ACCOUNTING AND LEASING

Before November 1976, a firm could arrange to use an asset through a lease and not disclose the asset or the lease contract on the balance sheet. Lessees needed only to report information on leasing activity in the footnotes of their financial statements. Thus, leasing led to off–balance-sheet financing.
In November 1976, the Financial Accounting Standards Board (FASB) issued its
Statement of Financial Accounting Standards No. 13 (FAS 13), “Accounting for Leases.”
Under FAS 13, certain leases are classified as capital leases. For a capital lease, the present value of the lease payments appears on the right-hand side of the balance sheet. The identical value appears on the left-hand side of the balance sheet as an asset.
FASB classifies all other leases as operating leases, though FASB’s definition differs from that of nonaccountants. No mention of the lease appears on the balance sheet for operating leases.
The accounting implications of this distinction are illustrated in Table 21.1. Imagine a firm that, years ago, issued $100,000 of equity in order to purchase land. It now wants to use a $100,000 truck, which it can either purchase or lease. The balance sheet reflecting purchase of the truck is shown at the top of the table. (We assume that the truck is financed entirely with debt.) Alternatively, imagine that the firm leases the truck. If the lease is judged to be an operating one, the middle balance sheet is created. Here, neither the lease liability nor the truck appears on the balance sheet. The bottom balance sheet reflects a cap-
ital lease. The truck is shown as an asset and the lease is shown as a liability.
Accountants generally argue that a firm’s financial strength is inversely related to the amount of its liabilities. Since the lease liability is hidden with an operating lease, the balance sheet of a firm with an operating lease looks stronger than the balance sheet of a firm with an otherwise-identical capital lease. Given the choice, firms would probably classify all their leases as operating ones. Because of this tendency, FAS 13 states that a lease must
be classified as a capital one if at least one of the following four criteria is met:
1. The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease.
2. The lease transfers ownership of the property to the lessee by the end of the term of the lease.
3. The lease term is 75 percent or more of the estimated economic life of the asset.
4. The lessee can purchase the asset at a price below fair market value when the lease expires. This is frequently called a bargain-purchase-price option.
These rules capitalize those leases that are similar to purchases. For example, the first two rules capitalize leases where the asset is likely to be purchased at the end of the lease period. The last two rules capitalize long-term leases.
Some firms have tried to cook the books by exploiting this classification scheme.
Suppose a trucking firm wants to lease a $200,000 truck that it expects to use for 15 years.
A clever financial manager could try to negotiate a lease contract for 10 years with lease payments having a present value of $178,000. These terms would get around criteria (1) and (3). If criteria (2) and (4) could be circumvented, the arrangement would be an operating lease and would not show up on the balance sheet.
Does this sort of gimmickry pay? The semistrong form of the efficient-capital-markets hypothesis implies that stock prices reflect all publicly available information. As we discussed earlier in this text, the empirical evidence generally supports this form of the hypothesis. Though operating leases do not appear in the firm’s balance sheet, information on these leases must be disclosed elsewhere in the annual report. Because of this, attempts to keep leases off the balance sheet will not affect stock price in an efficient capital market.

 TAXES,THE IRS, AND LEASES
The lessee can deduct lease payments for income tax purposes if the lease is qualified by the Internal Revenue Service. Because tax shields are critical to the economic viability of any lease, all interested parties generally obtain an opinion from the IRS before agreeing to a major lease transaction. The opinion of the IRS will reflect the following guidelines:
1. The term of the lease must be less than 30 years. If the term is greater than 30 years, the transaction will be regarded as a conditional sale.
2. The lease should not have an option to acquire the asset at a price below its fair market value. This type of bargain option would give the lessee the asset’s residual scrap value, implying an equity interest.
3. The lease should not have a schedule of payments that is very high at the start of the lease term and thereafter very low. Early balloon payments would be evidence that the lease was being used to avoid taxes and not for a legitimate business purpose.
4. The lease payments must provide the lessor with a fair market rate of return. The profit potential of the lease to the lessor should be apart from the deal’s tax benefits.
5. The lease should not limit the lessee’s right to issue debt or pay dividends while the lease is operative.
6. Renewal options must be reasonable and reflect fair market value of the asset. This requirement can be met by granting the lessee the first option to meet a competing outside offer.
The reason the IRS is concerned about lease contracts is that many times they appear to be set up solely to avoid taxes. To see how this could happen, suppose that a firm plans to purchase a $1 million bus that has a five-year class life. Depreciation expense would be $200,000 per year, assuming straight-line depreciation. Now suppose that the firm can lease the bus for $500,000 per year for two years and buy the bus for $1 at the end of the two-year term. The present value of the tax benefits from acquiring the bus would clearly be less
than if the bus were leased. The speedup of lease payments would greatly benefit the firm and de facto give it a form of accelerated depreciation. If the tax rates of the lessor and lessee are different, leasing can be a form of tax avoidance.
 
