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ful, but only $50 million if it is unsuccessful. You believe that the probability of success is
only about 50 percent.

a. Would you build the plant?
b. Suppose that the plant can be sold for $90 million to another automaker if the auto line
is not successful. Now would you build the plant?
c. Illustrate the option to abandon in (b) using a decision tree.
25. Production Options. Explain why options to expand or contract production are most valu-
able when forecasts about future business conditions are most uncertain.


26. Abandonment Option. Hit or Miss Sports is introducing a new product this year. If its see-
Challenge at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price
Problems of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The
variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing
equipment is $6 million, and the project life is estimated at 10 years. The firm will use
straight-line depreciation over the 10-year life of the project. The firm™s tax rate is 35 per-
cent and the discount rate is 12 percent.

a. If each outcome is equally likely, what is expected NPV? Will the firm accept the proj-
ect?
b. Suppose now that the firm can abandon the project and sell off the manufacturing equip-
ment for $5.4 million if demand for the balls turns out to be weak. The firm will make
the decision to continue or abandon after the first year of sales. Does the option to aban-
don change the firm™s decision to accept the project?
27. Expansion Option. Now suppose that Hit or Miss Sports from the previous problem can ex-
pand production if the project is successful. By paying its workers overtime, it can increase
production by 20,000 units; the variable cost of each ball will be higher, however, equal to
$35 per unit. By how much does this option to expand production increase the NPV of the
project?


1 Cash flow forecasts for Finefodder™s new superstore:
Solutions to
Year 0 Years 1“12
Self-Test
Investment “5,400,000
Questions 1. Sales 16,000,000
2. Variable costs 13,280,000
3. Fixed costs 2,000,000
4. Depreciation 450,000
5. Pretax profit (1 “ 2 “ 3 “ 4) 270,000
6. Taxes (at 40%) 108,000
7. Profit after tax 162,000
8. Cash flow from operations (4 + 7) 612,000
Net cash flow “5,400,000 612,000

NPV = “$5.4 million + (7.536 — $612,000) = “$788,000

2 Both calculate how NPV depends on input assumptions. Sensitivity analysis changes inputs
one at a time, whereas scenario analysis changes several variables at once. The changes
should add up to a consistent scenario for the project as a whole.
490 SECTION FIVE


3 With the lower initial investment, depreciation is also lower; it now equals $417,000 per
year. Cash flow is now as follows:

1. Variable costs 81.25 percent of sales
2. Fixed costs $2 million
3. Depreciation $417,000
(.1875 — sales) “ $2.417 million
4. Pretax profit
.4 — (.1875 — sales “ $2.417 million)
5. Tax (at 40%)
.6 — (.1875 — sales “ $2.417 million)
6. Profit after tax
.6 — (.1875 — sales “ $2.417 million) + $417,000
7. Cash flow (3 + 6)
= .1125 — sales “ $1.033 million

Break-even occurs when
PV (cash inflows) = investment
7.536 — (.1125 — sales “ $1.033 million) = $5.0 million
and sales = $15.08 million.
4 Break-even analysis finds the level of sales or revenue at which NPV = 0. Sensitivity analy-
sis changes these and other input variables to optimistic and pessimistic values and recalcu-
lates NPV.
5 Reworking Table 8.6 for the normal level of sales and 10 percent higher sales gives the fol-
lowing:

High Fixed Costs High Variable Costs
Normal 10% Higher Sales Normal 10% Higher Sales
Sales 16,000 17,600 16,000 17,600
“ Variable costs 13,000 14,300 13,440 14,784
“ Fixed costs 2,000 2,000 1,560 1,560
“ Depreciation 450 450 450 450
= Pretax profit 550 850 550 806

For the high-fixed-cost policy, profits increase by 54.5 percent, from $550,000 to $850,000.
For the low-fixed-cost policy, profits increase by 46.5 percent. In both cases the percentage
increase in profits equals DOL times the percentage increase in sales. This illustrates that
DOL measures the sensitivity of profits to changes in sales.
6 The option to shut down is valuable because the mine operator can avoid incurring losses
when copper prices are low. If the shut-down option were not available, cash flow in the low-
price periods would be negative. With the option, the worst cash flow is zero. By allowing
managers to respond to market conditions, the option makes the worst-case cash flow bet-
ter than it would be otherwise. The average cash flow (that is, averaging over all possible
scenarios) therefore must improve, which increases project NPV .
7 Abandonment options, options due to flexible production facilities, investment timing op-
tions.
Project Analysis 491




