Principles of Finance

SENIOR CONTRIBUTING AUTHORS

JULIE DAHLQUIST, TEXAS CHRISTIAN UNIVERSITY
RAINFORD KNIGHT, FLORIDA ATLANTIC UNIVERSITY
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348 11 • Key Terms

that it generally refers to fixed, tangible assets such as buildings, machinery, furniture, fixtures, and
equipment
discounted cash flow (DCF) a method for estimating the value of an investment based on the present value
of its expected future cash flows
dividend a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its
profits or reserves
dividend discount model (DDM) a quantitative method for predicting the price of a company’s stock based
on the theory that its present-day price is worth the sum of all of its future dividend payments when
discounted back to their present value
dividend yield a financial ratio (dividend/price) that shows how much a company pays out in dividends each
year relative to its stock price, expressed as a percentage
earnings per share (EPS) the ratio of a company’s profits to the outstanding shares of its common stock;
serves as an indicator of a company’s profitability
EBIT short for earnings before interest and taxes; an indicator of a firm’s profitability before the effects of
interest or taxes; also referred to as operating earnings, operating profit, and profit before interest and tax
efficient markets markets in which costs are minimal and prices are current, fair, and reflective of all
available relevant information
enterprise value (EV) a company’s total value; often used as a more comprehensive alternative to equity
market capitalization
enterprise value (EV) multiples also known as company value multiples; ratios used to determine the
overall value of a company and, by extension, the value of its common stock
equity multiples metrics that calculate the expected or achieved total return on an initial investment
Gordon growth model a methodology used to determine the intrinsic value of a stock based on a future
series of dividends that grow at a constant rate
growth rate the rate at which the dollar amount of dividends paid on a specific stock holding increases
intangible assets assets that are not physical in nature, such as goodwill, brand recognition, and intellectual
property (i.e., patents, trademarks, and copyrights)
intrinsic value the value of a firm’s stock based entirely on internal factors, such as products, management,
and the strength of company brands in the marketplace
market capitalization the value of a company traded on the stock market, calculated by multiplying the
total number of shares by the current share price
NASDAQ (National Association of Securities Dealers Automated Quotations) short for National
Association of Securities Dealers Automated Quotations; an American stock exchange based in New York
City, ranked second behind the New York Stock Exchange in terms of total market capitalization of shares
traded
net book value also called net asset value (NAV); the total assets of a company minus its total liabilities
NYSE (New York Stock Exchange) the world’s largest stock exchange by market capitalization of its listed
companies, based in New York City; often referred to as the “Big Board”
perpetuity in terms of investments, an annuity with no end date
precedent transaction analysis (precedents) a method for valuating a company in which the price paid for
similar companies in the past is considered an indicator of the company’s current value
preferred stock stock that entitles the holder to a fixed dividend, the payment of which takes priority over
payment of common stock dividends
price-to-book (P/B) ratio also called the market-to-book (M/B) ratio; a metric used to compare a company’s
market capitalization, or market value, to its book value
price-to-cash-flow (P/CF) ratio a stock valuation indicator or multiple that measures the value of a stock’s
price relative to its operating cash flow per share
price-to-earnings (P/E) ratio a ratio that indicates the dollar amount an investor can expect to invest in a
company in order to receive one dollar of that company’s earnings
price-to-sales (P/S) ratio a ratio that indicates how much investors are willing to pay for a company’s stock

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 11 • CFA Institute 349

per dollar of that company’s sales

required return the minimum return an investor expects to achieve by investing in a project
secondary markets markets where investors buy and sell securities they already own
stock value also called intrinsic value; the fundamental, objective value of a share of stock

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/CFA_Level_I_Study_Session). Reference with permission of CFA Institute.

Multiple Choice
1. The price-to-earnings (P/E) ratio is _______________.
a. used to calculate a company’s book value
b. a multiplier used in enterprise valuation
c. only applied when valuing preferred stock
d. a metric for showing the expectations of the market

2. The price-to-book (P/B) ratio is also called the _______________ ratio.

a. market-to-book
b. enterprise-to-book
c. asset-to-price
d. liability-to-book

3. The two primary types of stock valuation multiples are _______________.

a. enterprise value multiples and comparable company value multiples
b. equity multiples and enterprise value multiples
c. asset value multiples and liability value multiples
d. None of the above

4. Dividend yield is a form of equity multiple that is primarily used when _______________.
a. the subject company is operating at a loss
b. conducting comparisons between companies in different industries
c. conducting comparisons between cash returns and investment types
d. analyzing mature companies that have been paying dividends for several years

5. Dividend yield is computed as the proportion of dividend per share to _______________.

a. share price
b. earnings per share
c. market value per share
d. book value per share

6. Which of the following statements about enterprise value metrics is NOT true?
a. EV to revenue can be used to assess companies with negative cash flows or firms that are currently
experiencing financial losses.
b. ROCE is a profitability ratio that measures the return on the equity in a company in comparison to its
financing over a short period of time.
c. EBIT allows investors to assess the core operations of the business without worrying about the costs
of the capital structure.
d. EBITDAR is a metric that is used in businesses that have substantial rental and least expenses.
350 11 • Review Questions

7. If an investor’s required rate of return increases and all other characteristics of a stock remain the same,
the value of the stock will _______________.
a. remain the same
b. increase
c. decrease
d. None of the above

8. A major limitation of the dividend discount model (DDM) is that _______________.

a. it is extremely complicated to use
b. it cannot be used with companies that do not pay dividends
c. it must always be used in conjunction with another metric
d. None of the above

9. In which of the following ways does preferred stock differ from common stock?
a. Preferred stock carries voting rights for its ownership.
b. Preferred stock must be purchased through a broker dealer.
c. Preferred stock may have a cumulative dividend feature.
d. In the event of corporate liquidation, preferred stockholders are paid last.

10. The term efficient markets refers to the idea that _______________.
a. publicly traded companies always file their financial reports on time
b. investors are able to identify underpriced stocks for purchase
c. stocks trade with minimal costs and prices are current and fair to all traders
d. financial information on companies and their stock is only available to efficient traders

Review Questions
1. Briefly discuss one of the primary benefits of using comparative P/E ratios.

2. Name an important characteristic of companies for which the price-to-book (P/B) ratio does not work well.

3. Briefly describe the main type of scenario in which the two-stage DDM approach might be used to value a
firm and its stock.

4. Briefly describe a major shortcoming of the zero growth DDM model.

5. Briefly describe the required inputs for the discounted cash flow (DCF) model.

6. Briefly describe preferred stock and some of its ownership advantages compared to common stock.

7. Briefly explain what is meant by the terms cumulative and noncumulative as they relate to preferred
stocks.

8. What were SuperDOT and SOES, and what were they designed to do?

9. What are operational efficiency and informational efficiency, and how do they differ in terms of trading
markets?

10. What is meant by informational efficiency, and how does it affect the price of a stock?

Problems
1. Today, Sysco Enterprises paid dividends on its common stock of $1.25 per share. If dividends per share are
expected to increase to $3.50 per share six years from now, what is the percentage dividend growth rate?

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 11 • Video Activity 351

2. Let’s say you want to purchase shares of Fontaine Ltd. and then hold this stock for six years. The company
has a stated dividend policy of $2.00 annually per share for the next six years, at the end of which time you
will sell the stock. You expect to be able to sell the stock for $35.00 at that time. If you want to earn an 8%
return on this investment, what price should you pay today for this stock?

3. Damian Painting Systems has established a dividend policy of $3.00 per share per year. If the company
plans to be in business forever, what is the value of this stock if an investor wants a 10% return?

4. Wilk Productions wants its shareholders to earn a 12% return on their investment in the company. At what
value would Wilk stock be priced if the company paid $2.75 per share in constant annual dividends
forever?

5. Dax Industrial Systems has stock currently priced at $50.00 per share. If investors are earning a 7% return
on Dax Industrial, what is the company’s annual dividend payment per share?

6. If a stock is selling at $400 with a current dividend of $40 and a potential investor’s required rate of return
is 15%, what would be the anticipated dividend growth rate?

7. Mind Max Inc. has a dividend policy that increases annual dividends by 3% each year. If last year’s
dividend was $2.00, the company intends to stay in business for 50 years, and an investor wants a 9%
return, what would be the price of Mind Max stock?

8. Odon Corp. paid dividends today in the amount of $1.50 per share. If Odon will pay dividends of $5.00 10
years from today, what is the annual dividend growth rate over this 10-year period?

9. The Kirkson Distributors common stock is currently selling at $52.00 per share, pays dividends annually at
$2.50 per share, and has an annual dividend growth rate of 2%. What is the required return?

10. If a preferred share of stock pays dividends of $2.50 per year and the required rate of return for the stock
is 6%, what is its intrinsic value?

Video Activity
Efficient Markets

Click to view content (https://openstax.org/r/Efficient_Markets)

1. In the efficient market hypothesis (EMH), describe what is meant by the terms weak form efficiency, semi-
strong form efficiency, and strong form efficiency. How do these forms of market efficiency differ from
each other, and what are their characteristics?

2. What is meant by the term random walk, and how does this concept relate to the EMH?

What Is Preferred Stock?

Click to view content (https://openstax.org/r/Preferred_Stock)

3. Discuss the relative risks of the following financial instruments and how they compare to each other:
bonds, common stocks, and preferred stocks. How and why will these three investment types typically
carry different levels of risk to an investor?

4. Discuss some of the important differences between preferred stocks and common stocks.
352 11 • Video Activity

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 12 • Why It Matters 353

12
Historical Performance of US Markets

Figure 12.1 Stock markets are affected by many factors, such as interest rates, inflation, and politics. (credit: modification of "That
was supposed to be going up, wasn't it? by Rafael Matsunaga/flickr, CC BY 2.0)

Chapter Outline
12.1 Overview of US Financial Markets
12.2 Historical Picture of Inflation
12.3 Historical Picture of Returns to Bonds
12.4 Historical Picture of Returns to Stocks

Why It Matters
Author Mark Twain spoke for many when he wrote, “October—this is one of the peculiarly dangerous months
to speculate in stocks. The others are July, January, September, April, November, May, March, June, December,
August, and February.” Twain’s comment, though humorous, reflects the serious risks associated with
investing in the stock market. So why should we study the history of the US financial markets? Financial
experts regularly remind us that past performance is no guarantee of future results. However, past
performance can provide targets or benchmarks around which to build expectations. We can learn about the
past to prepare for future possibilities, or we can suffer what Winston Churchill warned, “Those that fail to
learn from history are doomed to repeat it.”

Carlos Slim Helu, a Mexican businessman and the richest person in the world from 2010 to 2013, once said,
“With a good perspective on history, we can have a better understanding of the past and present, and thus a
1
clear vision of the future.” In this chapter, we examine current and historical performance in money, bond,
and stock markets. Studying past market risk and return also allows investors to understand what is
reasonable and what is not.

1 Dan Western. “45 Carlos Slim Helu Quotes About Wealth and Success.” Wealthy Gorilla. https://wealthygorilla.com/carlos-slim-
helu-quotes/
354 12 • Historical Performance of US Markets

12.1 Overview of US Financial Markets

Learning Outcomes
By the end of this section, you will be able to:
• Identify the various aspects of the US money markets.
• Characterize government and corporate bond markets.
• Detail the structure and operations of US equity markets.

Money Markets
The money market is a multitrillion-dollar market. Features of money market securities include being short-
term (with maturities of less than one year) and very low risk (rarely failing to make their required payments).
Further, money market securities are also liquid, which means that they trade easily without losing value.

Financial institutions, corporations, and governments that have short-term borrowing and/or lending needs
issue securities in the money market. Most of the transactions are quite large, with typical amounts of $10,000,
$100,000, $1 million, or more. Money market securities are available in smaller amounts if you choose to invest
in money market mutual funds (MMMFs) or certain types of exchange-traded funds (ETFs).

Treasury bills (T-bills) are short-term debt instruments issued by the federal government. T-bills are
auctioned weekly by the Treasury Department through the trading window of the Federal Reserve Bank of
New York, with maturities of 4, 8, 13, or 26 weeks. The Treasury also auctions 52-week T-bills once every four
weeks. The federal government uses T-bills to meet short-term liquidity needs. T-bills have very short
maturities and a broad secondary market and are default-risk free. T-bills are also exempt from state and local
income taxes. As a result, they carry some of the lowest effective interest rates on publicly traded debt
securities.

The volume of T-bills auctioned depends upon government borrowing needs. Much of the money raised at
weekly T-bill auctions goes to repay the money borrowed 4, 8, 13, 26, or 52 weeks earlier. The gross amount of
new T-bills issued in December 2020 was $1,591.1 billion, and the amount of T-bills retired in the same month
was $1,570.6 billion, resulting in net new borrowing of “only” $20.5 billion.

In addition to the regular auction of new T-bills, there is also an active secondary market where investors can
trade used or previously issued T-bills. Since 2001, the average daily trading volume for T-bills has exceeded
$75 billion.

Commercial paper (CP) is a short-term, unsecured debt security issued by corporations and financial
institutions to meet short-term financing needs such as inventory and receivables. For example, credit card
companies use commercial paper to finance credit card payments. Commercial paper is a short-term debt
instrument, with a typical maturity of 30 days and up to 270 days. The short maturity reduces US Securities and
Exchange Commission (SEC) oversight. The lesser oversight and the unsecured nature of CP means that only
highly rated firms are able to issue the uninsured paper.

Commercial paper typically carries a minimum face value of $100,000 and sells at a discount, with the face
value as the repayment amount. Corporations and financial institutions, not the government, issue CP; thus,
returns are taxable. Further, unlike T-bills, there is not a robust secondary market for CP. Most purchasers are
large, such as mutual fund investment companies, and they tend to hold commercial paper until maturity. The
default rate on commercial paper is typically low, but default rates did increase into the double-digit range
during the financial crisis of 2008.

Negotiable certificates of deposit (NCDs) are very large CDs issued by financial institutions. They are
redeemable only at maturity, but they can and often do trade prior to maturity in a broad secondary market.
NCDs, or jumbo CDs, are so called because they sell in increments of $100,000 or more. However, typical
amounts are $1 million, with a maturity of two weeks to six months.

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 12.1 • Overview of US Financial Markets 355

NCDs differ in some important ways from the typical CD you may be familiar with from your local bank or
credit union. The typical CD has a maturity date, interest rate, and face amount and has FDIC insurance.
However, if an investor wishes to cash out prior to maturity, they will incur a substantial penalty from the
issuer (bank or credit union). An NCD also has a maturity date and amount, but it is much larger than a regular
CD and appeals to institutional investors. The principal is not insured. When the investor wishes to cash out
early, there is a robust secondary market for trading the NCD. The issuing institution can offer higher rates on
NCDs compared to CDs because it knows it will have use of the purchase amount for the entire maturity of the
NCD and because the reserve requirements on NCDs by the Federal Reserve is lower than for other types of
deposits.

Investment companies such as Vanguard and Fidelity, among many others, sell shares in money market
mutual funds (MMMFs). The investment company purchases money market instruments, such as T-bills, CP, or
NCDs; pools them; and then sells shares of ownership to investors (see Table 12.1). Generally, MMMFs invest
only in taxable securities, such as commercial paper and negotiable certificates of deposit, or only in tax-
exempt government securities, such as T-bills. Investors can then choose which type of short-term liquid
securities they would like to hold, taxable or nontaxable. MMMFs provide smaller firms and investors the
opportunity to participate in the money market by facilitating smaller individual investment amounts.

Financial Instrument Typical Maturity Minimum Amount Issuer

Treasury bills 4–52 weeks $10,000 Federal government
Commercial paper 270 days $100,000 Businesses
Negotiable CDs 6 months $100,000 Financial institutions
MMMFs Investment companies
Federal funds 1 day $1 million Financial institutions

Table 12.1 Money Market Instrument Characteristics (Selected)

The market for federal funds is notable because the Federal Reserve (Fed) targets the equilibrium interest rate
on federal funds as one of its most important monetary policy tools. The federal funds market traditionally
consists of the overnight borrowing and lending of immediately available funds among depository financial
institutions, notably domestic commercial banks. Financial institutions such as banks are required to keep a
fraction of their deposits on reserve with the Fed. When banks find they are short of reserves and immediately
need cash to meet reserve requirements, they can borrow directly from the Fed through the so-called
“discount window” or purchase excess reserves from other banks in the federal funds market. Often, the
maturity of a federal funds contract is as short as a single day or overnight. The participants in the market
negotiate the federal funds interest rate. However, the Federal Reserve effectively sets the target interest rate
range in the federal funds market by controlling the supply of funds available for use in the market.

Since the financial crisis of 2008, the activities and functioning of the federal funds market has changed. The
federal funds rate is still the rate targeted by the Fed for monetary policy, but the participants have evolved for
several reasons. The market now includes foreign banks and non-depository financial institutions, such as the
Federal Home Loan Banks. These institutions do not need to meet Fed reserve requirements and are not
required to keep reserves with the Fed. In addition, the Fed now pays interest to commercial banks for
reserves held at the Federal Reserve banks. Paying interest on reserves reduces the incentive for domestic
commercial banks to enter the federal funds market since they can already earn interest on their excess
reserves.
356 12 • Historical Performance of US Markets

Daily trading volume in the federal funds market from 2016 through 2020 ranged from a high of $115 billion in
2
March of 2018 to a low of only $34 billion on December 31, 2020. The volume of federal funds activity is lower
in periods of slower economic growth because banks have fewer good opportunities to issue loans and are
less likely to be short of required reserves.

Bond Markets
Bond markets are financial markets that make payments to investors for a specific period of time. Investors
decide how much to pay for a bond depending on how much they expect inflation to affect the value of the
fixed payment. There are several types of bonds: government bonds, corporate bonds, and municipal bonds.

Government Bond Markets

In the section on money markets, we discussed T-bills, and we now discuss longer-term government securities
in the form of Treasury notes and Treasury bonds.

We learned in Bonds and Bond Valuation that the federal government issues Treasury notes and bonds to
raise money for current spending and to repay past borrowing. The size of the Treasury market is quite large,
as the US federal government over the years has accumulated a total indebtedness of over $28 trillion dollars.
The debt has grown so large we even have a real-time debt calculator online at https://www.usdebtclock.org/
(https://openstax.org/r/usdebtclock).

Treasury notes (T-notes) are US government debt instruments with maturities of 2, 3, 5, 7, or 10 years. The
Treasury auctions notes on a regular basis, and investors may purchase new notes from TreasuryDirect.gov
(https://openstax.org/r/treasurydirect.gov) in the same way they would a T-bill. T-notes differ from T-bills in
that they are longer term and pay semiannual coupon interest payments, as well as the par or face value of
the note at maturity. T-bills, as you will recall, sell at a discount and pay the face value at maturity with no
explicit interest payments. Upon issue of a note, the size, number, and timing of note payments is fixed.
However, prices do change in the secondary market as interest rates change. Like T-bills, T-notes are generally
exempt from state and local taxes.

Economists and investors keep a close eye on the 10-year T-note for several reasons. Mortgage lenders use it
as a basis for setting and adjusting mortgage interest rates. In general, the rate on the 10-year T-note is a
reliable market indicator of investor confidence.

There is an active secondary market for Treasury notes. From 2001 to 2020, the daily trading volume for
Treasury notes has averaged $395 billion, or roughly five times the daily trading volume of T-bills. Treasury
notes are the largest single type of government debt instrument, with over $11 trillion outstanding. As you can
see from Figure 12.2, the Treasury dramatically increased borrowing by issuing notes following the 2008
financial crisis.

Brokers, dealers, and investment companies provide secondary market opportunities for individual and
institutional investors. Exchange-traded funds (ETFs) are popular investment vehicles for many types of
government T-bill, T-note, and T-bond portfolios. An ETF is a basket of securities that can trade like stocks on a
stock exchange. For example, IEI is an iShares ETF managed by BlackRock that invests in Treasury securities
with three to seven years to maturity. When investors buy this ETF, they purchase a small bundle of Treasury
notes that they can buy or sell, just as if they owned an individual share of stock. ETFs are a convenient way for
investors to own broad portfolios of securities while still being able to trade the whole group in a single
transaction if they choose.

2 Federal Reserve Bank of New York. “Effective Federal Funds Rate.” Federal Reserve Bank of New York.
https://www.newyorkfed.org/markets/reference-rates/effr

Access for free at openstax.org

 12.1 • Overview of US Financial Markets 357

Figure 12.2 Daily Trading Volume for US Treasury Notes and Bonds (data source: treasurydirect.gov)

Longer-term Treasury issues, Treasury bonds, have maturities of 20 or 30 years. T-bonds are like T-notes in
that they pay semiannual coupon interest payments for the life of the security and pay the face value at
maturity. They are longer term than notes and typically have higher coupon rates. T-bonds with maturities of
20 and 30 years are each auctioned only once per month. At the end of 2020, there were approximately $2.8
trillion of T-bonds outstanding, compared to approximately $11.1 trillion and $5 trillion of T-notes and T-bills.

In 1997, the Treasury began offering a new type of longer-term debt instrument, Treasury Inflation-Protected
Securities, or TIPS. TIPS currently have maturities of 5, 10, or 30 years and are auctioned by the Treasury once
per month. Like T-notes and T-bonds, they offer semiannual coupon interest payments for the life of the
security and pay face value at maturity. The coupon interest rates are fixed, but the principal value adjusts
monthly in response to changes in the consumer price index (CPI). Inflation and deflation cause the value of
the principal to increase or decrease, which results in a larger or smaller semiannual coupon payment. With a
total outstanding value of approximately $1.6 trillion at the end of 2020, TIPS are the smallest form of Treasury
3
borrowing we have discussed.

State and local governments and taxing districts can issue debt in the form of municipal bonds (munis). Local
borrowing carries more risk than Treasury securities, and default or bankruptcy is atypical but possible. Thus,
munis have ratings that run a spectrum similar to corporate bonds in that they receive a bond rating based on
the perceived default risk. The defining feature of municipal bonds is that some interest payments are tax-
free. Interest on munis (municipal bonds) is always exempt from federal taxes and sometimes exempt from
state and local taxes. This makes them very attractive to investors in high income brackets.

There are two primary types of municipal bonds: revenue bonds and general obligation (GO) bonds. GO bonds
generate cash flows to repay the bonds by taxing a project. For instance, a local school district may tax
residents to pay for capital construction, or a city may tax citizens to pay for a new public works building.
Revenue bonds, on the other hand, may apply to projects that generate sufficient cash flows to repay the
bond—perhaps a utility or local toll road.

Corporate Bond Markets

Just as governments borrow money in the long-term from investors, so do corporations. A corporation often
uses bank loans, commercial paper, or supplier credit for short-term borrowing needs and issues bonds for
longer-term financing. Bond contracts identify very specific terms of agreement and outline the rules for the
order, timing, and amount of contractual payments, as well as processes for when one or more of the required
activities lapse. Indenture is the legal term for a bond contract. The indenture also includes limitations on the

3 Nick Lioudis. “Where Can I Buy Government Bonds?” Investopedia. December 30, 2020. https://www.investopedia.com/ask/
answers/where-can-i-buy-government-bonds/; TreasuryDirect. “Today’s Auction Results.” TreasuryDirect.
https://www.treasurydirect.gov/instit/annceresult/press/press_auctionresults.htm
358 12 • Historical Performance of US Markets

corporation for how they may use the bond proceeds.

A bond indenture includes both standard boilerplate contract language and specific conditions unique to a
particular issue. Because of these non-standardized features of a bond contract, the secondary market for
trading used bonds typically requires a broker, dealer, or investment company to facilitate a trade.

When a corporation uses a real asset, such as property or buildings, to guarantee a bond, the firm has issued a
mortgage bond. However, it is more common for a corporation to issue an unsecured bond known as a
debenture. The risk of a debenture reflects the risk of the entire corporation and does not rely on the value of
a specific underlying asset, as is the case with a mortgage bond.

The risk a bondholder bears for buying a bond depends in part on the terms of the bond indenture, market
conditions over the life of the bond contract, and the ability or inability of the firm to generate sufficient cash
flows to meet its bond obligations. Fortunately, investors do not have to make these determinations about risk
on their own. They can rely on bond rating services such as Moody’s, Standard and Poor’s, or Fitch to generate
evaluations of the creditworthiness of bond issuers.

Ratings firms must adhere to rigorous standards when evaluating client creditworthiness. For example,
Standard and Poor’s begins the explanation of its evaluation process with these paragraphs:

“S&P Global Ratings provides a Credit Rating only when, in its opinion, there is information of satisfactory
quality to form a credible opinion on creditworthiness, consistent with its Quality of the Rating Process –
Sufficient Information (Quality of Information) Policy, and only after applicable quantitative, qualitative, and
legal analyses are performed. Throughout the ratings and surveillance process, the analytical team reviews
information from both public and nonpublic sources.”

“For corporate, government, and financial services company or entity (collectively referred to as “C&G” Credit
Ratings), the analysis generally includes historical and projected financial information, industry and/or
economic data, peer comparisons, and details on planned financings. In addition, the analysis is based on
qualitative factors, such as the institutional or governance framework, the financial strategy of the rated entity
4
and, generally, the experience and credibility of management.”

Table 12.2 is a summary of how the three major credit rating agencies identify their ratings. Bond ratings are
important for many reasons. The higher a firm’s rating, the lower the expected default risk and the lower the
cost of borrowing for the firm. Pension funds may be restricted to investing in only medium- or higher-grade
bonds. This could limit the number of investors who can participate in the market for lower-grade bonds,
thereby reducing the liquidity, price, and tradability of those debt securities.
5
There are only two US companies with AAA credit ratings: Microsoft and Johnson & Johnson. Over the past 40
years, there has been a steady decline of AAA-rated companies (from sixty in 1980). Many institutions have
found that this rating requires a more conservative approach to debt that can inhibit growth and revenue. So,
in today’s market, credit ratings have begun to lose their importance. It seems that the ability to pay debts has
become secondary to the potential for growth.

Fitch Moody’s S&P Bond Grade/Risk

AAA Aaa AAA Investment/low risk
AA Aa AA Investment/low risk
A A A Investment/low risk

Table 12.2 Credit Scale Ratings from the Three Credit

Rating Agencies

4 S&P Global Ratings. “Transparency Statement.” S&P Global Ratings. https://www.spglobal.com/ratings/en/about/transparency

5 The Wall Street Insider. “Why Only Two Companies Are Left with the AAA Rating.” The Wall Street Insider. June 12, 2020.
https://www.thewallstreetinsider.com/trends/why-only-two-companies-are-left-with-the-aaa-rating

Access for free at openstax.org

 12.1 • Overview of US Financial Markets 359

Fitch Moody’s S&P Bond Grade/Risk

BBB Baa BBB Investment/medium risk
BB Ba BB Junk/high risk
B B B Junk/high risk
CCC Caa CCC Junk/highest risk

Table 12.2 Credit Scale Ratings from the Three Credit

Rating Agencies

Equity Markets
An important goal of firm managers is to maximize owners’ wealth. For corporations, shares of stock
represent ownership. A corporation could have 100 shares, one million shares, or even several billion shares of
stock. Stocks are difficult to value compared to bonds. Bonds typically provide periodic interest payments and
a principal payment at maturity. The bond indenture specifies the timing and the amount of payments. Stocks
might have periodic dividend payments, and an investor can plan to sell the stock at some point in the future.
However, no contract guarantees the size of the dividends or the time and resale price of the stock. Thus, the
cash flows from stock ownership are more uncertain and risky.

Corporations are the dominant form of business enterprise in the United States because of the ability to raise
capital, the ease of transfer of ownership, and the benefit of limited liability to the owners. There are generally
two types of stock, preferred and common. Preferred stock is a hybrid between common stock and bonds.
Preferred stock has a higher claim to cash flows than common stockholders have (thus the term preferred),
but it is lower than that of bondholders. In addition, preferred stock has fixed cash flows as bonds have and
typically has no or few voting rights. Preferred stock dividends are after-tax payments by the corporation, as
are common stock dividends, but bond interest payments, paid prior to taxes, are tax-deductible for firms. Of
the three, preferred stock is the least used form of capital financing for corporations.

Common stockholders are the residual claimants and owners of the corporation. After all others who have a
claim against the firm are paid, the common stockholders own all that remains. Common stockholders have
voting rights, typically one vote per share, and choose the board of directors.

One popular way to rank the size of companies is to determine the value of their market capitalization, or
market cap. Market cap is equal to the current stock price multiplied by the number of shares outstanding.
According to the World Bank, the total market cap of US firms at the end of 2020 was $50.8 trillion, making up
6
over half of the world’s total value of equity, estimated at $90 trillion. The largest US company at that time
was Apple, followed by Microsoft, Amazon, Alphabet (Google), and Facebook. The largest company by sales
7
volume in 2020 was Walmart.

Geographical Location of Exchanges

Ownership is easily transferable for stocks that trade in one of the organized stock exchanges or in an over-
the-counter (OTC) market. Definitions of a stock exchange and an OTC market blur as financial markets quickly
adapt to innovations. However, stock markets have a centralized trading location, transactions require a
broker to connect buyers and sellers, and the exchanges guarantee a basic level of liquidity so that investors
are always able to buy or sell their stocks. An OTC market is an electronic market conducted on computer
screens and consists of direct transactions among buyers and sellers, with no broker to bring the two

6 Siblis Research. “Total Market Value of US Stock Market.” Siblis Research. https://siblisresearch.com/data/us-stock-market-value/;
The World Bank. “Market Capitalization of Listed Domestic Companies (current US$).” The World Bank. https://data.worldbank.org/
indicator/CM.MKT.LCAP.CD
7 Companies Market Cap. “Largest American Companies by Market Capitalization.” Companies Market Cap.
https://companiesmarketcap.com/usa/largest-companies-in-the-usa-by-market-cap/; National Retail Federation. “Top 100 Retailers
2020 List.” National Retail Federation. 2020. https://nrf.com/resources/top-retailers/top-100-retailers/top-100-retailers-2020-list
360 12 • Historical Performance of US Markets

together. Because there is no formal exchange present, it is possible that investors will have trouble finding
buyers or sellers for their stocks.

Most of the trading consists of used or previously issued stocks in over-the-counter markets and organized
exchanges. The two largest stock exchanges in the world, as measured by the market capitalization of the
companies listed on the exchange, are the New York Stock Exchange (NYSE) and the NASDAQ. Both exchanges
are located in the United States. Other large stock exchanges are located in Japan, China, Hong Kong,
continental Europe, London, and Saudi Arabia.

Process of Offering Equities

The primary market is the market for new securities, and the secondary market is the market for used
securities. When issuing new equity, the issuing firm receives the proceeds of the sale. Having an active
secondary market makes it easier for corporations to issue stock, as investors know they can resell if desired.
Most of the trading of equity securities is for used securities on the secondary market.

