Harold Bierman

An Analytical Model of Bond Risk Differentials

There is broad consensus that three types of risk confront the potential bond purchaser: the risk of default (possible interest and/or principal loss), the risk of interest rate changes (possible principal loss or gain if the bonds are sold before maturity), and price level risk (loss of purchasing power). The analysis in this paper is directed toward the first of these risks, the risk of default. By assuming that investors require interest rate adjustments on debt subject to default sufficient to give them an expected present value equal to the present value associated with the investment of their funds in default-free securities, we examine the process that determines the risk-adjusted equilibrium interest rate and the factors affecting that rate. We also examine the implications of the model for the cost of debt and a firms debt capacity.

THE BOND REFUNDING DECISION

with reasonable certainty. Nevertheless, it is a decision about which there has been a great deal of confusion and misleading recommendations. This article is concerned with the question of whether or not to refund. Here we assume that refunding in the future will be less desirable than refunding now. Implicitly the possibility of future refunding is not considered. There are several articles that have stressed the importance of considering whether it is more desirable to wait and refund in

Ruin Considerations: Optimal Working Capital and Capital Structure

At any point in time a firm must decide both the level of working capital consistent with its productive assets and how to finance these assets. Academic theorists in business administration have traditionally approached decision making of the firm on a segmented rather than on a global basis and have been satisfied with developing suboptimizing decision rules. Thus there has been concern about managing working capital and concern about choosing the optimum capital structure, but traditionally the two decisions have not been made jointly. And even if they were made jointly, decisions would still remain in the working capital area involving inventories, credit granting, and marketable securities. This article is an attempt to interrelate working capital and capital structure decisions with working capital used not only as a buffer to avoid ruin but also to affect sales via changing inventory levels and credit policies. The possibility of ruin introduces a discontinuity that precludes perfect elimination of leverage effects via a market. In this article the acquired working capital serves as a buffer against ruin, as well as a means of increasing earnings, while the debt used to finance the working capital increases the size of the fixed payment obligations, and the cost of debt tends to reduce the total earnings of stockholders.

Ruin Considerations and Debt Issuance

The current literature or business finance states that debt is a cheaper source of capital than stock (tending to reduce the firms cost of capital), because interest is deductible for income tax purposes while the return to common stockholders is subject to tax. It is even possible to issue debt without increasing the risk to the owners (the debt is issued to stockholders in proportion to the ownership of stock, or equivalently investors buy a mixture of stocks and bonds on the market). However, it is argued in this paper that if we assume that the present stockholders have no further resources available for investment in the firm, but the enterprise needs additional resources, then the present stockholders have to make a basic decision about whether to issue stock or debt to raise the additional needed capital. The issuance of debt in this situation increases risk, and the issuance of stock dilutes ownership. Even when bondholders require a much lower contractual return than the expected annual return of stockholders, the issuance of more stock may be preferred to the issuance of debt.

A Utility Approach to the Portfolio Allocation Decision and the Investment Horizon

o equity investments become less risky if they are held for longer time periods? Is the value of an equity investment increased compared to D a risk-flee (or any other target return) if the stocks are held for a longer period of time? Dfierent viewpoints have been presented by, among others, Bodie [1995], Merton [1969], Samuelson [1989, 1990, 19941, Thorley [1995], and Merrdl and Thorley [1996]. Taggart uses a logarithmic utility function, where U(w> = 1nW for any wealth W, since “presumably the investor is truly interested in total wealth at the end of the investment horizon” [1996, p. 2461. Using a specific numerical example, Taggart notes:

An introduction to managerial finance

 General Areas of Finance o Financial Markets and Institutions—the financial marketplace and the relationships of banking, insurance, estate planning, and so forth. o Investments—evaluating financial assets, such as stocks and bonds, and determining which investments to include in a portfolio of financial assets. o Financial Services—service organizations and mechanisms related to the management of money. o Managerial Finance—often called corporate finance, includes decisions regarding types of real investments (i.e., plant and equipment) that should be made and how such investments should be financed (i.e., stocks or bonds), whether dividends should be paid, and so forth.

The Cost of Warrants

It is likely that warrants will be used increasingly in the future by corporations both as means of sweetening other securities such as preferred stocks and bonds, and as securities in their own right. Many authors have analyzed the characteristics of warrants from the point of view of investors but attempts to develop a procedure for determining the cost to a corporation of issuing warrants have been lacking. We will find it convenient to measure the yield to a corporation of issuing warrants instead of common stock, rather than determining the percentage cost of warrants analogous to the cost of common stock equity, preferred stock, and interest-bearing debt.

The Bond Issue Size Decision

The highly quantitative bond issue size decision is generally made in a somewhat qualitative manner. The subjective opinions of brokers and intuitive rules of thumb of financial officers are rarely, if ever, compared to the optimum issue size resulting from calculations incorporating the costs of issuing bonds, and the costs of carrying extra cash. Unfortunately performance measurement in this area is very difficult, thus both good and bad decision processes tend to go unnoticed. It is possible to look at a financial decision which has been made, and, with the aid of hindsight, conclude it was a bad decision, but this proves very little. Some financial officers have done very well administering the Financial affairs of their corporations, but this does not indicate that the decision process cannot be improved. In a previous article the author of this paper investigated the question of the optimum size of bond issue.

The capital structure decision

1. Why Capital Structure is Important.- 2. Capital Structure Decision With Zero Taxes.- 3. Capital Structure Decision With Corporate Tax.- 4. Capital Structure Decision With Corporate and Investor Taxes.- 5. Capital Structure Decision With Costs of Financial Distress.- 6. Capital Structure Decision With Friendly and Unfriendly Debt.- 7. Capital Structure and Earnings Per Share.- 8. Capital Structure and Capital Budgeting Decisions.- 9. The Power of Tax Deductible Debt.- 10. Preferred Stock.- 11. Convertible Bonds.- 12. Leasing as a Method of Financing.- 13. Disparate Objectives.- 14. An Overview.

Valuation of Stocks with Extraordinary Growth Prospects

The objective of this article is to suggest a systematic approach for evaluating stocks with extraordinary growth prospects to supplement the conventional valuation of growth companies. The approach is simple but the determination of the necessary inputs remains as difficult as ever. Also, the proposed calculation does not replace conventional valuation measures, but complements them. The objective is to compute the minimum period of extraordinary growth that justifies the current stock price. The minimum required growth periods for different assumed earning growth rates can be readily computed. When the earnings history of the company consists of all loss years, any calculation will have a large subjective component.