 THECASH FLOWS OF LEASING
In this section we identify the basic cash flows used in evaluating a lease. Consider the decision confronting the Xomox corporation, which manufactures pipe. Business has been expanding, and Xomox currently has a five-year backlog of pipe orders for the Trans-Honduran Pipeline.
The International Boring Machine Corporation (IBMC) makes a pipe-boring machine that can be purchased for $10,000. Xomox has determined that it needs a new machine, and the IBMC model will save Xomox $6,000 per year in reduced electricity bills for the next five years. These savings are known with certainty because Xomox has a long-term electricity purchase agreement with State Electric Utilities, Inc.
Xomox has a corporate tax rate of 34 percent. We assume that five-year straight-line depreciation is used for the pipe-boring machine, and the machine will be worthless after five years.
However, Friendly Leasing Corporation has offered to lease the same pipe-boring machine to Xomox for $2,500 per year for five years. With the lease, Xomox would remain responsible for maintenance, insurance, and operating expenses.
Simon Smart, a recently hired MBA, has been asked to calculate the incremental cash flows from leasing the IBMC machine in lieu of buying it. He has prepared Table 21.2, which shows the direct cash flow consequences of buying the pipe-boring machine and also signing the lease agreement with Friendly Leasing.
To simplify matters, Simon Smart has prepared Table 21.3, which subtracts the direct cash flows of buying the pipe-boring machine from those of leasing it. Noting that only the net advantage of leasing is relevant to Xomox, he concludes the following from his analysis:

1. Operating costs are not directly affected by leasing. Xomox will save $3,960 (after taxes) from use of the IBMC boring machine regardless of whether the machine is owned or leased. Thus, this cash flow stream does not appear in Table 21.3.
2. If the machine is leased, Xomox will save the $10,000 it would have used to purchase the machine. This saving shows up as an initial cash inflow of $10,000 in year 0.
3. If Xomox leases the pipe-boring machine, it will no longer own this machine and must give up the depreciation tax benefits. These tax benefits show up as an outflow.
4. If Xomox chooses to lease the machine, it must pay $2,500 per year for five years. The first payment is due at the end of the first year. (This is a break, because sometimes the first payment is due immediately.) The lease payments are tax-deductible and, as a consequence, generate tax benefits of $850 (0.34 ϫ $2,500).
Of course, the cash flows here are the opposite of those in the bottom line of Table 21.3.
Depending on our purpose, we may look at either the purchase relative to the lease or vice versa. Thus, the student should become comfortable with either viewpoint. Now that we have the cash flows, we can make our decision by discounting the flows properly. However, because the discount rate is tricky, we take a detour in the next section before moving back to the Xomox case. In this next section, we show that cash flows in the lease-versus-buy decision should be discounted at the after-tax interest rate (i.e., the after-tax cost of debt capital).

TYPES OF LEASES

The Basics
A lease is a contractual agreement between a lessee and lessor. The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset. The lessor is either the asset’s manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. Then the lessor delivers the asset to the lessee, and the lease goes into effect.
As far as the lessee is concerned, it is the use of the asset that is most important, not who owns the asset. The use of an asset can be obtained by a lease contract. Because the user can also buy the asset, leasing and buying involve alternative financing arrangements for the use of an asset. This is illustrated in Figure 21.1.

The specific example in Figure 21.1 happens often in the computer industry. Firm U, the lessee, might be a hospital, a law firm, or any other firm that uses computers. The lessor is an independent leasing company who purchased the equipment from a manufacturer such as IBM or Apple. Leases of this type are called direct leases. In the figure, the lessor issued both debt and equity to finance the purchase.
Of course, a manufacturer like IBM could lease its own computers, though we do not show this situation in the example. Leases of this type are called sales-type leasing. In this case, IBM would compete with the independent computer-leasing company.