An initial public offering, or IPO, occurs when a firm offers stock to the public for the first time. With a typical
IPO, a private company decides to raise capital and go public with the help of an investment banker. The
investment banker agrees to provide financial advice, recommend the price and number of shares to issue,
and establish a syndicate of underwriters to finance and ultimately distribute the new shares to investors (see
Figure 12.3). An IPO is expensive for the issuing firm, and it can expect to incur costs of 5% to 8% or more of
the value of the IPO. As of the end of 2020, the largest successful IPO belongs to Saudi Aramco, a petroleum
8
company, valued at $25.6 billion at issue in December 2019. The Ant Group had planned an IPO valued at
over $34 billion dollars in 2020, but as of the end of 2020 that issue was put on hold by the Chinese
9
government.

Institutional and preferred individual investors are typically the initial purchasers of IPOs. Smaller investors
rarely have the opportunity to purchase. However, any investor can buy the new shares once available for
public trading. Investment author and financial expert Professor Burton Malkiel cautions that buying IPOs
immediately after issue can be a money-losing investment. He cites research showing that, historically, IPOs
10
have underperformed the market by an average of 4% per year.

Another way for a corporation to raise capital in the equity market is through a seasoned equity offering
(SEO). An IPO occurs when a firm transitions from a private to a public company. An SEO takes place when a
corporation that is already publicly traded issues additional shares of stock to the public. An SEO is often part
of a SEC Rule 415 offering, or so-called shelf registration. Shelf registrations allow a company to register with
the SEC to issue new shares but wait up to two years before issuing the shares. This gives companies the
ability to register their intent to issue new shares and to “set them on the shelf” until market conditions are
most favorable for issuance to the public.

8 Jennifer Rudden. “Largest IPOs Worldwide as of January 21, 2021.” Statista. 2021. https://www.statista.com/statistics/269343/
worlds-largest-ipos/
9 Deborah D’Souza. “Ant Group Set to Be World’s Largest IPO Ever.” Investopedia. October 27, 2020.
https://www.investopedia.com/ant-group-set-to-be-world-s-largest-ipo-ever-5084457; Jasper Jolly. “Ant Group Forced to Suspend
Biggest Share Offering in History.” The Guardian. https://www.theguardian.com/business/2020/nov/03/biggest-share-offering-in-
history-on-hold-as-ant-group-suspends-launch
10 Burton Malkiel. A Random Walk down Wall Street. 10th ed. W. W. Norton, 2012.

Access for free at openstax.org

 12.1 • Overview of US Financial Markets 361

Figure 12.3 The IPO Process

Alternative Methods of Raising Capital

11
Special purpose acquisition companies (SPACs) were born in the 1990s and came of age in 2019. SPACs
are a special form of IPO. We know that firms with products or services to sell and a documented operational
and financial history often initiate an IPO to raise money by going public. A SPAC, however, is like an IPO that
puts the cart before the horse. By this, we mean that rather than having a company ready to go public to raise
capital, with a SPAC, a sponsor raises capital in anticipation of finding a firm ready to go public. This is why we
sometimes refer to SPACs as “blank check” companies. Investors are providing capital to a firm that has no
assets with the expectation that the sponsor will find a good investment.

Forming a SPAC shifts the risk and expenses associated with a firm going public. Because the money raised by
the SPAC sponsor is the only asset, the process of filing with the SEC is less complicated, less expensive, and
less time-consuming than filing an IPO. Often, when formed, a SPAC has a target company in mind, but this is
not a requirement. Once the SPAC identifies a target firm, the sponsor can negotiate a purchase price and
12
essentially merge with the target. Underpricing of IPOs is well documented, and the owners of a private
company going public do not capture the significant increase in stock price that frequently occurs in the
months following an IPO.

A SPAC offering allows the private firm owners to negotiate for a better price. A July 2020 study from
Renaissance Capital reports that “of 223 SPAC IPOs conducted from the start of 2015 through July 2020, 89
have completed mergers and taken a company public.” According to the study, of those 89 mergers, “the
common shares have delivered an average loss of 18.8% and a median return of minus 36.1%. That compares
13
with the average after-market return from traditional IPOs of 37.2%” over the same time period.

Sequence of Trade Execution

Investors who wish to trade stocks (buy or sell) execute trades via a broker. Many online brokers today will
execute your trades at low to no cost once you have established a brokerage account. When trading, it is most

11 Nicholas Jasinksi. “Blank Check Companies Are Hot on Wall Street. Investors Can’t Ignore Them.” Barron’s. January 17, 2020.
https://www.barrons.com/articles/boom-in-blank-check-companies-or-spacs-what-investors-need-to-know-51579299261; Julie
Young. “Special Purpose Acquisition Company (SPAC).” Investopedia. November 24, 2020. https://www.investopedia.com/terms/s/
spac.asp
12 R. G. Ibbotson, J. L. Sindelar, and J. R. Ritter. “The Market’s Problems with the Pricing of Initial Public Offerings.” Journal of
Applied Corporate Finance 7 (Spring 1994).
13 Ciara Linnane. “2020 Is the Year of the SPAC—Yet Traditional IPOs Offer Better Returns, Report Finds.” MarketWatch. September
16, 2020. https://www.marketwatch.com/story/2020-is-the-year-of-the-spac-yet-traditional-ipos-offer-better-returns-report-
finds-2020-09-04; Barron’s. “What Is a SPAC?” Barron’s (video). December 11, 2020. https://www.barrons.com/video/what-is-a-spac/
86E80342-FBC2-44DA-99E2-DF808CD147FF.html
362 12 • Historical Performance of US Markets

common to make a market order or a limit order. A market order executes a trade at the current price, while a
limit order specifies the price at which the investor is willing to buy or sell. Figure 12.4 provides a visual
representation of how payment for an order flow works.

Figure 12.4 The Order of Payments for Trade Executions

12.2 Historical Picture of Inflation

Learning Outcomes
By the end of this section, you will be able to:
• Define inflation with concrete examples.
• Describe the practical impact of inflation on consumption and salary.
• Explain how expected and actual inflation are measured.
• Detail the behavior of inflation over various historical periods.

Over time, returns in the stock market have easily outperformed returns in the bond market. However, not
everyone is comfortable investing in stocks. Taking a more informed and opposing view, financial economist
Jeremy Siegel queries, “You have never lost money in stocks over any 20-year period, but you have wiped out
14
half your portfolio in bonds (after inflation). So which is the riskier asset?” Siegel brings up a valid point
about inflation. Returns adjusted for changes in prices provide a better measure of value or wealth. Baseball
pundit Sam Ewing noted, “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get
15
for five dollars when you had hair.” If what you have earned on your investments fails to keep up with
changing prices, you may have a larger portfolio with less purchasing power.

Expected versus Actual Inflation

Inflation occurs when things cost more and your money buys less today than it did yesterday. It is
understandable to dislike inflation and to be concerned over the prospect of rising prices. In fact, two of the
primary policy objectives of the Federal Reserve are to work for price stability and moderate interest rates.
However, is inflation necessarily good or bad? In practice, inflation can benefit some people and harm others
at the same time. Consider the impact of differences in expected and actual realized inflation. Empirical
evidence suggests that, on average, economists do a good job of developing inflation rate forecasts that
match the actual rate of inflation. Estimated inflation is built into the interest rates investors require or are
willing to pay for financial products, such as fixed-rate loans or bonds. When the actual rate of inflation
exceeds the estimated rate on a product, such as a mortgage loan, this means borrowers are repaying the
loan with less-valuable dollars and benefit from the increased inflation rate. Lenders, however, receive those
inflation-impacted dollars and are harmed due to their unexpected decrease in purchasing power.

Deflation, or falling prices, is associated with economic recessions or even depressions and is thought to be an
even more serious problem than inflation. Generally, policy makers tend to support moderate inflation, being
careful to stay away from zero or negative price changes.

14 Jeremy J. Siegel. Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies.
McGraw-Hill, 2002. First published 1994.
15 Sam Ewing. “Sam Ewing Quotes.” Brainy Quotes. https://www.brainyquote.com/authors/sam-ewing-quotes

Access for free at openstax.org

 12.2 • Historical Picture of Inflation 363

Inflation Impacts
Ultimately, inflation redistributes wealth. Lenders providing fixed-rate loans receive less-valuable dollars in
return. Borrowers repay with those same less-valuable dollars. Workers receive less-valuable dollars, especially
when their wage increases lag behind changes in prices. Modest inflation can benefit a consumer-driven
economy like the United States if consumers are motivated to spend money before prices increase. However,
too much inflation can cause frenzied buying, drive prices even higher, and outpace the rate of wage
increases. Higher inflation raises the rates on new borrowing instruments and can slow the rate of business
investment and economic growth. Inflation raises overall prices and may cause hardship for consumers on a
fixed income.

Finally, inflation does not have an equal impact on all goods and services. As Table 12.3 shows, consumer
prices did not increase at the same rate for the selected items shown. From 1980 to 2020, inflation, as
measured by the consumer price index (CPI), grew at an average annual rate of 2.90%. However, the price of
college tuition and fees increased at more than double that rate. Rent, another large expense for most college
students, increased at an annual rate of 3.67%, also well above the average increase in the CPI. The price
increases for ground beef and butter were slightly less than the CPI average. For the selected items presented
here, only the average price for used cars and trucks rose at a rate significantly lower than the average rate of
inflation.

Year 1980 2000 2020 Annual Change

College tuition and fees 70.8 331.9 877.3 6.49%
Rent 80.9 183.9 341.5 3.67%
Used cars and trucks 62.3 155.8 144.2 2.12%
Ground beef 104.6 125.2 296.2 2.64%
Butter 89.4 135.9 248.7 2.59%
CPI (1982 to 1984 = 100) 82.4 172.2 258.8 2.90%

Table 12.3 Changing Consumer Price Levels—Selected Goods (source:

US Bureau of Labor Statistics, Consumer Price Index)

Using Graphs and Charts to Plot Inflation Behavior

The CPI is a measure of how prices have changed for a basket of goods across the United States. Figure 12.5
16
shows the eight major categories of expenditures included in the CPI. Different regions of the country and
population subgroups may experience different rates of inflation. Retired people may spend a greater portion
17
of their income on healthcare than someone in their twenties. Residents on the East and West Coasts spend
18
a higher percentage of their earnings on housing than those living in the Midwest. As such, there are several
19
different measures of inflation based on geographic region or other factors. It is worth noting that a basket
of goods and services that cost $100 in 1984 would cost approximately $260 by the end of 2020, an increase of
160% (see Figure 12.6)! Over that same period, the average annual rate of inflation as measured by the CPI
was 2.55%. These numbers make it easy to see that even a relatively modest annual inflation rate, lower than
the long-run annual US inflation rate of 3%, results in significant price increases.

16 US Bureau of Labor Statistics. “Consumer Price Index.” US Bureau of Labor Statistics. https://www.bls.gov/cpi/
17 Chris Farrell. “The Truth About Health Care Costs in Retirement.” Forbes. June 28, 2018. https://www.forbes.com/sites/
nextavenue/2018/06/28/the-truth-about-health-care-costs-in-retirement/
18 US Department of Housing and Urban Development, Office of Policy Development and Research. “Rental Burdens: Rethinking
Affordability Measures.” PD&R Edge. September 22, 2014. https://www.huduser.gov/portal/pdredge/
pdr_edge_featd_article_092214.html
19 Khan Academy. “How Changes in the Cost of Living Are Measured.” Khan Academy. https://www.khanacademy.org/economics-
finance-domain/macroeconomics/macro-economic-indicators-and-the-business-cycle/macro-price-indices-and-inflation/a/how-
changes-in-the-cost-of-living-are-measured-cnx
364 12 • Historical Performance of US Markets

Figure 12.5 The Market Basket Categories of the CPI

Figure 12.6 United States Consumer Price Index (CPI) 1984–2020 (data source: US Bureau of Labor Statistics)

Access for free at openstax.org

 12.2 • Historical Picture of Inflation 365

CONCEPTS IN PRACTICE

Profile of Janet Yellen

Figure 12.7 Janet Yellen (credit: “Janet Yellen Official Federal Reserve Portrait.” United States Federal Reserve/Wikimedia
Commons, Public Domain)

Janet Yellen has led a life of firsts. After graduating as valedictorian of her high school class, Yellen later
attended Yale University and was the only woman in her 1971 PhD graduating class in economics. Men have
long dominated the “dismal science” of economics, but Yellen has proved to be an exception.

Motivated by an undergraduate economics professor at Pembroke College of Brown University, Yellen

realized how much the US central bank, known as the Federal Reserve, could influence the lives of ordinary
people. She changed her major to economics, and the rest, as they say, is history.

In her first stint working with the Federal Reserve in 1977, Yellen met and married George Ackerlof. Ackerlof
would go on to win a Nobel Prize in Economics. Ackerlof and Yellen eventually established themselves as
faculty members at the University of California, Berkeley. Yellen was twice named Outstanding Teacher in
the Haas School of Business and was recognized for her award-winning research.

In 1993, Yellen began her second tour at the Federal Reserve as an appointed member of the Board of
Governors. She left this position in 1997 to head President Bill Clinton’s Council of Economic Advisers. Yellen
became just the second woman to head the presidential council.

She then returned to California and the Bay Area, eventually becoming president of the Federal Reserve
Bank of San Francisco from 2004 to 2010. Later that year she became the vice chair of the Federal Reserve.
Four years later, in 2014, Yellen assumed leadership as the first woman chair of the Federal Reserve System.

As Fed chair, Yellen earned an enviable record. During her four-year tenure, the rate of unemployment
decreased by more than 2.5%, and employment increased in every month of her term. This is the first and
only time in the history of the Federal Reserve that the board chair has overseen continuous increases in
366 12 • Historical Performance of US Markets

employment over their entire tenure.

Now, another first: In 2021, President Joe Biden appointed Yellen as the first woman Secretary of the
Treasury. Yellen has a storied career and a long list of accomplishments, but surely her record of firsts will
prove to be an important and lasting legacy for women in business, government, and economics
everywhere.

(Sources: Ann Saphir. “Factbox: Janet Yellen’s Road to US Treasury Secretary.” Reuters. November 24, 2020.
https://www.reuters.com/article/idUSKBN2832WS; Ylan Q. Mui. “New Fed Chief Janet Yellen Lets a Long
Career of Breaking Barriers Speak for Itself.” Washington Post. February 2, 2014.
https://www.washingtonpost.com/business/economy/new-fed-chief-janet-yellen-has-long-history-of-
breaking-barriers/2014/02/02/9e8965ca-876d-11e3-833c-33098f9e5267_story.html; Stephanie Grace.
“Banker to the Nation.” Brown Alumni Magazine. October 30, 2013.
https://www.brownalumnimagazine.com/articles/2013-10-30/banker-to-the-nation)

12.3 Historical Picture of Returns to Bonds

Learning Outcomes
By the end of this section, you will be able to:
• Detail the behavior of sovereign (government) bonds over various historical periods.
• Detail the behavior of corporate bonds over various historical periods.
• Extract sovereign and corporate bond investment results from plots and charts.

Federal Government Bond Behavior, Discussion, Charts, and Graphs

United States Treasury (sovereign) bonds are among the safest investments available. In fact, T-bonds often
serve as the proxy for a risk-free investment in financial modeling. However, even though T-bonds may be
essentially default-risk free, they do change value as interest rates change. Look at Figure 12.8, showing
annual T-bond returns from 1980 to 1999. None of these bonds defaulted, yet investors realized very different
returns on their investments from year to year. The total returns reflect interest payments plus the change in
price because of changes in interest rates.

The late 1970s experienced high rates of inflation and interest rates. As those rates began to fall in late 1981,
bond prices rose. Investors holding T-bond portfolios realized very large returns on their risk-free investments
in 1982. That year provided the highest annual return in the 20-year period, with an annual return of 32.81%.
The lowest annual return was in 1999, as the Federal Reserve began to raise rates to temper an overheating
stock market caused by dot-com speculation gaining momentum. When the Fed raised interest rates, the
prices on existing bonds fell, and investors realized a -8.25% return on their bond portfolios. Thus, the range in
returns on these “low risk” investment securities was over 41% from the highest to the lowest annual return in
this particular two-decade span. Overall, the average annual return on T-bonds from 1980 to 1999 was a robust
10.21%, boosted in part by the above average annual inflation rate of 4.28%.

Access for free at openstax.org

 12.3 • Historical Picture of Returns to Bonds 367

Figure 12.8 Treasury Bond Performance, 1980–1999 (data source: Aswath Damodaran Online)

Inflation slowed from 2000 to 2020, and the average annual rate of return on T-bonds fell accordingly (see
Figure 12.9). With reduced variability of interest rates in the new century and interest rates in general being
lower, the returns on bond portfolios were also lower on average. T-bonds in the first two decades of the
twenty-first century averaged an annual return of 5.77%, very close to the long-run average return in the
previous century. The range of returns was also smaller than the previous two decades, with the highest
annual return topping out at 20.10% in 2008 and the lower end dipping down to -11.12% in 2009 as the Fed
made a significant effort to reduce interest rates in an attempt to stimulate the economy following the Great
Recession.

Corporate Bond Behavior, Discussion, Charts, and Graphs

The performance of Baa bonds is very similar to T-Bonds over the four decades spanning 1980 to 2020 (see
Figure 12.10). These bonds are not default-risk free and require a risk premium for investors. The average
annual return of 12.07% from 1980 to 1999 topped T-bonds by 1.86%. The margin was greater in the period
from 2000 to 2020 (see Figure 12.11), with Baa bonds (mid-tier corporate bonds) realizing an average annual
premium of 2.30% over the default-risk free T-bonds.

These premiums translate to a substantial increase in investment performance. For example, had an investor
placed $100 into a T-bond portfolio in 1980, the value of the investment would have been $1,931 by year-end
2020. This would have easily outpaced the rate of inflation but significantly lagged the ending value of $4,506
on a similar Baa bond portfolio investment (see Figure 12.12).
368 12 • Historical Performance of US Markets

Figure 12.9 Treasury Bond Performance, 2000–2020 (data source: Aswath Damodaran Online)

Figure 12.10 Baa Bond Performance, 1980–1999 (data source: Aswath Damodaran Online)

Figure 12.11 Baa Bond Performance, 2000–2020 (data source: Aswath Damodaran Online)

Access for free at openstax.org

 12.3 • Historical Picture of Returns to Bonds 369

Figure 12.12 Baa Bonds versus T-Bonds Performance, 1980–2020 (data source: Aswath Damodaran Online)

CONCEPTS IN PRACTICE

Profile of Bill Gross

Bill Gross may be the most successful fixed-income investor ever, but he is also a prime example of the
application of the efficient market theory. In over 40 years of investing in bonds and other types of fixed-
income securities worldwide, Bill Gross earned his moniker “the bond king.”

In 1971, Gross cofounded and began his long tenure as managing director and chief investment officer of
Pacific Investment Management Company, better known as Pimco. Gross was not yet 30 years old, but he
had already graduated from college, served in the Navy in Vietnam, and even briefly worked as a
professional blackjack player in Las Vegas to bankroll the cost of his MBA from UCLA.

Gross helped change the definition of success for bond investors by focusing on total returns, including
price changes, rather than simply bond yields. He used mathematical modeling and invested worldwide
and in different types of bond markets seeking risk-adjusted returns. Gross made active rather than passive
management of bond funds a successful investment strategy. In the process, he changed how mangers
oversee fixed-income portfolios today.

Pimco grew into an investment powerhouse under Gross’s direction, eventually managing over $1.5 trillion
dollars in assets. During the financial crisis of 2008, Gross served as an adviser to the US Treasury.
Morningstar named him “fixed income fund manager of the decade” in 2010. In addition, Gross profited
from his investment prowess, amassing a fortune in excess of $2 billion.

Gross’s investment strategy was to carefully analyze the known factors about debt instruments and pair
that analysis with the unknown future. He was uncanny in his ability to estimate future prices, interest
rates, and macroeconomic conditions to make profitable investments.

However, as efficient markets would posit, the odds began to catch up with Gross in the latter part of his
investing career. After leaving Pimco in 2014, Gross was unable to match his earlier performance successes
and failed to beat bond fund performance averages. Much of Gross’s investment strategy allowed him to
look for bond returns by investing in any type of bond, with any maturity, in any country, and in any
location. For decades, he was right more often than wrong in his investment choices. However, statistically,
370 12 • Historical Performance of US Markets

his approach to investing suggested that, unless he could see the future, at some point his expectations
would be incorrect. Perhaps Gross’s greatest competition comes from a generation of investment
managers who learned and improved upon his proven strategies. He retired as an active public fund
manager in 2019.

Today, Gross continues to manage his personal fortune, as well as the assets in his family charitable
foundation. Gross and the foundation have donated over $800 million to several causes over the last two
decades. In 2020, Gross joined Bill Gates, Warren Buffett, and hundreds of other billionaires in signing the
Giving Pledge, whose signees promise to donate over 50% of their wealth during their lifetime and/or upon
their death.

(Sources: Mary Childs. “Bill Gross Made the Bond Market What It Is Today.” Barron’s. February 8, 2019.
https://www.barrons.com/articles/bill-gross-bond-market-investing-legacy-51549669974; Jeff Sommer.
“Once the ‘Bond King,’ Bill Gross Is Retiring, His Star Dimmed.” New York Times. February 4, 2019.
https://www.nytimes.com/2019/02/04/business/bond-king-bill-gross-retirement.html; CNN. “Bill Gross Fast
Facts.” CNN. March 31, 2021. https://www.cnn.com/2013/04/08/us/bill-gross-fast-facts/)

12.4 Historical Picture of Returns to Stocks

Learning Outcomes
By the end of this section, you will be able to:
• Explain overall equity market behavior over various historical periods.
• Explain different equity style and size behavior over various historical periods.
• Extract various equity market performance results from plots and charts.

Using Graphs and Charts to Plot Equity Market Behavior Stock Size Considerations
The Dow Jones Industrial Average (DJIA), also known as the Dow 30) and the S&P 500 Index are the most
frequently quoted stock market indices among scholars, businesses, and the public in general. Both indices
track the change in value of a group of large capitalization stocks. The changes in the two indices are highly
correlated.

It may be fair to question if either index is a good representation of the value of equity and the changes in
value in the market because there are over 6,000 publicly traded companies listed on organized exchanges
and thousands of additional companies that trade only over the counter. As of year-end 2020, the S&P 500
firms had a combined market capitalization of $33.4 trillion, about 66% of the estimated US equity market
20
capitalization of $50.8 trillion. It is widely agreed that the performance of the S&P 500 is a good
representation of the broader market and more specifically of large capitalization firms.

Figure 12.13 provides a visualization of how S&P 500 stock returns have stacked up since 1900. This figure
makes it clear that equity returns roughly follow a bell curve, or normal distribution. Thus, we are able to
measure risk with standard deviation. A lower standard deviation of returns suggests less uncertainty of
returns and therefore less risk.

Capital market history demonstrates that the average return to stocks has significantly outperformed other
financial security classes, such as government bonds, corporate bonds, or the money market. Table 12.4
provides the return and standard deviation of several US investment classes over the 40-year period
1981–2020. As you can see, stocks outperformed bonds, bills, and inflation. This has led many investment
advisers to emphasize asset allocation first and individual security selection second. The intuition is that the

20 Spencer Israel. “The Number of Companies Publicly Traded in the US Is Shrinking—Or Is It?” MarketWatch. October 30, 2020.
https://www.marketwatch.com/story/the-number-of-companies-publicly-traded-in-the-us-is-shrinkingor-is-it-2020-10-30; Siblis
Research. “Total Market Value of US Stock Market.” Siblis Research. https://siblisresearch.com/data/us-stock-market-value/

Access for free at openstax.org

 12.4 • Historical Picture of Returns to Stocks 371

decision to invest in stocks rather than bonds has a greater long-run payoff than the change in performance
resulting from the selection of any individual or group of stocks.

Figure 12.14 demonstrates the growth of a $100 investment at the start of 1928. Note that the value of the
large company portfolio is more than 50 times greater than the equal investment in long-term US government
bonds. This supports the importance of thoughtful asset allocation.

Still, the size of a firm has a significant impact on how investors choose equity securities. Capital market
history also shows that a portfolio of small company stocks has realized larger average annual returns, as well
as greater variability, than a portfolio of large companies as represented by the S&P 500. Small-cap stock total
returns ranged from a high of 142.9% in 1933 to a low of -58.0% in 1937.

More recently, the differential return between small and large capital stocks has not been as pronounced.
From 1980 through 2020, the Wilshire US Small-Cap Index has averaged an annual compound return of 12.13%
compared to the Wilshire US Large Cap Index average of 11.82% over the same period. The 31-basis point
premium is much smaller than that realized in the 1926–2019 period, which saw a small-cap average annual
compounded return of 11.90% versus 10.14% for the large-cap portfolio.

Figure 12.13 The Pyramid of Equity Returns: Distribution of Annual Returns for the S&P 500 Index, 1928–2020 (data source:
Aswath Damodaran Online)
372 12 • Historical Performance of US Markets

Nominal Average Standard Deviation

Asset Class Annual Returns of Returns
1981–2020 1981–2020
Large company stocks 12.64% 16.06%
Baa bonds 10.34% 7.67%
10-year T-bonds 8.21% 9.92%
US T-bills 3.94% 3.39%
Inflation 2.93% 1.76%

Table 12.4 Arithmetic Average Annual Returns and Standard Deviation by

Asset Class, 1981–2020 (source: Aswatch Damodaran Online)

Figure 12.14 Growth of a $100 Investment into Selected Asset Portfolios, 1928–2020 (data source: Aswath Damodaran Online)

LINK TO LEARNING

Would You Like to Research More Historical Returns?

This article on historical returns and risks (https://openstax.org/r/6-what-to-invest-in) contains calculators
that can help you find returns over your selected periods for US stocks, bonds, and inflation. How have the
markets done since you were born? This second article about global equity markets (https://openstax.org/
r/returns-of-global-stocks) has a comparable calculator. You can also go to the Global Wealth Report
(https://openstax.org/r/global-wealth-report), an annual publication by Credit Suisse, to dig more deeply.

LINK TO LEARNING

Does It Pay to Time the Market?

Over the period 1980 to mid-2020, an investment of $10,000 into an S&P 500 index fund would have yielded
the investor $697,421. However, missing the 5 best-performing days in the market would have reduced the

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 12.4 • Historical Picture of Returns to Stocks 373

final portfolio balance to $432,411. Stay out of the market on the 10 best days, and the balance would have
ended at only $313,377, or less than half of the return earned in the full time period. Watch this Wall Street
Journal (https://openstax.org/r/wall-street-journal-video) video on the DJIA to learn more.

CONCEPTS IN PRACTICE

Warren Buffett

Figure 12.15 Warren Buffett (credit: “Warren Buffet at the 2015 Select USA Investment Summit.” USA International Trade
Administration/Wikimedia Commons, CC Public Domain Mark)

Warren Buffett has not always been one of the richest people in the world, but he has always been one of
the hardest workers. An entrepreneur from an early age, Buffett’s yearbook photo caption noted that he
“likes math: a future stockbroker.” Before leaving high school, Buffett had already earned thousands of
dollars running a paper route and through one of his start-up businesses of installing and maintaining
pinball machines in barbershops.

As they say in Nebraska, “you need to make hay while the sun shines,” and Buffett has made his share of
hay, so to speak. In his career, Buffett has accumulated enough hay to be one of the wealthiest people in
the world, with a net worth of over $80 billion by the end of 2020.

The “Oracle of Omaha,” as Buffett is known, grew his fortune through investing partnerships and most
notably as the chairman, president, CEO, and largest stockholder of Berkshire Hathaway (BRK). Berkshire
Hathaway was a New England textile manufacturer when Buffett and his investment partners began buying
shares in the 1960s. By 1966, after a dispute with the then CEO of Berkshire, Buffett assumed control of the
company and fired the CEO. Soon, Buffett’s partnerships merged into Berkshire and moved the business
away from textiles; it eventually became the largest financial services company in the world, including total
ownership of the Geico Insurance Company.

Buffett’s career is notable for how he developed his fortune, how he explained his philosophy, and for his
current and future plans. Buffett followed the method of Benjamin Graham, famous value investor and
author of Security Analysis, The Intelligent Investor. However, Buffett expanded beyond Graham’s analysis
374 12 • Historical Performance of US Markets

of financial statements and intrinsic value to examine the character of executive management. He applied
the same criteria to hiring employees as well. Buffett once noted, “We look for three things when we hire
people. We look for intelligence, we look for initiative or energy, and we look for integrity. And if they don’t
have the latter, the first two will kill you, because if you’re going to get someone without integrity, you want
them lazy and dumb.” When speaking of integrity, Buffett went on to say, “Only when the tide goes out do
you discover who’s been swimming naked.”

Buffett’s folksy way of making his point will undoubtedly be another of his legacies. When asked repeatedly
about how he managed to be such a successful investor, Buffett replied, “Never invest in a business you
can’t understand.” Never was this truer than in the late 1990s and 2000, when the dot-com craze fueled the
stock market with technology firms enjoying tremendous price increases without the corresponding
earnings. Buffett’s value investing lagged until the bubble burst, and suddenly he was back on top. When
asked about his change in fortune he replied, “In the business world, the rearview mirror is always clearer
than the windshield.”

Buffett believes in long-term rather than short-term investing. He once remarked that “Someone’s sitting in
the shade today because someone planted a tree a long time ago” and “If you aren’t willing to own a stock
for 10 years, don’t even think about owning it for 10 minutes.”

The third aspect of Buffett’s legacy will be how his money works now and after he is gone. With Bill and
Melinda Gates, Buffett started the Giving Pledge, and to date they have gathered the pledge of over 200
billionaires to give away half or more of their fortune during and after their lifetimes. Buffett states, “If
you’re in the luckiest 1% of humanity, you owe it to the rest of humanity to think about the other 99%.”
Buffett has begun the process to give away most of his fortune, but he has left this pearl of wisdom for his
own children: “A very rich person should leave his kids enough to do anything, but not enough to do
nothing.”

(Sources: Joshua Kennon. “How Warren Buffett Became One of the Wealthiest People in America.” The
Balance. May 4, 2021. https://www.thebalance.com/warren-Buffett-timeline-356439; Ty Haqqi. “Five Largest
Financial Services Companies in the World.” Insider Monkey. November 26, 2020.
https://www.insidermonkey.com/blog/5-largest-financial-services-companies-in-the-world-891348/2/;
Mohit Oberoi. “Warren Buffett: Growth Stocks Look Like Dot-Com Bubble.” Market Realist. September 4,
2020. https://marketrealist.com/2020/07/warren-buffett-growth-stocks-like-dot-com-bubble/)

LINK TO LEARNING

Does It Pay to Invest Globally?

On a global basis, US equity markets have been among the highest performing since 1900. Only Australia
shows a higher average annual return over the 121-year period. Many factors contribute to long-run stock
performance in any given country. However, over the period studied, the United States benefited from an
entrepreneurial spirit and distance from the center of two world wars. An article reviewing global stock
market returns from 1900 to 2020 summarizes and analyzes global market return information created by
21
researchers Elroy Dimson, Paul Marsh, and Mike Staunton for Credit Suisse.

