Quantitative Corporate Finance

The corporation is the major institution for private capital formation in our economy. The corporate firm acquires funds from many different sources to purchase or hire economic resources, which are then used to produce marketable goods and services. Investors in the corporation expect to be rewarded for the use of their funds; they also take losses if the investment does not succeed. The study of corporation finance deals with the legal arrangement of the corporation (i.e., its structure as an economic institution), the instruments and institutions through which capital can be raised, the management of the flow of funds through the individual firm, and the methods of dividing the risks and returns among the various contributors of funds. The goal of corporate management is to maximize stockholder wealth. A major societal function of the firm is to accumulate capital, provide productive employment, and distribute wealth. The firm distributes wealth by compensating labor, paying interest on loans, purchasing goods and services, and accumulating capital by making investments in real productive facilities. The goal of corporate finance is to maximize the firm’s stock price. We will discuss management—stockholder relations. We will discuss, in considerable detail, socially responsible investing and the firm. Companies can “do good while doing good.” However, we firmly believe that management creates its corporate investment, dividend, research and development, acquisitions, and debt policies to maximize the stock price, which maximizes the market value of the firm.

The corporate structure was the dominant form of business organization, as reported in Schwartz (1962). In Guerard and Schwartz (2007), the authors reported that in 2000 there were somewhat more than 25 million nonfarm business firms in the United States. About 5.045 million of these were corporations of all classes; the other 2.058 million were partnerships, and 17.805 million were nonfarm proprietorships. We also reported that 66 percent of the gross national product originated in the business sector flows through the corporate sector in 2000.

This chapter on the balance sheet and the following one on the income statement are designed to serve two modest purposes: to acquaint the student with accounting and financial terminology and concepts used throughout the book and to explain the two important accounting statements on an uncomplicated level so that the student can appreciate and use some of the information presented by the accountants. It is not the purpose of these chapters to review all the procedures of accounting.

The balance sheet of a company and the income statement are related. The balance sheet is an accounting snapshot at a point in time. The income, profit and loss, or operating statement is a condensation of the firm’s operating experiences over a given period of time. It depicts certain changes that have occurred between the last balance sheet and the present one. The balance sheet (position statement) and the income statement may be reconciled through the retained earnings, or earned surplus, account. If this reconciliation is presented formally, it becomes the surplus statement.

Current financing encompasses managing and utilizing current assets and incurring and repaying current debt. The current assets of a firm differ from fixed assets; these differences are not abrupt but represent a continuum. The current assets (cash, receivables, inventory, etc.) support the short-run operations of the business. Current assets are what the classical economists called “circulating capital.” Within the current asset grouping, however, some items remain in the firm’s possession longer than others.

A firm with increasing sales volume needs increased current assets to service the new level of activity. Given normal inventory turnover, higher sales necessitate a higher level of stocks. Similarly, greater sales levels enlarge the average amount of receivables the firm carries since additions to the accounts come in faster than old accounts are collected. The corporation officers responsible for working capital management must decide how to finance the required increase in current assets.

The essential advantage of the corporation over other forms of business organization lies in its ability to bring together large amounts of capital. This is especially true of those corporations, which are publicly held or widely held. The small family-held, closely held, or closed corporation has basically the same financial sources as other business forms, i.e., trade credit, the banks, and the resources of family and friends willing to invest in the business. A widely held corporation, although it will also finance through trade creditors and banks, has the additional ability to tap the flow of investment funds available in the security markets, the market for stocks and bonds. The security market, alternately called the investment, financial, or capital market, comprises the group of institutions through which old corporate securities are traded and new issues of securities are floated. These markets have provided a significant part of the capital that has nourished the growth of corporate enterprise. Thus, to understand the birth of new corporations and the growth of established firms, it is necessary to understand the functions of the security markets.

This chapter deals mainly with the financial function of stockholding, i.e., the supplying of risk capital and the expected rewards thereof. The shareholders’ expected return is the supply cost of equity capital. Only if the firm is able to give its shareholders at the minimum the “normal” rate of return on risk capital can the company be considered an economic success. Thus, a large part of the discussion is centered on the behavior of the investment markets. This follows from the assumption that the major objective of financial management is to maximize the long-run value of the common stock. If management is to develop financial strategies aimed at maximizing the long-run value of the common stock, it must understand the rationale of the investment markets. It is this market that measures relative risk and provides approximations of the rates of return on different classes of risk capital.