Operating Leases
Years ago, a lease where the lessee received an operator along with the equipment was called an operating lease. Though the operating lease defies an exact definition today, this form for leasing has several important characteristics.
1. Operating leases are usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. This occurs because the term or life of the operating lease is usually less than the economic life of the asset. Thus, the lessor must expect to recover the costs of the asset by renewing the lease or by selling the asset for its residual value.
2. Operating leases usually require the lessor to maintain and insure the leased assets.
3. Perhaps the most interesting feature of an operating lease is the cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.
If the option to cancel is exercised, the lessee must return the equipment to the lessor. The value of a cancellation clause depends on whether future technological and/or economic conditions are likely to make the value of the asset to the lessee less than the value of the future lease payments under the lease.
To leasing practitioners, the above characteristics constitute an operating lease.
However, accountants use the term in a slightly different way, as we will see shortly.
Financial Leases
Financial leases are the exact opposite of operating leases, as is seen from their important characteristics:
1.
 Financial leases do not provide for maintenance or service by the lessor.
2.
 Financial leases are fully amortized.
3.
 The lessee usually has a right to renew the lease on expiration.
4.
 Generally, financial leases cannot be canceled. In other words, the lessee must make all payments or face the risk of bankruptcy.
Because of the above characteristics, particularly (2), this lease provides an alternative method of financing to purchase. Hence, its name is a sensible one. Two special types of financial leases are the sale and lease-back arrangement and the leveraged lease.
Sale and Lease-Back A sale and lease-back occurs when a company sells an asset it owns to another firm and immediately leases it back. In a sale and lease-back, two things happen:
1. The lessee receives cash from the sale of the asset.
2. The lessee makes periodic lease payments, thereby retaining use of the asset.
An example of a sale and lease-back occurred when the city of Oakland, California, used the proceeds of a sale of its city hall and 23 other buildings to help meet the liabilities of the $150 million Police and Retirement System. As part of the same transaction, Oakland leased back the buildings to obtain their continued use.
Leveraged Leases A leveraged lease is a three-sided arrangement among the lessee, the lessor, and the lenders:
1. As in other leases, the lessee uses the assets and makes periodic lease payments.
2. As in other leases, the lessor purchases the assets, delivers them to the lessee, and collects the lease payments. However, the lessor puts up no more than 40 to 50 percent of the purchase price.
3. The lenders supply the remaining financing and receive interest payments from the lessor. Thus, the arrangement on the right-hand side of Figure 24.1 would be a leveraged lease if the bulk of the financing was supplied by creditors.
The lenders in a leveraged lease typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default. However, the lender is protected in two ways:
1. The lender has a first lien on the asset.
2. In the event of loan default, the lease payments are made directly to the lender.
The lessor puts up only part of the funds but gets the lease payments and all the tax benefits of ownership. These lease payments are used to pay the debt service of the nonrecourse loan. The lessee benefits because, in a competitive market, the lease payment is lowered when the lessor saves taxes.

CORPORATE STRATEGY AND POSITIVE NPV

The intuition behind discounted cash flow analysis is that a project must generate a higher rate of return than the one that can be earned in the capital markets. Only if this is true will a project’s NPV be positive. A significant part of corporate strategy analysis is seeking investment opportunities that can produce positive NPV.
Simple “number crunching” in a discounted cash flow analysis can sometimes erroneously lead to a positive NPV calculation. In calculating discounted cash flows, it is always useful to ask: What is it about this project that produces a positive NPV? or Where does the positive NPV in capital budgeting come from? In other words, we must be able to point to the specific sources of positive increments to present value in doing discounted cash flow analysis. In general, it is sensible to assume that positive NPV projects are hard to 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 than competitors.
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 is important 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 projects in a competitive industry than a noncompetitive industry.
Now we ask another question: How can someone find out whether a firm is obtaining positive 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 managers 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 invests in a project that is worth more than its cost, the project will produce positive NPV, and the firm’s stock price should go up. However, the popular financial press frequently suggests that the best way for a firm to increase its share price is to report high short-term earnings (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 increase
short-term profits and stock prices.1 Moreover, it is claimed that U.S. firms that have valid long-term goals and undertake long-term capital budgeting at the expense of short-term profits are hurt by shortsighted stock market reactions. Sometimes institutional investors are blamed for this state of affairs. By contrast, Japanese firms are said to have a long-term perspective and make the necessary investments in research and development to provide a competitive edge against U.S. firms.
Of course, these claims rest, in part, on the assumption that the U.S. stock market systematically overvalues short-term earnings and undervalues long-term earnings. The available evidence suggests the contrary. McConnell and Muscarella looked closely at the effect of corporate investment on the market value of equity. They found that, for most industrial firms, announcements of increases in planned capital spending were associated with significant 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 research suggests that the stock market does pay close attention to corporate capital spending and it reacts positively to firms making long-term investments.
In another highly regarded study, Woolridge studied the stock market reaction to the strategic capital spending programs of several hundred U.S. firms.3 He looked at firms announcing joint ventures, research and development spending, new-product strategies, and capital spending for expansion and modernization. He found a strong positive stock reaction to these types of announcements. This finding provides significant support for the notion that the stock market encourages managers to make long-term strategic investment decisions in order to maximize shareholders’ value. It strongly opposes the viewpoint that markets and managers are myopic.


How Firms Can Learn about NPV from the Stock Market:
The AT&T Decision to Acquire NCR and to Change Its CEO