While most established economies have not generated higher returns than the US equity markets, they do
offer the benefits of diversification. Further, the greatest return potential—and the greatest risk of

21 Karl Steiner. “Historical Returns of Global Stocks.” Mindfully Investing. July 6, 2020. https://www.mindfullyinvesting.com/
historical-returns-of-global-stocks/; Elroy Dimson, Paul Marsh, and Mike Staunton. Summary Edition Credit Suisse Global Investment
Returns Yearbook 2020. Credit Suisse, February 2020. https://www.credit-suisse.com/media/assets/corporate/docs/about-us/
research/publications/credit-suisse-global-investment-returns-yearbook-2020-summary-edition.pdf

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 12.4 • Historical Picture of Returns to Stocks 375

loss—may lie in developing economies. Investing experts are not in complete agreement about the
advantages and disadvantages of investing in foreign equity markets. This article provides a framework for
analysis and tools (https://openstax.org/r/returns-of-global-stocks) for comparing equity returns by
country from 1970 through 2020. Has Australia continued to be the top-performing equity market since
1970? Have equity markets performed as well or better in the last 21 years compared to the 121-year
period? Does the article encourage you to diversify internationally or focus only on domestic securities?
376 12 • Summary

Summary
12.1 Overview of US Financial Markets
One way to parse financial markets is by the maturity of financial instruments. With this dichotomy, we
explored the money market and the capital market. The money market consists of short-term securities and
the capital market of longer-term securities. The capital market discussion focused on debt and equity as
financial instruments used to finance longer-term capital financing needs. IPOs or SPACs are vehicles for
raising new equity. Most trading on organized exchanges or over-the-counter markets is for used, or
secondary, securities.

12.2 Historical Picture of Inflation

The Federal Reserve considers moderate inflation rates optimal in their oversight of the US economy. We
measure inflation by comparing the price of a bundle or basket of goods over time and documenting how
prices change. Since not everyone consumes similar baskets of goods, we calculate several different measures
of inflation. The most commonly quoted measure of inflation uses changes in the Consumer Price Index (CPI).

12.3 Historical Picture of Returns to Bonds

Historical bond yields are published going back hundreds of years but are only reliably available for the last
100 years or so. In large part, the returns realized on portfolios of bonds have been smaller and less variable
than the returns realized for equities.

12.4 Historical Picture of Returns to Stocks

Stocks have produced the greatest average annual rates of return of the money and capital market assets
discussed in this chapter. Stockholders bear more risk than bondholders or money market investors and
receive on average higher average annual returns. Despite the relatively high average annual rate of return for
portfolios of stock, history shows that the equity markets earn negative annual returns about 25% of the time.
The negative returns realized by equities occur far more often than the negative results realized by money
market or debt market instruments.

Key Terms
bond returns sums the periodic interest payments and the change in bond price in a given period and
divides by the bond price at the beginning of the period
commercial paper (CP) a short-term, unsecured security issued by corporations and financial institutions to
meet short-term financing needs such as inventory and receivables
debenture a common type of unsecured bond issued by a corporation
indenture legal term for a bond contract
inflation a general increase in prices and a reduction in purchasing power; expected rate is a key component
of interest rates
initial public offering (IPO) the first time a firm offers stock to the public
mortgage bond bond issued by a corporation using a real asset, such as property or buildings, to guarantee
it
municipal bonds (munis) bonds issued by a local government, territory, or agency; generally used to
finance infrastructure projects
negotiable certificates of deposit (NCDs) large CDs issued by financial institutions; redeemable at maturity
but can trade prior to maturity in a broad secondary market
primary market market for new securities
seasoned equity offering (SEO) a method used by new IPOs to raise capital by offering additional shares of
stock to the public
secondary market market for used securities

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 12 • Multiple Choice 377

shelf registration part of Securities and Exchange Commission (SEC) Rule 415; allows a company to register
with the SEC to issue new shares but allows up to two years before issuing the shares
special purpose acquisition companies (SPACs) a special form of IPO
stock returns sums the periodic dividend payments plus the change in stock price in a given period divided
by the stock price at the beginning of the period
total returns the sum of all cash flows received from an investment; includes periodic cash flows plus price
appreciation or price depreciation
Treasury bills (T-bills) short-term debt instruments issued by the federal government and maturing in a
year or less
Treasury bonds government debt instruments with maturities of 20 or 30 years
Treasury notes (T-notes) government debt instruments with maturities of 2, 3, 5, 7, or 10 years

Multiple Choice
1. Which of the following statements about Treasury bills is false?
a. T-bills sell at a discount from face value and pay the face value at maturity.
b. T-bills have maturities of 2, 3, 5, 7, or 10 years.
c. T-bill auctions take place weekly.
d. T-bill denominations are relatively small compared to other money market instruments, with initial
auction sizes of as little as $10,000 per T-bill.

2. If an investor wishes to simply execute a stock trade at the current market price, they should issue a
________.
a. limit order
b. stop loss order
c. market order
d. hedge order

3. Based on nominal average annual returns over the period 1980–2020, list the order of returns by asset
class from highest to lowest.
a. large company stocks, Baa bonds, small company stocks, T-bills
b. small company stocks, large company stocks, Baa bonds, T-bills
c. T-bills, Baa bonds, small company stocks, large company stocks
d. small company stocks, large company stocks, T-bills, Baa bonds

4. A $1 investment in a portfolio of small company stocks in 1928 would have grown to over ________ by
mid-2019.
a. $35,000
b. $8,000
c. $800
d. $80

5. Since 1980, the compound average annual growth rate for large company stocks has been ________.
a. greater than Baa bonds but less than small company stocks
b. greater than small company stocks but less than Baa bonds
c. greater than Baa bonds and small company stocks
d. less than Baa bonds and small company stocks
378 12 • Review Questions

Review Questions
1. Define the competitive and noncompetitive bid process for US Treasury bills.

2. How does a negotiable certificate of deposit (NCD) differ from the typical certificate of deposit you may
see advertised by your local bank?

3. If you are an investor concerned about unexpected inflation in the coming years which of the following
investments offers the greatest protection against inflation, and why: T-notes, T-bonds, or TIPS?

4. Debentures are more common than mortgage bonds issued by corporations. Why do you think
debentures are more popular with investors? Be sure to define each bond contract in your discussion.

5. Market capitalization is a common way to rank firm size. Search the internet to identify and define at least
two other ways to rank firms based on size. Identify at least one reason you prefer market capitalization as
the method of choice to rank firm size.

6. Compare and contrast an SEO, IPO, and SPAC. If Ford Motor Company wished to raise new equity capital,
which of these vehicles would they use?

7. Compared to a “best efforts” form of underwriting, how does “firm commitment” underwriting transfer
risk from the issuing firm to the underwriter?

8. How would a decrease in inflation affect the interest rate on an adjustable-rate debenture?

9. If inflation unexpectedly rises by 3%, would a corporation that had recently borrowed money by issuing
fixed-rate bonds to pay for a new investment benefit or lose?

10. If wages on average rise at least as fast as inflation, why do people worry about how inflation affects
incomes?

11. Identify at least one item that you use regularly whose price has changed significantly.

12. What has been the average annual rate of inflation between 1985 and 2020? What is the long-run average
annual rate of inflation over the last century?

13. Between 1985 and 2020, what year had the lowest realized annual rate of inflation in the United States?
Why do you think inflation was so low in this particular year?

14. Go to https://www.usinflationcalculator.com/ (https://openstax.org/r/usinflationcalculator). How much

money would it take today to purchase what one dollar would have bought in 1950, in 1975, and in your
birth year?

15. Are US Treasury bonds truly risk free?

16. At the end of 2020 and the beginning of 2021, coupon rates on long-term T-notes and T-bonds were near
historic lows. Further, the federal government was running a historically large budget deficit in an effort to
stimulate an economy battered by COVID-19 and to support millions of unemployed workers. Some
investment advisers warned that this could be a particularly bad time to invest in government bonds or
bonds in general. Why?

17. Which group of securities earned a higher average annual return from 2000 to 2020, T-bonds or Baa
bonds? Why do think this was so?

18. Which earned a higher average annual return, a portfolio of T-bonds from 1980 to 2000 or from 2000 to
2020? Why do think this was so?

19. Why is standard deviation of returns a reasonable measure of risk for a portfolio of equity securities?

20. Many popular-press articles claim that growth investing is “clearly better” than value investing or that

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 12 • Video Activity 379

value investing is “dead.” How would you respond to proponents of growth investing after observing
Figure 12.15?

21. Over the last 120 years, few countries have achieved the realized rate of returns enjoyed by US equity
markets. Does this mean investors should ignore international investments and focus only on domestic
markets in an effort to maximize returns?

Video Activity
How Private Companies Are Bypassing the IPO Process

Click to view content (https://openstax.org/r/blank-check-companies)

1. Can you identify three apparent advantages and three disadvantages for investors in a SPAC (special
purpose acquisition company) versus a traditional IPO process?

2. The video concludes with a question about whether SPACs are a current fad doomed to fade away or a
new and growing method of publicly financing firms. What do you think? Search for information related to
SPACs and proposals for SPAC regulation, and report your conclusion.

A Secret Meeting and the Birth of the Federal Reserve

Click to view content (https://openstax.org/r/the-birth-of-the-federal)

3. How can an institution like the United State Federal Reserve System prevent bank runs?

4. After the passage of the Federal Reserve Act in 1913 (https://openstax.org/r/federal-reserve-act), the
United States has suffered through three great global financial crises: the Great Depression of the 1930s,
the Great Recession of 2007–2009 (https://openstax.org/r/the-worlds-most-devastating), and the
COVID-19 pandemic of 2020–2021 (https://openstax.org/r/tracking-the-covid-19-recessions-effects).
Research one of the latter two crises, and identify and discuss some of the tools used by the Fed to lessen
the length and economic severity of the economic hardships. In what ways has this research project
supported or changed your opinion about the United States having the Federal Reserve System?
380 12 • Video Activity

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 13 • Why It Matters 381

13
Statistical Analysis in Finance

Figure 13.1 Graphical displays are used extensively in the finance field. (credit: modification of "Analysing target market" by Marco
Verch/flickr CC BY 2.0)

Chapter Outline
13.1 Measures of Center
13.2 Measures of Spread
13.3 Measures of Position
13.4 Statistical Distributions
13.5 Probability Distributions
13.6 Data Visualization and Graphical Displays
13.7 The R Statistical Analysis Tool

Why It Matters
Statistical analysis is used extensively in finance, with applications ranging from consumer concerns such as
credit scores, retirement planning, and insurance to business concerns such as assessing stock market
volatility and predicting inflation rates. As a consumer, you will make many financial decisions throughout your
life, and many of these decisions will be guided by statistical analysis. For example, what is the probability that
interest rates will rise over the next year, and how will that affect your decision on whether to refinance a
mortgage? In your retirement planning, how should the investment mix be allocated among stocks and bonds
to minimize volatility and ensure a high probability for a secure retirement? When running a business, how
can statistical quality control methods be used to maintain high quality levels and minimize waste? Should a
business make use of consumer focus groups or customer surveys to obtain business intelligence data to
improve service levels? These questions and more can benefit from the use and application of statistical
methods.

Running a business and tracking its finances is a complex process. From day-to-day activities such as
managing inventory levels to longer-range activities such as developing new products or expanding a
customer base, statistical methods are a key to business success. For finance considerations, a business must
manage risk versus return and optimize investments to ensure shareholder value. Business managers employ
a wide range of statistical processes and tools to accomplish these goals. Increasingly, companies are also
382 13 • Statistical Analysis in Finance

interested in data analytics to optimize the value gleaned from business- and consumer-related data, and
statistical analysis forms the core of such analytics.

13.1 Measures of Center

By the end of this section, you will be able to:
• Calculate various measures of the average of a data set, such as mean, median, mode, and geometric
mean.
• Recognize when a certain measure of center is more appropriate to use, such as weighted mean.
• Distinguish among arithmetic mean, geometric mean, and weighted mean.

Arithmetic Mean
The average of a data set is a way of describing location. The most widely used measures of the center of a
data set are the mean (average), median, and mode. The arithmetic mean is the most common measure of the
average. We will discuss the geometric mean later.

Note that the words mean and average are often used interchangeably. The substitution of one word for the
other is common practice. The technical term is arithmetic mean, and average technically refers only to a
center location. Formally, the arithmetic mean is called the first moment of the distribution by
mathematicians. However, in practice among non-statisticians, average is commonly accepted as a synonym
for arithmetic mean.

To calculate the arithmetic mean value of 50 stock portfolios, add the 50 portfolio dollar values together and
divide the sum by 50. To calculate the arithmetic mean for a set of numbers, add the numbers together and
then divide by the number of data values.

In statistical analysis, you will encounter two types of data sets: sample data and population data. Population
data represents all the outcomes or measurements that are of interest. Sample data represents outcomes or
measurements collected from a subset, or part, of the population of interest.

The notation is used to indicate the sample mean, where the arithmetic mean is calculated based on data
taken from a sample. The notation is used to denote the sum of the data values, and is used to indicate
the number of data values in the sample, also known as the sample size.

The sample mean can be calculated using the following formula:

Finance professionals often rely on averages of Treasury bill auction amounts to determine their value. Table
13.1 lists the Treasury bill auction amounts for a sample of auctions from December 2020.

Maturity Amount ($Billions)

4-week T-bills $32.9
8-week T-bills 38.4
13-week T-bills 63.1
26-week T-bills 59.6
52-week T-bills 39.7
Total $233.7

Table 13.1 United States Treasury Bill

Auctions, December 22 and 24, 2020
(source: Treasury Direct)

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 13.1 • Measures of Center 383

To calculate the arithmetic mean of the amount paid for Treasury bills at auction, in billions of dollars, we use
the following formula:

Median
To determine the median of a data set, order the data from smallest to largest, and then find the middle value
in the ordered data set. For example, to find the median value of 50 portfolios, find the number that splits the
data into two equal parts. The portfolio values owned by 25 people will be below the median, and 25 people
will have portfolio values above the median. The median is generally a better measure of the average when
there are extreme values or outliers in the data set.

An outlier or extreme value is a data value that is significantly different from the other data values in a data
set. The median is preferred when outliers are present because the median is not affected by the numerical
values of the outliers.

The ordered data set from Table 13.1 appears as follows:

The middle value in this ordered data set is the third data value, which is 39.7. Thus, the median is $39.7 billion.

You can quickly find the location of the median by using the expression . The variable n represents the
total number of data values in the sample. If n is an odd number, the median is the middle value of the data
values when ordered from smallest to largest. If n is an even number, the median is equal to the two middle
values of the ordered data values added together and divided by 2. In the example from Table 13.1, there are
five data values, so n = 5. To identify the position of the median, calculate , which is , or 3. This
indicates that the median is located in the third data position, which corresponds to the value 39.7.

As mentioned earlier, when outliers are present in a data set, the mean can be nonrepresentative of the center
of the data set, and the median will provide a better measure of center. The following Think It Through
example illustrates this point.

THINK IT THROUGH

Finding the Measure of Center

Suppose that in a small village of 50 people, one person earns a salary of $5 million per year, and the other
49 individuals each earn $30,000. Which is the better measure of center: the mean or the median?

Solution:

The mean, in dollars, would be arrived at mathematically as follows:

However, the median would be $30,000. There are 49 people who earn $30,000 and one person who earns
$5,000,000.

The median is a better measure of the “average” than the mean because 49 of the values are $30,000 and
one is $5,000,000. The $5,000,000 is an outlier. The $30,000 gives us a better sense of the middle of the data
set.
384 13 • Statistical Analysis in Finance

Mode
Another measure of center is the mode. The mode is the most frequent value. There can be more than one
mode in a data set as long as those values have the same frequency and that frequency is the highest. A data
set with two modes is called bimodal. For example, assume that the weekly closing stock price for a technology
stock, in dollars, is recorded for 20 consecutive weeks as follows:

To find the mode, determine the most frequent score, which is 72. It occurs five times. Thus, the mode of this
data set is 72. It is helpful to know that the most common closing price of this particular stock over the past 20
weeks has been $72.00.

Geometric Mean
The arithmetic mean, median, and mode are all measures of the center of a data set, or the average. They are
all, in their own way, trying to measure the common point within the data—that which is “normal.” In the case
of the arithmetic mean, this is accomplished by finding the value from which all points are equal linear
distances. We can imagine that all the data values are combined through addition and then distributed back to
each data point in equal amounts.

The geometric mean redistributes not the sum of the values but their product. It is calculated by multiplying
all the individual values and then redistributing them in equal portions such that the total product remains the
same. This can be seen from the formula for the geometric mean, x̃ (pronounced x-tilde):

The geometric mean is relevant in economics and finance for dealing with growth—of markets, in investments,
and so on. For an example of a finance application, assume we would like to know the equivalent percentage
growth rate over a five-year period, given the yearly growth rates for the investment.

For a five-year period, the annual rate of return for a certificate of deposit (CD) investment is as follows:
3.21%, 2.79%, 1.88%, 1.42%, 1.17%. Find the single percentage growth rate that is equivalent to these five
annual consecutive rates of return. The geometric mean of these five rates of return will provide the solution.
1
To calculate the geometric mean for these values (which must all be positive), first multiply the rates of return
together—after adding 1 to the decimal equivalent of each interest rate—and then take the nth root of the
product. We are interested in calculating the equivalent overall rate of return for the yearly rates of return,
which can be expressed as 1.0321, 1.0279, 1.0188, 1.0142, and 1.0117:

Based on the geometric mean, the equivalent annual rate of return for this time period is 2.09%.

LINK TO LEARNING

Arithmetic versus Geometric Means

In this video on arithmetic versus geometric means (https://openstax.org/r/arithmetic-versus-geometric),
the returns of the S&P 500 are tracked using an arithmetic mean versus a geometric mean, and the
difference between these two measurements is discussed.

Weighted Mean
A weighted mean is a measure of the center, or average, of a data set where each data value is assigned a
corresponding weight. A common financial application of a weighted mean is in determining the average price

1 In this chapter, the interpunct dot will be used to indicate the multiplication operation in formulas.

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 13.2 • Measures of Spread 385

per share for a certain stock when the stock has been purchased at different points in time and at different
share prices.

To calculate a weighted mean, create a table with the data values in one column and the weights in a second
column. Then create a third column in which each data value is multiplied by each weight on a row-by-row
basis. Then, the weighted mean is calculated as the sum of the results from the third column divided by the
sum of the weights.

THINK IT THROUGH

Calculating the Weighted Mean

Assume your portfolio contains 1,000 shares of XYZ Corporation, purchased on three different dates, as
shown in Table 13.2. Calculate the weighted mean of the purchase price for the 1,000 shares.

Price ($) Times

Date Purchased Purchase Price ($) Number of Shares Purchased
Number of Shares
January 17 78 200 15,600
February 10 122 300 36,600
March 23 131 500 65,500
Total NA 1,000 117,700

Table 13.2 1,000 Shares of XYZ Corporation

Solution:

In this example, the purchase price is weighted by the number of shares. The sum of the third column is
$117,700, and sum of the weights is 1,000. The weighted mean is calculated as $117,700 divided by 1,000,
which is $117.70.

Thus, the average cost per share for the 1,000 shares of XYZ Corporation is $117.70.

13.2 Measures of Spread

By the end of this section, you will be able to:
• Define and calculate standard deviation for a data set.
• Define and calculate variance for a data set.
• Explain the relationship between standard deviation and variance.

Standard Deviation
An important characteristic of any set of data is the variation in the data. In some data sets, the data values are
concentrated close to the mean; in other data sets, the data values are more widely spread out. For example,
an investor might examine the yearly returns for Stock A, which are 1%, 2%, -1%, 0%, and 3%, and compare
them to the yearly returns for Stock B, which are -9%, 2%, 15%, -5%, and 0%.

Notice that Stock B exhibits more volatility in yearly returns than Stock A. The investor may want to quantify
this variation in order to make the best investment decisions for a particular investment objective.

The most common measure of variation, or spread, is standard deviation. The standard deviation of a data
set is a measure of how far the data values are from their mean. A standard deviation

• provides a numerical measure of the overall amount of variation in a data set; and
386 13 • Statistical Analysis in Finance

• can be used to determine whether a particular data value is close to or far from the mean.

The standard deviation provides a measure of the overall variation in a data set. The standard deviation is
always positive or zero. It is small when the data values are all concentrated close to the mean, exhibiting little
variation or spread. It is larger when the data values are more spread out from the mean, exhibiting more
variation.

Suppose that we are studying the variability of two different stocks, Stock A and Stock B. The average stock
price for both stocks is $5. For Stock A, the standard deviation of the stock price is 2, whereas the standard
deviation for Stock B is 4. Because Stock B has a higher standard deviation, we know that there is more
variation in the stock price for Stock B than in the price for Stock A.

There are two different formulas for calculating standard deviation. Which formula to use depends on whether
the data represents a sample or a population. The notation s is used to represent the sample standard
deviation, and the notation is used to represent the population standard deviation. In the formulas shown
below, x̄ is the sample mean, is the population mean, n is the sample size, and N is the population size.

Formula for the sample standard deviation:

Formula for the population standard deviation:

Variance
Variance also provides a measure of the spread of data values. The variance of a data set measures the extent
to which each data value differs from the mean. The more the individual data values differ from the mean, the
larger the variance. Both the standard deviation and the variance provide similar information.

In a finance application, variance can be used to determine the volatility of an investment and therefore to
help guide financial decisions. For example, a more cautious investor might opt for investments with low
volatility.

Similar to standard deviation, the formula used to calculate variance also depends on whether the data is
collected from a sample or a population. The notation is used to represent the sample variance, and the
2
notation σ is used to represent the population variance.

Formula for the sample variance:

Formula for the population variance:

This is the method to calculate standard deviation and variance for a sample:

1. First, find the mean of the data set by adding the data values and dividing the sum by the number of
data values.
2. Set up a table with three columns, and in the first column, list the data values in the data set.
3. For each row, subtract the mean from the data value , and enter the difference in the second

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 13.2 • Measures of Spread 387

column. Note that the values in this column may be positive or negative. The sum of the values in this
column will be zero.
4. In the third column, for each row, square the value in the second column. So this third column will contain
the quantity (Data Value – Mean)2 for each row. We can write this quantity as . Note that the
values in this third column will always be positive because they represent a squared quantity.
5. Add up all the values in the third column. This sum can be written as .
6. Divide this sum by the quantity (n – 1), where n is the number of data points. We can write this as

.
7. This result is called the sample variance, denoted by s2. Thus, the formula for the sample variance is

.
8. Now take the square root of the sample variance. This value is the sample standard deviation, called s.

Thus, the formula for the sample standard deviation is .

9. Round-off rule: The sample variance and sample standard deviation are typically rounded to one more
decimal place than the data values themselves.

THINK IT THROUGH

Finding Standard Deviation and Variance

A brokerage firm advertises a new financial analyst position and receives 210 applications. The ages of a
sample of 10 applicants for the position are as follows:

The brokerage firm is interested in determining the standard deviation and variance for this sample of 10
ages.

Solution:

Find the sample variance and sample standard deviation by creating a table with three columns (see Table
13.3).

1. The data set is 40, 36, 44, 51, 54, 55, 39, 47, 44, 50.
2. This data set has 10 data values. Thus, .
3. The mean is calculated as .
4. Column 1 will contain the data values themselves.
5. Column 2 will contain .
6. Column 3 will contain .
Column 1 Column 2 Column 3

40

36

44

51

Table 13.3 Calculations for Standard Deviation for

Age Example
388 13 • Statistical Analysis in Finance

Column 1 Column 2 Column 3

54

55

39

47

44

50

Table 13.3 Calculations for Standard Deviation for

Age Example

7. To calculate the sample variance, use the sample variance formula:

8. To calculate the sample standard deviation, use the sample standard deviation formula:

As the above example illustrates, calculating the variance and standard deviation is a tedious process. A
financial calculator can calculate statistical measurements such as mean and standard deviation quickly and
efficiently.

There are two steps needed to perform statistical calculations on the calculator:

1. Enter the data in the calculator using the [DATA] function, which is located above the 7 key.
2. Access the statistical results provided by the calculator using the [STAT] function, which is located above
the 8 key.

Follow the steps in Table 13.4 to calculate mean and standard deviation using the financial calculator. The ages
data set from the Think It Through example above is used again here: 40, 36, 44, 51, 54, 55, 39, 47, 44, 50.

Step Description Enter Display

1 Enter [DATA] entry mode 2ND [DATA] X01 0.00

2 Clear any previous data 2ND [CLR WORK] X01 0.00

3 Enter first data value of 40 40 ENTER X01 = 40.00

4 Move to next data entry ↓ Y01 = 1.00
5 Move to next data entry ↓ X02 0.0
6 Enter second data value of 36 36 ENTER X02 = 36.00

2
Table 13.4 Calculator Steps for Mean and Standard Deviation

2 The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other
financial calculators for these types of calculations.

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 13.2 • Measures of Spread 389

Step Description Enter Display

7 Move to next data entry ↓ Y02 = 1.00
8 Move to next data entry ↓ X03 0.00
9 Enter third data value of 44 44 ENTER X03 = 44.00
10 Move to next data entry ↓ Y03 = 1.00
11 Continue to enter remaining data values
12 Enter [STAT] mode 2nd [STAT] LIN
13 Move to first statistical result ↓ n= 10.00
14 Move to next statistical result ↓ 46.00
15 Move to next statistical result ↓ Sx = 6.50

2
Table 13.4 Calculator Steps for Mean and Standard Deviation

From the statistical results, the mean is shown as 46, and the sample standard deviation is shown as 6.50.

Excel provides a similar analysis using the built-in functions =AVERAGE (for the mean) and =STDEV.S (for the
sample standard deviation). To calculate these statistical results in Excel, enter the data values in a column.
Let’s assume the data values are placed in cells A2 through A11. In any cell, type the Excel command
=AVERAGE(A2:A11) and press enter. Excel will calculate the arithmetic mean in this cell. Then, in any other cell,
type the Excel command =STDEV.S(A2:A11) and press enter. Excel will calculate the sample standard deviation
in this cell. Figure 13.2 shows the mean and standard deviation for the 10 ages.

Figure 13.2 Mean and Standard Deviation in Excel.

Relationship between Standard Deviation and Variance

In the formulas shown above for variance and standard deviation, notice that the variance is the square of the
standard deviation, and the standard deviation is the square root of the variance.

Once you have calculated one of these values, you can directly calculate the other value. For example, if you
know the standard deviation of a data set is 12.5, you can calculate the variance by squaring this standard
deviation. The variance is then 12.52, which is 156.25.

In the same way, if you know the value of the variance, you can determine the standard deviation by
calculating the square root of the variance. For example, if the variance of a data set is known to be 31.36, then
the standard deviation can be calculated as the square root of 31.36, which is 5.6.
390 13 • Statistical Analysis in Finance

One disadvantage of using the variance is that the variance is measured in square units, which are different
from the units in the data set. For example, if the data set consists of ages measured in years, then the
variance would be measured in years squared, which can be confusing. The standard deviation is measured in
the same units as the original data set, and thus the standard deviation is used more commonly than the
variance to measure the spread of a data set.

13.3 Measures of Position

By the end of this section, you will be able to:
• Define and calculate z-scores for a measurement.
• Define and calculate quartiles and percentiles for a data set.
• Use quartiles as a method to detect outliers in a data set.

z-Scores
A z-score, also called a z-value, is a measure of the position of an entry in a data set. It represents the number
of standard deviations by which a data value differs from the mean. For example, suppose that in a certain
year, the rates of return for various technology-focused mutual funds are examined, and the mean return is
7.8% with a standard deviation of 2.3%. A certain mutual fund publishes its rate of return as 12.4%. Based on
this rate of return of 12.4%, we can calculate the relative standing of this mutual fund compared to the other
technology-focused mutual funds. The corresponding z-score of a measurement considers the given
measurement in relation to the mean and standard deviation for the entire population.

The formula for a z-score calculation is as follows:

where x is the measurement, is the mean, and is the standard deviation.

THINK IT THROUGH

Interpreting a z-Score
A certain technology-based mutual fund reports a rate of return of 12.4% for a certain year, while the mean
rate of return for comparable funds is 7.8% and the standard deviation is 2.3%. Calculate and interpret the
z-score for this particular mutual fund.

Solution:

In this example, the measurement and Using the z-score formula, the
calculation is performed as follows:

The resulting z-score indicates the number of standard deviations by which a particular measurement is
above or below the mean. In this example, the rate of return for this particular mutual fund is 2 standard
deviations above the mean, indicating that this mutual fund generated a significantly better rate of return
than all other technology-based mutual funds for the same time period.

Quartiles and Percentiles

If a person takes an IQ test, their resulting score might be reported as in the 87th percentile. This percentile
indicates the person’s relative performance compared to others taking the IQ test. A person scoring in the
87th percentile has an IQ score higher than 87% of all others taking the test. This is the same as saying that the

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 13.3 • Measures of Position 391

person is in the top 13% of all people taking the IQ test.

Common measures of location are quartiles and percentiles. Quartiles are special percentiles. The first
quartile, Q1, is the same as the 25th percentile, and the third quartile, Q3, is the same as the 75th percentile.
The median, M, is called both the second quartile and the 50th percentile.

To calculate quartiles and percentiles, the data must be ordered from smallest to largest. Quartiles divide
ordered data into quarters. Percentiles divide ordered data into hundredths. If you score in the 90th percentile
of an exam, that does not necessarily mean that you receive 90% on the test. It means that 90% of the test
scores are the same as or less than your score and the remaining 10% of the scores are the same as or greater
than your score.

Percentiles are useful for comparing values. In a finance example, a mutual fund might report that the
performance for the fund over the past year was in the 80th percentile of all mutual funds in the peer group.
This indicates that the fund performed better than 80% of all other funds in the peer group. This also indicates
that 20% of the funds performed better than this particular fund.

Quartiles are values that separate the data into quarters. Quartiles may or may not be part of the data. To find
the quartiles, first find the median, or second quartile. The first quartile, Q1, is the middle value, or median, of
the lower half of the data, and the third quartile, Q3, is the middle value of the upper half of the data. As an
example, consider the following ordered data set, which represents the rates of return for a group of
technology-based mutual funds in a certain year:

The median, or second quartile, is the middle value in this data set, which is 7.2. Notice that 50% of the data
values are below the median, and 50% of the data values are above the median. The lower half of the data
values are 5.4, 6.0, 6.3, 6.8, 7.1 Notice that these are the data values below the median. The upper half of the
data values are 7.4, 7.5, 7.9, 8.2, 8.7, which are the data values above the median.)

To find the first quartile, Q1, locate the middle value of the lower half of the data. The middle value of the lower
half of the data set is 6.3. Notice that one-fourth, or 25%, of the data values are below this first quartile, and
75% of the data values are above this first quartile.