Long-term debt is the term given to those obligations the firm does not have to pay for at least a year. They are also called funded debt or fixed liabilities. Items that may be classed as long-term debt are bonds, debentures, term loans, or, in small firms, mortgages on buildings. The portion of the long-term debt due within the current year is carried in the current liability section of the balance sheet. Firms in the United States issue far more debt than equity shares. In most years during the 1963–2003 period, firms have issued six to eight times more debt than equity. (Of course, most increase in equity is through retained earnings.) Issuing debt raises capital for firm growth and expansion without possibly lessening current stockholder control. The floatation costs are less on debt than on equity, and the cost of debt is less than the expected shareholder return on equity.

Traditionally the capital structure of a firm has been defined as the book value of its common stock, its preferred stock, and its bonds, or fixed liabilities. These items are considered to be the “permanent” financing of the firm. The special importance is given to them, however, which may lead to an error in financial analysis. Thus, a company which only has common shares in its capital structure is often described as conservatively or safely financed. But if, for example, the firm has considerable trade debt outstanding, owes on a bank loan, or is tied up with long-run rental contracts, it may not be “safely” financed.

Capital budgeting, or investment decision, depends heavily on forecasts of the cash and a correct calculation of the firm’s cost of capital. Given the cost of capital, that is, the appropriate discount rate and a reasonable forecast of the inflows, the determination of a worthwhile capital investment is straightforward. An investment is desirable when the present value of the estimated net inflow of benefits (or net cash inflow for pure financial investments) over time, discounted at the cost of capital, exceeds or equals the initial outlay on the project. If the project’s present value of expected cash flow meets these criteria, it is potentially “profitable” or economically desirable; its yield equals or exceeds the appropriate discount rate. On a formal level, it does not appear too difficult to carry out the theoretical criteria. The stream of the forecasted net future cash flows must be quantified; each year’s return must be discounted to obtain its present value. The sum of the present values is compared to the total investment outlay on the project; if the sum of the present values exceeds this outlay, the project should be accepted.

In February 2020, the US unemployment rate was at a 50-year low. One of the great economic problems of the COVID pandemic is the dramatic increase in unemployment claims. In this chapter, we specifically address the unemployment rate in 2020 as the COVID virus closed down the US economy in March 2020, with profound and highly significant impacts on US output, as measured by gross domestic product. Regression analysis is the primary technique discussed and estimated in this chapter. More specifically, regression analysis seeks to find the “line of best fit” through the data points. The regression line is drawn to best approximate the relationship between the two variables. Techniques for estimating the regression line (i.e., its intercept on the Y axis and its slope) are the subject of this chapter.

An important aspect of financial decision-making may depend on the forecasting effectiveness of the composite index of leading economic indicators, LEI. The leading indicators can be used as an input to a transfer function model of real gross domestic product, GDP. The previous chapter employed four quarterly lags of the LEI series to estimate regression models of association between current rates of growth of real US GDP and the composite index of leading economic indicators. This chapter examines whether changes in forecasted economic indexes help forecast changes in real economic growth. The transfer function model forecasts are compared to several naïve models in order to test which model produces the most accurate forecast of real GDP. No-change forecasts of real GDP and random walk with drift models may be useful when forecasting benchmarks (Mincer & Zarnowitz, 1969; Granger & Newbold, 1977). Economists have constructed leading economic indicator series to serve as a business barometer of the changing US economy since the time of Wesley C. Mitchell (1913). The purpose of this study is to examine the time series forecasts of composite economic indexes produced by The Conference Board (TCB) and test the hypothesis that the leading indicators are useful as an input to a time series model to forecast real output in the United States.

