows. Beware of these approaches as well.

THE PAYBACK PERIOD RULE

Defining the Rule
One of the most popular alternatives to NPV is the payback period rule. Here is how thepayback period rule works.

Consider a project with an initial investment of $50,000. Cash flows are $30,000,$20,000, and $10,000 in the first three years, respectively. These flows are illustrated inFigure 6.1. A useful way of writing down investments like the preceding is with the notation:
(-$50,000, $30,000, $20,000, $10,000)

The minus sign in front of the $50,000 reminds us that this is a cash outflow for the investor,and the commas between the different numbers indicate that they are received—or if theyare cash outflows, that they are paid out—at different times. In this example we are assum-ing that the cash flows occur one year apart, with the first one occurring the moment we de-cide to take on the investment.

The firm receives cash flows of $30,000 and $20,000 in the first two years, which addup to the $50,000 original investment. This means that the firm has recovered its investmenwithin two years. In this case two years is the payback period of the investment.

The payback period rule for making investment decisions is simple. A particular cut-off time, say two years, is selected. All investment projects that have payback periods oftwo years or less are accepted and all of those that pay off in more than two years—if atall—are rejected.

Problems with the Payback Method

There are at least three problems with the payback method. To illustrate the first two prob-lems, we consider the three projects in Table 6.1. All three projects have the same three-year payback period, so they should all be equally attractive—right?

Actually, they are not equally attractive, as can be seen by a comparison of differentpairs of projects.

Problem 1: Timing of Cash Flows within the Payback Period Let us compare projectA with project B. In years 1 through 3, the cash flows of project A rise from $20 to $50 whilethe cash flows of project B fall from $50 to $20. Because the large cash flow of $50 comesearlier with project B, its net present value must be higher. Nevertheless, we saw above thatthe payback periods of the two projects are identical. Thus, a problem with the payback pe-riod is that it does not consider the timing of the cash flows within the payback period. Thisshows that the payback method is inferior to NPV because, as we pointed out earlier, theNPV approach discounts the cash flows properly.

Problem 2: Payments after the Payback Period Now consider projects B and C, whichhave identical cash flows within the payback period. However, project C is clearly preferredbecause it has the cash flow of $60,000 in the fourth year. Thus, another problem with thepayback method is that it ignores all cash flows occurring after the payback period. Thisflaw is not present with the NPV approach because, as we pointed out earlier, the NPV ap-proach uses all the cash flows of the project. The payback method forces managers to havean artificially short-term orientation, which may lead to decisions not in the shareholders’best interests.

Problem 3: Arbitrary Standard for Payback Period We do not need to refer to Table6.1 when considering a third problem with the payback approach. When a firm uses theNPV approach, it can go to the capital market to get the discount rate. There is no compa-rable guide for choosing the payback period, so the choice is arbitrary to some extent.

Managerial Perspective
The payback rule is often used by large and sophisticated companies when making rela-tively small decisions. The decision to build a small warehouse, for example, or to pay fora tune-up for a truck is the sort of decision that is often made by lower-level management.Typically a manager might reason that a tune-up would cost, say, $200, and if it saved $120each year in reduced fuel costs, it would pay for itself in less than two years. On such a ba-sis the decision would be made.

Although the treasurer of the company might not have made the decision in the sameway, the company endorses such decision making. Why would upper management condoneor even encourage such retrograde activity in its employees? One answer would be that itis easy to make decisions using the payback rule. Multiply the tune-up decision into 50 suchdecisions a month, and the appeal of this simple rule becomes clearer.

Perhaps most important though, the payback rule also has some desirable features formanagerial control. Just as important as the investment decision itself is the company’s abil-ity to evaluate the manager’s decision-making ability. Under the NPV rule, a long time maypass before one decides whether or not a decision was correct. With the payback rule weknow in two years whether the manager’s assessment of the cash flows was correct.

It has also been suggested that firms with very good investment opportunities but no avail-able cash may justifiably use the payback method. For example, the payback method could beused by small, privately held firms with good growth prospects but limited access to the capi-tal markets. Quick cash recovery may enhance the reinvestment possibilities for such firms.

Notwithstanding all of the preceding rationale, it is not surprising to discover that asthe decision grows in importance, which is to say when firms look at bigger projects, theNPV becomes the order of the day. When questions of controlling and evaluating the man-ager become less important than making the right investment decision, the payback periodis used less frequently. For the big-ticket decisions, such as whether or not to buy a machine,build a factory, or acquire a company, the payback rule is seldom used.

Summary of the Payback Period Rule

To summarize, the payback period is not the same as the NPV rule and is therefore con-ceptually wrong. With its arbitrary cutoff date and its blindness to cash flows after that date,it can lead to some flagrantly foolish decisions if it is used too literally. Nevertheless, be-cause it is so simple, companies often use it as a screen for making the myriad of minor in-vestment decisions they continually face.