To find the third quartile, Q3, locate the middle value of the upper half of the data. The middle value of the
upper half of the data set is 7.9. Notice that one-fourth, or 25%, of the data values are above this third quartile,
and 75% of the data values are below this third quartile.

The interquartile range (IQR) is a number that indicates the spread of the middle half, or the middle 50%, of
the data. It is the difference between the third quartile, Q3, and the first quartile, Q1.

In the above example, the IQR can be calculated as

Outlier Detection
Quartiles and the IQR can be used to flag possible outliers in a data set. For example, if most employees at a
company earn about $50,000 and the CEO of the company earns $2.5 million, then we consider the CEO’s
salary to be an outlier data value because is significantly different from all the other salaries in the data set. An
outlier data value can also be a value much lower than the other data values, so if one employee only makes
$15,000, then this employee’s low salary might also be considered an outlier.

To detect outliers, use the quartiles and the IQR to calculate a lower and an upper bound for outliers. Then any
data values below the lower bound or above the upper bound will be flagged as outliers. These data values
should be further investigated to determine the nature of the outlier condition.
392 13 • Statistical Analysis in Finance

To calculate the lower and upper bounds for outliers, use the following formulas:

THINK IT THROUGH

Calculating the IQR

Calculate the IQR for the following 13 portfolio values, and determine if any of the portfolio values are
potential outliers. Data values are in dollars.

389,950; 230,500; 158,000; 479,000; 639,000; 114,950; 5,500,000; 387,000; 659,000; 529,000; 575,000; 488,800;
1,095,000

Solution:

Order the data from smallest to largest.

114,950; 158,000; 230,500; 387,000; 389,950; 479,000; 488,800; 529,000; 575,000; 639,000; 659,000; 1,095,000;
5,500,000

No portfolio value price is less than -201,625. However, 5,500,000 is more than 1,159,375. Therefore, the
portfolio value of 5,500,000 is a potential outlier. This is important because the presence of outliers could
potentially indicate data errors or some other anomalies in the data set that should be investigated.

13.4 Statistical Distributions

By the end of this section, you will be able to:
• Construct and interpret a frequency distribution.
• Apply and evaluate probabilities using the normal distribution.
• Apply and evaluate probabilities using the exponential distribution.

Frequency Distributions
A frequency distribution provides a method to organize and summarize a data set. For example, we might be
interested in the spread, center, and shape of the data set’s distribution. When a data set has many data
values, it can be difficult to see patterns and come to conclusions about important characteristics of the data.
A frequency distribution allows us to organize and tabulate the data in a summarized way and also to create
graphs to help facilitate an interpretation of the data set.

To create a basic frequency distribution, set up a table with three columns. The first column will show the
intervals for the data, and the second column will show the frequency of the data values, or the count of how

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 13.4 • Statistical Distributions 393

many data values fall within each interval. A third column can be added to include the relative frequency for
each row, which is calculated by taking the frequency for that row and dividing it by the sum of all the
frequencies in the table.

THINK IT THROUGH

Graphing Demand and Supply

A financial consultant at a brokerage firm records the portfolio values for 20 clients, as shown in Table 13.5,
where the portfolio values are shown in thousands of dollars.

278 318 422 577 618

735 798 864 903 944
1,052 1,099 1,132 1,180 1,279
1,365 1,471 1,572 1,787 1,905

Table 13.5 Portfolio Values for 20

Clients at a Brokerage Firm
($000s)

Create a frequency distribution table using the following intervals for the portfolio values:

0–299

300–599

600–899

900–1,199

1,200–1,499

1,500–1,799

1,800–2,099

Solution:

Create a table where the intervals for portfolio value are listed in the first column. For this example, it was
decided to create a frequency distribution table with seven rows and a class width set to 300. The class
width is the distance from the start of one interval to the start of the next interval in the subsequent row.
For example, the interval for the second row starts at 300, the interval for the third row starts at 600, and so
on.

In the second column, record the frequency, or the number of data values that fall within the interval, for
each row. For example, for the first row, count the number of data values that fall between 0 and 299.
Because there is only one data value (278) that falls in this interval, the corresponding frequency is 1. For
the second row, there are 3 data values that fall between 300 and 599 (318, 422, and 577). Thus, the
frequency for the second row is 3.

For the third column, called relative frequency, take the frequency for each row and divide it by the sum of
the frequencies, which is 20. For example, in the first row, the relative frequency will be 1 divided by 20,
which is 0.05. The relative frequency for the second row will be 3 divided by 20, which is 0.15. The resulting
frequency distribution table is shown in Table 13.6.
394 13 • Statistical Analysis in Finance

Portfolio Value Interval ($000s) Frequency Relative Frequency

0–299 1 0.05
300–599 3 0.15
600–899 4 0.20
900–1,199 6 0.30
1,200–1,499 3 0.15
1,500–1,799 2 0.10
1,800–2,099 1 0.05

Table 13.6 Frequency Distribution of Portfolio Values for 20 Clients at a

Brokerage Firm ($000s)

The frequency table indicates that most customers have portfolio values between $300,000 and $599,000, as
this row in the table shows the highest frequency. Very few customers have portfolios with a value below
$299,000 or above $1,800,000, as these frequencies in these rows are very low. Because the highest
frequency corresponds to the row in the middle of the table and the frequencies decrease with each
interval below and above this middle interval, the frequency table indicates that this distribution is a bell-
shaped distribution.

The following is a summary of how to create a frequency distribution table (for integer data). Note that the
number of classes in a frequency table is the same as the number of rows in the table.

1. Calculate the class width using the formula

◦ Note: For integer data, round the class width up to the next whole number.

2. Create a table with a number of rows equal to the number of classes. Create columns for Lower Class
Limit, Upper Class Limit, Frequency, and Relative Frequency.
3. Set the lower class limit for the first row equal to the minimum value from the data set, or some other
appropriate value.
4. Calculate the lower class limit for the second row by adding the class width to the lower class limit from
the first row. Add the class width to each new lower class limit to calculate the lower class limit for each
subsequent row.
5. The upper class limit for each row is 1 less than the lower class limit of the subsequent row. You can
also add the class width to each upper class limit to determine the upper class limit for the subsequent
row.
6. Record the frequency for each row by counting how many data values fall between the lower class limit
and the upper class limit for that row.
7. Calculate the relative frequency for each row by taking the frequency for that row and dividing by the
total number of data values.

Normal Distribution
The normal probability density function, a continuous distribution, is the most important of all the
distributions. The normal distribution is applicable when the frequency of data values decreases with each
class above and below the mean. The normal distribution can be applied to many examples from the finance
industry, including average returns for mutual funds over a certain time period, portfolio values, and others.
The normal distribution has two parameters, or numerical descriptive measures: the mean, , and the
standard deviation, . The variable x represents the quantity being measured whose data values have a

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 13.4 • Statistical Distributions 395

normal distribution.

Figure 13.3 Graph of the Normal Distribution

The curve in Figure 13.3 is symmetric about a vertical line drawn through the mean, . The mean is the same
as the median, which is the same as the mode, because the graph is symmetric about . As the notation
indicates, the normal distribution depends only on the mean and the standard deviation. Because the area
under the curve must equal 1, a change in the standard deviation, , causes a change in the shape of the
normal curve; the curve becomes fatter and wider or skinnier and taller depending on . A change in causes
the graph to shift to the left or right. This means there are an infinite number of normal probability
distributions.

To determine probabilities associated with the normal distribution, we find specific areas under the normal
curve, and this is further discussed in Apply the Normal Distribution in Financial Contexts. For example,
suppose that at a financial consulting company, the mean employee salary is $60,000 with a standard
deviation of $7,500. A normal curve can be drawn to represent this scenario, in which the mean of $60,000
would be plotted on the horizontal axis, corresponding to the peak of the curve. Then, to find the probability
that an employee earns more than $75,000, you would calculate the area under the normal curve to the right
of the data value $75,000.

Excel uses the following command to find the area under the normal curve to the left of a specified value:

=NORM.DIST(XVALUE, MEAN, STANDARD_DEV, TRUE)

For example, at the financial consulting company mentioned above, the mean employee salary is $60,000 with
a standard deviation of $7,500. To find the probability that a random employee’s salary is less than $55,000
using Excel, this is the command you would use:

=NORM.DIST(55000, 60000, 7500, TRUE)

Result: 0.25249

Thus, there is a probability of about 25% that a random employee has a salary less than $55,000.

Exponential Distribution
The exponential distribution is often concerned with the amount of time until some specific event occurs. For
example, a finance professional might want to model the time to default on payments for company debt
holders.

An exponential distribution is one in which there are fewer large values and more small values. For example,
marketing studies have shown that the amount of money customers spend in a store follows an exponential
distribution. There are more people who spend small amounts of money and fewer people who spend large
amounts of money.

Exponential distributions are commonly used in calculations of product reliability, or the length of time a
product lasts. The random variable for the exponential distribution is continuous and often measures a
396 13 • Statistical Analysis in Finance

passage of time, although it can be used in other applications. Typical questions may be, What is the
probability that some event will occur between x1 hours and x2 hours? or What is the probability that the event
will take more than x1 hours to perform? In these examples, the random variable x equals either the time
between events or the passage of time to complete an action (e.g., wait on a customer). The probability
density function is given by

where is the historical average of the values of the random variable (e.g., the historical average waiting
time). This probability density function has a mean and standard deviation of .

To determine probabilities associated with the exponential distribution, we find specific areas under the
exponential distribution curve. The following formula can be used to calculate the area under the exponential
curve to the left of a certain value:

THINK IT THROUGH

Calculating Probability
At a financial company, the mean time between incoming phone calls is 45 seconds, and the time between
phone calls follows an exponential distribution, where the time is measured in minutes. Calculate the
probability of having 2 minutes or less between phone calls.

Solution:

To calculate the probability, find the area under the curve to the left of 1 minute. The mean time is given as
45 seconds, which is the same as 0.75 minutes. The probability can then be calculated as follows:

13.5 Probability Distributions

By the end of this section, you will be able to:
• Calculate portfolio weights in an investment.
• Calculate and interpret the expected values.
• Apply the normal distribution to characterize average and standard deviation in financial contexts.

Calculate Portfolio Weights

In many financial analyses, the weightings by asset category in a portfolio are a key index used to assess if
the portfolio is meeting allocation metrics. For example, an investor approaching retirement age may wish to
shift assets in a portfolio to more conservative and lower-volatility investments. Weightings can be calculated
in several different ways—for example, based on individual stocks in a portfolio or on various sectors in a
portfolio. Weightings can also be calculated based on number of shares or the value of shares of a stock.

To calculate a weighting in a portfolio based on value, take the value of the particular investment and divide it
by the total value of the overall portfolio. As an example, consider an individual’s retirement account for which
the desired portfolio weighting is determined to be 40% stocks, 50% bonds, and 10% cash equivalents. Table
13.7 shows the current assets in the individual’s portfolio, broken out according to stocks, bonds, and cash
equivalents.

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 13.5 • Probability Distributions 397

Asset Value ($)

Stock A 134,000
Stock B 172,000
Bond C 38,000
Bond D 102,000
Bond E 96,000
Cash in CDs 35,700
Cash in savings 22,500
Total Value 600,200

Table 13.7 Portfolio Assets in

Stocks, Bonds, and Cash
Equivalents

To determine the weighting in this portfolio for stocks, bonds, and cash, take the total value for each category
and divide it by the total value of the entire portfolio. These results are summarized in Table 13.8. Notice that
the portfolio weightings shown in the table do not match the target, or desired, allocation weightings of 40%
stocks, 50% bonds, and 10% cash equivalents.

Asset Category Category Value ($) Portfolio Weighting

Stocks

Bonds

Cash

Total Value

Table 13.8 Portfolio Weightings for Stocks, Bonds, and Cash

Equivalents

Portfolio rebalancing is a process whereby the investor buys or sells assets to achieve the desired portfolio
weightings. In this example, the investor could sell approximately 10% of the stock assets and purchase bonds
with the proceeds to align the asset categories to the desired portfolio weightings.

Calculate and Interpret Expected Values

A probability distribution is a mathematical function that assigns probabilities to various outcomes. For
example, we can assign a probability to the outcome of a certain stock increasing in value or decreasing in
value. One application of a probability distribution function is determining expected value.

In many financial situations, we are interested in determining the expected value of the return on a particular
investment or the expected return on a portfolio of multiple investments. To calculate expected returns, we
formulate a probability distribution and then use the following formula to calculate expected value:

where P1, P2, P3, ⋯ Pn are the probabilities of the various returns and R1, R2, R3, ⋯ Rn are the various rates of
return.

In essence, expected value is a weighted mean where the probabilities form the weights. Typically, these
values for Pn and Rn are derived from historical data. As an example, consider a probability distribution for
398 13 • Statistical Analysis in Finance

potential returns for United Airlines common stock. Assume that from historical data gathered over a certain
time period, there is a 15% probability of generating a 12% return on investment for this stock, a 35%
probability of generating a 5% return, a 25% probability of generating a 2% return, a 14% probability of
generating a 5% loss, and an 11% probability of resulting in a 10% loss. This data can be organized into a
probability distribution table as seen in Table 13.9.

Using the expected value formula, the expected return of United Airlines stock over an extended period of
time follows:

Based on the probability distribution, the expected value of the rate of return for United Airlines common
stock over an extended period of time is 2.25%.

Historical Return (%) Associated Probability (%)

12 15
5 35
2 25
-5 14
-10 11

Table 13.9 Probability Distribution for Historical Returns

on United Airlines Stock

We can extend this analysis to evaluate the expected return for an investment portfolio consisting of various
asset categories, such as stocks, bonds, and cash equivalents, where the probabilities are associated with the
weighting of each category relative to the total value of the portfolio. Using historical return data for each of
the asset categories, the expected return of the overall portfolio can be calculated using the expected value
formula.

Assume an investor has assets in stocks, bonds, and cash equivalents as shown in Table 13.10.

Asset Category Value ($) Portfolio Weighting Historical Return (%)

Stocks 13.0

Bonds 4.0

Cash 2.5

Total Value

Table 13.10 Portfolio Weightings and Historical Returns for Various Asset
Categories

Based on the probability distribution, the expected value of the rate of return for this portfolio over an
extended period of time is 8.44%.

Apply the Normal Distribution in Financial Contexts

The normal, or bell-shaped, distribution can be utilized in many applications, including financial contexts.

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 13.5 • Probability Distributions 399

Remember that the normal distribution has two parameters: the mean, which is the center of the distribution,
and the standard deviation, which measures the spread of the distribution. Here are several examples of
applications of the normal distribution:

• IQ scores follow a normal distribution, with a mean IQ score of 100 and a standard deviation of 15.
• Salaries at a certain company follow a normal distribution, with a mean salary of $52,000 and a standard
deviation of $4,800.
• Grade point averages (GPAs) at a certain college follow a normal distribution, with a mean GPA of 3.27 and
a standard deviation of 0.24.
• The average annual gain of the Dow Jones Industrial Average (DJIA) over a 40-year time period follows a
normal distribution, with a mean gain of 485 points and a standard deviation of 1,065 points.
• The average annual return on the S&P 500 over a 50-year time period follows a normal distribution, with a
mean rate of return of 10.5% and a standard deviation of 14.3%.
• The average annual return on mid-cap stock funds over the five-year period from 2010 to 2015 follows a
normal distribution, with a mean rate of return of 8.9% and a standard deviation of 3.7%.

When analyzing data sets that follow a normal distribution, probabilities can be calculated by finding areas
under the normal curve. To find the probability that a measurement is within a specific interval, we can
compute the area under the normal curve corresponding to the interval of interest.

Areas under the normal curve are available in tables, and Excel also provides a method to find these areas. The
empirical rule is one method for determining areas under the normal curve that fall within a certain number
of standard deviations of the mean (see Figure 13.4).

Figure 13.4 Normal Distribution Showing Mean and Increments of Standard Deviation

If x is a random variable and has a normal distribution with mean µ and standard deviation , then the
empirical rule states the following:

• About 68% of the x-values lie between and units from the mean (within one standard deviation
of the mean).
• About 95% of the x-values lie between and units from the mean (within two standard
deviations of the mean).
• About 99.7% of the x-values lie between and units from the mean (within three standard
deviations of the mean). Notice that almost all the x-values lie within three standard deviations of the
mean.
• The z-scores for and are and , respectively.
• The z-scores for and are and , respectively.
• The z-scores for and are and , respectively.

As an example of using the empirical rule, suppose we know that the average annual return for mid-cap stock
funds over the five-year period from 2010 to 2015 follows a normal distribution, with a mean rate of return of
8.9% and a standard deviation of 3.7%. We are interested in knowing the likelihood that a randomly selected
mid-cap stock fund provides a rate of return that falls within one standard deviation of the mean, which
400 13 • Statistical Analysis in Finance

implies a rate of return between 5.2% and 12.6%. Using the empirical rule, the area under the normal curve
within one standard deviation of the mean is 68%. Thus, there is a probability, or likelihood, of 0.68 that a mid-
cap stock fund will provide a rate of return between 5.2% and 12.6%.

If the interval of interest is extended to two standard deviations from the mean (a rate of return between 1.5%
and 16.3%), using the empirical rule, we can determine that the area under the normal curve within two
standard deviations of the mean is 95%. Thus, there is a probability, or likelihood, of 0.95 that a mid-cap stock
fund will provide a rate of return between 1.5% and 16.3%.

13.6 Data Visualization and Graphical Displays

By the end of this section, you will be able to:
• Determine appropriate graphs to use for various types of data.
• Create and interpret univariate graphs such as bar graphs and histograms.
• Create and interpret bivariate graphs such as time series graphs and scatter plot graphs.

Graphing Univariate Data

Data visualization refers to the use of graphical displays to summarize data to help to interpret patterns and
trends in the data. Univariate data refers to observations recorded for a single characteristic or attribute, such
as salaries or blood pressure measurements. When graphing univariate data, we can choose from among
several types of graphs, such as bar graphs, time series graphs, and so on.

The most effective type of graph to use for a certain data set will depend on the nature of the data and the
purpose of the graph. For example, a time series graph is typically used to show how a measurement is
changing over time and to identify patterns or trends over time.

Below are some examples of typical applications for various graphs and displays.

Graphs used to show the distribution of data:

• Bar chart: used to show frequency or relative frequency distributions for categorical data
• Histogram: used to show frequency or relative frequency distributions for continuous data

Graphs used to show relationships between data points:

• Time series graph: used to show measurement data plotted against time, where time is displayed on the
horizontal axis
• Scatter plot: used to show the relationship between a dependent variable and an independent variable

Bar Graphs

A bar graph consists of bars that are separated from each other and compare percentages. The bars can be
rectangles, or they can be rectangular boxes (used in three-dimensional plots), and they can be vertical or
horizontal. The bar graph shown in the example below has age groups represented on the x-axis and
proportions on the y-axis.

By the end of 2021, a certain social media site had over 146 million users in the United States. Table 13.11
shows three age groups, the number of users in each age group, and the proportion (%) of users in each age
group. A bar graph using this data is shown in Figure 13.5.

Age Groups Number of Site Users Percent of Site Users

13–25 65,082,280 45
26–44 53,300,200 36

Table 13.11 Data for Bar Graph of Age Groups

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 13.6 • Data Visualization and Graphical Displays 401

Age Groups Number of Site Users Percent of Site Users

45–64 27,885,100 19

Table 13.11 Data for Bar Graph of Age Groups

Figure 13.5 Bar Graph of Age Groups

Histograms

A histogram is a bar graph that is used for continuous numeric data, such as salaries, blood pressures,
heights, and so on. One advantage of a histogram is that it can readily display large data sets. A rule of thumb
is to use a histogram when the data set consists of 100 values or more.

A histogram consists of contiguous (adjoining) boxes. It has both a horizontal axis and a vertical axis. The
horizontal axis is labeled with what the data represents (for instance, distance from your home to school). The
vertical axis is labeled either Frequency or Relative Frequency (or Percent Frequency or Probability). The graph
will have the same shape regardless of the label on the vertical axis. A histogram, like a stem-and-leaf plot, can
give you the shape of the data, the center, and the spread of the data.

The relative frequency is equal to the frequency of an observed data value divided by the total number of data
values in the sample. Remember, frequency is defined as the number of times a solution occurs. Relative
frequency is calculated using the formula

where f = frequency, n = the total number of data values (or the sum of the individual frequencies), and RF =
relative frequency.

To construct a histogram, first decide how many bars or intervals, also called classes, will represent the data.
Many histograms consist of 5 to 15 bars or classes for clarity. The number of bars needs to be chosen. Choose
a starting point for the first interval that is less than the smallest data value. A convenient starting point is a
lower value carried out to one more decimal place than the value with the most decimal places. For example, if
the value with the most decimal places is 6.1, and if this is the smallest value, a convenient starting point is
6.05 (because ). We say that 6.05 has more precision. If the value with the most decimal
places is 2.23 and the lowest value is 1.5, a convenient starting point is 1.495 ( ). If the value
with the most decimal places is 3.234 and the lowest value is 1.0, a convenient starting point is
. If all the data values happen to be integers and the smallest value is 2, then a
convenient starting point is . Also, when the starting point and other boundaries are
carried to one additional decimal place, no data value will fall on a boundary. The next two examples go into
detail about how to construct a histogram using continuous data and how to create a histogram using discrete
data.
402 13 • Statistical Analysis in Finance

Example: The following data values are the portfolio values, in thousands of dollars, for 100 investors.

60, 60.5, 61, 61, 61.5

63.5, 63.5, 63.5
64, 64, 64, 64, 64, 64, 64, 64.5, 64.5, 64.5, 64.5, 64.5, 64.5, 64.5, 64.5
66, 66, 66, 66, 66, 66, 66, 66, 66, 66, 66.5, 66.5, 66.5, 66.5, 66.5, 66.5, 66.5, 66.5, 66.5, 66.5, 66.5, 67, 67, 67, 67, 67,
67, 67, 67, 67, 67, 67, 67, 67.5, 67.5, 67.5, 67.5, 67.5, 67.5, 67.5
68, 68, 69, 69, 69, 69, 69, 69, 69, 69, 69, 69, 69.5, 69.5, 69.5, 69.5, 69.5
70, 70, 70, 70, 70, 70, 70.5, 70.5, 70.5, 71, 71, 71
72, 72, 72, 72.5, 72.5, 73, 73.5
74

The smallest data value is 60. Because the data values with the most decimal places have one decimal place
(for instance, 61.5), we want our starting point to have two decimal places. Because the numbers 0.5, 0.05,
0.005, and so on are convenient numbers, use 0.05 and subtract it from 60, the smallest value, to get a
convenient starting point: , which is more precise than, say, 61.5 by one decimal place. Thus,
the starting point is 59.95. The largest value is 74, and , so 74.05 is the ending value.

Next, calculate the width of each bar or class interval. To calculate this width, subtract the starting point from
the ending value and divide the result by the number of bars (you must choose the number of bars you
desire). Suppose you choose eight bars. The interval width is calculated as follows:

We will round up to 2 and make each bar or class interval 2 units wide. Rounding up to 2 is one way to prevent
a value from falling on a boundary. Rounding to the next number is often necessary, even if it goes against the
standard rules of rounding. For this example, using 1.76 as the width would also work. A guideline that is
followed by some for the width of a bar or class interval is to take the square root of the number of data values
and then round to the nearest whole number if necessary. For example, if there are 150 data values, take the
square root of 150 and round to 12 bars or intervals. The boundaries are as follows:

The data values 60 through 61.5 are in the interval 59.95–61.95. The data values of 63.5 are in the interval
61.95–63.95. The data values of 64 and 64.5 are in the interval 63.95–65.95. The data values 66 through 67.5 are
in the interval 65.95–67.95. The data values 68 through 69.5 are in the interval 67.95–69.95. The data values 70
through 71 are in the interval 69.95–71.95. The data values 72 through 73.5 are in the interval 71.95–73.95. The
data value 74 is in the interval 73.95–75.95. The histogram shown in Figure 13.6 displays the portfolio values on
the x-axis and relative frequency on the y-axis.

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 13.6 • Data Visualization and Graphical Displays 403

Figure 13.6 Histogram of Portfolio Values

Graphing Bivariate Data

Bivariate data refers to paired data, where each value of one variable is paired with a value of a second
variable. An example of paired data would be if data were collected on employees’ years of experience and
their corresponding salaries. Typically, it is of interest to investigate possible associations or correlations
between the two variables under analysis.

Time Series Graphs

Suppose that we want to track the consumer price index (CPI) over the past 10 years. One feature of the data
that we may want to consider is the element of time. Because each year is paired with the CPI value for that
year, we do not have to think of the data as being random. We can instead use the years given to impose a
chronological order on the data. A graph that recognizes this ordering and displays the changing CPI value as
the decade progresses is called a time series graph.

To construct a time series graph, we must look at both pieces of our paired data set. We start with a standard
Cartesian coordinate system. The horizontal axis is used to plot the time increments, and the vertical axis is
used to plot the values of the variable that we are measuring. By doing this, we make each point on the graph
correspond to a point in time and a measured quantity. The points on the graph are typically connected by
straight lines in the order in which they occur.

Example: The following data set shows the annual CPI for 10 years. We need to construct a time series graph
for the (rounded) annual CPI data (see Table 13.12). The time series graph is shown in Figure 13.7.

Year CPI
2012 226.65
2013 230.28
2014 233.91

Table 13.12
Data for Time
Series Graph
of Annual CPI,
2012–2021
(source: US
Bureau of
Labor
Statistics)
404 13 • Statistical Analysis in Finance

Year CPI
2015 233.70
2016 236.91
2017 242.84
2018 247.87
2019 251.71
2020 257.97
2021 261.58

Table 13.12
Data for Time
Series Graph
of Annual CPI,
2012–2021
(source: US
Bureau of
Labor
Statistics)

Figure 13.7 Time Series Graph of Annual CPI, 2012–2021

Scatter Plots

A scatter plot, or scatter diagram, is a graphical display intended to show the relationship between two
variables. The setup of the scatter plot is that one variable is plotted on the horizontal axis and the other
variable is plotted on the vertical axis. Then each pair of data values is considered as an (x, y) point, and the
various points are plotted on the diagram. A visual inspection of the plot is then made to detect any patterns
or trends. Additional statistical analysis can be conducted to determine if there is a correlation or other
statistically significant relationship between the two variables.

Assume we are interested in tracking the closing price of Nike stock over the one-year time period from April
2020 to March 2021. We would also like to know if there is a correlation or relationship between the price of
Nike stock and the value of the S&P 500 over the same time period. To visualize this relationship, we can create
a scatter plot based on the (x, y) data shown in Table 13.13. The resulting scatter plot is shown in Figure 13.8.

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 13.6 • Data Visualization and Graphical Displays 405

Date S&P 500 Nike Stock Price ($)

4/1/2020 2,912.43 87.18
5/1/2020 3,044.31 98.58
6/1/2020 3,100.29 98.05
7/1/2020 3,271.12 97.61
8/1/2020 3,500.31 111.89
9/1/2020 3,363.00 125.54
10/1/2020 3,269.96 120.08
11/1/2020 3,621.63 134.70
12/1/2020 3,756.07 141.47
1/1/2021 3,714.24 133.59
2/1/2021 3,811.15 134.78
3/1/2021 3,943.34 140.45
3/12/2021 3,943.34 140.45

Table 13.13 Data for S&P 500 and Nike Stock

Price over a 12-Month Period (source: Yahoo!
Finance)

Figure 13.8 Scatter Plot of Nike Stock Price versus S&P 500

Note the linear pattern of the points on the scatter plot. Because the data points generally align along a
straight line, this provides an indication of a linear correlation between the price of Nike stock and the value of
the S&P 500 over this one-year time period.

The scatter plot can be generated using Excel as follows:

1. Enter the x-data in column A of a spreadsheet.

2. Enter the y-data in column B.
3. Highlight the data with your mouse.
4. Go to the Insert menu and select the icon for a scatter plot, as shown in Figure 13.9.
406 13 • Statistical Analysis in Finance

Figure 13.9 Excel Menu Showing the Scatter Plot Icon

13.7 The R Statistical Analysis Tool

By the end of this section, you will be able to:
• Create a vector of data values for the R statistical analysis tool.
• Write basic statistical commands using the R statistical analysis tool.

Commands and Vectors in R

R is a statistical analysis tool that is widely used in the finance industry. It is available as a free program and
provides an integrated suite of functions for data analysis, graphing, and statistical programming. R is
increasingly being used as a data analysis and statistical tool as it is an open-source language and additional
features are constantly being added by the user community. The tool can be used on many different
computing platforms and can be downloaded at the R Project website (https://openstax.org/r/the-R-project-
website).

LINK TO LEARNING

Using the R Statistical Tool

There are many resources for learning and using the R statistical tool, including the following:

How to install R on different computer operating systems (https://openstax.org/r/how-to-install)

Introduction to using R (https://openstax.org/r/introduction-to-using-R)

How to import and export data using R (https://openstax.org/r/how-to-import-and-export)

Frequently asked questions (FAQ) on using R (https://openstax.org/r/frequently-asked-questions)

Once you have installed and started R on your computer, at the bottom of the R console, you should see the
symbol >, which indicates that R is ready to accept commands.

Type 'demo()' for some demos, 'help()' for on-line help, or 'help.start()' for an HTML
browser interface to help. Type 'q()' to quit R.

>

R is a command-driven language, meaning that the user enters commands at the prompt, which R then
executes one at a time. R can also execute a program containing multiple commands. There are ways to add a
graphic user interface (GUI) to R. An example of a GUI tool for R is RStudio (https://openstax.org/r/RStudio).

The R command line can be used to perform any numeric calculation, similar to a handheld calculator. For

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 13.7 • The R Statistical Analysis Tool 407

example, to evaluate the expression enter the following expression at the command line prompt
and hit return:

> 10+3*7

[1] 31

Most calculations in R are handled via functions. For statistical analysis, there are many preestablished
functions in R to calculate mean, median, standard deviation, quartiles, and so on. Variables can be named and
assigned values using the assignment operator <-. For example, the following R commands assign the value of
20 to the variable named x and assign the value of 30 to the variable named y:

> x <- 20

> y <- 30

These variable names can be used in any calculation, such as multiplying x by y to produce the result 600:

> x*y

[1] 600

The typical method for using functions in statistical applications is to first create a vector of data values. There
are several ways to create vectors in R. For example, the c function is often used to combine values into a
vector. The following R command will generate a vector called salaries that contains the data values 40,000,
50,000, 75,000, and 92,000:

> salaries <- c(40000, 50000, 75000, 92000)

This vector salaries can then be used in statistical functions such as mean, median, min, max, and so on, as
shown:

> mean(salaries)

[1] 64250

> median(salaries)

[1] 62500

> min(salaries)

[1] 40000

> max(salaries)

[1] 92000
408 13 • Statistical Analysis in Finance

Another option for generating a vector in R is to use the seq function, which will automatically generate a
sequence of numbers. For example, we can generate a sequence of numbers from 1 to 5, incremented by 0.5,
and call this vector example1, as follows:

> example1 <- seq(1, 5, by=0.5)

If we then type the name of the vector and hit enter, R will provide a listing of numeric values for that vector
name.