Individual investors must be compensated for bearing risk. It seems intuitive to the reader that there should be a direct linkage between the risk of a security and its rate of return. We are interested in securing the maximum return for a given level of risk, or the minimum risk for a given level of return. The concept of such risk-return analysis is the efficient frontier of Harry Markowitz (1952, 1959). If an investor can invest in a government security, which is backed by the taxing power of the federal government, then that government security is relatively risk-free. The 90-day Treasury bill rate is used as the basic risk-free rate. Supposedly, the taxing power of the federal government eliminates default risk of government debt issues. A liquidity premium is paid for longer-term maturities, due to the increasing level of interest rate risk. Investors are paid interest payments, as determined by the bond’s coupon rate, and may earn market price appreciation on longer bonds if market rates fall or losses if market rates rise. During the period from 1928 to 2017, Treasury bills returned 3.44%, longer-term (10-year Treasury) government bonds earned 5.15%, and corporate stocks, as measured by the stock of the S&P 500 index, earned 11.53% annually, as measured by the mean annual return. The annualized standard deviations are 3.06%, 7.72%, and 19.66%, respectively, for Treasury bills, Treasury bonds, and S&P stocks. The risk-return trade-off has been relevant for the 1928–2017 period. The correlation coefficient between annual returns for Treasury bills and the S&P 500 stock returns were −0.030 for the 1928–2017 time period. This was essentially no correlation between Treasury bills and large stocks, as measured by the S&P 500 stock. The correlation coefficient between annual returns for Treasury bonds and the S&P 500 stock returns was 0.30 for the 1928–2017 time period. Why do corporate stocks offer investors higher returns for stocks than bonds?

The previous chapter introduced the reader to Markowitz mean-variance analysis and the Capital Asset Pricing Model. The cost of capital calculated in Chap. 10 assumes that the cost of equity is derived from the Capital Asset Pricing Model and its corresponding beta or measure of systematic risk. The Gordon Model, used for equity valuation in Chap. 8, assumes that the stock price will fluctuate randomly about its fair market value. The cost of equity is dependent upon the security beta. In this chapter, we address the issues inherent in a multi-beta or multiple factor risk model. The purpose of this chapter is to introduce the reader to multifactor risk models. There are academic multifactor risk models, such as those of Cohen and Pogue (1967), Farrell (1974), Stone (1974), Ross (1976), Roll and Ross (1980), Dhrymes et al. (1984, 1985), and Fama and French (1992, 1995, 2008). There are practitioner multifactor risk models, such as Barra, created during the 1973–1979 time period, Advanced Portfolio Technologies (APT), created in 1987, and Axioma, created in the late 1990s, which gained practitioner acceptance in the 2000–2019 time period. The former academicians who created these practitioner models are Barr Rosenberg, Andrew Rudd, John Blin, Steve Bender, and Sebastian Ceria. We will introduce the reader to the practitioner models and their academician creators in this chapter. Which models are best? We, at McKinley Capital Management, MCM, have tested these models. None of the models are perfect, but the models are generally statistically significant when the statistically significant tilt variables of Chap. 14 are used for portfolio construction. In this chapter, we discuss the MCM Horse Races of the 2010–2019 time period to test stock selection within the commercially available multifactor risk models. We trace the development of the Barra, APT, and Axioma commercially available risk models. We conclude with an update of US and non-US portfolios for the 1996–2020 time period. Long-term portfolio strategies have worked for the past 24 years, not just out-of-sample, but post publication of Bloch et al. (1993) with the Axioma Statistical Risk Model.

Options can be generalized as contracts that can be bought at a given price, enabling one to buy or sell an asset or security at a possible future profit. If the profitable opportunity does not arise, the price paid for the option is foregone. An understanding of options theory and analysis is useful to financial managers as it enables them to estimate trends and may be employed to temporarily secure assets until a decision is made whether to buy or not and to hold on to new projects or innovations until a final decision.

Chapter 11 dealt with the capital budgeting process in which a financial manager accepts a project only if the discounted cash flow of that project exceeds the initial costs of the project. The discount rate is the cost of capital. The difference between the discounted cash flow and the initial cash outlay is the net present value, NPV, which should be positive to accept a project. This chapter discusses another application of cash flow and valuation, the application of real option theory.

A company can grow by taking over the assets or facilities of another. The various methods by which one firm obtains or “marries into” the business, assets, or facilities of another company are mergers, combinations, or acquisitions. These terms are not used rigidly. In general, however, a merger signifies that one firm obtains another by issuing its stock in exchange for the shares belonging to owners of the acquired firm, or buys another firm with cash. Company X gives some of its shares to Company Y shareholders for the outstanding Y stock. When the transaction is complete, Company X owns Company Y because it has all (or almost all) of the Y stock. Company Y’s former stockholders are now stockholders in Company X. In a combination, a new corporation is formed from two or more companies who wish to combine. The shares of the new company are exchanged for those of the original companies. The difference between a combination and a merger lies more in legal distinctions than in any discernible differences in the economic or financial result. In practice, the terms merger and combination are often used interchangeably. The study of merger profitability is as old as corporate finance itself. Arthur S. Dewing (1921, 1953) reported on the relative unsuccessfulness of mergers for the 1893–1902 time period; and Livermore (1935) reported very mixed merger results for the 1901–1932 time period. Mandelker (1974) put forth the Perfectly Competitive Acquisitions Market (PCAM) hypothesis in which competition equates returns on assets of similar risk, such that acquiring firms should pay premiums to the extent that no excess returns are realized to their stockholders. The PCAM holds that only the acquired firms’ stockholders earn excess returns. Jensen and Ruback (1983) reported that acquired firms profited handsomely, while acquiring firms lost little money such that wealth was enhanced. Recent evidence by Jarrell et al. (1988), Ravenscraft and Scherer (1989), and Alberts and Varaiya (1989) finds little gain to the acquiring firm and significant merger premiums paid for the acquired firms.