MINICASE but cost overruns of 10 percent or 15 percent were common in the
Maxine Peru, the CEO of Peru Resources, hardly noticed the
mining business. In addition, new environmental regulations, if
plate of savory quenelles de brochet and the glass of Corton
enacted, could increase the cost of the mine by $1.5 million.
Charlemagne ™94 on the table before her. She was absorbed by
There was a cheaper design for the mine, which would reduce
the engineering report handed to her just as she entered the exec-
its cost by $1.7 million and eliminate much of the uncertainty
utive dining room.
about cost overruns. Unfortunately, this design would require
The report described a proposed new mine on the North Ridge
much higher fixed operating costs. Fixed costs would increase to
of Mt. Zircon. A vein of transcendental zirconium ore had been
$850,000 per year at planned production levels.
discovered there on land owned by Ms. Peru™s company. Test bor-
The current price of transcendental zirconium was $10,000
ings indicated sufficient reserves to produce 340 tons per year of
per ton, but there was no consensus about future prices.1 Some
transcendental zirconium over a 7-year period.
The vein probably also contained hydrated zircon gemstones. experts were projecting rapid price increases to as much as
The amount and quality of these zircons were hard to predict, $14,000 per ton. On the other hand, there were pessimists saying
since they tended to occur in “pockets.” The new mine might that prices could be as low as $7,500 per ton. Ms. Peru did not
come across one, two, or dozens of pockets. The mining engineer have strong views either way: her best guess was that price would
guessed that 150 pounds per year might be found. The current just increase with inflation at about 3.5 percent per year. (Mine
price for high-quality hydrated zircon gemstones was $3,300 per operating costs would also increase with inflation.)
pound. Ms. Peru had wide experience in the mining business, and she
Peru Resources was a family-owned business with total assets knew that investors in similar projects usually wanted a fore-
of $45 million, including cash reserves of $4 million. The outlay casted nominal rate of return of at least 14 percent.
required for the new mine would be a major commitment. Fortu- You have been asked to assist Ms. Peru in evaluating this proj-
nately, Peru Resources was conservatively financed, and Ms. Peru ect. Lay out the base-case NPV analysis and undertake sensitiv-
believed that the company could borrow up to $9 million at an in- ity, scenario, or break-even analyses as appropriate. Assume that
terest rate of about 8 percent. Peru Resources pays tax at a 35 percent rate. For simplicity, also
The mine™s operating costs were projected at $900,000 per assume that the investment in the mine could be depreciated for
year, including $400,000 of fixed costs and $500,000 of variable tax purposes straight-line over 7 years.
costs. Ms. Peru thought these forecasts were accurate. The big What forecasts or scenarios should worry Ms. Peru the most?
question marks seemed to be the initial cost of the mine and the Where would additional information be most helpful? Is there a
selling price of transcendental zirconium. case for delaying construction of the new mine?
Opening the mine, and providing the necessary machinery 1 There
were no traded forward or futures contracts on transcendental zir-
and ore-crunching facilities, was supposed to cost $10 million, conium.
AN OVERVIEW OF
CORPORATE FINANCING
Common Stock
Book Value versus Market Value
Dividends
Stockholders™ Rights
Voting Procedures
Classes of Stock
Corporate Governance in the United States and Elsewhere

Preferred Stock
Corporate Debt
Debt Comes in Many Forms
Innovation in the Debt Market

Convertible Securities
Patterns of Corporate Financing
Do Firms Rely Too Heavily on Internal Funds?
External Sources of Capital

Summary




There are more than 57 different kinds of security that a company can issue.
Scott Goodwin Photography



493
his material begins our analysis of long-term financing decisions. In later


T material this will involve a careful look at some classic finance prob-
lems, such as how much firms should borrow and what dividends they
should pay their shareholders. But before getting down to specifics, we will
provide a brief overview of types of long-term finance.
It is customary to classify sources of finance as debt or equity. When the firm bor-
rows, it promises to repay the debt with interest. If it doesn™t keep its promise, the
debtholders may force the firm into bankruptcy. However, no such commitments are
made to the equityholders. They are entitled to whatever is left over after the debthold-
ers have been paid off. For this reason, equity is called a residual claim on the firm.
However, a simple division of sources of finance into debt and equity would miss the
enormous variety of financing instruments that companies use today. For example,
Table 5.7 shows the many long-term securities issued by H. J. Heinz. Yet H. J. Heinz has
not come close to exhausting the menu of possible securities.
This material introduces you to the principal families of securities and explains how
they are used by corporations. We also draw attention to some of the interesting aspects
of firms issuing these securities.
After studying this material you should be able to
Describe the major classes of securities issued by firms to raise capital.
Summarize recent trends in the use made by firms of different sources of finance.




Common Stock
Most major corporations are far too large to be owned by one investor. For example,
you would need to lay your hands on over $17 billion if you wanted to own the whole
TREASURY STOCK
H. J. Heinz Company.
Stock that has been
Heinz is owned by about 61,000 different investors, each of whom holds a number
repurchased by the company
of shares of common stock. These investors are therefore known as shareholders or
and held in its treasury.
stockholders. Altogether Heinz has outstanding 358 million shares of common stock.
Thus if you were to buy one Heinz share, you would own 1/358,000,000, or about
ISSUED SHARES
.00000028 percent of the company. Of course, a large pension fund might hold many
Shares that have been issued
thousands of Heinz shares.
by the company.
The 358 million shares held by investors are not the only shares that have been is-
sued by Heinz. The company has also issued a further 72 million shares, which it later
OUTSTANDING
bought back from investors. These shares are held in the company™s treasury and are
SHARES Shares that
known as treasury stock. The shares held by investors are said to be issued and out-
have been issued by the
standing shares. By contrast, the 72 million treasury shares are said to be issued but
company and are held by
not outstanding.
investors.
If Heinz wishes to raise more money, it can sell more shares. However, there is a
limit to the number that it can issue without getting the approval of the current share-

494
An Overview of Corporate Financing 495


TABLE 5.7
Equity
Large firms use many
Common stock
different kinds of securities.
Preferred stock
Look at the variety of
Debt
securities issued by H. J.
Commercial paper
Heinz
Senior unsecured notes
Revenue bonds
Promissory notes
Eurodollar bonds
Sterling notes
Italian lira notes
Australian dollar notes
Bank loans



holders. The maximum number of shares that can be issued is known as the authorized
AUTHORIZED SHARE
CAPITAL Maximum share capital”for Heinz, this is 600 million shares. Since Heinz has already issued
number of shares that the 431 million shares, it can issue 169 million more without shareholders™ approval.
company is permitted to Table 5.8 shows how the investment by Heinz™s common stockholders is recorded in
issue, as specified in the the company™s books. The price at which each share is recorded is known as its par
firm™s articles of value. In Heinz™s case each share has a par value of $.25. Thus the total par value of the
issued shares is 431 million shares — $.25 per share = $108 million. Par value has little
incorporation.

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