Therefore, it is not surprising that the stock market usually reacts positively to the proposed capital budgeting programs of U.S. firms. However, this is not always the case. Sometimes the stock market provides negative clues to a new project’s NPV.
Consider AT&T’s repeated attempts to penetrate the computer-manufacturing industry. On December 6, 1990, AT&T made a $90 per share or $6.12 billion cash offer for all of NCR Corporation’s common stock. From December 4, 1990, to December 11, 1990, AT&T’s stock dropped from $303⁄ 8 per share to $291 ⁄ 2, representing a loss of about $1 billion to the shareholders of AT&T.
Five months later, when these firms finally agreed to a deal, AT&T’s stock dropped again. Why did AT&T buy NCR, a large computer manufacturer? Why did the stock market reaction suggest that the acquisition was a negative NPV investment for AT&T? AT&T was apparently convinced that the telecommunications and computer industries were becoming one industry. AT&T’s basic idea was that telephone switches are big computers and success in computers means success in telephones. The message from the stock market is that AT&T could be wrong. That is, making computers is basically a manufacturing business and telephone communications is basically a service
business. The core competency of making computers (efficient manufacturing) is different from that of providing telecommunications for business (service support and software). Of course, even if AT&T had acquired NCR for the “right” reasons, it is possible that it paid too much. The negative stock market reaction suggests that AT&T shareholders believed that NCR was worth less than its cost to AT&T. On September 20, 1995, when AT&T announced its intention to spin off NCR (as well as Lucent), its stock price increased by about 11 percent. On the other hand, when it was announced, on November 5, 1992, that AT&T was negotiating the purchase of one-third of McCaw Cellular Communications with the option to obtain voting control, AT&T’s stock price jumped from $426⁄ 8 to $443 ⁄ 8, representing a gain in market value close to $2 billion.
Two years later,the Federal Communications Commission approved the acquisition of all of McCaw by AT&T, and AT&T’s stock price was holding at over $55 per share. The positive stock market reaction suggests that the shareholders of AT&T believe that AT&T’s acquisition of McCaw is a positive NPV decision. AT&T could use McCaw’s cellular telephone network to bypass local telephone companies for completing long distance telephone calls, eliminating the access fees normally paid to them. Perhaps because of AT&T’s spotty acquisition record, its stock price rose 13.5 percent when on October 17,
1997, it was learned that Robert Allen would step down and Michael Armstrong would become the new CEO. On June 24, 1998, when it was disclosed that AT&T appeared close to a deal to acquire TCI for $30 billion, AT&T’s stock jumped 4 percent.The market believed that by buying TCI, which owned a large portfolio of cable lines, AT&T might be able to bypass the local phone monopolies of the “baby bells.”TCI would offer AT&T a detour around the “last mile” and ultimately be part of AT&T’s broadband strategy. AT&T’s market share of long-distance business continues to fall and there have been reports of pressure by the credit rating agencies for it to reduce its $62 billion of debt and $3 billion of interest costs.
AT&T’s stock price fell by more than 60 percent during the year 2000, a year that included AT&T’s announced breakup into three companies: wireless, broadband, and business services. The stock market appeared to be very skeptical of AT&T’s ability to carry out its long term strategy.
At the end of the year, it was reported that AT&T was expected to reduce its dividend by about 60 percent from its current level. This would be the first time in the company’s more than 100-year history that it had cut its dividend. Upon the report of a dividend cut, AT&T’s stock price increased.
Overall, the evidence suggests that firms can use the stock market to help potentially short-sighted managers make positive net present value decisions. Unfortunately only a few firms use the market as effectively as they could to help them make capital budgeting decisions.

INCREMENTAL CASH FLOWS

Cash Flows—Not Accounting Income
You may not have thought about it, but there is a big difference between corporate finance courses and financial accounting courses. Techniques in corporate finance generally use cash flows, whereas financial accounting generally stresses income or earnings numbers.
Certainly, our text has followed this tradition since our net present value techniques discounted cash flows, not earnings. When considering a single project, we discounted the cash flows that the firm receives from the project. When valuing the firm as a whole, we discounted dividends—not earnings— because dividends are the cash flows that an investor receives.
There are many differences between earnings and cash flows. In fact, much of a standard financial accounting course delineates these differences. Because we have no desire to duplicate such course material, we merely discuss one example of the differences. Consider a firm buying a building for $100,000 today. The entire $100,000 is an immediate cash outflow.
However, assuming straight-line depreciation over 20 years, only $5,000 ($100,000/20) is considered an accounting expense in the current year. Current earnings are thereby reduced only by $5,000. The remaining $95,000 is expensed over the following 19 years.
Because the seller of the property demands immediate payment, the cost at date 0 of the project to the firm is $100,000. Thus, the full $100,000 figure should be viewed as an immediate outflow for capital budgeting purposes. This is not merely our opinion but the unanimous verdict of both academics and practitioners.
In addition, it is not enough to use cash flows. In calculating the NPV of a project, only cash flows that are incremental to the project should be used. These cash flows are the changes in the firm’s cash flows that occur as a direct consequence of accepting the project. That is, we are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.
The use of incremental cash flows sounds easy enough, but pitfalls abound in the real world. In this section we describe how to avoid some of the pitfalls of determining incre- mental cash flows.

Sunk Costs
A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. Just as we “let bygones be bygones,” we should ignore such costs. Sunk costs are not incremental cash outflows.

Opportunity Costs
Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets.
 
Side Effects
Another difficulty in determining incremental cash flows comes from the side effects of the proposed project on other parts of the firm. The most important side effect is erosion. Erosion is the cash flow transferred to a new project from customers and sales of other products of the firm.