> salaries

[1] 40000 50000 75000 92000

> example1

[1] 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

Often, we are interested in generating a quick statistical summary of a data set in the form of its mean,
median, quartiles, min, and max. The R command called summary provides these results.

> summary(salaries)

Min. 1st Qu. Median Mean 3rd Qu. Max.

40000 47500 62500 64250 79250 92000

For measures of spread, R includes a command for standard deviation, called sd, and a command for variance,
called var. The standard deviation and variance are calculated with the assumption that the data set was
collected from a sample.

> sd(salaries)

[1] 23641.42

> var(salaries)

[1] 558916667

To calculate a weighted mean in R, create two vectors, one of which contains the data values and the other of
which contains the associated weights. Then enter the R command weighted.mean(values, weights).

The following is an example of a weighted mean calculation in R:

Assume your portfolio contains 1,000 shares of XYZ Corporation, purchased on three different dates, as shown
in Table 13.14. Calculate the weighted mean of the purchase price, where the weights are based on the
number of shares in the portfolio.

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 13.7 • The R Statistical Analysis Tool 409

Date Purchased Purchase Price ($) Number of Shares Purchased

January 17 78 200
February 10 122 300
March 23 131 500
Total 1,000

Table 13.14 Portfolio of XYZ Shares

Here is how you would create two vectors in R: the price vector will contain the purchase price, and the shares
vector will contain the number of shares. Then execute the R command weighted.mean(price, shares), as
follows:

> price <- c(78, 122, 131)

> shares <- c(200, 300, 500)

> weighted.mean(price, shares)

[1] 117.7

A list of common R statistical commands appears in Table 13.15.

R Command Result
mean( ) Calculates the arithmetic mean
median( ) Calculates the median
min( ) Calculates the minimum value
max( ) Calculates the maximum value
weighted.mean( ) Calculates the weighted mean
sum( ) Calculates the sum of values
summary( ) Calculates the mean, median, quartiles, min, and max
sd( ) Calculates the sample standard deviation
var( ) Calculates the sample variance
IQR( ) Calculates the interquartile range
barplot( ) Plots a bar chart of non-numeric data
boxplot( ) Plots a boxplot of numeric data
hist( ) Plots a histogram of numeric data
plot( ) Plots various graphs, including a scatter plot
freq( ) Creates a frequency distribution table

Table 13.15 List of Common R Statistical Commands

Graphing in R
There are many statistical applications in R, and many graphical representations are possible, such as bar
graphs, histograms, time series plots, scatter plots, and others. The basic command to create a plot in R is the
410 13 • Statistical Analysis in Finance

plot command, plot(x, y), where x is a vector containing the x-values of the data set and y is a vector containing
the y-values of the data set.

The general format of the command is as follows:

>plot(x, y, main="text for title of graph", xlab="text for x-axis label", ylab="text
for y-axis label")

For example, we are interested in creating a scatter plot to examine the correlation between the value of the
S&P 500 and Nike stock prices. Assume we have the data shown in Table 13.13, collected over a one-year time
period.

Note that data can be read into R from a text file or Excel file or from the clipboard by using various R
commands. Assume the values of the S&P 500 have been loaded into the vector SP500 and the values of Nike
stock prices have been loaded into the vector Nike. Then, to generate the scatter plot, we can use the following
R command:

>plot(SP500, Nike, main="Scatter Plot of Nike Stock Price vs. S&P 500", xlab="S&P
500", ylab="Nike Stock Price")

As a result of these commands, R provides the scatter plot shown in Figure 13.10. This is the same data that
was used to generate the scatter plot in Figure 13.8 in Excel.

Figure 13.10 Scatter Plot Generated by R for Nike Stock Price versus S&P 500

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 13 • Summary 411

Summary
13.1 Measures of Center
Several measurements are used to provide the average of a data set, including mean, median, and mode. The
terms mean and average are often used interchangeably. To calculate the mean for a set of numbers, add the
numbers together and then divide the sum by the number of data values. The geometric mean redistributes
not the sum of the values but the product by multiplying all of the individual values and then redistributing
them in equal portions such that the total product remains the same. To calculate the median for a set of
numbers, order the data from smallest to largest and identify the middle data value in the ordered data set.

13.2 Measures of Spread

The standard deviation and variance are measures of the spread of a data set. The standard deviation is small
when the data values are all concentrated close to the mean, exhibiting little variation or spread. The standard
deviation is larger when the data values are more spread out from the mean, exhibiting more variation. The
formula used to calculate the standard deviation depends on whether the data represents a sample or a
population, as the formulas for the sample standard deviation and the population standard deviation are
slightly different.

13.3 Measures of Position

Several measures are used to indicate the position of a data value in a data set. One measure of position is the
z-score for a particular measurement. The z-score indicates how many standard deviations a particular
measurement is above or below the mean. Other measures of position include quartiles and percentiles.
Quartiles are special percentiles. The first quartile, Q1, is the same as the 25th percentile, and the third quartile,
Q3, is the same as the 75th percentile. The median, M, is called both the second quartile and the 50th
percentile. To calculate quartiles and percentiles, the data must be ordered from smallest to largest. Quartiles
divide ordered data into quarters. Percentiles divide ordered data into hundredths.

13.4 Statistical Distributions

A frequency distribution provides a method of organizing and summarizing a data set and allows us to
organize and tabulate the data in a summarized way. Once a frequency distribution is generated, it can be
used to create graphs to help facilitate an interpretation of the data set. The normal distribution has two
parameters, or numerical descriptive measures: the mean, , and the standard deviation, . The exponential
distribution is often concerned with the amount of time until some specific event occurs.

13.5 Probability Distributions

A probability distribution is a mathematical function that assigns probabilities to various outcomes. In many
financial situations, we are interested in determining the expected value of the return on a particular
investment or the expected return on a portfolio of multiple investments. When analyzing distributions that
follow a normal distribution, probabilities can be calculated by finding the area under the graph of the normal
curve.

13.6 Data Visualization and Graphical Displays

Data visualization refers to the use of graphical displays to summarize a data set to help to interpret patterns
and trends in the data. Univariate data refers to observations recorded for a single characteristic or attribute,
such as salaries or blood pressure measurements. When graphing univariate data, we can choose from among
several types of graphs. The type of graph to be used for a certain data set will depend on the nature of the
data and the purpose of the graph. Examples of graphs for univariate data include line graphs, bar graphs,
and histograms. Bivariate data refers to paired data where each value of one variable is paired with a value of
a second variable. Examples of graphs for bivariate data include time series graphs and scatter plots.
412 13 • Key Terms

13.7 The R Statistical Analysis Tool

R is an open-source statistical analysis tool that is widely used in the finance industry. It provides an integrated
suite of functions for data analysis, graphing, and statistical programming. R is increasingly being used as a
data analysis and statistical tool as it is an open-source language, and additional features are constantly being
added by the user community. This tool can be used on many different computing platforms and can be
downloaded at The R Project for Statistical Computing (https://openstax.org/r/The-R-Project).

Key Terms
arithmetic mean a measure of center of a data set, calculated by adding up the data values and dividing the
sum by the number of data values
bar graph a chart that presents categorical data in a summarized form based on frequency or relative
frequency
bivariate data paired data in which each value of one variable is paired with a value of a second variable
data visualization the use of graphical displays, such as bar charts, histograms, and scatter plots, to help
interpret patterns and trends in a data set
empirical rule a rule that provides the percentages of data values falling within one, two, and three standard
deviations from the mean for a bell-shaped (normal) distribution
expected value a weighted average of the values of a variable where the weights are the associated
probabilities
exponential distribution a continuous probability distribution that is useful for calculating probabilities
within the time between events
frequency distribution a method of organizing and summarizing a data set that provides the frequency
with which each value in the data set occurs
geometric mean a measure of center of a data set, calculated by multiplying the data values and then
raising the product to the exponent , where n is the number of data values
histogram a graphical display of continuous data showing class intervals on the horizontal axis and
frequency or relative frequency on the vertical axis
interquartile range (IQR) a number that indicates the spread of the middle half, or middle 50%, of the data;
the difference between the third quartile (Q3) and the first quartile (Q1)
median the middle value in an ordered data set
mode the most frequently occurring data value in a data set
normal distribution a bell-shaped distribution curve that is used to model many measurements, including
IQ scores, salaries, heights, weights, blood pressures, etc.
outliers data values that are significantly different from the other data values in a data set
percentiles numbers that divide an ordered data set into hundredths; often used to indicate position of a
data value in a data set
population data data representing all the outcomes or measurements that are of interest
portfolio a collection of financial investments, such as stocks, bonds, mutual funds, certificates of deposit,
etc.
probability distribution a mathematical function that assigns probabilities to various outcomes
quartiles numbers that divide an ordered data set into quarters; the second quartile is the same as the
median
sample data data representing outcomes or measurements collected from a subset or part of a population
scatter plot (or scatter diagram) a graphical display that shows the relationship between a dependent
variable and an independent variable
standard deviation a measure of the spread of a data set that indicates how far a typical data value is from
the mean
time series graph a graphical display used to show measurement data plotted versus time, where time is

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 13 • CFA Institute 413

displayed on the horizontal axis

variance the measure of the spread of data values calculated as the square of the standard deviation
weighted mean a measure of center of a data set in which each data value has a corresponding weighting
x-axis the horizontal axis in a rectangular coordinate system
y-axis the vertical axis in a rectangular coordinate system
z-score (or z-value) a measure of the position of a data value in the data set, calculated by subtracting the
mean from the data value and then dividing the difference by the standard deviation

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-level1-study-session). Reference with permission of CFA Institute.

Multiple Choice
1. A data set of salaries contains an outlier salary. The best measure of center to use for this data set is the
________.
a. mean
b. median
c. mode
d. standard deviation

2. A portfolio includes shares of United Airlines stock that were purchased at different times and different
prices. Which measure is best to determine the average cost of the shares of the stock?
a. mean
b. median
c. weighted mean
d. standard deviation

3. Standard deviation is a measure of the ________.

a. center of a data set
b. position of a data value in a data set
c. area under a normal curve
d. spread of a distribution

4. How are standard deviation and variance related?

a. The two measures are equal to one another.
b. Variance is the square root of the standard deviation.
c. Standard deviation is the square root of the variance.
d. The two squared measures are equal to one another.

5. Which of the following is the best definition of a z-score?

a. the distance of a data value from the mean
b. the number of standard deviations that a data value is from the mean
c. the distance of a data value from the mean divided by the sample size
d. the number of quartiles that a data value is from the mean

6. The results of a standardized test indicate that you are in the 85th percentile. What is the best
interpretation of this result?
a. You scored in the top 85% of all students taking the test.
414 13 • Review Questions

b. You scored in the top 15% of all students taking the test.
c. Your score on the test is 85 when measured on a scale from 0 to 100.
d. You scored in the bottom 15% of all students taking the test.

7. The interquartile range is ________.

a. the middle 50% of a data set
b. the upper 50% of a data set
c. the lower 50% of a data set
d. equal to the median

8. In a frequency distribution table, the sum of the relative frequencies must be equal to ________.
a. the sample size
b. 1, or 100%
c. zero
d. the standard deviation of the distribution

9. A change in the standard deviation of a normal distribution will result in ________.

a. a change in the location of the peak of the curve
b. a change in the area under the curve
c. a change in the shape of the curve
d. a change that shifts the graph to the left or the right

10. When calculating an expected value, ________.

a. the result should always be 1
b. the result should always be a positive value
c. the result should always be a negative value
d. the result can be a positive or negative value

11. The area under a normal curve between a z-score of -2 and a z-score of +2 is ________.
a. 0.68
b. 0.95
c. 0.997
d. dependent on the mean and standard deviation

12. A scatter plot is a visualization for ________.

a. univariate data only
b. bivariate data only
c. either univariate or bivariate data
d. test scores

13. Which of the following is NOT a benefit of using the R statistical analysis tool?
a. Additional features are constantly being added by the user community.
b. It can be used on many computer platforms, including Mac, Windows, and Linux.
c. It is free to download.
d. Users pay an annual subscription fee.

Review Questions
1. Explain the considerations that determine whether the mean or the median is the best measure of central
tendency for a data set.

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 13 • Problems 415

2. Explain the difference between a mean and a weighted mean.

3. Explain why the standard deviation of a data set cannot be a negative value.

4. Explain what a negative z-score, a positive z-score, and a z-score of zero imply.

5. Explain how quartiles can be used to detect outliers in a data set.

Problems
1. You purchased 1,000 shares of a stock for $12 per share. Then, two months later, you purchased an
additional 500 shares of the same stock at $9 per share. Calculate the weighted mean of the purchase
price for the total of 1,500 shares.

2. You score a 60 on a biology test. The mean test grade is 70, and the standard deviation is 5. Calculate and
interpret your corresponding z-score.

3. You score a 60 on a biology test. The mean test grade is 70, and the standard deviation is 5. What
percentile does your grade correspond to?

4. A fast food restaurant has measured service time for customers waiting in line, and the service time
follows an exponential distribution with a mean waiting time of 1.9 minutes. The restaurant has a
guarantee that if customers wait in line for more than 5 minutes, their meal is free. What is the probability
that a customer will receive a free meal?

5. The total value of your portfolio consists of approximately 65% stock assets, 25% bonds, and 10% cash
equivalents. Historical returns have shown that stocks provide a return of 12%, bonds provide a return of
3.5%, and cash savings provide a return of 1.5%. What is the expected value of the return on this portfolio?

6. The distribution of the average annual return of the S&P 500 over a 50-year time period follows a normal
distribution with a mean rate of return of 10.5% and a standard deviation of 14.3%. What is the probability
that an average annual return will fall between -3.8% and 24.8%?

7. Write a short R program to find the expected return for the data set in Table 13.16.
Historical Return on Associated
United Airlines Stock Probability
12% 15%
5% 35%
2% 25%
-5% 14%
-10% 11%

Table 13.16

Video Activity
Normal Distribution Stock Return Calculations

Click to view content (https://openstax.org/r/stock-return)

1. Assume the return on stocks follows a normal distribution. Is it more likely that a stock will return between
-1 and +1 standard deviations from the mean or between -2 and +2 standard deviations from the mean?
Why?
416 13 • Video Activity

2. Would an investor be likely to prefer a stock that has a smaller standard deviation for annual stock returns
or one with a larger standard deviation for annual stock returns? Why?

Portfolio Weights

Click to view content (https://openstax.org/r/port-weights)

3. What are the reasons for calculating portfolio weights? What useful information does this provide to the
investor?

4. What are the advantages and disadvantages of the equal weighting approach and the market cap
weighting approach for portfolio allocation strategy?

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 14 • Why It Matters 417

14
Regression Analysis in Finance

Figure 14.1 Regression analysis is used in financial decision-making. (credit: modification of “Stock exchange” by Jack Sem/flickr, CC
BY 2.0)

Chapter Outline
14.1 Correlation Analysis
14.2 Linear Regression Analysis
14.3 Best-Fit Linear Model
14.4 Regression Applications in Finance
14.5 Predictions and Prediction Intervals
14.6 Use of R Statistical Analysis Tool for Regression Analysis

Why It Matters
Correlation and regression analysis are used extensively in finance applications. Correlation analysis allows the
determination of a statistical relationship between two numeric quantities. Regression analysis can be used to
predict one quantity based on a second quantity, assuming there is a significant correlation between the two
quantities. For example, in finance, we use regression analysis to calculate the beta coefficient of a stock,
which represents the volatility of the stock versus overall market volatility, with volatility being a measure of
risk.

A business may want to establish a correlation between the amount the company spent on advertising versus
its recorded sales. If a strong enough correlation is established, then the business manager can predict sales
based on the amount spent on advertising for a given time period.

Finance professionals often use correlation analysis to predict future trends and mitigate risk in a stock
portfolio. For example, if two investments are strongly correlated, an investor might not want to have both
investments in a certain portfolio since the two investments would tend to move in the same directions during
up markets or down markets. To diversify a portfolio, an investor might seek investments that are not strongly
correlated with one another.

Regression analysis can be used to establish a mathematical equation that relates a dependent variable (such
as sales) to an independent variable (such as advertising expenditure). In this discussion, the focus will be on
418 14 • Regression Analysis in Finance

analyzing the relationship between one dependent variable and one independent variable, where the
relationship can be modeled using a linear equation. This type of analysis is called linear regression.

14.1 Correlation Analysis

Learning Outcomes
By the end of this section, you will be able to:
• Calculate a correlation coefficient.
• Interpret a correlation coefficient.
• Test for the significance of a correlation coefficient.

Calculate a Correlation Coefficient

In correlation analysis, we study the relationship between bivariate data, which is data collected on two
variables where the data values are paired with one another.

Correlation is the measure of association between two numeric variables. For example, we may be interested
to know if there is a correlation between bond prices and interest rates or between the age of a car and the
value of the car. To investigate the correlation between two numeric quantities, the first step is to create a
scatter plot that will graph the (x, y) ordered pairs. The independent, or explanatory, quantity is labeled as the
x-variable, and the dependent, or response, quantity is labeled as the y-variable.

For example, we may be interested to know if the price of Nike stock is correlated with the value of the S&P 500
(Standard & Poor’s 500 stock market index). To investigate this, monthly data can be collected for Nike stock
prices and value of the S&P 500 for a period of time, and a scatter plot can be created and examined. A scatter
plot, or scatter diagram, is a graphical display intended to show the relationship between two variables. The
setup of the scatter plot is that one variable is plotted on the horizontal axis and the other variable is plotted
on the vertical axis. Each pair of data values is considered as an (x, y) point, and the various points are plotted
on the diagram. A visual inspection of the plot is then made to detect any patterns or trends on the scatter
diagram. Table 14.1 shows the relationship between the Nike stock price and its S&P value over a one-year
time period.

To assess linear correlation, the graphical trend of the data points is examined on the scatter plot to determine
if a straight-line pattern exists. If a linear pattern exists, the correlation may indicate either a positive or a
negative correlation. A positive correlation indicates that as the independent variable increases, the dependent
variable tends to increase as well, or, as the independent variable decreases, the dependent variable tends to
decrease (the two quantities move in the same direction). A negative correlation indicates that as the
independent variable increases, the dependent variable decreases, or, as the independent variable decreases,
the dependent variable increases (the two quantities move in opposite directions). If there is no relationship or
association between the two quantities, where one quantity changing does not affect the other quantity, we
conclude that there is no correlation between the two variables.

Nike
Date S&P 500
Stock Price

4/1/2020 2,912.43 87.18

5/1/2020 3,044.31 98.58
6/1/2020 3,100.29 98.05

Table 14.1 Nike Stock Price ($) and

Value of S&P 500 over a One-Year
Time Period (source: Yahoo! Finance)

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 14.1 • Correlation Analysis 419

Nike
Date S&P 500
Stock Price

7/1/2020 3,271.12 97.61

8/1/2020 3,500.31 111.89
9/1/2020 3,363.00 125.54
10/1/2020 3,269.96 120.08
11/1/2020 3,621.63 134.70
12/1/2020 3,756.07 141.47
1/1/2021 3,714.24 133.59
2/1/2021 3,811.15 134.78
3/1/2021 3,943.34 140.45
3/12/2021 3,943.34 140.45

Table 14.1 Nike Stock Price ($) and

Value of S&P 500 over a One-Year
Time Period (source: Yahoo! Finance)

From the scatter plot in the Nike stock versus S&P 500 example (see Figure 14.2), we note that the trend
reflects a positive correlation in that as the value of the S&P 500 increases, the price of Nike stock tends to
increase as well.

Figure 14.2 Scatter Plot of Nike Stock Price ($) and Value of S&P 500 (data source: Yahoo! Finance)

When inspecting a scatter plot, it may be difficult to assess a correlation based on a visual inspection of the
graph alone. A more precise assessment of the correlation between the two quantities can be obtained by
calculating the numeric correlation coefficient (referred to using the symbol r).

The correlation coefficient, which was developed by statistician Karl Pearson in the early 1900s, is a measure
of the strength and direction of the correlation between the independent variable x and the dependent
variable y.

The formula for r is shown below; however, technology, such as Excel or the statistical analysis program R, is
typically used to calculate the correlation coefficient.
420 14 • Regression Analysis in Finance

where n refers to the number of data pairs and the symbol indicates to sum the x-values.

Table 14.2 provides a step-by-step procedure on how to calculate the correlation coefficient r.

Step Representation in Symbols

1. Calculate the sum of the x-values.
2. Calculate the sum of the y-values.
3. Multiply each x-value by the corresponding y-value and calculate the
sum of these xy products.
4. Square each x-value and then calculate the sum of these squared
values.
5. Square each y-value and then calculate the sum of these squared
values.
6. Determine the value of n, which is the number of data pairs. n

7. Use these results to then substitute into the formula for the
correlation coefficient.

Table 14.2 Steps for Calculating the Correlation Coefficient

Note that since r is calculated using sample data, r is considered a sample statistic used to measure the
strength of the correlation for the two population variables. Sample data indicates data based on a subset of
the entire population.

Given the complexity of this calculation, Excel or other software is typically used to calculate the correlation
coefficient.

The Excel command to calculate the correlation coefficient uses the following format:

=CORREL(A1:A10, B1:B10)

where A1:A10 are the cells containing the x-values and B1:B10 are the cells containing the y-values.

Download the spreadsheet file (https://openstax.org/r/excel_exhibits) containing key Chapter 14 Excel

exhibits.

Interpret a Correlation Coefficient

Once the value of r is calculated, this measurement provides two indicators for the correlation:

a. the strength of the correlation based on the value of r

b. the direction of the correlation based on the sign of r

The value of r gives us this information:

• The value of r is always between and : .

• The size of the correlation r indicates the strength of the linear relationship between the two variables.
Values of r close to or to indicate a stronger linear relationship.
• If , there is no linear relationship between the two variables (no linear correlation).
• If , there is perfect positive correlation.
• If there is perfect negative correlation. In both of these cases, all the original data points lie on a
straight line.

The sign of r gives us this information:

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 14.1 • Correlation Analysis 421

• A positive value of r means that when x increases, y tends to increase, and when x decreases, y tends to
decrease (positive correlation).
• A negative value of r means that when x increases, y tends to decrease, and when x decreases, y tends to
increase (negative correlation).

LINK TO LEARNING

Correlation in Finance Applications

This video on correlation concepts (https://openstax.org/r/video_correlation) discusses them with a specific
focus on finance applications.

The Excel command used to find the value of the correlation coefficient for the Nike stock versus S&P 500
example (refer back to Table 14.1) is

=CORREL(B2:B14,C2:C14)

In this example, the value of is calculated by Excel to be .

Since this is a positive value close to 1, we conclude that the relationship between Nike stock and the value of
the S&P 500 over this time period represents a strong, positive correlation.

The correlation coefficient r can also be determined using the statistical capability on the financial calculator:

• Step 1 is to enter the data in the calculator (using the [DATA] function that is located above the 7 key).
• Step 2 is to access the statistical results provided by the calculator (using the [STAT] function that is
located above the 8 key) and scroll to the correlation coefficient results.

Follow the steps in Table 14.3 for calculating the correlation data for the data set of Nike stock price and value
of the S&P 500 shown previously.

Step Description Enter Display

1 Enter [DATA] entry mode 2ND [DATA] X01 0.00

2 Clear any previous data 2ND [CLR WORK] X01 0.00

3 Enter first x-value of 2912.43 2912.43 ENTER X01 = 2,912.43

4 Move to next data entry ↓ Y01 = 1.00
5 Enter first y-value of 87.18 87.18 ENTER Y01 = 87.18
6 Move to next data entry ↓ X02 0.00
7 Enter second x-value of 3044.31 3044.31 ENTER X02 = 3,044.31
8 Move to next data entry ↓ Y02 = 1.00
9 Enter second y-value of 98.58 98.58 ENTER Y02 = 98.58
10 Move to next data entry ↓ X03 0.00
11 Continue to enter remaining data values
12 Enter [STAT] mode 2ND [STAT]

1
Table 14.3 Calculator Steps for Finding the Relationship between Nike Stock Price and Value of S&P 500

1 The specific financial calculator in these examples is the Texas Instruments BA II Plus TM Professional model, but you can use
other financial calculators for these types of calculations.
422 14 • Regression Analysis in Finance

Step Description Enter Display

13 Press [SET] until LIN appears 2ND [SET] LIN
14 Move to 1st statistical result ↓ 13.00
15 Move to next statistical result ↓ 3,480.86
16 Continue to scroll down until the value of r is displayed ↓ 0.93

1
Table 14.3 Calculator Steps for Finding the Relationship between Nike Stock Price and Value of S&P 500

From the statistical results shown on the calculator display, the correlation coefficient r is 0.93, which indicates
that the relationship between Nike stock and the value of the S&P 500 over this time period represents a
strong, positive correlation.

Note: A strong correlation does not suggest that x causes y or y causes x. We must remember that correlation
does not imply causation.

Test a Correlation Coefficient for Significance

The correlation coefficient, r, tells us about the strength and direction of the linear relationship between x and
y. The sample data are used to compute r, the correlation coefficient for the sample. If we had data for the
entire population (that is, all measurements of interest), we could find the population correlation coefficient,
which is labeled as the Greek letter ρ (pronounced “rho”). But because we have only sample data, we cannot
calculate the population correlation coefficient. The sample correlation coefficient, r, is our estimate of the
unknown population correlation coefficient.

• ρ = population correlation coefficient (unknown)

• r = sample correlation coefficient (known; calculated from sample data)

An important step in the correlation analysis is to determine if the correlation is significant. By this, we are
asking if the correlation is strong enough to allow meaningful predictions for y based on values of x. One
method to test the significance of the correlation is to employ a hypothesis test. The hypothesis test lets us
decide whether the value of the population correlation coefficient ρ is close to zero or significantly different
from zero. We decide this based on the sample correlation coefficient r and the sample size n.

If the test concludes that the correlation coefficient is significantly different from zero, we say that the
correlation coefficient is significant.

• Conclusion: There is sufficient evidence to conclude that there is a significant linear relationship between x
and y variables because the correlation coefficient is significantly different from zero.
• What the conclusion means: There is a significant linear relationship between the x and y variables. If the
test concludes that the correlation coefficient is not significantly different from zero (it is close to zero), we
say that the correlation coefficient is not significant.

A hypothesis test can be performed to test if the correlation is significant. A hypothesis test is a statistical
method that uses sample data to test a claim regarding the value of a population parameter. In this case, the
hypothesis test will be used to test the claim that the population correlation coefficient ρ is equal to zero.

Use these hypotheses when performing the hypothesis test:

• Null hypothesis:
• Alternate hypothesis:

The hypotheses can be stated in words as follows:

• Null hypothesis : The population correlation coefficient is not significantly different from zero. There is
not a significant linear relationship (correlation) between x and y in the population.

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 14.1 • Correlation Analysis 423

• Alternate hypothesis : The population correlation coefficient is significantly different from zero. There
is a significant linear relationship (correlation) between x and y in the population.

A quick shorthand way to test correlations is the relationship between the sample size and the correlation. If
then this implies that the correlation between the two variables demonstrates that a linear

relationship exists and is statistically significant at approximately the 0.05 level of significance. As the formula
indicates, there is an inverse relationship between the sample size and the required correlation for significance
of a linear relationship. With only 10 observations, the required correlation for significance is 0.6325; for 30
observations, the required correlation for significance decreases to 0.3651; and at 100 observations, the
required level is only 0.2000.

NOTE:

• If r is significant and the scatter plot shows a linear trend, the line can be used to predict the value of y for
values of x that are within the domain of observed x-values.
• If r is not significant OR if the scatter plot does not show a linear trend, the line should not be used for
prediction.
• If r is significant and the scatter plot shows a linear trend, the line may not be appropriate or reliable for
prediction outside the domain of observed x-values in the data.

THINK IT THROUGH

Determining If a Correlation Is Significant

Suppose that the chief financial officer (CFO) of a corporation is investigating the correlation between stock
prices and unemployment rate over a period of 10 years and finds the correlation coefficient to be -0.68.
There are 10 (x, y) data points in the data set. Should the CFO conclude that the correlation is significant for
the relationship between stock prices and unemployment rate based on a level of significance of 0.05?

Solution:

When using a level of significance of 0.05, if then this implies that the correlation between the

two variables demonstrates a linear relationship that is statistically significant at approximately the 0.05
level of significance. In this example, we check if is greater than or equal to where .

Since is approximately 0.632, this indicates that the absolute value of r of is greater than ,

and thus the correlation is deemed as significant.

Correlations may be helpful in visualizing the data, but they are not appropriately used to explain a
relationship between two variables. Perhaps no single statistic is more misused than the correlation
coefficient. Citing correlations between health conditions and everything from place of residence to eye color
have the effect of implying a cause-and-effect relationship. This simply cannot be accomplished with a
correlation coefficient. The correlation coefficient is, of course, innocent of this misinterpretation. It is the duty
of analysts to use a statistic that is designed to test for cause-and-effect relationships and to report only those
results, if they are intending to make such a claim. The problem is that passing this more rigorous test is
difficult, therefore lazy and/or unscrupulous researchers fall back on correlations when they cannot make their
case legitimately.
424 14 • Regression Analysis in Finance

14.2 Linear Regression Analysis

Learning Outcomes
By the end of this section, you will be able to:
• Analyze a regression using the method of least squares and residuals.
• Test the assumptions for linear regression.

Method of Least Squares and Residuals

Once the correlation coefficient has been calculated and a determination has been made that the correlation
is significant, typically a regression model is then developed. In this discussion we will focus on linear
regression, where a straight line is used to model the relationship between the two variables. Once a straight-
line model is developed, this model can then be used to predict the value of the dependent variable for a
specific value of the independent variable.

Recall from algebra that the equation of a straight line is given by

where m is the slope of the line and b is the y-intercept of the line.

The slope measures the steepness of the line, and the y-intercept is that point on the y-axis where the graph
crosses, or intercepts, the y-axis.

In linear regression analysis, the equation of the straight line is written in a slightly different way using the
model

In this format, b is the slope of the line, and a is the y-intercept. The notation is called y-hat and is used to
indicate a predicted value of the dependent variable y for a certain value of the independent variable x.

If a line extends uphill from left to right, the slope is a positive value, and if the line extends downhill from left
to right, the slope is a negative value. Refer to Figure 14.3.

Figure 14.3 Three Possible Graphs of (a) If , the line slopes upward to the right. (b) If , the line is horizontal.
(c) If , the line slopes downward to the right.

When generating the equation of a line in algebra using , two (x, y) points were required to
generate the equation. However, in regression analysis, all (x, y) points in the data set will be utilized to
develop the linear regression model.