Although this means that you should be wary of trying to change rules like the paybackperiod when you encounter them in companies, you should probably be careful not to fall intothe sloppy financial thinking they represent. After this course you would do your company adisservice if you ever used the payback period instead of the NPV when you had a choice.

THE DISCOUNTED PAYBACK PERIOD RULE

Aware of the pitfalls of the payback approach, some decision makers use a variant called thediscounted payback period rule.Under this approach,we first discount the cash flows. Thenwe ask how long it takes for the discounted cash flows to equal the initial investment.

For example, suppose that the discount rate is 10 percent and the cash flows on a proj-ect are given by
(-$100, $50, $50, $20)

This investment has a payback period of two years, because the investment is paid back inthat time.
To compute the project’s discounted payback period, we first discount each of the casflows at the 10-percent rate. In discounted terms, then, the cash flows look like
[-$100, $50/1.1, $50/(1.1)]=(-$100, $45.45, $41.32, $15.03)

The discounted payback period of the original investment is simply the payback period forthese discounted cash flows. The payback period for the discounted cash flows is slightly lessthan three years since the discounted cash flows over the three years are $101.80 ($45.45 $41.32  $15.03). As long as the cash flows are positive, the discounted payback period willnever be smaller than the payback period, because discounting will lower the cash flows.

At first glance the discounted payback may seem like an attractive alternative, but oncloser inspection we see that it has some of the same major flaws as the payback. Like pay-back, discounted payback first requires us to make a somewhat magical choice of an arbi-trary cutoff period, and then it ignores all of the cash flows after that date.

If we have already gone to the trouble of discounting the cash flows, any small appealto simplicity or to managerial control that payback may have, has been lost. We might justas well add up the discounted cash flows and use the NPV to make the decision. Althoughdiscounted payback looks a bit like the NPV, it is just a poor compromise between the pay-back method and the NPV.

How to Value Bonds and Stocks

How bonds are valued，Since the future cashflows of bonds are known, application of net-present-value techniques is fairly straightfor-ward. The uncertainty of future cash flows makes the pricing of stocks according to NPVmore difficult.

DEFINITION AND EXAMPLE OF A BOND

A bond is a certificate showing that a borrower owes a specified sum. In order to repay themoney, the borrower has agreed to make interest and principal payments on designateddates. For example, imagine that Kreuger Enterprises just issued 100,000 bonds for $1,000each, where the bonds have a coupon rate of 5 percent and a maturity of two years. Intereston the bonds is to be paid yearly. This means that:
1. $100 million (100,000  $1,000) has been borrowed by the firm
.2. The firm must pay interest of $5 million (5%  $100 million) at the end of one year
.3. The firm must pay both $5 million of interest and $100 million of principal at the end oftwo years.

We now consider how to value a few different types of bonds.

HOW TO VALUE BONDS

Pure Discount Bonds
The pure discount bond is perhaps the simplest kind of bond. It promises a single payment,say $1, at a fixed future date. If the payment is one year from now, it is called a one-year dis-count bond; if it is two years from now, it is called a two-year discount bond, and so on. Thedate when the issuer of the bond makes the last payment is called the maturity date of thebond, or just its maturity for short. The bond is said to mature or expire on the date of its fi-nal payment. The payment at maturity ($1 in this example) is termed the bond’s face value.
Pure discount bonds are often called zero-coupon bonds or zeros to emphasize the factthat the holder receives no cash payments until maturity. We will use the terms zero, bullet,and discount interchangeably to refer to bonds that pay no coupons.

The first row of Figure 5.1 shows the pattern of cash flows from a four-year pure dis-count bond. Note that the face value, F, is paid when the bond expires in the 48th month.There are no payments of either interest or principal prior to this date.

In the previous chapter, we indicated that one discounts a future cash flow to determineits present value. The present value of a pure discount bond can easily be determined by thetechniques of the previous chapter. For short, we sometimes speak of the value of a bondinstead of its present value.

Consider a pure discount bond that pays a face value of F in T years, where the interestrate is r in each of the T years. (We also refer to this rate as the market interest rate.) Becausethe face value is the only cash flow that the bond pays, the present value of this face amount is

The present value formula can produce some surprising results. Suppose that the in-terest rate is 10 percent. Consider a bond with a face value of $1 million that matures in 20years. Applying the formula to this bond, its PV is given by

Level-Coupon Bonds
Many bonds, however, are not of the simple, pure discount variety. Typical bonds issued byeither governments or corporations offer cash payments not just at maturity, but also at reg-ular times in between. For example, payments on U.S. government issues and Americancorporate bonds are made every six months until the bond matures. These payments arecalled the coupons of the bond. The middle row of Figure 5.1 illustrates the case of a four-year, level-coupon bond: The coupon, C, is paid every six months and is the same through-out the life of the bond.

Note that the face value of the bond, F, is paid at maturity (end of year 4). F is some-times called the principal or the denomination. Bonds issued in the United States typicallyhave face values of $1,000, though this can vary with the type of bond.