 THE BALDWINCOMPANY : AN EXAMPLE
We next consider the example of a proposed investment in machinery and related items. Our example involves the Baldwin Company and colored bowling balls. The Baldwin Company, originally established in 1965 to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. In 1973 the company introduced “High Flite,” its first line of high-performance golf balls. The Baldwin management has sought opportunities in whatever businesses seem to have some potential for cash flow. In 1999 W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers. That market was for brightly colored bowling balls, and he believed a large number of bowlers valued appearance and style above performance. He also believed that it would be difficult for competitors to take advantage of the opportunity because of Baldwin’s cost advantages and because of its ability to use its highly developed marketing skills.
As a result, in late 2000 the Baldwin Company decided to evaluate the marketing potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly colored bowling ball could achieve a 10- to 15-percent share of the market. Of course, some people at Baldwin complained about the cost of the test marketing, which was $250,000. However,
Meadows argued that it was a sunk cost and should not be included in project evaluation. In any case, the Baldwin Company is now considering investing in a machine to produce bowling balls. The bowling balls would be produced in a building owned by the firm and located near Los Angeles. This building, which is vacant, and the land can be sold to net $150,000 after taxes. The adjusted basis of this property, the original purchase price of the property less depreciation, is zero.
Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is $100,000. The machine has an estimated market value at the end of five years of $30,000.
Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be $20. The bowling ball market is highly competitive, so Meadows believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent. Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be $10 per unit. Meadows has determined, based upon Baldwin’s taxable income,
that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent. Net working capital is defined as the difference between current assets and current liabilities. Baldwin finds that it must maintain an investment in working capital. Like any manufacturing firm, it will purchase raw materials before production and sale, giving rise to an investment in inventory. It will maintain cash as a buffer against unforeseen expenditures. Its credit sales will generate accounts receivable. Management believes that the investment in the different items of working capital totals $10,000 in year 0, rises somewhat
in the early years of the project, and falls to $0 by the project’s end. In other words, the investment in working capital is completely recovered by the end of the project’s life.

An Analysis of the Project
Investments The investment outlays required for the project are summarized in the top segment of Table 7.1. They consist of three parts:
1. The Bowling Ball Machine. The purchase requires a cash outflow of $100,000 at year 0. The firm realizes a cash inflow when the machine is sold in year 5. These cash flows are shown in line 1 of Table 7.1. As indicated in the footnote to the table, taxes are incurred when the asset is sold.
2. The Opportunity Cost of Not Selling the Warehouse. If Baldwin accepts the bowlingball project, it will use a warehouse and land that could otherwise be sold. The estimated sales price of the warehouse and land is therefore included as an opportunity cost, as budgeting. In other words, all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected. Increases in working capital in the early years must be funded by cash generated elsewhere in the firm. Hence, these increases are viewed as cash outflows. Conversely, decreases in working capital in the later
years are viewed as cash inflows. All of these cash flows are presented in line 6. A more complete discussion of working capital is provided later in this section. The total cash flow from the above three investments is shown in line 7.
Income and Taxes Next, the determination of income is presented in the bottom segment of Table 7.1. While we are ultimately interested in cash flow—not income—we need the income calculation in order to determine taxes. Lines 8 and 9 of Table 7.1 show sales revenues and operating costs, respectively. The projections in these lines are based on the sales revenues and operating costs computed in columns 4 and 6 of Table 7.2. The estimates of revenues and costs follow from assumptions made by the corporate planning staff at Baldwin.
In other words, the estimates critically depend on the fact that product prices are projected to increase at 2 percent per year and costs are projected to increase at 10 percent per year.
Depreciation of the $100,000 capital investment is based on the amount allowed by the 1986 Tax Reform Act.2 Depreciation schedules under the act for three-year, five-year, and seven-year recovery periods are presented in Table 7.3. The IRS ruled that Baldwin is to depreciate its capital investment over five years, so the middle column of the table applies to this case.

THE PAYBACK PERIOD RULE

Defining the Rule
One of the most popular alternatives to NPV is the payback period rule. Here is how the payback period rule works.
Consider a project with an initial investment of Ϫ$50,000. Cash flows are $30,000, $20,000, and $10,000 in the first three years, respectively. These flows are illustrated in Figure 6.1. A useful way of writing down investments like the preceding is with the notation:
(Ϫ$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 they are cash outflows, that they are paid out—at different times. In this example we are assuming that the cash flows occur one year apart, with the first one occurring the moment we decide to take on the investment.

The firm receives cash flows of $30,000 and $20,000 in the first two years, which add up to the $50,000 original investment. This means that the firm has recovered its investment within 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 of two years or less are accepted and all of those that pay off in more than two years—if at all—are rejected.

