Stanley B. Block

The Use of Interest Rate Futures and Options by Corporate Financial Managers

existence as currency futures began trading on the International Monetary Market of the Chicago Mercantile Exchange. By 1975, the definition of financial futures was greatly expanded when interest rate futures on GNMA certificates were initiated on the Chicago Board of Trade. By early 1976, the Chicago Mercantile Exchange quickly countered with interest rate futures on 90-day U.S. Treasury bills. A number of other products rapidly followed. Futures contracts were introduced for Treasury bonds, Treasury notes, commercial paper, certificates of deposit, and other interest-related instruments. The enthusiasm eventually spread to the equity markets in the early 1980s with the introduction of stock index futures on the Value Line Index by the Kansas City Board of Trade. The Chicago Mercantile Exchange quickly came into the equity picture with the Standard and Poors 500 Index futures contract as did the New York S ock Exchange with the NYSE Composite Index futures.

Are “Real Options” Actually Used in the Real World?

The inability of classic NPV analysis to capture the future value of options in a capital budgeting analysis is now well documented by Trigeorgis (1993, 2005), Copeland and Antikarov (2001), and others. In spite of this, traditional NPV analysis continues to be described as a normative approach. The author surveys Fortune 1,000 companies to see if they have picked up on the use of real options to complement traditional analysis. Out of 279 respondents, 40 were currently using real options (14.3%). While the percentage is small, the number is higher than in previous studies. The author goes on to describe in what manner real options are being used and, of equal importance, why they are resisted by many. Somewhat encouraging is the intent of well over half the nonusers to consider the use of real options in the future.

CAPITAL BUDGETING TECHNIQUES USED BY SMALL BUSINESS FIRMS IN THE 1990S

ABSTRACT In recent times, small business firms have created 80 percent of the new jobs in the United States. Thus, their methodology for capital investment decisions is very important, though it continues to be somewhat different from that used by larger business firms. A questionnaire survey with 232 small business respondents indicates that the payback method is still the preferred approach by 42.7 percent of the firms. Unlike many larger firms, their time horizon is often the period over which a financial institution will extend them funding. In any event, the “average” minimal payback period in the survey averaged 2.81 years, a time period far shorter than the useful life of the asset and one that would indicate a required return far higher than most firms anticipate. Somewhat encouraging was the increased use of discounted cash flow methods (27.6 percent), which is a higher rate of utilization than that indicated in other surveys of smaller firms over the last few decades.

ARE THERE DIFFERENCES IN CAPITAL BUDGETING PROCEDURES BETWEEN INDUSTRIES? AN EMPIRICAL STUDY

Abstract This study breaks down the use of capital budgeting procedures between industries. While it is easy to state that the use of capital budgeting analysis has become more sophisticated over the decades, the question remains as to whether different industries have followed the same pattern. Three hundred two Fortune 1,000 companies responded to a survey organized along industry lines. Chi-square independence of classification tests indicated that a null hypothesis of no significant relationship between industry classification and capital budgeting procedures could be rejected in a number of decision-making areas including goal setting, rates of return, and portfolio considerations. Just as industry patterns affect financing decisions (debt vs. equity), they also affect capital budgeting decisions, and this study emphasizes that point.

Divisional Cost of Capital: A Study of Its Use by Major U.S. Firms

Abstract The study examines the use of divisional cost of capital by Fortune 1000 companies. Two hundred and ninety eight firms (29.8 percent) responded to the survey. While the concept of weighted average cost of capital is utilized by 85.2 percent of the respondents, less than 50 percent use divisional cost of capital. By using a single firm cut-off criterion for all projects, there is the potential for intrafirm misallocation of capital since projects initiated by high risk divisions are more likely to be accepted because of high returns. Lower return divisions with less risk may be starved for capital when only a single weighted average cost of capital is used. The author also suggests some normative approaches to solve the problem.

INTEGRATING TRADITIONAL CAPITAL BUDGETING CONCEPTS INTO AN INTERNATIONAL DECISION-MAKING ENVIRONMENT

Abstract The capital budgeting policies of 146 multinational companies are analyzed in light of current financial theory. Extensions of domestic practices into the international area are examined. There are a number of misapplications such as applying corporatewide weighted average cost of capital to foreign affiliate cash flows rather than to cash flows actually remitted to the corporation. Also, risk is frequently measured on a local project basis (in a foreign country) rather than considering the portfolio effect on the total corporation. Ultimately, it is shown that the survey respondents hedge against the uncertainty of the procedures by adding a premium to the weighted average cost of capital as computed by financial analysts.

NYSE execution costs: A case study of a leading bank

Using trade data obtained from a major bank and a measure of indirect execution costs based on the stock price when orders are placed, we investigate indirect costs and their relation to brokerage commissions. For all trades the mean brokerage commission is 6.5 cents per share, and the mean indirect execution cost is about 3.6 cents per share, or 0.1084% of the transactions amount. Contrary to the prediction of the price pressure hypothesis, indirect execution costs are lower for larger size trades. Further, higher indirect execution costs are not associated with lower brokerage commission.

Does the Weighted Average Cost of Capital Describe the Real-World Approach to the Discount Rate?

Almost every capital budgeting textbook has a chapter on the weighted average cost of capital (WACC). Though this is theoretically satisfying, it does not describe how companies actually operate. The WACC calls for a balanced capital structure in which debt and equity are utilized at some predetermined percentage. The problem is that researchers have shown that firms try to avoid selling new shares whenever possible. This leads to the pecking order theory in which firms first use internal funds, then low-risk debt, then high-risk debt, and finally, as a last resort, new common stock. There is no attempt to balance the capital structure. This survey study basically confirms that approach.

The Changing Nature of Dividend Policy and Its Implications for the Investor

Dividend yields are at an all-time low in the current decade, and the dividend payout ratio is down to 30%. This article examines the reasons why these changes have taken place, whether they are likely to continue in the future, and the implications for the investor. Empirical investigation of high-yield stock performance after the passage of the 2003 Tax Act indicates, at best, a neutral performance. The author’s survey of 1,207 practicing financial analysts portends a continuation of less emphasis on dividend payout and a great emphasis on stock buybacks and internal reinvestment of profits. The total return concept will continue to take on greater meaning for the investor.

Applying Capital Budgeting Techniques to Mergers

The most important capital budgeting decision a firm may make is a merger or acquisition. Yet the literature in finance provides little coverage of the topic. Mergers are frequently analyzed on the basis of the exchange rate determination and the impact on earnings per share. Though this topic is covered in the latter part of the article, the main emphasis is on the capital budgeting aspects of a merger analysis. Thus, the key metric to be considered is free cash flow and not earnings per share. Also, the article considers the importance of residual value or the value of the target firm after the traditional 5 or 10 years of cash flow or earnings analysis. By ignoring residual value, as over 50% of Fortune 500 companies do, it is implicitly being assigned a value of zero. This neglect may substantially understate the true value of the target. The article also points out the fallacy of considering relative price/earnings (P/E) ratios on postmerger EPS.