The first step in any regression analysis is to create the scatter plot. Then proceed to calculate the correlation
coefficient r, and check this value for significance. If we think that the points show a linear relationship, we
would like to draw a line on the scatter plot. This line can be calculated through a process called linear
regression. However, we only calculate a regression line if one of the variables helps to explain or predict the
other variable. If x is the independent variable and y the dependent variable, then we can use a regression line
to predict y for a given value of x.

As an example of a regression equation, assume that a correlation exists between the monthly amount spent

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 14.2 • Linear Regression Analysis 425

on advertising and the monthly revenue for a Fortune 500 company. After collecting (x, y) data for a certain
time period, the company determines the regression equation is of the form

where x represents the monthly amount spent on advertising (in thousands of dollars) and represents the
monthly revenues for the company (in thousands of dollars).

A scatter plot of the (x, y) data is shown in Figure 14.4.

Figure 14.4 Scatter Plot of Revenue versus Advertising for a Fortune 500 Company ($000s)

The Fortune 500 company would like to predict the monthly revenue if its executives decide to spend $150,000
in advertising next month. To determine the estimate of monthly revenue, let in the regression
equation and calculate a corresponding value for :

This predicted value of y indicates that the anticipated revenue would be $18,646,700, given the advertising
spend of $150,000.

Notice that from past data, there may have been a month where the company actually did spend $150,000 on
advertising, and thus the company may have an actual result for the monthly revenue. This actual, or
observed, amount can be compared to the prediction from the linear regression model to calculate a residual.

A residual is the difference between an observed y-value and the predicted y-value obtained from the linear
regression equation. As an example, assume that in a previous month, the actual monthly revenue for an
advertising spend of $150,000 was $19,200,000, and thus . The residual for this data point can be
calculated as follows:

Notice that residuals can be positive, negative, or zero. If the observed y-value exactly matches the predicted
y-value, then the residual will be zero. If the observed y-value is greater than the predicted y-value, then the
residual will be a positive value. If the observed y-value is less than the predicted y-value, then the residual will
be a negative value.

When formulating the linear regression line of best fit to the points on the scatter plot, the mathematical
426 14 • Regression Analysis in Finance

analysis generates a linear equation where the sum of the squared residuals is minimized. This analysis is
referred to as the method of least squares. The result is that the analysis generates a linear equation that is
the “best fit” to the points on the scatter plot, in the sense that the line minimizes the differences between the
predicted values and observed values for y.

THINK IT THROUGH

Calculating a Residual
Suppose that the chief financial officer of a corporation has created a linear model for the relationship
between the company stock and interest rates. When interest rates are at 5%, the company stock has a
value of $94. Using the linear model, when interest rates are at 5%, the model predicts the value of the
company stock to be $99. Calculate the residual for this data point.

Solution:

A residual is the difference between an observed y-value and the predicted y-value obtained from the linear
regression equation

The goal in the regression analysis is to determine the coefficients a and b in the following regression
equation:

Once the (x, y) has been collected, the slope (b) and y-intercept (a) can be calculated using the following
formulas:

where n refers to the number of data pairs and indicates sum of the x-values.

Notice that the formula for the y-intercept requires the use of the slope result (b), and thus the slope should
be calculated first and the y-intercept should be calculated second.

When making predictions for y, it is always important to plot a scatter diagram first. If the scatter plot indicates
that there is a linear relationship between the variables, then it is reasonable to use a best-fit line to make
predictions for y, given x within the domain of x-values in the sample data, but not necessarily for x-values
outside that domain.

Note: Computer spreadsheets, statistical software, and many calculators can quickly calculate the best-fit line
and create the graphs. The calculations tend to be tedious if done by hand.

Assumptions for Linear Regression

Testing the significance of the correlation coefficient requires that certain assumptions about the data are
satisfied. The premise of this test is that the data are a sample of observed points taken from a larger
population. We have not examined the entire population because it is not possible or feasible to do so. We are
examining the sample to draw a conclusion about whether the linear relationship that we see between x and y
in the sample data provides strong enough evidence that we can conclude that there is a linear relationship

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 14.3 • Best-Fit Linear Model 427

between x and y in the population.

The regression line equation that we calculate from the sample data gives the best-fit line for our particular
sample. We want to use this best-fit line for the sample as an estimate of the best-fit line for the population
(Figure 14.5). Examining the scatter plot and testing the significance of the correlation coefficient helps us
determine if it is appropriate to do this.

These are the assumptions underlying the test of significance:

1. There is a linear relationship in the population that models the average value of y for varying values of x.
In other words, the expected value of y for each particular value lies on a straight line in the population.
(We do not know the equation for the line for the population. Our regression line from the sample is our
best estimate of this line in the population.)
2. The y-values for any particular x-value are normally distributed about the line. This implies that there are
more y-values scattered closer to the line than are scattered farther away. Assumption (1) implies that
these normal distributions are centered on the line: the means of these normal distributions of y-values lie
on the line.
3. The standard deviations of the population y-values about the line are equal for each value of x. In other
words, each of these normal distributions of y-values has the same shape and spread about the line.
4. The residual errors are mutually independent (no pattern).
5. The data are produced from a well-designed, random sample or randomized experiment.

Figure 14.5 Best-Fit Line The y-values for each x-value are normally distributed about the line with the same standard deviation. For
each x-value, the mean of the y-values lies on the regression line. More y-values lie near the line than are scattered further away
from the line.

14.3 Best-Fit Linear Model

Learning Outcomes
By the end of this section, you will be able to:
• Calculate the slope and y-intercept for a linear regression model using technology.
• Interpret and apply the slope and y-intercepts.

Calculate the Slope and y-Intercept for a Linear Regression Model Using Technology
Once a correlation has been deemed as significant, a best-fit linear regression model is developed. The goal
in the regression analysis is to determine the coefficients a and b in the following regression equation:

The slope (b) and y-intercept (a) can be calculated using the following formulas:
428 14 • Regression Analysis in Finance

These formulas can be quite cumbersome, especially for a significant number of data pairs, and thus
technology is often used (such as Excel, a calculator, R statistical software, etc.).

Using Excel: To calculate the slope and y-intercept of the linear model, start by entering the (x, y) data in two
columns in Excel. Then the Excel commands =SLOPE and =INTERCEPT can be used to calculate the slope and
intercept, respectively.

The following data set will be used as an example: the monthly amount spent on advertising and the monthly
revenue for a Fortune 500 company for 12 months (data is shown in Table 14.4).

Advertising
Month Revenue
Expenditure

Jan 49 12,210
Feb 145 17,590
Mar 57 13,215
Apr 153 19,200
May 92 14,600
Jun 83 14,100
Jul 117 17,100
Aug 142 18,400
Sep 69 14,100
Oct 106 15,500
Nov 109 16,300
Dec 121 17,020

Table 14.4 Revenue versus

Advertising for Fortune 500
Company ($000s)

To calculate the slope of the regression model, use the Excel command

=SLOPE(y-data range, x-data range)

It’s important to note that this Excel command expects that the y-data range is entered first and the x-data
range is entered second. Since revenue depends on amount spent on advertising, revenue is considered the
y-variable and amount spent on advertising is considered the x-variable. Notice the y-data is contained in cells
C2 through C13 and the x-data is contained in cells B2 through B13. Thus the Excel command for slope would
be entered as

=SLOPE(C2:C13, B2:B13)

In the same way, the Excel command to calculate the y-intercept of the regression model is

=INTERCEPT(y-data range, x-data range)

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 14.3 • Best-Fit Linear Model 429

For the data set shown in the above table, the Excel command would be

=INTERCEPT(C2:C13, B2:B13)

The results are shown in Figure 14.6, where

Figure 14.6 Revenue versus Advertising for Fortune 500 Company ($000s) Showing Slope and y-Intercept Calculation in Excel

Based on this, the regression equation can be written as

where x represents the amount spent on advertising (in thousands of dollars) and y represents the amount of
revenue (in thousands of dollars).

Using a Financial Calculator

The financial calculator provides the slope and y-intercept for the linear regression model once the (x, y) data
is inputted into the calculator.

Follow the steps in Table 14.5 for calculating the slope and y-intercept for the data set of amounts spent on
advertising and revenue shown previously.

Step Description Enter Display

1 Enter [DATA] entry mode 2ND [DATA] X01 0.00

2 Clear any previous data 2ND [CLR WORK] X01 0.00

3 Enter first x-value of 49 49 ENTER X01 = 49.00

4 Move to next data entry ↓ Y01 = 1.00

Table 14.5 Calculator Steps for the Slope and y-Intercept

430 14 • Regression Analysis in Finance

Step Description Enter Display

5 Enter first y-value of 12210 12210 ENTER Y01 = 12,210.00
6 Move to next data entry ↓ X02 0.00
7 Enter second x-value of 145 145 ENTER X02 = 145.00
8 Move to next data entry ↓ Y02 = 1.00
9 Enter second y-value of 17590 17590ENTER
ENTER Y02 = 17,590.00
10 Move to next data entry ↓ X03 0.00
11 Continue to enter remaining data values
12 Enter [STAT] mode 2ND [STAT]

13 Press [SET] until LIN appears 2ND [SET] LIN

14 Move to 1st statistical result ↓ 12.00
15 Move to next statistical result ↓ 103.58
16 Continue to scroll down until the value of a is displayed ↓ 9,376.70
17 Continue to scroll down until the value of b is displayed ↓ 61.80

Table 14.5 Calculator Steps for the Slope and y-Intercept

From the statistical results shown on the calculator display, the slope b is 61.8 and the y-intercept a is 9,367.7.

Based on this, the regression equation can be written as

Interpret and Apply the Slope and y-Intercept

The slope of the line, b, describes how changes in the variables are related. It is important to interpret the
slope of the line in the context of the situation represented by the data. You should be able to write a sentence
interpreting the slope in plain English.

Interpretation of the Slope

The slope of the best-fit line tells us how the dependent variable (y) changes for every one unit increase in the
independent (x) variable, on average.

In the previous example, the linear regression model for the monthly amount spent on advertising and the
monthly revenue for a Fortune 500 company for 12 months was generated as follows:

Since the slope was determined to be 61.8, the company can interpret this to mean that for every $1,000
dollars spent on advertising, on average, this will result in an increase in revenues of $61,800.

The intercept of the regression equation is the corresponding y-value when.

Interpretation of the Intercept

The intercept of the best-fit line tells us the expected mean value of y in the case where the x-variable is equal
to zero.

However, in many scenarios it may not make sense to have the x-variable equal zero, and in these cases, the

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 14.4 • Regression Applications in Finance 431

intercept does not have any meaning in the context of the problem. In other examples, the x-value of zero is
outside the range of the x-data that was collected. In this case, we should not assign any interpretation to the
y-intercept.

In the previous example, the range of data collected for the x-variable was from $49 to $153 spent per month
on advertising. Since this interval does not include an x-value of zero, we would not provide any interpretation
for the intercept.

14.4 Regression Applications in Finance

Learning Outcomes
By the end of this section, you will be able to:
• Calculate the regression model for a single independent variable as applied to financial forecasting.
• Extract measures of slope and intercept from regression analysis in financial applications.

Regression Model for a Single Independent Variable

Regression analysis is used extensively in finance-related applications. Many typical applications involve
determining if there is a correlation between various stock market indices such as the S&P 500, the Dow Jones
Industrial Average (DJIA), and the Russell 2000 index.

As an example, suppose we would like to determine if there is a correlation between the Russell 2000 index
and the DJIA. Does the value of the Russell 2000 index depend on the value of the DJIA? Is it possible to predict
the value of the Russell 2000 index for a certain value of the DJIA? We can explore these questions using
regression analysis.

Table 14.6 shows a summary of monthly closing prices of the DJIA and the Russell 2000 for a 12-month time
period. We consider the DJIA to be the independent variable and the Russell 2000 index to be the dependent
variable.

Monthly Close DJIA Russell 2000

1-Apr-21 34,200.67 2,262.67
1-Mar-21 32,981.55 2,220.52
1-Feb-21 30,932.37 2,201.05
1-Jan-21 29,982.62 2,073.64
1-Dec-20 30,606.48 1,974.86
1-Nov-20 29,638.64 1,819.82
1-Oct-20 26,501.60 1,538.48
1-Sep-20 27,781.70 1,507.69
1-Aug-20 28,430.05 1,561.88
1-Jul-20 26,428.32 1,480.43
1-Jun-20 25,812.88 1,441.37
1-May-20 25,383.11 1,394.04

Table 14.6 Monthly Closing Prices of the DJIA

and the Russell 2000 for a 12-Month Time
Period (source: Yahoo! Finance)

The first step is to create a scatter plot to determine if the data points appear to follow a linear pattern. The
scatter plot is shown in Figure 14.7. The scatter plot clearly shows a linear pattern; the next step is to calculate
432 14 • Regression Analysis in Finance

the correlation coefficient and determine if the correlation is significant.

• Using the Excel command =CORREL, the correlation coefficient is calculated to be 0.947. This value of the
correlation coefficient is significant using the test for significance referenced earlier in Correlation
Analysis.
• Using the Excel commands =SLOPE and =INTERCEPT, the value of the slope and y-intercept are calculated
as 0.11 and , respectively, when rounded to two decimal places.

The Excel output is shown below:

=CORREL(C3:C14,B3:B14): 0.947

=SLOPE(C3:C14,B3:B14): 0.113

=INTERCEPT(C3:C14,B3:B14): -1,496.340

Figure 14.7 Scatter Plot for Monthly Closing Prices of the DJIA versus the Russell 2000 for a 12-Month Time Period (data
source: Yahoo! Finance)

Based on these results, the corresponding linear regression model is

Assume the DJIA has reached a value of 32,000. Predict the corresponding value of the Russell 2000 index. To
determine this, substitute the value of the independent variable, (this is the given value of the
DJIA), and calculate the corresponding value for the dependent variable, which is the predicted value for the
Russell 2000 index:

Thus the predicted value for the Russell 2000 index is approximately 2,024 when the DJIA reached a value of
32,000.

Measures of Slope and Intercept from Regression Analysis

An important application of regression analysis is to determine the systematic risk for a particular stock, which
is referred to as beta. A stock’s beta is a measure of the volatility of the stock compared to a benchmark such
as the S&P 500 index. If a stock has more volatility compared to the benchmark, then the stock will have a beta
greater than 1.0. If a stock has less volatility compared to the benchmark, then the stock will have a beta less

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 14.4 • Regression Applications in Finance 433

than 1.0.

Beta can be determined as the slope of the regression line when the stock returns are plotted versus the
returns for the benchmark, such as the S&P 500. As an example, consider the calculation for beta of Nike stock
based on monthly returns of Nike stock versus monthly returns for the S&P 500 over the time period from May
2020 to March 2021. The monthly return data is shown in Table 14.7.

S&P Nike Nike

Date S&P 500 Monthly Stock Monthly

Return (%) Price ($) Return (%)

4/1/2020 2,912.43 N/A 87.18 N/A

5/1/2020 3,044.31 0.05 98.58 0.13
6/1/2020 3,100.29 0.02 98.05 -0.01
7/1/2020 3,271.12 0.06 97.61 0.00
8/1/2020 3,500.31 0.07 111.89 0.15
9/1/2020 3,363.00 -0.04 125.54 0.12
10/1/2020 3,269.96 -0.03 120.08 -0.04
11/1/2020 3,621.63 0.11 134.70 0.12
12/1/2020 3,756.07 0.04 141.47 0.05
1/1/2021 3,714.24 -0.01 133.59 -0.06
2/1/2021 3,811.15 0.03 134.78 0.01
3/1/2021 3,943.34 0.03 140.45 0.04
3/12/2021 3,943.34 0.00 140.45 0.00

Table 14.7 Monthly Returns of Nike Stock versus Monthly

Returns for the S&P 500 (source: Yahoo! Finance)

The scatter plot that graphs S&P monthly return versus Nike monthly return is shown in Figure 14.8.
434 14 • Regression Analysis in Finance

Figure 14.8 Scatter Plot of Monthly Returns of Nike Stock versus Monthly Returns for the S&P 500 ($) (data source: Yahoo!
Finance)

The slope of the regression line is 0.83, obtained by using the =SLOPE command in Excel.

=SLOPE (E4:E15,C4:C15)

=0.830681658

This indicates the value of beta for Nike stock is 0.83, which indicates that Nike stock had lower volatility versus
the S&P 500 for the time period of interest.

14.5 Predictions and Prediction Intervals

Learning Outcomes
By the end of this section, you will be able to:
• Calculate predictions for the dependent variable using the regression model.
• Generate prediction intervals based on a prediction for the dependent variable.

Predicting the Dependent Variable Using the Regression Model

A key aspect of generating the linear regression model is to use the model for predictions, provided the
correlation is significant. To generate predictions or forecasts using the linear regression model, substitute the
value of the independent variable (x) in the regression equation and solve the equation for the dependent
variable (y).

In a previous example, the linear regression equation was generated to relate the amount of monthly revenue
for a Fortune 500 company to the amount of monthly advertising spend. From the previous example, it was
determined that the regression equation can be written as

where x represents the amount spent on advertising (in thousands of dollars) and y represents the amount of

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 14.5 • Predictions and Prediction Intervals 435

revenue (in thousands of dollars).

Let’s assume the Fortune 500 company would like to predict the monthly revenue for a month where it plans
to spend $80,000 for advertising. To determine the estimate of monthly revenue, let in the regression
equation and calculate a corresponding value for ŷ:

This predicted value of y indicates that the forecasted revenue would be $14,320,700, assuming an advertising
spend of $80,000.

• Excel can provide this forecasted value directly using the =FORECAST command.
• To use this command, enter the value of the independent variable x, followed by the cell range for the
y-data and the cell range for the x-data, as follows: =FORECAST(X_VALUE, Range of Y-DATA, Range
of X-DATA)

• Using this Excel command, the forecasted value for the revenue is $14,320.52 when the advertising spend
is $80 (in thousands of dollars) (see Figure 14.9). (Note: The discrepancy in the more precise Excel result
and the formula result is due to rounding in interim calculations.)

Figure 14.9 Revenue versus Advertising for Fortune 500 Company ($000s) Showing FORECAST Command in Excel

A word of caution when predicting values for y: it is generally recommended to only predict values for y using
values of x that are in the original range of the data collection.

As an example, assume we have developed a linear model to predict the height of male children based on
their age. We have collected data for the age range from years old to years old, and we have
confirmed that the scatter plot shows a linear trend and that the correlation is significant.

It would be erroneous to use this model to predict the height of a 25-year-old male since is outside the
range of the x-data, which was from 3 to 10 years old. The reason this is not recommended is that a linear
pattern cannot be assumed to continue beyond the x-value of 10 years old unless some data collection has
occurred at ages greater than 10 to confirm that the linear pattern is consistent for x-values beyond 10 years
436 14 • Regression Analysis in Finance

old.

Generating Prediction Intervals

One important value of an estimated regression equation is its ability to predict the effects on y of a change in
one or more values of the independent variables. The value of this is obvious. Careful policy cannot be made
without estimates of the effects that may result. Indeed, it is the desire for particular results that drive the
formation of most policy. Regression models can be, and have been, invaluable aids in forming such policies.

Remember that point estimates do not carry a particular level of probability, or level of confidence, because
points have no “width” above which there is an area to measure. There are actually two different approaches
to the issue of developing estimates of changes in the independent variable (or variables) on the dependent
variable. The first approach wishes to measure the expected mean value of y from a specific change in the
value of x.

The second approach to estimate the effect of a specific value of x on y treats the event as a single experiment:
you choose x and multiply it times the coefficient, and that provides a single estimate of y. Because this
approach acts as if there were a single experiment, the variance that exists in the parameter estimate is larger
than the variance associated with the expected value approach.

The conclusion is that we have two different ways to predict the effect of values of the independent variable(s)
on the dependent variable, and thus we have two different intervals. Both are correct answers to the question
being asked, but there are two different questions. To avoid confusion, the first case where we are asking for
the expected value of the mean of the estimated y is called a confidence interval. The second case, where we
are asking for the estimate of the impact on the dependent variable y of a single experiment using a value of x,
is called the prediction interval.

The prediction interval for an individual y for can be calculated as

where se is the standard deviation of the error term, sx is the standard deviation of the x-variable, and is

the critical value of the t-distribution at the confidence level.

Tabulated values of the t-distribution are available in online references such as the Engineering Statistics
Handbook (https://openstax.org/r/engineering_handbook). The mathematical computations for prediction
intervals are complex, and usually the calculations are performed using software. The formula above can be
implemented in Excel to create a 95% prediction interval for the forecast for monthly revenue when
is spent on monthly advertising. Figure 14.10 shows the detailed calculations in Excel to arrive at a
95% prediction interval of (13,270.95, 15,370.09) for the monthly revenue. (The commands refer to the Excel
data table shown in Figure 14.9.)

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 14.5 • Predictions and Prediction Intervals 437

Figure 14.10 Calculations for 95% Prediction Interval for Monthly Revenue

This prediction interval can be interpreted as follows: there is 95% confidence that when the amount spent on
monthly advertising is $80,000, the corresponding monthly revenue will be between $13,270.95 and
$15,370.09.

Various computer regression software packages provide programs within the regression functions to provide
answers to inquiries of estimated predicted values of y given various values chosen for the x-variable(s). For
example, the statistical program R provides these prediction intervals directly. It is important to know just
which interval is being tested in the computer package because the difference in the size of the standard
deviations will change the size of the interval estimated. This is shown in Figure 14.11.

Figure 14.11 Prediction and Confidence Intervals for Regression Equation at 95% Confidence Level

Figure 14.11 shows visually the difference the standard deviation makes in the size of the estimated intervals.
The confidence interval, measuring the expected value of the dependent variable, is smaller than the
prediction interval for the same level of confidence. The expected value method assumes that the experiment
is conducted multiple times rather than just once, as in the other method. The logic here is similar, although
not identical, to that discussed when developing the relationship between the sample size and the confidence
interval using the central limit theorem. There, as the number of experiments increased, the distribution
438 14 • Regression Analysis in Finance

narrowed, and the confidence interval became tighter around the expected value of the mean.

It is also important to note that the intervals around a point estimate are highly dependent upon the range of
data used to estimate the equation, regardless of which approach is being used for prediction. Remember that
all regression equations go through the point of means—that is, the mean value of y and the mean values of
all independent variables in the equation. As the value of x gets further and further from the (x, y) point
corresponding to the mean value of x and the mean value of y, the width of the estimated interval around the
point estimate increases. Choosing values of x beyond the range of the data used to estimate the equation
poses an even greater danger of creating estimates with little use, very large intervals, and risk of error. Figure
14.12 shows this relationship.

Figure 14.12 Confidence Interval for an Individual Value of x, , at 95% Confidence Level

Figure 14.12 demonstrates the concern for the quality of the estimated interval, whether it is a prediction
interval or a confidence interval. As the value chosen to predict y, in the graph, is further from the central
weight of the data, , we see the interval expand in width even while holding constant the level of confidence.
This shows that the precision of any estimate will diminish as one tries to predict beyond the largest weight of
the data and most certainly will degrade rapidly for predictions beyond the range of the data. Unfortunately,
this is just where most predictions are desired. They can be made, but the width of the confidence interval may
be so large as to render the prediction useless.

14.6 Use of R Statistical Analysis Tool for Regression Analysis

Learning Outcomes
By the end of this section, you will be able to:
• Generate correlation coefficients using the R statistical tool.
• Generate linear regression models using the R statistical tool.

Generate Correlation Coefficients Using the R Statistical Tool

R is an open-source statistical analysis tool that is widely used in the finance industry. R is available as a free
program and provides an integrated suite of functions for data analysis, graphing, and statistical
programming. R provides many functions and capabilities for regression analysis.

Recall that most calculations in R are handled via functions.

The typical method for using functions in statistical applications is to first create a vector of data values. There
are several ways to create vectors in R. For example, the c function is often used to combine values into a
vector. For example, this R command will generate a vector called salaries, containing the data values 40,000,
50,000, 75,000, and 92,000:

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 14.6 • Use of R Statistical Analysis Tool for Regression Analysis 439

> salaries <- c(40000, 50000, 75000, 92000)

To calculate the correlation coefficient r, we use the R command called cor.

As an example, consider the data set in Table 14.8, which tracks the return on the S&P 500 versus return on
Coca-Cola stock for a seven-month time period.

S&P 500 Coca-Cola

Month Monthly Monthly

Return (%) Return (%)

Jan 8 6
Feb 1 0
Mar 0 -2
Apr 2 1
May -3 -1
Jun 7 8
Jul 4 2

Table 14.8 Monthly Returns of Coca-

Cola Stock versus Monthly Returns
for the S&P 500

Create two vectors in R, one vector for the S&P 500 returns and a second vector for Coca-Cola returns:

> SP500 <- c(8,1,0,2,-3,7,4)

> CocaCola <- c(6,0,-2,1,-1,8,2)

The R command called cor returns the correlation coefficient for the x-data vector and y-data vector:

> cor(SP500, CocaCola)

Generate Linear Regression Models Using the R Statistical Tool

To create a linear model in R, assuming the correlation is significant, the command lm (for linear model) will
provide the slope and y-intercept for the linear regression equation.

The format of the R command is

lm(dependent_variable_vector ~ independent_variable_vector)

Notice the use of the tilde symbol as the separator between the dependent variable vector and the
independent variable vector.

We use the returns on Coca-Cola stock as the dependent variable and the returns on the S&P 500 as the
independent variable, and thus the R command would be
440 14 • Regression Analysis in Finance

> lm(CocaCola ~ SP500)

Call:

lm(formula = CocaCola ~ SP500)

Coefficients:

(Intercept) SP500

-0.3453 0.8641

The R output provides the value of the y-intercept as and the value of the slope as 0.8641. Based on
this, the linear model would be

where x represents the value of S&P 500 return and y represents the value of Coca-Cola stock return.

The results can also be saved as a formula and called “model” using the following R command. To obtain more
detailed results for the linear regression, the summary command can be used, as follows:

> model <- lm(CocaCola ~ SP500)

> summary(model)

Call:

lm(formula = CocaCola ~ SP500)

Residuals:

1 2 3 4 5 6 7

-0.5672 -0.5188 -1.6547 -0.3828 1.9375 2.2969 -1.1109

Coefficients:

Estimate Std. Error t value Pr(>|t|)

(Intercept) -0.3453 0.7836 -0.441 0.67783

SP500 0.8641 0.1734 4.984 0.00416 **

---

Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1

Residual standard error: 1.658 on 5 degrees of freedom

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 14.6 • Use of R Statistical Analysis Tool for Regression Analysis 441

Multiple R-squared: 0.8325, Adjusted R-squared: 0.7989

F-statistic: 24.84 on 1 and 5 DF, p-value: 0.004161

In this output, the y-intercept and slope is given, as well as the residuals for each x-value. The output includes
additional statistical details regarding the regression analysis.

Predicted values and prediction intervals can also be generated within R.

First, we can create a structure in R called a data frame to hold the values of the independent variable for
which we want to generate a prediction. For example, we would like to generate the predicted return for Coca-
Cola stock, given that the return for the S&P 500 is 6.

We use the R command called predict.

To generate a prediction for the linear regression equation called model, using the data frame where the value
of the S&P 500 is 6, the R commands will be

> a <- data.frame(SP500=6)

> predict(model, a)

4.839062

The output from the predict command indicates that the predicted return for Coca-Cola stock will be 4.8%
when the return for the S&P 500 is 6%.

We can extend this analysis to generate a 95% prediction interval for this result by using the following R
command, which adds an option to the predict command to generate a prediction interval:

> predict(model,a, interval="predict")

fit lwr upr

1 4.839062 0.05417466 9.62395

Thus the 95% prediction interval for Coca-Cola return is (0.05%, 9.62%) when the return for the S&P 500 is 6%.
442 14 • Summary

Summary
14.1 Correlation Analysis
Correlation is the measure of association between two numeric variables. A correlation coefficient called r is
used to assess the strength and direction of the correlation. The value of r is always between and . The
size of the correlation r indicates the strength of the linear relationship between the two variables. Values of r
close to or to indicate a stronger linear relationship. A positive value of r means that when x increases, y
tends to increase and when x decreases, y tends to decrease (positive correlation). A negative value of r means
that when x increases, y tends to decrease and when x decreases, y tends to increase (negative correlation).

14.2 Linear Regression Analysis

Linear regression analysis uses a straight-line fit to model the relationship between the two variables. Once a
straight-line model is developed, this model can then be used to predict the value of the dependent variable
for a specific value of the independent variable. Two parameters are calculated for the linear model, the slope
of the best-fit line and the y-intercept of the best-fit line. The method of least squares is used to generate
these parameters; this method is based on minimizing the squared differences between the predicted values
and observed values for y.

14.3 Best-Fit Linear Model

Once a correlation has been deemed significant, a linear regression model is developed. The goal in the
regression analysis is to determine the coefficients a and b in the following regression equation: .
Typically some technology, such as Excel, R statistical tool, or a calculator, is used to generate the coefficients a
and b since manual calculations are cumbersome.

14.4 Regression Applications in Finance

Regression analysis is used extensively in finance-related applications. Many typical applications involve
determining if there is a correlation between various stock market indices such as the S&P 500, the DJIA, and
the Russell 2000 index. The procedure is to first generate a scatter plot to determine if a visual trend is
observed, then calculate a correlation coefficient and check for significance. If the correlation coefficient is
significant, a linear model can then be generated and used for predictions.

14.5 Predictions and Prediction Intervals

A key aspect of generating the linear regression model is to then use the model for predictions, provided that
the correlation is significant. To generate predictions or forecasts using the linear regression model, substitute
the value of the independent variable (x) in the regression equation and solve the equation for the dependent
variable (y). When making predictions using the linear model, it is generally recommended to only predict
values for y using values of x that are in the original range of the data collection.

14.6 Use of R Statistical Analysis Tool for Regression Analysis

R is an open-source statistical analysis tool that is widely used in the finance industry and can be found online
(https://openstax.org/r/finance_industry). R provides an integrated suite of functions for data analysis,
graphing, and correlation and regression analysis. R is increasingly being used as a data analysis and statistical
tool because it is an open-source language and additional features are constantly being added by the user
community. The tool can be used on many different computing platforms.