Problems with the Payback Method
There are at least three problems with the payback method. To illustrate the first two problems, 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 different pairs of projects.
Problem 1: Timing of Cash Flows within the Payback Period Let us compare project A with project B. In years 1 through 3, the cash flows of project A rise from $20 to $50 while the cash flows of project B fall from $50 to $20. Because the large cash flow of $50 comes earlier with project B, its net present value must be higher. Nevertheless, we saw above that the payback periods of the two projects are identical. Thus, a problem with the payback period is that it does not consider the timing of the cash flows within the payback period. This shows that the payback method is inferior to NPV because, as we pointed out earlier, the NPV approach discounts the cash flows properly.
Problem 2: Payments after the Payback Period Now consider projects B and C, which have identical cash flows within the payback period. However, project C is clearly preferred because it has the cash flow of $60,000 in the fourth year. Thus, another problem with the payback method is that it ignores all cash flows occurring after the payback period. This flaw is not present with the NPV approach because, as we pointed out earlier, the NPV approach uses all the cash flows of the project. The payback method forces managers to have an 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 Table 6.1 when considering a third problem with the payback approach. When a firm uses the NPV approach, it can go to the capital market to get the discount rate. There is no comparable 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 relatively small decisions. The decision to build a small warehouse, for example, or to pay for a 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 $120 each year in reduced fuel costs, it would pay for itself in less than two years. On such a basis the decision would be made.
Although the treasurer of the company might not have made the decision in the same way, the company endorses such decision making. Why would upper management condone or even encourage such retrograde activity in its employees? One answer would be that it is easy to make decisions using the payback rule. Multiply the tune-up decision into 50 such decisions a month, and the appeal of this simple rule becomes clearer.
Perhaps most important though, the payback rule also has some desirable features for managerial control. Just as important as the investment decision itself is the company’s ability to evaluate the manager’s decision-making ability. Under the NPV rule, a long time may pass before one decides whether or not a decision was correct. With the payback rule we know 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 available cash may justifiably use the payback method. For example, the payback method could be used by small, privately held firms with good growth prospects but limited access to the capital 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 as the decision grows in importance, which is to say when firms look at bigger projects, the NPV becomes the order of the day. When questions of controlling and evaluating the manager become less important than making the right investment decision, the payback period is 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 conceptually 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, because it is so simple, companies often use it as a screen for making the myriad of minor investment decisions they continually face.
Although this means that you should be wary of trying to change rules like the payback period when you encounter them in companies, you should probably be careful not to fall into the sloppy financial thinking they represent. After this course you would do your company a disservice if you ever used the payback period instead of the NPV when you had a choice.

Dividends or Earnings: Which to Discount?

As mentioned earlier, this chapter applied the growing-perpetuity formula to the valuation of stocks. In our application, we discounted dividends, not earnings. This is sensible since investors select a stock for what they can get out of it. They only get two things out of a stock: dividends and the ultimate sales price, which is determined by what future investors expect to receive in dividends.
The calculated stock price would be too high were earnings to be discounted instead of dividends. As we saw in our estimation of a firm’s growth rate, only a portion of earnings goes to the stockholders as dividends. The remainder is retained to generate future dividends. In our model, retained earnings are equal to the firm’s investment. To discount earnings instead of dividends would be to ignore the investment that a firm must make today in order to generate future returns.

The No-Dividend Firm
Students frequently ask the following questions: If the dividend-discount model is correct, why aren’t no-dividend stocks selling at zero? This is a good question and gets at the goals of the firm. A firm with many growth opportunities is faced with a dilemma. The firm can pay out dividends now, or it can forgo dividends now so that it can make investments that will generate even greater dividends in the future. This is often a painful choice, because a strategy of dividend deferment may be optimal yet unpopular among certain stockholders.
Many firms choose to pay no dividends—and these firms sell at positive prices. Rational shareholders believe that they will either receive dividends at some point or they will receive something just as good. That is, the firm will be acquired in a merger, with the stockholders receiving either cash or shares of stock at that time.
Of course, the actual application of the dividend-discount model is difficult for firms of this type. Clearly, the model for constant growth of dividends does not apply. Though the differential growth model can work in theory, the difficulties of estimating the date of first dividend, the growth rate of dividends after that date, and the ultimate merger price make application of the model quite difficult in reality.
Empirical evidence suggests that firms with high growth rates are likely to pay lower dividends, a result consistent with the above analysis. For example, consider McDonald’s Corporation. The company started in the 1950s and grew rapidly for many years. It paid its first dividend in 1975, though it was a billion-dollar company (in both sales and market value of stockholder’s equity) prior to that date. Why did it wait so long to pay a dividend? It waited because it had so many positive growth opportunities, that is, additional locations for new hamburger outlets, to take advantage of.
Utilities are an interesting contrast because, as a group, they have few growth opportunities. Because of this, they pay out a large fraction of their earnings in dividends. For example, Consolited Edison, Sempra Energy, and Kansas City Power and Light have had payout ratios of over 70 percent in many recent years.

