Michael C. Ehrhardt

The Search For Value: Measuring The Company's Cost Of Capital

In The Search for Value: Measuring the Companys Cost of Capital, Michael C. Ehrhardt analyzes the latest prescriptive techniques and models for determining the cost of capital. He provides a comprehensive framework for practitioners by detailing the various methods for accurately evaluating investment in projects, divisions, or entire companies. He begins with a general discussion of the cost of capital within the context of a firms overall search for value and continues on to cover such topics as discounted cash flow analysis, flotation costs, long-term projects, and international projects, as well as situations in which traditional cash flow analysis may not apply, such as regulated companies. Ehrhardt moves easily through a variety of technical concepts, providing numerous step-by-step examples to explain how theoretical constructs can be applied to daily financial decisions. He also provides a particularly detailed analysis of estimating capital costs in multidivisional, multiproduct, and multinational firms. Each chapter features an extensive bibliography for further reading. Written for financial directors, planners, managers, and analysts as well as for those who study finance issues, this work successfully addresses the concerns of financial practitioners. In todays competitive business environment, the consequences of miscalculation can be devastating. Correctly evaluating the cost of capital and thereby determining the value-creating potential of investments is a business imperative. The Search for Value is a unique synthesis of the issues surrounding the cost of capital, presenting the most comprehensive treatment of the topic to date. Those who implement the ideas in this book will enjoy the returns made possible by accurate measurements of the cost of capital as an integral part of capital budgeting and strategic planning.

A Full-information Approach for Estimating Divisional Betas

A new approach for estimating divisional betas is developed in this study. The approach is based on a sound theoretical foundation; utilizes all available information, yet still has parsimonious data requirements; can be implemented with simple statistical tools; and provides unambiguously interpretable results. The proposed methodology is applied to a large sample of stocks. The results indicate that the proposed methodology can more accurately estimate divisional betas than other approaches previously advocated in the finance literature.

Reverse Mortgages and Interest Rate Risk

We develop and apply a valuation model that quantifies the interest rate risk inherent in fixed-rate reverse mortgages. Consistent with intuition, our results show that the interest rate risk of a reverse mortgage is greater than that of either a typical coupon bond or a regular mortgage. Somewhat surprisingly, we find that this difference in interest rate risk is extremely large. In fact, the interest rate risk of a reverse mortgage often is several orders of magnitude greater than the interest rate risk of other fixed-income securities. Copyright American Real Estate and Urban Economics Association.

Tests for tax-clientele and tax-option effects in U.S. treasury bonds

Abstract In markets with taxes the deviations of the price of a bond from its present value may be due to tax clientele and tax option effects. Detecting these effects is complicated by noise in bond prices. Previous empirical research has lacked a theory of how tax effects will influence the deviations in the presence of noise. This paper develops such a theory and demonstrates a methodology for detecting tax effects. In empirical tests the tax option effect comes through most clearly, but the existence of tax clienteles cannot be ruled out.

A note on January returns in the U.S. government bond market: The term effect

This study documents a previously unobserved January effect in the market for riskless debt. Long-term government bonds have significantly lower returns in January than in the rest of the year. This January effect is opposite in sign to the January effects that have been previously documented in the markets for equity and the markets for risky debt. Tax-loss selling in the equity markets in conjunction with “parking the proceeds” may provide a possible explanation for the negative January effect in the market for government bonds.

Convertible Securities, Employee Stock Options and the Cost of Equity

We provide a method for calculating the cost of equity and the cost of capital in the presence of convertible securities and employee stock options. We demonstrate how this approach can be applied if a company already has issued convertible claims or if it is considering doing so for the first time. We provide several numerical examples illustrating the significance of errors in estimating the cost of capital that can result when (1) employee stock options are ignored or (2) the observable stock price is used as a proxy for the unobservable underlying asset.

Equilibrium characterization of initial bond offerings: Implications for empirical research

Abstract Many studies of initial bond offerings have been criticized because they lack a solid theoretical foundation for the empirical test commonly employed, i.e., a linear regression with yield as the dependent variable and the independent variables comprised of both security specific attribute and macroeconomic descriptors. In this study, it is shown that a linear multifactor specification is appropriate and that under certain conditions, yield is an appropriate dependent variable. Although particular variables are not identified, the independent variables should include security specific attributes and macroeconomic descriptors. The estimated model is interpretable within an equilibrium risk-return framework.

Creating a synthetic after-tax zero-coupon bond using US Treasury STRIP bonds: implications for the true after-tax spot rate

For an individual or company that is subject to taxes, we develop a method that uses laddered Separate Trading of Registered Interest and Principal (STRIP) bonds to determine the value (and composition) of a portfolio that replicates a risk-free after-tax cash flow that will occur on a single future date. In contrast to previous approaches, our method does not require rebalancing or short sales. In addition, we show that the standard after-tax risk-free spot rate, defined as the after-tax yield on a US Treasury STRIP bond, is correct only for a flat-term structure. Using our method, we provide a true measure of the after-tax risk-free spot rate that applies to any term structure.

Dividends and market efficiency: a multi‐index arbitrage investment strategy

Outlines previous research on the relationship between dividend policy and stock returns; and uses a linear programme and multi‐index model to form an investment strategy to see whether dividend yields increase stock returns. Explains the methodology, tests it on 1965‐1989 US data and presents the results, which suggests that the multi‐index model is superior to the single index market model in terms of explanatory power and volatility; but provides conflicting conclusions on the relevance of dividends to stock returns. Suggests that the negative relationship between dividends and stock returns can be explained by Jensen’s (1986) free cash flow theory and the influence of transaction costs.