Key Terms
best-fit linear regression model an equation of the form that provides the best-fit straight line
to the (x, y) data points
beta the measure of the volatility of a stock as compared to a benchmark such as the S&P 500 index

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 14 • Multiple Choice 443

correlation the measure of association between two numeric variables

correlation coefficient a measure of the strength and direction of the linear relationship between two
variables
linear correlation a measure of the association between two variables that exhibit an approximate straight-
line fit when plotted on a scatter plot
method of least squares a mathematical method to generate a linear equation that is the “best fit” to the
points on the scatter plot in the sense that the line minimizes the differences between the predicted values
and observed values for y
prediction a forecast for the dependent variable based on a specific value of the independent variable
generated using the linear model
residual the difference between an observed y-value and the predicted y-value obtained from the linear
regression equation
scatter plot (scatter diagram) graphical display that shows values of the independent variable plotted on
the x-axis and values of the dependent variable plotted on the y-axis

Multiple Choice
1. Two correlation coefficients are compared: Correlation Coefficient A is 0.83. Correlation Coefficient B is
. Which correlation coefficient represents the stronger linear relationship?
a. Correlation Coefficient A
b. Correlation Coefficient B
c. equal strength
d. not enough information to determine

2. A data set containing 10 pairs of (x, y) data points is analyzed, and the correlation coefficient is calculated
to be 0.58. Does this value of indicate a significant or nonsignificant correlation?
a. significant
b. nonsignificant
c. neither significant nor nonsignificant
d. not enough information to determine

3. A linear regression model is developed, and for , the corresponding predicted y-value is 22.7. The
actual observed value for is . Is the residual for this data point positive, negative, or zero?
a. positive
b. negative
c. zero
d. not enough information to determine

4. A linear model is developed for the relationship between salary of finance professionals and years of
experience. The data was collected based on years of experience ranging from 1 to 15. Assuming the
correlation is significant, should the linear model be used to predict the salary for a person with 25 years
of experience?
a. It is acceptable to predict the salary for a person with 25 years of experience.
b. A linear model cannot be created for these two variables.
c. It is not recommended to predict the salary for a person with 25 years of experience.
d. There is not enough information to determine the answer.

5. Which of the following is the best interpretation for the slope of the linear regression model?
a. The slope is the expected mean value of y when the x-variable is equal to zero.
b. The slope indicates the change in y for every unit increase in x.
444 14 • Review Questions

c. The slope indicates the strength of the linear relationship between x and y.
d. The slope indicates the direction of the linear relationship between x and y.

6. A linear model is developed for the relationship between the annual salary of finance professionals and
years of experience, and the following is the linear model . Which is the correct
interpretation of this linear model?
a.
b.
c.
d.

7. Which of the following is the correct sequence of steps needed to create a linear regression model?
a. create scatter plot, calculate correlation coefficient, check for significance, create linear model
b. create linear model, calculate correlation coefficient, check for significance, create scatter plot
c. check for significance, create linear model, calculate correlation coefficient, create scatter plot
d. create scatter plot, check for significance, create linear model, calculate correlation coefficient

8. A linear model is developed for the relationship between the annual salary of finance professionals and
years of experience, and the linear model is: The correlation is determined to be
significant. Predict the salary for a finance professional with 7 years of experience.
a. $55,010
b. $60,000
c. $62,000
d. $125,000

9. As predictions are made for x-values that are further and further away from the mean of x, which is true
about the prediction intervals for these x-values?
a. The prediction intervals will become smaller.
b. The prediction intervals will become larger.
c. The prediction intervals will remain the same.
d. There is not enough information to determine the answer.

10. Which of the following is the R command to calculate the correlation coefficient r?
a. correl
b. cor
c. slope
d. lm

11. Which of the following is the R command to calculate the slope and y-intercept for a linear regression
model?
a. cor
b. slope
c. lm
d. intercept

Review Questions
1. A correlation coefficient is calculated as . Provide an interpretation for this correlation coefficient.

2. Explain what a residual is and how this relates to the best-fit regression model.

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 14 • Problems 445

3. Explain how to interpret the slope of the best-fit line.

4. Explain how to generate a prediction using a linear regression model.

5. Will the sign of the correlation coefficient always be the same as the sign of the slope of the best-fit linear
regression model?

Problems
1. A Fortune 500 company is tracking revenues versus cash flow for recent years, and the data is shown in
the table below. Consider cash flow to be the dependent variable. Create a scatter plot of the data set,
comment on the correlation between these two variables, and comment on the correlation for this data
(all dollar amounts are in thousands).
Revenues ($000s) Cash Flow ($000s)
237 82
241 86
229 77
284 94
307 93

Table 14.9

2. A Fortune 500 company is tracking revenues versus cash flow for recent years, and the data is shown in
the table below. Consider cash flow to be the dependent variable. Calculate the correlation coefficient for
this data (all dollar amounts are in thousands).
Revenues ($000s) Cash Flow ($000s)
237 82
241 86
229 77
284 94
307 93

Table 14.10

3. A chief financial officer calculates the correlation coefficient for bond prices versus interest rate as -0.71.
The data set contained nine (x, y) data points. Determine if the correlation is significant or not significant
at the 0.05 level of significance.

4. A Fortune 500 company is tracking revenues versus cash flow for recent years, and the data is shown in
the table below. Consider cash flow to be the dependent variable. Determine the best-fit linear regression
equation for this data set (all dollar amounts are in thousands).
Revenues ($000s) Cash Flow ($000s)
237 82
241 86

Table 14.11
446 14 • Problems

229 77
284 94
307 93

Table 14.11

5. A Fortune 500 company is tracking revenues versus cash flow for recent years, and the data is shown in
the table below. Consider cash flow to be the dependent variable. Assume the correlation is significant.
Predict the cash flow for company revenues of $250,000 (all dollar amounts are in thousands).
Revenues ($000s) Cash Flow ($000s)
237 82
241 86
229 77
284 94
307 93

Table 14.12

6. A Fortune 500 company is tracking revenues versus cash flow for recent years, and the data is shown in
the table below. Consider cash flow to be the dependent variable. Assume the correlation is significant.
Predict the cash flow for company revenues of $750,000 (all dollar amounts are in thousands).
Revenues ($000s) Cash Flow ($000s)
237 82
241 86
229 77
284 94
307 93

Table 14.13

7. A Fortune 500 company is tracking revenues versus cash flow for recent years, and the data is shown in
the table below. Consider cash flow to be the dependent variable. Calculate the residual for the revenue
value of $284,000 (all dollar amounts are in thousands):
Revenues ($000s) Cash Flow ($000s)
237 82
241 86
229 77
284 94
307 93

Table 14.14

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 14 • Video Activity 447

Video Activity
Simple Linear Regression

Click to view content (https://openstax.org/r/linear_regression)

1. Based on the scatter plot shown, will the correlation coefficient be a positive value or negative value?
Would you estimate that the correlation is significant for the relationship between radio ads and revenue?

2. For the linear regression model for ads versus revenue, the slope is shown as 78.075. How would this slope
be interpreted (that is, provide a verbal description for the meaning of the slope of 78.075)?

How to Calculate Correlation for Stocks, Bonds, and Funds

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3. Based on the presentation shown in the video, is the FTSE 100 index correlated with the value of sterling?
Or are the two measures uncorrelated? What data leads to your conclusion?

4. Based on the presentation in the video, is there a correlation between stock funds and bond funds? Why is
this information important to an investor trying to design a portfolio?
448 14 • Video Activity

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 15 • Why It Matters 449

15
How to Think about Investing

Figure 15.1 Investing can often provide great returns, but it can also be a risk. (credit: modification of work “E-ticker” by klip game/
Wikimedia Commons, Public Domain)

Chapter Outline
15.1 Risk and Return to an Individual Asset
15.2 Risk and Return to Multiple Assets
15.3 The Capital Asset Pricing Model (CAPM)
15.4 Applications in Performance Measurement
15.5 Using Excel to Make Investment Decisions

Why It Matters
Having finished her college degree and embarked on her career, Maria is now contemplating her financial
future. She is considering how she might invest some of her hard-earned money. As a short-term goal, she
wants to build an emergency fund so that she could cover her expenses for six months if she became ill or
injured and had to take time off of work. She would also like to save money for a down payment on a home
and to purchase new furniture. Although she is not yet 30 years old, Maria also knows that it is prudent to
begin saving for retirement.

What should she do with her savings? Maria has some friends who have told her how successful they have
been investing in stocks. Bart bragged about doubling his money in just over a year when he purchased
Facebook stock, and Tiffany quickly tripled her money when she purchased shares in Netflix. But Maria also
knows that her uncle lost a significant amount of money when his Boeing stock dropped from over $300 per
share to under $150 within a couple of months at the beginning of 2020. Just how risky would it be to invest in
stocks? What type of return might Maria expect? Are there strategies she could follow that would allow her to
avoid her uncle’s fate?
450 15 • How to Think about Investing

15.1 Risk and Return to an Individual Asset

Learning Outcomes
By the end of this section, you will be able to:
• Compute the realized return from an individual investment.
• Compute the average return and volatility of returns from historical data.
• Describe firm-specific risk.

Measuring Historical Returns

Risk and return are often referred to as the two Rs of finance. Investors are interested in both risk and return
because understanding one without the other is really meaningless. In terms of investment, the concept of
return is fairly straightforward; return is the benefit, or profit, the investor expects from an expenditure. It is
the reward for investing—the reason an investment is made in the first place. However, no investment is a
sure thing. The return may not be what the investor was expecting. This uncertainty about what the return will
be is referred to as risk.

We begin by looking at how to measure both risk and return when considering an individual asset, such as one
stock. If your grandparents bought 100 shares of Apple, Inc. stock for you when you were born, you are
interested in knowing how well that investment has done. You may even want to compare how that
investment has fared to how an investment in a different stock, perhaps Disney, would have done. You are
interested in measuring the historical return.

Individual Investment Realized Return

The realized return of an investment is the total return that occurs over a particular time period. Suppose that
you purchased a share of Target (TGT) at the beginning of January 2020 for $128.74. At the end of the year, you
sold the stock for $176.53, which was $47.79 more than you paid for it. This increase in value is known as a
capital gain. As the owner of the stock, you also received $2.68 in dividends during 2020. The total dollar return
from your investment is calculated as

It is common to express investment returns in percentage terms rather than dollar terms. This allows you to
answer the question “How much do I receive for each dollar invested?” so that you can compare investments
of different sizes. The total percent return from your investment is

The dividend yield is calculated by dividing the dividends you received by the initial stock price. This
calculation says that for each dollar invested in TGT in 2020, you received $0.0208 in dividends. The capital
gain yield is the change in the stock price divided by the initial stock price. This calculation says that for each
dollar invested in TGT in 2020, you received $0.3712 in capital gains. Your total percent return of 39.20% means
that you made $0.392 for every dollar invested when your gains from both dividends and stock price
appreciation are totaled together.

THINK IT THROUGH

Calculating Return
You purchased 10 shares of 3M (MMM) stock in January 2020 for $175 per share, received dividends of $5.91

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 15.1 • Risk and Return to an Individual Asset 451

per share, and sold the stock at the end of the year for $169.72 per share. Calculate your total dollar return,
your dividend yield, your capital gain yield, and your total percent yield.

Solution:

Because you purchased 10 shares, you received in dividend income. You spent
to purchase the stock, and you sold it for Your total
dollar return is

Your dividend yield is , or 3.38%, and your capital gain yield is

or 3.02%. Your total percent return is

Notice that you sold MMM for a price lower than what you paid for it at the beginning of the year. Your
capital gain is negative, or what is often referred to as a capital loss. Although the price fell, you still had a
positive total dollar return because of the dividend income.

Of course, investors seldom purchase a stock and then sell it exactly one year later. Assume that you
purchased shares of Facebook (FB) on June 1, 2020, for $228.50 per share and sold the shares three months
later for $261.90. You received no dividends. In this case, your holding period percentage return is calculated
as

This 14.62% is your return for a three-month holding period. To compare them to other investment
opportunities, you need to express returns on a per-year, or annualized, basis. The holding period returned is
converted to an effective annual rate (EAR) using the formula

where m is the number of holding periods in a year.

There are four three-month periods in a year. So, the EAR for this investment is

What happens if you own a stock for more than one year? Your holding period return would have occurred
over a period longer than a year, but the process to calculate the EAR is the same. Suppose you purchased
shares of FB in May 2015, when it was selling for $79.30 per share. You held the stock until May 2020, when you
sold it for $224.59. Your holding period percentage return would be . You more
than tripled your money, but it took you five years to do so. Your EAR, which will be smaller than this five-year
holding period return rate, is calculated as

Average Annual Returns

Suppose that you purchased shares of Delta Airlines (DAL) at the beginning of 2011 for $11.19 and held the
stock for 10 years before selling it for $40.21. You made on your investment over
a 10-year period. This is a 259.34% holding period return. The EAR for this investment is
452 15 • How to Think about Investing

To calculate the EAR using the above formula, the holding period return must first be calculated. The holding
period return represents the percentage return earned over the entire time the investment is held. Then the
holding period return is converted to an annual percentage rate using the formula.

You can also use the basic time value of money formula to calculate the EAR on an investment. In time value of
money language, the initial price paid for the investment, $11.19, is the present value. The price the stock is
sold for, $40.21, is the future value. It takes 10 years for the $11.19 to grow to $40.21. Using the time value of
money will result in a calculation of

The EAR formula and the time value of money both result in a 13.65% annual return. Mathematically, the two
formulas are the same; one is simply an algebraic rearrangement of the other.

If you earned 13.65% each year, compounded for 10 years, you would have converted your $11.19 per share
investment to $40.21 per share. Of course, DAL stock did not increase by exactly 13.65% each year. The returns
for DAL for each year are shown in Table 15.1. Some years, the return was much higher than 13.65%. In 2013,
the return was almost 133%! Other years, the return was much lower than 13.65%; in fact, in the return was
negative in four of the years.

Year Return Value of Investment ($)

Initial investment of 11.19
2011 −0.3579 7.19
2012 0.4672 10.54
2013 1.3261 24.52
2014 0.8053 44.27
2015 0.0405 46.06
2016 −0.0135 45.44
2017 0.1623 52.81
2018 −0.0866 48.24
2019 0.2038 58.07
2020 −0.3077 40.20

Table 15.1 Yearly Returns for DAL, 2011–2020:

Value of Initial Investment at Each Year End

Although an investment in DAL of $11.19 at the beginning of 2011 grew to $40.20 by the end of 2020, this
growth was not consistent each year. The amount that the stock was worth at the end of each year is also
shown in Table 15.1. During 2011, the return for DAL was −35.79%, resulting in the value of the investment
falling to . The following year, 2012, the return for DAL was 46.72%.
Therefore, the value of the investment was at the end of 2012. This
process continues each year that the stock is held.

The compounded annual return derived from the EAR and time value of money formulas is also known as a
geometric average return. A geometric average return is calculated using the formula

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 15.1 • Risk and Return to an Individual Asset 453

where RN is the return for each year in the time period for which the average is calculated.

The calculation of the geometric average return for DAL is shown in the right column of Table 15.2. (The slight
difference in the geometric average return of 13.64% from the 13.65% derived from the EAR and time value of
money calculations is due to rounding errors.)

Year Return 1 + Return

2011 −0.3579 0.6421
2012 0.4672 1.4672
2013 1.3261 2.3261
2014 0.8053 1.8053
2015 0.0405 1.0405
2016 −0.0135 0.9865
2017 0.1623 1.1623
2018 −0.0866 0.9134
2019 0.2038 1.2038
2020 −0.3077 0.6923
Arithmetic Avg 0.2240 3.5928 Product of (1 + Return)
Std Dev 0.5190 1.1364 Product raised to 1/N
0.1364 Geometric Average

Table 15.2 Yearly Returns for DAL, 2011–2020, with Calculation of the
Arithmetic Mean, Standard Deviation, and Geometric Mean

Looking at Table 15.2, you will notice that the geometric average return differs from the mean return. Adding
each of the annual returns and dividing the sum by 10 results in a 22.4% average annual return. This 22.4% is
called the arithmetic average return.

The geometric average return will be smaller than the arithmetic average return (unless the returns for all
years are identical). This is due to the basic arithmetic of compounding. Think of a very simple example in
which you invest $100 for two years. If you have a positive return of 50% the first year and a negative 50%
return the second year, you will have an arithmetic average return of , but you will have a
geometric average return of . With a 50% positive return the
first year, you ended the year with $150. The second year, you lost 50% of that balance and were left with only
$75.

Another important fact when studying average returns is that the order in which you earn the returns is not
important. Consider what would have occurred if the returns in the two years were reversed, so that you faced
a loss of 50% in the first year of your investment and a gain of 50% in the second year of your investment. With
a −50% return in the first year, you would have ended that year with only $50. Then, if that $50 earned a
positive 50% return the second year, you would have a $75 balance at the end of the two-year period. A
negative return of 50% followed by a positive return of 50% still results in an arithmetic average return of 0%
and a geometric average return of .
454 15 • How to Think about Investing

THINK IT THROUGH

Calculating Arithmetic and Geometric Average Return

The annual returns for CVS Health Corp. (CVS) for the 10-year period of 2011–2020 are shown in Table 15.3.

Year Returns
2011 18.94%
2012 20.28%
2013 50.38%
2014 37.12%
2015 2.90%
2016 −17.83%
2017 −5.75%
2018 −7.04%
2019 17.26%
2020 −5.14%

Table 15.3 CVS

Annual Returns,
2011–2020
(source: Yahoo!
Finance)

What was the arithmetic average return during the decade? What was the geometric average return during
the decade?

Solution:

See Table 15.4 for the arithmetic mean and geometric mean calculations.

Arithmetic Average Calculation Geometric Average Calculation

Year Return 1 + Return
2011 0.1894 1.1894
2012 0.2028 1.2028
2013 0.5038 1.5038
2014 0.3712 1.3712
2015 0.0290 1.0290
2016 −0.1783 0.8217
2017 −0.0575 0.9425
2018 −0.0704 0.9296
2019 0.1726 1.1726
2020 −0.0514 0.9486

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 15.1 • Risk and Return to an Individual Asset 455

Arithmetic Average Calculation Geometric Average Calculation

Sum of Returns 1.1112 2.4309 Product of (1 + Return)
Sum Divided by 10 0.1111 1.0929 Raise Product to 1/10
0.0929 Subtract 1
Arithmetic Average 11.11%
9.29% Geometric Average

Table 15.4 Yearly Returns for CVS, 2011–2020

The arithmetic average return for CVS was 11.11%, and the geometric average return was 9.29%.

Both the arithmetic average return and the geometric average return are “correct” calculations. They simply
answer different questions. The geometric average tells you what you actually earned per year on average,
compounded annually. It is useful for calculating how much a particular investment grows over a period of
time. The arithmetic average tells you what you earned in a typical year. When we are looking at the historical
description of the distribution of returns and want to predict what to expect in a particular year, the arithmetic
average is the relevant calculation.

Measuring Risk
Although the arithmetic average return for Delta Airlines (DAL) for 2011–2020 was 22.4%, there is not a year in
which the return was exactly 22.4%. In fact, in some years, the return was much higher than the average, such
as in 2013, when it was 132.61%. In other years, the return was negative, such as 2011, when it was −35.79%.
Looking at the yearly returns in Table 15.2, the return for DAL varies widely from year to year. In finance, this
volatility of returns is considered risk.

Volatility of Returns

The most commonly used measure of volatility of returns in finance is the standard deviation of the returns.
The standard deviation of returns for DAL for the sample period 2011–2020 is 51.9%. Remember that if the
normal distribution (a bell−shaped curve) describes returns, then 68% (or about two-thirds) of the time, the
return in a particular year will be within one standard deviation above and one standard deviation below the
arithmetic average return. Given DAL’s average return of 22.4%, the actual yearly return will be somewhere
between −29.5% and 74.29% in two out of three years. A very high return of greater than 74.29% would occur
16% of the time; a very large loss of more than 29.5% would also occur 16% of the time.

As you can see, there is a wide range of what can be considered a “typical” year for DAL. Although we can
calculate an average return, the return in any particular year is likely to vary from that average. The larger the
standard deviation, the greater this range of returns is. Thus, a larger standard deviation indicates a greater
volatility of returns and, hence, more risk.

THINK IT THROUGH

Calculating the Standard Deviation of Returns

You calculated the arithmetic average return for CVS to be 11.11% for the 10-year period of 2011–2020.
Calculate the standard deviation of returns for CVS for the same period (see Table 15.5). What does this tell
you about what an investor in CVS experienced in a typical year during that decade?

Solution:
456 15 • How to Think about Investing

Year Return Return − Mean Squared Difference

2011 0.1894 0.0783 0.0061
2012 0.2028 0.0917 0.0084
2013 0.5038 0.3927 0.1542
2014 0.3712 0.2601 0.0676
2015 0.0290 −0.0821 0.0067
2016 −0.1783 −0.2894 0.0838
2017 −0.0575 −0.1686 0.0284
2018 −0.0704 −0.1815 0.0329
2019 0.1726 0.0615 0.0038
2020 −0.0514 −0.1625 0.0264
Mean 0.1111 0.4185 Sum of Squared Differences
0.0465 Sum Divided by N – 1
0.2156 Square Root

Table 15.5 Standard Deviation of CVS Returns

The standard deviation of returns for CVS during the sample period of 2011–2020 was 21.56%. With an
arithmetic average return of 11.11%, the return would lie between −10.45% and 32.67% in about two out of
three years. Even though the average return is 11.11%, a return in a particular year might be much higher
or much lower than that average. In fact, a loss of more than 10.45% would be expected about once every
six years. Also, about once every six years, a return greater than 32.67% would be expected.

Firm-Specific Risk

Investors purchase a share of stock hoping that the stock will increase in value and they will receive a positive
return. You can see, however, that even with well-established companies such as ExxonMobil and CVS, returns
are highly volatile. Investors can never perfectly predict what the return on a stock will be, or even if it will be
positive.

The yearly returns for four companies—Delta Airlines (DAL), Southwest Airlines (LUV), ExxonMobil (XOM), and
CVS Health Corp. (CVS)—are shown in Table 15.6. Each of these stocks had years in which the performance was
much better or much worse than the arithmetic average. In fact, none of the stocks appear to have a typical
return that occurs year after year.

Two-Stock Portfolio
Year DAL LUV XOM CVS
2011 −35.79% −33.93% 18.67% 18.94%
2012 46.72% 20.03% 4.70% 20.28%
2013 132.61% 85.38% 20.12% 50.38%
2014 80.53% 126.47% −6.06% 37.12%
2015 4.05% 2.43% −12.79% 2.90%

Table 15.6 Yearly Returns for DAL, LUV, XOM, and

CVS (source: Yahoo! Finance)

Access for free at openstax.org

 15.1 • Risk and Return to an Individual Asset 457

Two-Stock Portfolio
Year DAL LUV XOM CVS
2016 −1.35% 16.72% 19.88% −17.83%
2017 16.23% 32.41% −3.81% −5.75%
2018 −8.66% −28.28% −15.09% −7.04%
2019 20.38% 17.69% 7.23% 17.26%
2020 −30.77% −13.04% −36.21% −5.14%
Average 22.40% 22.59% −0.34% 11.11%
Std Dev 51.90% 49.84% 18.18% 21.56%

Table 15.6 Yearly Returns for DAL, LUV, XOM, and

CVS (source: Yahoo! Finance)

Figure 15.2 contains a graph of the returns for each of these four stocks by year. In this graph, it is easy to see
that DAL and LUV both have more volatility, or returns that vary more from year to year, than do XOM or CVS.
This higher volatility leads to DAL and LUV having higher standard deviations of returns than XOM or CVS.

Figure 15.2 Yearly Returns for DAL, LUV, XOM, and CVS (data source: Yahoo! Finance)

Standard deviation is considered a measure of the risk of owning a stock. The larger the standard deviation of
a stock’s annual returns, the further from the average that stock’s return is likely to be in any given year. In
other words, the return for the stock is highly unpredictable. Although the return for CVS varies from year to
year, it is not subject to the wide swings of the returns for DAL or LUV.

Why are stock returns so volatile? The value of the stock of a company changes as the expectations of the
future revenues and expenses of the company change. These expectations may change due to a number of
events and new information. Good news about a company will tend to result in an increase in the stock price.
For example, DAL announcing that it will be opening new routes and flying to cities it has not previously
serviced suggests that DAL will have more customers and more revenue in future years. Or if CVS announces
that it has negotiated lower rent for many of its locations, investors will expect the expenses of the company to
fall, leading to more profits. Those types of announcements will often be associated with a higher stock price.
Conversely, if the pilots and flight attendants for DAL negotiate higher salaries, the expenses for DAL will
increase, putting downward pressure on profits and the stock price.
458 15 • How to Think about Investing

LINK TO LEARNING

Peloton and Risk

An example of how news can impact the price of a stock occurred on May 5, 2021, when Peloton recalled all
of its Tread+ and Tread products after the tragic death of a child and 70 injuries associated with use of its
1
products. The previous day, Peloton stock traded for $96.70 per share. The stock price dropped
approximately 15% when the recall was announced. The closing price for a share of Peloton on May 5 was
2
$82.62. You can read the company’s statement about this recall (https://openstax.org/r/
the_companys_recall) online.

15.2 Risk and Return to Multiple Assets

Learning Outcomes
By the end of this section, you will be able to:
• Explain the benefits of diversification.
• Describe the relationship between risk and return for large portfolios.
• Compare firm-specific and systematic risk.
• Discuss how portfolio size impacts risk.

Diversification
So far, we have looked at the return and the volatility of an individual stock. Most investors, however, own
shares of stock in multiple companies. This collection of stocks is known as a portfolio. Let’s explore why it is
wise for investors to hold a portfolio of stocks rather than to pick just one favorite stock to own.

We saw that investors who owned DAL experienced an average annual return of 20.87% but also a large
standard deviation of 51.16%. Investors who used all their funds to purchase DAL stock did exceptionally well
during 2012–2014. But in 2020, those investors lost almost one-third of their money as COVID-19 caused a
sharp reduction in air travel worldwide. To protect against these extreme outcomes, investors practice what is
called diversification, or owning a variety of stocks in their portfolios.

Suppose, for example, you have saved $50,000 that you want to invest. If you purchased $50,000 of DAL stock,
you would not be diversified. Your return would depend solely on the return on DAL stock. If, instead, you used
$5,000 to purchase DAL stock and used the remaining $45,000 to purchase nine other stocks, you would be
diversifying. Your return would depend not only on DAL’s return but also on the returns of the other nine
stocks in your portfolio. Investors practice diversification to manage risk.

It is akin to the saying “Don’t put all of your eggs in one basket.” If you place all of your eggs in one basket
and that basket breaks, all of your eggs will fall and crack. If you spread your eggs out across a number of
baskets, it is unlikely that all of the baskets will break and all of your eggs will crack. One basket may break,
and you will lose the eggs in that basket, but you will still have your other eggs. The same idea holds true for
investing. If you own stock in a company that does poorly, perhaps even goes out of business, you will lose the
money you placed in that particular investment. However, with a diversified portfolio, you do not lose all your
money because your money is spread out across a number of different companies.

1 Trefis Team and Great Speculations. “Is Peloton’s Tread+ Recall an Opportunity to Buy the Stock?” Forbes, May 7, 2021.
https://www.forbes.com/sites/greatspeculations/2021/05/07/is-pelotons-tread-recall-an-opportunity-to-buy-the-stock/
2 Tomi Kilgore. “Peloton Stock Sinks to 8-Month Low after 125,000 Treadmills Recalled for ‘Risk of Injury or Death.’” MarketWatch.
May 6, 2021. https://www.marketwatch.com/story/peloton-stock-sinks-toward-9-month-low-after-125-000-treadmills-recalled-for-
risk-of-injury-or-death-11620233715

Access for free at openstax.org

 15.2 • Risk and Return to Multiple Assets 459

LINK TO LEARNING

Diversification
Fidelity Investments Inc. is a multinational financial services firm and one of the largest asset managers in
the world. In this educational video for investors (https://openstax.org/r/educational_investors), Fidelity
provides an explanation of what diversification is and how it impacts an investor’s portfolio.

Table 15.7 shows the returns of investors who placed 50% of their money in DAL and the remaining 50% in
LUV, XOM, or CVS. Notice that the standard deviation of returns is lower for the two-stock portfolios than for
DAL as an individual investment.

Two-Stock Portfolio
Year DAL DAL and LUV DAL and XOM DAL and CVS
2011 −35.79% −34.86% −8.56% −8.43%
2012 46.72% 33.38% 25.71% 33.50%
2013 132.61% 109.00% 76.36% 91.50%
2014 80.53% 103.50% 37.24% 58.83%
2015 4.05% 3.24% −4.37% 3.47%
2016 −1.35% 7.69% 9.27% −9.59%
2017 16.23% 24.32% 6.21% 5.24%
2018 −8.66% −18.47% −11.88% −7.85%
2019 20.38% 19.03% 13.81% 18.82%
2020 −30.77% −21.90% −33.49% −17.95%
Average 22.40% 22.49% 11.03% 16.75%
Std Dev 51.90% 49.11% 30.43% 35.10%

Table 15.7 Yearly Returns for DAL Versus a Two-Stock Portfolio

Containing DAL and LUV, XOM, or CVS (data source: Yahoo! Finance)

As investors diversify their portfolios, the volatility of one particular stock becomes less important. XOM has
good years with above-average returns and bad years with below-average (and even negative) returns, just
like DAL. But the years in which those above-average and below-average returns occur are not always the
same for the two companies. In 2014, for example, the return for DAL was greater than 80%, while the return
for XOM was negative. On the other hand, in 2011, when DAL had a return of −35.15%, XOM had a positive
return. When more than one stock is held, the gains in one stock can offset the losses in another stock,
washing away some of the volatility.

When an investor holds only one stock, that one stock’s volatility contributes 100% to the portfolio’s volatility.
When two stocks are held, the volatility of each stock contributes to the volatility of the portfolio. However, the
volatility of the portfolio is not simply the average of the volatility of each stock held independently. How
correlated the two stocks are, or how much they move together, will impact the volatility of the portfolio.

You will recall from our study of correlation in Regression Analysis in Finance that a correlation coefficient
describes how two variables move relative to each other. A correlation coefficient of 1 means that there is a
perfect, positive correlation between the two variables, while a correlation coefficient of −1 means that the two
variables move exactly opposite of each other. Stocks that are in the same industry will tend to be more
460 15 • How to Think about Investing

strongly correlated than stocks that are in much different industries. During the 2011–2020 time period, the
correlation coefficient for DAL and LUV was 0.87, the correlation coefficient for DAL and XOM was 0.35, and the
correlation coefficient for DAL and CVS was 0.79. Combining stocks that are not perfectly positively correlated
in a portfolio decreases risk.

Notice that investors who owned DAL and LUV from 2011 to 2020 would have had a lower portfolio standard
deviation, but not much lower, than investors who just owned DAL. Because the correlation coefficient is less
than one, the standard deviation fell. However, because the two stocks are in the same industry and exposed
to many of the same economic issues, the correlation coefficient is relatively high, and combining those two
stocks provides only a small decrease in risk.

This is because, as airlines, DAL and LUV face many of the same market conditions. In years when the economy
is strong, the weather is good, fuel prices are low, and people are traveling a lot, both companies will do well.
When something such as bad weather conditions reduces the amount of air travel for several weeks, both
companies are harmed. By holding LUV in addition to DAL, investors can reduce exposure to risk that is
specific to DAL (perhaps a problem that DAL has with its reservation system), but they do not reduce exposure
to the risk associated with the airline industry (perhaps rising jet fuel prices). DAL and LUV tend to experience
positive returns in the same years and negative returns in the same years.