 PRICE-EARNINGS RATIO
This explanation seems to hold fairly well in the real world. Electronic and other high-tech stocks generally sell at very high P/E ratios (or multiples, as they are often called) because they are perceived to have high growth rates. In fact, some technology stocks sell at high prices even though the companies have never earned a profit. The P/E ratios of these companies are infinite. Conversely, railroads, utilities, and steel companies sell at lower multiples because of the prospects of lower growth.
Of course, the market is merely pricing perceptions of the future, not the future itself.
We will argue later in the text that the stock market generally has realistic perceptions of a firm’s prospects. However, this is not always true. In the late 1960s, many electronics firms were selling at multiples of 200 times earnings. The high perceived growth rates did not materialize, causing great declines in stock prices during the early 1970s. In earlier decades, fortunes were made in stocks like IBM and Xerox because the high growth rates were not
anticipated by investors.
One of the most puzzling phenomena to American investors has been the high P/E ratios in the Japanese stock market. The average P/E ratio for the Tokyo Stock Exchange has varied between 40 and 100 in recent years, while the average American stock had a multiple of around 25 during this time. Our formula indicates that Japanese companies have been perceived to have great growth opportunities. However, American commentators have frequently suggested that investors in the Japanese markets have been overestimating these
growth prospects.13 This enigma (at least to American investors) can only be resolved with the passage of time. Some selected country average P/E ratios appear in Table 5.2. You can see Japan’s P/E ratio has trended down.
There are two additional factors explaining the P/E ratio. The above formula shows that the P/E ratio is negatively related to the firm’s discount rate.
We have already suggested that the discount rate is positively related to the stock’s risk or variability. Thus, the P/E ratio is negatively related to the stock’s risk. To see that this is a sensible result, consider two firms, A and B, behaving as cash cows. The stock market expects both firms to have annual earnings of $1 per share forever. However, the earnings of firm A are known with certainty while the earnings of firm B are quite variable. A rational stockholder is likely to pay more for a share of firm A because of the absence of risk. If a share of firm A sells at a higher price and both firms have the same EPS, the P/E ratio of firm A must be higher.
The second additional factor concerns the firm’s choice of accounting methods. Under current accounting rules, companies are given a fair amount of leeway. For example, consider inventory accounting where either FIFO or LIFO may be used. In an inflationary environment, FIFO (first in–first out) accounting understates the true cost of inventory and hence inflates reported earnings. Inventory is valued according to more recent costs under LIFO (last in–first out), implying that reported earnings are lower here than they would be under FIFO. Thus, LIFO inventory accounting is a more conservative method than FIFO. Similar accounting leeway exists for construction costs (completed-contracts versus percentage-of-completion methods) and depreciation (accelerated depreciation versus straight-line depreciation).
As an example, consider two identical firms, C and D. Firm C uses LIFO and reports earnings of $2 per share. Firm D uses the less conservative accounting assumptions of FIFO and reports earnings of $3 per share. The market knows that both firms are identical and prices both at $18 per share. This price-earnings ratio is 9 ($18/$2) for firm C and 6 ($18/$3) for firm D. Thus, the firm with the more conservative principles has the higher P/E ratio.
This last example depends on the assumption that the market sees through differences in accounting treatments. A significant portion of the academic community believes that the market sees through virtually all accounting differences. These academics are adherents of the hypothesis of efficient capital markets, a theory that we explore in great detail later in the text. Though many financial people might be more moderate in their beliefs regarding this issue, the consensus view is certainly that many of the accounting differences are seen
through. Thus, the proposition that firms with conservative accountants have high P/E ratios is widely accepted.
This discussion argued that the P/E ratio is a function of three different factors. A company’s ratio or multiple is likely to be high if it has many growth opportunities, it has low risk, and it is accounted for in a conservative manner. While each of the three factors is important, it is our opinion that the first factor is much more so. Thus, our discussion of growth is quite relevant in understanding price-earnings multiples.

 STOCKMARKET REPORTING
The Wall Street Journal, the New York Times, or your own local newspaper provides useful information on a large number of stocks in several stock exchanges. Table 5.3 reproduces what has been reported on a particular day for several stocks listed on the New York Stock Exchange. In Table 5.3, you can easily find the line for General Electric (i.e., “GenElec”). Reading left to right, the first two numbers are the high and low share prices over the last 52 weeks.
For example, the highest price that General Electric traded for at the end of any particular day over the last 52 weeks was $6050. This is read as 60 and the decimal . The stock symbol for General Electric is GE. Its annual dividend is $0.55. Most dividend-paying companies such as General Electric pay dividends on a quarterly basis. So the annual dividend is actually the last quarterly dividend of multiplied by 4 (i.e., .138 ϫ 4 ϭ $0.55).
Some firms like GenenTech do not pay dividends. The Div column for GenenTech is blank. The “Yld” column stands for dividend yield. General Electric’s dividend yield is the current annual dividend, $0.55, divided by the current closing daily price, which is $5663 (you can find the closing price for this particular day in the next to last column). Note that $0.55/5663 Х 1.0 percent. The next column is labeled PE, which is the symbol for the price-earnings ratio. The price-earnings ratio is the closing price divided by the current earnings per share (based upon the latest quarterly earnings per share multiplied by 4). General Electric’s price-earnings ratio is 51. If we were financial analysts or investment bankers, we
would say General Electric “sells for 51 times earnings.” The next column is the volume of shares traded on this particular day (in hundreds). For General Electric, 18,305,100 shares traded. This was a heavy trading day for General Electric. The last columns are the High, the Low, and the Last (Close) share prices on this day. The “Net Chg” tells us that the General Electric closing price of $5663 was lower than its closing price on the previous day by 144. In other words, the price of General Electric dropped from $5807 to $5663, in one day.