Not every company justifies the confidence of its original investors placed in it. A free enterprise system is one of profit and loss. There is no guarantee that all capital will earn the “normal” rate of return. In a world of change, where sure knowledge of the future is lacking and decisions are made under conditions of more or less uncertainty, the operation of any business is a calculated risk. The data in Fig. 19.1 depict the failure rate per 10,000 firms in the United States during the 1930–1998 period. The reader obviously notes the high level of business failures during the Great Depression. The reader may be surprised by the high level of failures during the 1980s, given the excellent stock market performance. Failures have risen substantially during the past 40 years and were very high during the 1990–1992 period. As noted in Chap. 5, there was a deterioration in the Altman Z score, the bankruptcy prediction model, during the 1963–2003 period as a result of falling profit margins and sales efficiency. The large debt issuance of the 1975–2003 period, combined with high interest rates during several years of the period, was no doubt an important factor in the rising failure rate. Buell and Schwartz (1981) modeled the failure rate in the United States during the 1950–1978 period as a function of the total debt to total assets ratio and the variation about the time trend of the level of employment. Buell and Schwartz reported the increases in the debt ratio were (highly) statistically associated with the failure rate, whereas the failure rate is negatively associated with employment. An economic downturn is associated with decreasing cash flows and lower operating cash flows of firms. Under an increase in financial leverage, a favorable turn in economic events can bring a firm high earnings; however, on the other hand, a recession in demand or a miscalculation of costs may entail substantial losses.

Economic growth is usually defined as the rise in total measurable economic output over a given period, i.e., such as in the growth in real GDP modeled in Chaps. 12 and 13. This is a definition of gross growth. However, if the population increases significantly in the same period, output per capita may remain constant or even decline. The average citizen of the country is no better off than before, and thus in one very relevant sense, no economic growth has taken place. A net concept of growth (closer to welfare criteria) can be developed by using the increase in average output per capita. Another problem of measuring growth arises if society shows a desire for an increase in leisure. If the average output does not decline while the workweek shortens and vacations lengthen, growth has taken place, although its fruits have been absorbed as an increase in leisure. Growth is difficult to discover between the dips and rises of the business cycle. The national per capita output at a peak period may appear to have grown very rapidly compared to that of a preceding recession in business activity. Actually, the potential output of the recession period, the output possible were the economy operating at capacity, might be relatively high. Growth should thus be measured from one equilibrium period to another, or, if possible, measured in terms of increases in potential capacity product per capita. If a nation’s economy falls significantly from its capacity, the problem is essentially one of economic stability and not of economic growth.

With the adoption of flexible exchange rates in 1973, international capital markets have become more completely integrated. This chapter discusses portfolio selection of international equities, and how international diversification lowers total risk of portfolios. Particular attention is paid to the diversification implications of Asian stocks, other emerging markets, and Latin American securities. The US equity selection model developed and estimated in Chap. 14 is used to rank global (ex-US) securities, and produces statistically significant information coefficients and excess returns. An investor owns foreign stocks because their inclusion into portfolios produces higher Sharpe ratios than using only domestic securities. Global and (domestic) US securities may produce portfolios of higher returns for a given level of risk.

So long as a company is closely held, the control group and the stockholders are identical, and seldom is there a conflict of interest between them. However, once a company goes public, it acquires a group of shareholders who depend on the management for the safety and profitability of their investment. In short, an agency principal relation is established where the management is the agent and the shareholder is the principal. This relation implies a commitment by management that the outside shareholders will be treated fairly in such matters as cash payouts, expansion policies, accounting probity, and the level of executive compensation, and that in general, the company affairs will be directed vigorously and conscientiously.