MAKING CONSUMPTION CHOICES OVER TIME

Figure 3.2 illustrates the situation faced by a representative individual in the financial market. This person is assumed to have an income of $50,000 this year and an income of $60,000 next year. The market allows him not only to consume $50,000 worth of goods this year and $60,000 next year, but also to borrow and lend at the equilibrium interest rate.
The line AB in Figure 3.2 shows all of the consumption possibilities open to the person through borrowing or lending, and the shaded area contains all of the feasible choices. Let’s look at this figure more closely to see exactly why points in the shaded area are available.

In fact, this person can consume any point on the line AB. This line has a slope of Ϫ(1 ϩ r), which means that for each dollar that is added to the x coordinate along the line, (1 ϩ r) dollars are subtracted from the y coordinate. Moving along the line from point A, the initial point of $50,000 this year and $60,000 next year, toward point B gives the person more consumption today and less next year. In other words, moving toward point B is borrowing. Similarly, moving up toward point A, he is consuming less today and more next year and is lending. The
line is a straight line because the individual has no effect on the interest rate. This is one of the assumptions of perfectly competitive financial markets.
Where will the person actually be? The answer to that question depends on the individual’s tastes and personal situation, just as it did before there was a market. If the person is impatient, he might wish to borrow money at a point such as D, and if he is patient, he might wish to lend some of this year’s income and enjoy more consumption next year at, for example, a point such as C.
Notice that whether we think of someone as patient or impatient depends on the interest rate he or she faces in the market. Suppose that our individual was impatient and chose to borrow $10,000 and move to point D. Now suppose that we raise the interest rate to 20 percent or even 50 percent. Suddenly our impatient person may become very patient and might prefer to lend some of this year’s income to take advantage of the very high interest rate. The general result is depicted in Figure 3.3. We can see that lending at point C′ yields
much greater future income and consumption possibilities than before.

 THE COMPETITIVE MARKET
In the previous analysis we assumed the individual moves freely along the line AB, and we ignored—and assumed that the individual ignored—any effect his borrowing or lending decisions might have on the equilibrium interest rate itself. What would happen, though, if the total amount of loans outstanding in the market when the person was doing no borrowing or lending was $10 million, and if our person then decided to lend, say, $5 million? His lending would be half as much as the rest of the market put together, and it would not be unreasonable to think that the equilibrium interest rate would fall to induce more borrowers into the market to take his additional loans. In such a situation the person would have some power in the market to influence the equilibrium rate significantly, and he would take this power into consideration in making his decisions.
In the modern financial market, however, the total amount of borrowing and lending is not $10 million; it is closer to $10 trillion. In such a huge market no one investor or even any single company can have a significant effect (although
a government might). We assume, then, in all of our subsequent discussions and analyses that the financial market is competitive. By that we mean no individuals or firms think they have any effect whatsoever on the interest rates that they face no matter how much borrowing, lending, or investing they do. In the language of economics, individuals who respond to rates and prices by acting as though they have no influence on them are called price takers, and this assumption is sometimes called the price-taking assumption. It is the condition of perfectly competitive financial markets (or, more simply, perfect markets). The
following conditions are likely to lead to this:
1. Trading is costless. Access to the financial markets is free.
2. Information about borrowing and lending opportunities is available.
3. There are many traders, and no single trader can have a significant impact on market prices.

How Many Interest Rates Are There in a Competitive Market?
An important point about this one-year market where no defaults can take place is that only one interest rate can be quoted in the market at any one time. Suppose that some competing record keepers decide to set up a rival market. To attract customers, their business plan is to offer lower interest rates, say, 9 percent. Their business plan is based on the hope that they will be able to attract borrowers away from the first market and soon have all of the business.
Their business plan will work, but it will do so beyond their wildest expectations. They will indeed attract the borrowers, all $11 million worth of them! But the matter doesn’t stop there. By offering to borrow and lend at 9 percent when another market is offering 10 percent, they have created the proverbial money machine.
The world of finance is populated by sharp-eyed inhabitants who would not let this opportunity slip by them. Any one of these, whether a borrower or a lender, would go to the new market and borrow everything he could at the 9-percent rate. At the same time he was borrowing in the new market, he would also be striking a deal to lend in the old market at the 10-percent rate. If he could borrow $100 million at 9 percent and lend it at 10 percent, he would be able to net 1 percent, or $1 million, next year. He would repay the $109 million he owed to the new market from the $110 million he receives when the 10-percent loans
he made in the original market are repaid, pocketing $1 million profit.
This process of striking a deal in one market and an offsetting deal in another market simultaneously and at more favorable terms is called arbitrage, and doing it is called arbitraging. Of course, someone must be paying for all this free money, and it must be the record keepers because the borrowers and the lenders are all making money. Our intrepid entrepreneurs will lose their proverbial shirts and go out of business. The moral of this is clear:
As soon as different interest rates are offered for essentially the same risk-free loans, arbitrageurs will take advantage of the situation by borrowing at the low rate and lending at the high rate. The gap between the two rates will be closed quickly, and for all practical purposes there will be only one rate available in the market.