On the other hand, investors who added XOM to their portfolio saw a significantly lower standard deviation
than those who held just DAL. In years when jet fuel prices rise, harming the profits of both DAL and LUV, XOM
is likely to see high profits. Diversifying a portfolio across firms that are less correlated will reduce the
standard deviation of the portfolio more.

LINK TO LEARNING

How to Build a Diversified Portfolio

TV personality, former hedge fund manager, and author Jim Cramer encourages investors to build a
3
diversified portfolio, having no more than 20% of a portfolio in one sector. Watch this CNBC video
(https://openstax.org/r/CNBC_video) to learn more about how he suggests investors can build a diversified
portfolio by purchasing five to 10 stocks.

Portfolio Size and Risk

As you add more stocks to a portfolio, the volatility, or standard deviation, of the portfolio decreases. The
volatility of individual assets becomes less and less important. As we discussed earlier, the risk that is
associated with events related to a particular company is called firm-specific risk, or unsystematic, risk.
Examples of unsystematic risk would include a company facing a product liability lawsuit, a company inventing
a new product, or accounting irregularities being detected. Holding a portfolio of stocks means that if one
company you have invested in goes out of business because of poor management, you do not lose all your
savings because some of your money is invested in other companies. Portfolio diversification protects you
from being significantly impacted by unsystematic risk.

However, there is a level below which the portfolio risk does not drop, no matter how diversified the portfolio
becomes. The risk that never goes away is known as systematic risk. Systematic risk is the risk of holding the
market portfolio.

We have talked about reasons why a firm’s returns might be volatile; for example, the firm discovering a new
technology or having a product liability lawsuit brought against it will impact that firm specifically. There are
also events that broadly impact the stock market. Changes in the Federal Reserve Bank’s monetary policy and

3 Abigail Stevenson. “Jim Cramer Shares His #1 Rule for Investing.” Make It. CNBC, March 15, 2016. https://www.cnbc.com/2016/03/
03/cramer-forget-sectors-a-better-way-to-diversify.html

Access for free at openstax.org

 15.3 • The Capital Asset Pricing Model (CAPM) 461

interest rates impact all companies. Geopolitical events, major storms, and pandemics can also impact the
entire market. Investors in stocks cannot avoid this type of risk. This unavoidable risk is the systematic risk that
investors in stocks have. This systematic risk cannot be eliminated through diversification.
4
In addition, as per research conducted by Meir Statman, the standard deviation of a portfolio drops quickly as
the number of stocks in the portfolio increases from one to two or three (see Figure 2 illustration in this
subsequent article by Statman (https://openstax.org/r/subsequent_Statman) for context). Increasing the size
of the portfolio decreases the standard deviation, and thus the risk, of the portfolio. However, as the portfolio
increases in size, the amount of risk reduced by adding one more stock to the portfolio will decrease. How
many stocks does an investor need for a portfolio to be well-diversified? There is not an exact number that all
financial managers agree on. A portfolio of 15 highly correlated stocks will offer less benefits of diversification
than a portfolio of 10 stocks with lower correlation coefficients. A portfolio that consists of American Airlines,
Spirit Airlines, United Airlines, Southwest Airlines, Delta Airlines, and Jet Blue, along with a few other stocks, is
not very diversified because of the heavy concentration in the airline industry. The term diversified portfolio is
a relative concept, but the average investor can create a reasonably diversified portfolio with approximately a
dozen stocks.

15.3 The Capital Asset Pricing Model (CAPM)

Learning Outcomes
By the end of this section, you will be able to:
• Define risk premium.
• Explain the concept of beta.
• Compute the required return of a security using the CAPM.

Risk-Free Rate
The capital asset pricing model (CAPM) is a financial theory based on the idea that investors who are willing
to hold stocks that have higher systematic risk should be rewarded more for taking on this market risk. The
CAPM focuses on systematic risk, rather than a stock’s individual risk, because firm-specific risk can be
eliminated through diversification.

Suppose that your grandparents have given you a gift of $20,000. After you graduate from college, you plan to
work for a few years and then apply to law school. You want to use the $20,000 your grandparents gave you to
pay for part of your law school tuition. It will be several years before you are ready to spend the money, and
you want to keep the money safe. At the same time, you would like to invest the money and have it grow until
you are ready to start law school.

Although you would like to earn a return on the money so that you have more than $20,000 by the time you
start law school, your primary objective is to keep the money safe. You are looking for a risk-free investment.
Lending money to the US government is considered the lowest-risk investment that you can make. You can
purchase a US Treasury security. The chances of the US government not paying its debts is close to zero.
Although, in theory, no investment is 100% risk-free, investing in US government securities is generally
considered a risk-free investment because the risk is so miniscule.

4 Meir Statman. “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis 22, no. 3
(September 1987): 353–363. https://doi.org/10.2307/2330969
462 15 • How to Think about Investing

The rate that you can earn by purchasing US Treasury securities is a proxy for the risk-free rate. It is used as
an investing benchmark. The average rate of return for the three-month US Treasury security from 1928 to
5
2020 is 3.36%. You can see that you will not become immensely wealthy by investing in US Treasury bills.
Another characteristic of US Treasury securities, however, is that their volatility tends to be much lower than
that of stocks. In fact, the standard deviation of returns for the US Treasury bills is 3.0%. Unlike the returns for
stocks, the return on US Treasury bills has never been negative. The lowest annual return was 0.03%, which
6
occurred in 2014.

LINK TO LEARNING

US Treasury Securities
Visit the website of the US Department of the Treasury (https://openstax.org/r/home.treasury) to learn
more about US Treasury securities. You will find current interest rates for both short-term securities (US
Treasury bills) and long-term securities (US Treasury bonds).

Risk Premium
You know that if you use your $20,000 to invest in stock rather than in US Treasury bills, the outcome of the
investment will be uncertain. Your investments may do well, but there is also a risk of losing money. You will
only be willing to take on this risk if you are rewarded for doing so. In other words, you will only be willing to
take the risk of investing in stocks if you think that doing so will make you more than you would make
investing in US Treasury securities.

From 1928 to 2020, the average return for the S&P 500 stock index has been 11.64%, which is much higher
7
than the 3.36% average return for US Treasury bills. Stock returns, with a standard deviation of 19.49%,
however, have also been much more volatile. In fact, there were 25 years in which the return for the S&P 500
index was negative.

You may not be willing to take the risk of losing some of the money your grandparents gave you because you
have been setting it aside for law school. If that’s the case, you will want to invest in US Treasury securities.
You may have money that you are saving for other long-term goals, such as retirement, with which you are
willing to take some risk. The extra return that you will earn for taking on risk is known as the risk premium.
The risk premium can be thought of as your reward for being willing to bear risk.

The risk premium is calculated as the difference between the return you receive for taking on risk and what
you would have returned if you did not take on risk. Using the average return of the S&P 500 (to measure what
investors who bear the risk earn) and the US Treasury bill rate (to measure what investors who do not bear
risk earn), the risk premium is calculated as

Beta
The risk premium represents how much an investor who takes on the market portfolio is rewarded for risk.
Investors who purchase one stock—DAL, for example—experience volatility, which is measured by the
standard deviation of that stock’s returns. Remember that some of that volatility, the volatility caused by firm-
specific risk, can be diversified away. Because investors can eliminate firm-specific risk through diversification,
they will not be rewarded for that risk. Investors are rewarded for the amount of systematic risk they incur.

5 “Historical Return on Stocks, Bonds and Bills: 1928–2020.” Damodaran Online. Stern School of Business, New York University,
January 2021. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
6 Ibid.
7 Ibid.

Access for free at openstax.org

 15.3 • The Capital Asset Pricing Model (CAPM) 463

Interpreting Beta

The relevant risk for investors is the systematic risk they incur. The systematic risk of a particular stock is
measured by how much the stock moves with the market. The measure of how much a stock moves with the
market is known as its beta. A stock that tends to move in sync with the market will have a beta of 1. For these
stocks, if the market goes up 10%, the stock generally also goes up 10%; if the market goes down 5%, stocks
with a beta of 1 also tend to go down 5%.

If a company has a beta greater than 1, then the stock tends to have a more pronounced move in the same
direction as a market move. For example, if a stock has a beta of 2, the stock will tend to increase by 20% when
the market goes up by 10%. If the market falls by 5%, that same stock will tend to fall by twice as much, or 10%.
Thus, stocks with a beta greater than 1 experience greater swings than the overall market and are considered
to be riskier than the average stock.

On the other hand, stocks with a beta less than 1 experience smaller swings than the overall market. A beta of
0.5, for example, means that a stock tends to experience moves that are only 50% of overall market moves. So,
if the market increases by 10%, a stock with a beta of 0.5 would tend to rise by only 5%. A market decline of 5%
would tend to be associated with a 2.5% decrease in the stock.

Calculating Betas

The calculation of beta for DAL is demonstrated in Figure 15.3. Monthly returns for DAL and for the S&P 500
are plotted in the diagram. Each dot in the scatter plot corresponds to a month from 2018 to 2020; for
example, the dot that lies furthest in the upper right-hand corner represents November 2020. The return for
the S&P 500 was 10.88% that month; this return is plotted along the horizontal axis. The return for DAL during
November 2020 was 31.36%; this return is plotted along the vertical axis.

You can see that generally, when the overall stock market as measured by the S&P 500 is positive, the return
for DAL is also positive. Likewise, in months in which the return for the S&P 500 is negative, the return for DAL
is also usually negative. Drawing a line that best fits the data, also known as a regression line, summarizes the
relationship between the returns for DAL and the S&P 500. The slope of this line, 1.39, is DAL’s beta. Beta
measures the amount of systematic risk that DAL has.

Figure 15.3 Calculation of Beta for DAL (data source: Yahoo! Finance)
464 15 • How to Think about Investing

CAPM Equation
Because DAL’s beta of 1.39 is greater than 1, DAL is riskier than the average stock in the market. Finance
theory suggests that investors who purchase DAL will expect a higher rate of return to compensate them for
this risk. DAL has 139% of the average stock’s systematic risk; therefore, investors in the stock should receive
139% of the market risk premium.

The capital asset pricing model (CAPM) equation is

where Re is the expected return of the asset, Rf is the risk-free rate of return, and Rm is the expected return of
the market. Given the average S&P 500 return of 11.64% and the average US Treasury bill return of 3.36%, the
expected return of DAL would be calculated as

LINK TO LEARNING

Calculating Beta
Many providers of stock data and investment information will list a company’s beta. Two internet sources
that can be used to find a company’s beta are Yahoo! Finance (https://openstax.org/r/finance.yahoo) and
MarketWatch (https://openstax.org/r/marketwatch_search). Various sources may not provide the exact
same value for beta for a company. For example, in early February 2021, Yahoo! Finance reported that the
8 9
beta for DAL was 1.46, while MarketWatch reported it as 1.29. Both of these numbers are slightly
different from the 1.39 calculated in the graph above.

There are several reasons why beta may vary slightly from source to source. One is the time frame used in
the beta calculation. Data from three years were used to calculate the beta in Figure 15.3. Time frames
ranging from three to five years are commonly used when calculating beta. Another reason different
sources might report different betas is the frequency with which the data is collected. Monthly returns are
used in Figure 15.3; some analysts will use weekly data. Finally, the S&P 500 is used to measure the market
return in Figure 15.3; the S&P 500 is one of the most common measures of overall market returns, but
alternatives exist and are used by some analysts

LINK TO LEARNING

CAPM
Watch this video (https://openstax.org/r/pricing-model-capm) for further information about the CAPM.

8 “Delta Air Lines, Inc. (DAL).” Yahoo! Finance. Verizon Media, accessed February 2021. https://finance.yahoo.com/quote/DAL/
9 “Delta Air Lines Inc.” MarketWatch. Accessed February 2021. https://www.marketwatch.com/investing/stock/dal

Access for free at openstax.org

 15.4 • Applications in Performance Measurement 465

15.4 Applications in Performance Measurement

Learning Outcomes
By the end of this section, you will be able to:
• Interpret a Sharpe ratio.
• Interpret a Treynor measurement.
• Interpret Jensen’s alpha.

Sharpe Ratio
Investors want a measure of how good a professional money manager is before they entrust their hard-
earned funds to that professional for investing. Suppose that you see an advertisement in which McKinley
Investment Management claims that the portfolios of its clients have an average return of 20% per year. You
know that this average annual return is meaningless without also knowing something about the riskiness of
the firm’s strategy. In this section, we consider some ways to evaluate the riskiness of an investment strategy.

A basic measure of investment performance that includes an adjustment for risk is the Sharpe ratio. The
Sharpe ratio is computed as a portfolio’s risk premium divided by the standard deviation of the portfolio’s
return, using the formula

The portfolio risk premium is the portfolio return RP minus the risk-free return Rf; this is the basic reward for
bearing risk. If the risk-free return is 3%, McKinley Investment Management’s clients who are earning 20% on
their portfolios have an excess return of 17%.

The standard deviation of the portfolio’s return, , is a measure of risk. Although you see that McKinley’s
clients earn a nice 20% return on average, you find that the returns are highly volatile. In some years, the
clients earn much more than 20%, and in other years, the return is much lower, even negative. That volatility
leads to a standard deviation of returns of 26%. The Sharpe ratio would be , or 0.65.

Thus, the Sharpe ratio can be thought of as a reward-to-risk ratio. The standard deviation in the denominator
can be thought of as the units of risk the investor has. The numerator is the reward the investor is receiving for
taking on that risk.

LINK TO LEARNING

Sharpe Ratio
The Sharpe ratio was developed by Nobel laureate William F. Sharpe. You can visit Sharpe’s Stanford
University website (https://openstax.org/r/stanford_wfsharpe) to find videos in which he discusses financial
topics and links to his research as well as his advice on how to invest.

Treynor Measurement of Performance

Another reward-to-risk ratio measurement of investment performance is the Treynor ratio. The Treynor ratio
is calculated as

Just as with the Sharpe ratio, the numerator of the Treynor ratio is a portfolio’s risk premium; the difference is
that the Treynor ratio focus focuses on systematic risk, using the beta of the portfolio in the denominator,
while the Shape ratio focuses on total risk, using the standard deviation of the portfolio’s returns in the
466 15 • How to Think about Investing

denominator.

If McKinley Investment Management has a portfolio with a 20% return over the past five years, with a beta of
1.2 and a risk-free rate of 3%, the Treynor ratio would be

Both the Sharpe and Treynor ratios are relative measures of investment performance, meaning that there is
not an absolute number that indicates whether an investment performance is good or bad. An investment
manager’s performance must be considered in relation to that of other managers or to a benchmark index.

Jensen’s Alpha
Jensen’s alpha is another common measure of investment performance. It is computed as the raw portfolio
return minus the expected portfolio return predicted by the CAPM:

Suppose that the average market return has been 12%. What would Jensen’s alpha be for McKinley Investment
Management’s portfolio with a 20% average return and a beta of 1.2?

Unlike the Sharpe and Treynor ratios, which are meaningful in a relative sense, Jensen’s alpha is meaningful in
an absolute sense. An alpha of 0.062 indicates that the McKinley Investment Management portfolio provided a
return that was 6.2% higher than would be expected given the riskiness of the portfolio. A positive alpha
indicates that the portfolio had an abnormal return. If Jensen’s alpha equals zero, the portfolio return was
exactly what was expected given the riskiness of the portfolio as measured by beta.

THINK IT THROUGH

Comparing the Returns and Risks of Portfolios

You are interviewing two investment managers. Mr. Wong shows that the average return on his portfolio
for the past 10 years has been 14%, with a standard deviation of 8% and a beta of 1.2. Ms. Petrov shows that
the average return on her portfolio for the past 10 years has been 16%, with a standard deviation of 10%
and a beta of 1.6. You know that over the past 10 years, the US Treasury security rate has averaged 2% and
the return on the S&P 500 has averaged 11%. Which portfolio manager do you think has done the better
job?

Solution:

The Sharpe ratio for Mr. Wong’s portfolio is , and the Treynor ratio is . The
Sharpe ratio for Ms. Petrov’s portfolio is , and the Treynor ratio is .

Jensen’s alpha for Mr. Wong’s portfolio is

Jensen’s alpha for Ms. Petrov’s portfolio is

All three measures of portfolio performance suggest that Mr. Wong’s portfolio has performed better than
Ms. Petrov’s has. Although Ms. Petrov has had a larger average return, the portfolio she manages is riskier.
Ms. Petrov’s portfolio is more volatile than Mr. Wong’s, resulting in a higher standard deviation. Ms.
Petrov’s portfolio has a higher beta, which means it has a higher amount of systematic risk. The CAPM
suggests that a portfolio with a beta of 1.6 should have an expected return of 16.4%. Because Ms. Petrov’s

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 15.5 • Using Excel to Make Investment Decisions 467

portfolio has an average return of less than that, investors in Ms. Petrov’s portfolio are not rewarded for the
risk that they have taken as much as would be expected.

15.5 Using Excel to Make Investment Decisions

Learning Outcomes
By the end of this section, you will be able to:
• Calculate the average return and standard deviation for a stock.
• Calculate the average return and standard deviation for a portfolio.
• Calculate the beta of a stock.

Average Return and Standard Deviation for a Single Stock

Excel can be used to calculate the average returns and the standard deviation of returns for both a single stock
and a portfolio of stocks. It can also be used to calculate the beta for a stock. Historic stock price data for
stocks you are interested in analyzing can easily be downloaded from sites such as Yahoo! Finance into Excel.
The examples in this section use monthly stock data from December 2017 to December 2020 from Yahoo!
Finance.

Monthly price data for AMZN (Amazon) is shown in column B of Figure 15.4. To begin, monthly returns must be
calculated from the price data using the formula

The ending prices shown in Figure 15.4 are the last price the stock traded for each month. Each month, the
return is calculated under the assumption that you purchased the stock at the last trading price of the
previous month and sold at the last price of the current month. Thus, the return for January 2018 is calculated
as

This is accomplished in Excel by placing the formula =(B3-B2)/B2 in cell C3. This formula can then be copied
down the spreadsheet through row C38. Now that each monthly return is in column C, you can calculate the
average of the monthly returns in cell C39 and the standard deviation of returns in cell C40.
468 15 • How to Think about Investing

Figure 15.4 Calculating the Average Return and the Standard Deviation of Returns for AMZN (data source: Yahoo! Finance)

Over the three-year period, the average monthly return for AMZN was 3.3%. However, this return was highly
volatile, with a standard deviation of 9.33%. Remember that this means that approximately two-thirds of the
time, the monthly return from AMZN was between −6.03% and 12.63%.

Download the spreadsheet file (https://openstax.org/r/google_spread_sheet) containing key Chapter 15

Excel exhibits.

Average Return and Standard Deviation for a Portfolio

The Excel screenshot in Figure 15.5 shows the return and standard deviation calculation for a portfolio. This
sample four-stock portfolio contains AMZN, CVS, AAPL (Apple), and NFLX (Netflix). This portfolio is constructed
as an equally weighted portfolio; because there are four stocks in this portfolio, each has a weight of 25%.

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 15.5 • Using Excel to Make Investment Decisions 469

Figure 15.5 Calculation of the Average Return and Standard Deviation for a Portfolio (data source: Yahoo! Finance)

The monthly returns for each stock are recorded in their respective columns. The portfolio return for each
month is calculated as the weighted average of the four monthly individual stock returns. The formula for the
portfolio return is

The formula =$B$1*B3+$C$1*C3+$D$1*D3+$E$1*E3 is placed in cell F3. The formula is then copied down
column F to calculate the portfolio return for each month. After the monthly portfolio return is calculated, then
the average monthly portfolio return is calculated in cell F39. The average monthly portfolio return is 2.69%.

Because this is an equally weighted portfolio, with each of the four stocks impacting the portfolio return in the
same way, the average monthly portfolio return of 2.69% is the same as the sum of the average monthly
returns of the four stocks divided by four, or .

The standard deviation of the monthly portfolio returns is calculated in cell F40. This four-stock portfolio has a
standard deviation of 7.10%. Unlike the average return, this standard deviation is not equal to the average of
the standard deviations of returns of the four stocks. In fact, the standard deviation for the portfolio is less
than the standard deviation for any one of the four stocks. Remember that this occurs because the stock
returns are not perfectly positively correlated. The high return of one of the stocks in one month is dampened
by a lower return in another stock during the same month. Likewise, a negative return in one stock during a
month might be offset by a positive return in one of the other three stocks during the same month. This is the
risk reduction benefit of holding a portfolio of stocks.

Calculating Beta
The standard deviation of a stock’s returns indicates the stock’s volatility. Remember that the volatility is
caused by both firm-specific and systematic risk. Investors will not be rewarded for firm-specific risk because
470 15 • How to Think about Investing

they can diversify away from it. Investors are, however, rewarded for systematic risk. To determine how much
of a firm’s risk is due to systematic risk, you can use Excel to calculate the stock’s beta.

To calculate a stock’s beta, you need the monthly return for the market in addition to the monthly market
return for the stock. In column B in Figure 15.6, the monthly return for SPY, the SPDR S&P 500 Trust, is
recorded. SPY is an ETF that was created to mimic the performance of the S&P 500 index by State Street Global
Advisors and is often used as a proxy for the overall market performance. The monthly returns for AMZN are
visible in column C. It is important that these returns be lined up so that the returns for a particular month for
both securities appear in the same row number. Also, you want to place the returns for SPY in the column to
the left of the returns for AMZN so that when you create your graph, SPY will automatically appear on the
horizontal axis.

LINK TO LEARNING

State Street Global Advisors

You can learn more about State Street Global Advisors and its creation of the first ETF by visiting the
company’s history page at its website (ssga.com) (https://openstax.org/r/ssga_institutional_our-history).

You will use a scatter plot to create a graph. In Excel, go to the Insert tab, and then from the Chart menu,
choose the first scatter plot option.

Figure 15.6 Excel Format for Calculating Beta (data source: Yahoo! Finance)

Selecting the scatter plot option will result in a chart being inserted that looks like the chart in Figure 15.7. Each
dot represents one month’s combination of returns, with the return for SPY measured on the horizontal axis
and the return for AMZN measured on the vertical axis. Consider, for example, the dot in the furthest upper
right-hand section of the figure. This dot is the plot of returns for the month of April 2020, when the return for
SPY was 13.36% (measured on the horizontal axis) and the return for AMZN was 26.89% (measured on the

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 15.5 • Using Excel to Make Investment Decisions 471

vertical axis).

Hover your mouse over one of the dots, and right-click the dot to pull up a chart formatting menu. This menu
will allow you to add labels to your axis and polish your chart in additional ways if you would like. Select the
option Add Trendline.

Figure 15.7 Creating a Scatter Plot in Excel (data source: Yahoo! Finance)

When the trendline is inserted, a formatting box will appear on the right of your screen (see Figure 15.8). If it is
not already selected, choose the Linear trendline option. Scroll down and select the “Display Equation on
chart” option. You will see the equation appear on the screen. This is the equation
for the best-fit line that shows how AMZN moves when the market moves. The slope of this line, 1.1477, is the
beta for AMZN. This tells you that for every 10% move the overall market makes, AMZN tends to move
11.477%. Because AMZN tends to move a little more than the broader market, it has a little more systematic
risk than the average stock in the market.

Figure 15.8 Inserting a Trendline to Determine Beta (data source: Yahoo! Finance)
472 15 • Summary

Summary
15.1 Risk and Return to an Individual Asset
Investors are interested in both the return they can expect to receive when making an investment and the risk
associated with that investment. In finance, risk is considered the volatility of the return from time period to
time period. Historical returns are measured by the arithmetic average, and the risk is measured by the
standard deviation of returns.

15.2 Risk and Return to Multiple Assets

As investors hold multiple assets in a portfolio, they are able to eliminate firm-specific risk. However,
systematic or market risk remains, even if an investor holds the market portfolio. The return to a portfolio is
measured by the arithmetic average, and the risk is measured by the standard deviation of the returns of the
portfolio. The risk of the portfolio will be lower than the weighted average of the risk of the individual
securities because the returns of the securities are not perfectly correlated. A low or negative return for one
stock in a period can be offset by a high return for another stock in the same period.

15.3 The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) relates the expected return of an asset to the systematic risk of that
asset. Investors will be rewarded for taking on systematic risk. They will not be rewarded for taking on firm-
specific risk, however, because that risk can be diversified away.

15.4 Applications in Performance Measurement

Because investors are not simply interested in returns but are also interested in risk, the success of a portfolio
cannot be measured simply by considering the portfolio’s return. In order to compare investment portfolios,
risk and return must both be taken into consideration. The Sharpe ratio and the Treynor ratio are two
measures that provide a reward-to-risk measure of a portfolio. Jensen’s alpha provides a measure of the
abnormal return of a portfolio, considering the portfolio’s risk level.

15.5 Using Excel to Make Investment Decisions

Using Excel to manipulate publicly available stock data makes calculating the average return of a stock and the
standard deviation of returns easy. The average return for a portfolio and the standard deviation of the
portfolio returns can also be calculated easily. By comparing the returns of a stock with the returns of the
overall market using Excel charting tools, the beta for a stock, which measures systematic risk, can be
determined.

Key Terms
arithmetic average return the sum of an asset’s annual returns over a number of years divided by the
number of years
beta a measure of how a stock moves relative to the market
capital asset pricing model (CAPM) the expected return of a security, equal to the risk-free rate plus a
premium for the amount of risk taken
capital gain yield the difference between the price a stock is sold for and the price that was originally paid
for it divided by the price originally paid
diversification holding a variety of assets in a portfolio
dividend yield the total dividends received by the owner of a share of stock divided by the price originally
paid for the stock
effective annual rate (EAR) returns expressed on an annualized or yearly basis; allows for the comparison
of various investments
firm-specific risk the risk that an event may impact the expected revenue or costs of a firm, thereby

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 15 • CFA Institute 473

impacting the returns to investors; also known as diversifiable risk

geometric average return the compound annual return derived from the effective annual rate and time
value of money formulas
holding period percentage return the gain received from holding a stock, calculated by adding the amount
received when the stock is sold to any dividends earned while holding the stock, subtracting the price
originally paid for the stock, then dividing the difference by the price originally paid
Jensen’s alpha a measure of portfolio performance, calculated as the raw portfolio return minus the
expected portfolio return predicted by the CAPM
market risk premium the reward for taking on the average amount of market risk
portfolio a collection of owned stocks
realized return the total return of an investment that occurs over a particular time period
risk premium the extra return earned by taking on risk
risk-free rate the reward for lending money when there is no risk of not receiving the principal and interest
as promised
Sharpe ratio a reward-to-risk measure of portfolio performance, calculated by subtracting the risk-free rate
from the average portfolio return and then dividing by the standard deviation of the portfolio
systematic risk risk that impacts the entire market and cannot be diversified away; also known as market
risk
Treynor ratio a reward-to-risk measure of portfolio performance, calculated by subtracting the risk-free rate
from the average portfolio return and then dividing by the beta of the portfolio

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-inst-study-session). Reference with permission of CFA Institute.

Multiple Choice
1. The total dollar return equals _______________.
a. the EPS of a stock
b. capital gains income plus dividend income
c. the price paid for a share of stock minus the selling price of the stock
d. the price paid for a share of stock divided by the selling price of the stock

2. The dividend yield is calculated by _______________.

a. dividing the price of the stock by the EPS
b. subtracting any capital loss from the capital gain
c. dividing the annual dividend by the initial stock price
d. dividing the annual dividend by the net income for the year

3. Which of the following is the best example of firm-specific risk?

a. A global pandemic causes major disruptions in the economy.
b. The Federal Reserve increases the money supply dramatically, leading to massive inflation.
c. AAA Pharmaceuticals withdraws a medication as it studies whether strokes five people suffered after
taking the medication were related to the medication.
d. As an arctic blast descends on North America, most of the United States is blanketed in snow or ice.

4. Investors diversify their portfolio in order to _______________.

a. reduce risk
b. increase risk
474 15 • Review Questions

c. increase return
d. increase the standard deviation

5. Which of the following would be the best example of systematic risk?

a. An error in the company’s computer system miscalculates the amount of inventory that Monique’s
Boutique is holding.
b. BlueJay Air has a reduction in new reservations following a crash of one of its jets.
c. The spokesperson for Serena’s Sports Shoes is involved in an ethical scandal.
d. Interest rates rise after the Federal Reserve announces it will slow down the rate of growth of the
money supply.

6. As the number of stocks in a portfolio increases, _______________.

a. firm-specific risk increases
b. systematic risk becomes zero
c. systematic risk decreases and returns increase
d. firm-specific risk is reduced but systematic risk remains

7. Beta is a measure of _______________.

a. systematic risk
b. firm-specific risk
c. a firm’s profitability
d. a stock’s dividend yield

8. Which of the following would be the best estimate of the risk-free rate?
a. The rate of inflation
b. The average return on the S&P 500
c. The average return on Amazon’s stock
d. The average return on US Treasury bills

9. The Sharpe ratio can be considered a measure of _______________.

a. the reward of an investment in relation to the risk
b. the systematic risk of a stock
c. the total return of a stock investment
d. the historical return of an individual security

10. A positive Jensen’s alpha indicates that a portfolio has _______________.

a. a negative beta
b. an abnormal return
c. more total risk than the average portfolio
d. more systematic risk than the average portfolio

11. If an equally weighted portfolio contains 10 stocks, then _______________.

a. the stocks in the portfolio will each have a weight of 0.10
b. the return of the portfolio must be multiplied by 10 to get the annualized return
c. the standard deviation of the portfolio will be one-tenth the standard deviation of one of the stocks
d. the standard deviation of the portfolio will be 10 times the standard deviation of one of the stocks

Review Questions
1. What is the difference between firm-specific risk and unsystematic risk?

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 15 • Problems 475

2. Explain why diversification reduces unsystematic risk but not systematic risk.

3. Explain what happens to the standard deviation of returns of a portfolio as the number of stocks in the
portfolio increases.

4. Enrique owns five stocks: Alaska Airlines, American Airlines, Delta Airlines, Southwest Airlines, and Ford.
Radha also owns five stocks: Apple, McDonald’s, Tesla, Facebook, and Disney. Does Enrique or Radha have
a more diversified portfolio?

5. You are considering purchasing shares in a company that has a beta of 0.8. Explain what this beta means.

6. Explain how the Sharpe ratio and the Treynor ratio can be considered reward-to-risk measures.

Problems
1. You purchase 100 shares of COST (Costco) for $280 per share. Three months later, you sell the stock for
$290 per share. You receive a dividend of $0.57 a share. What is your total dollar return?

2. You purchase 100 shares of COST for $280 per share. Three months later, you sell the stock for $290 per
share. You receive a dividend of $0.57 a share. What are your dividend yield, capital gain yield, and total
percentage return?

3. You purchase 100 shares of COST for $280 per share. Three months later, you sell the stock for $290 per
share. You receive a dividend of $0.57 a share. What is the EAR of your investment?

4. You invest in a stock for four years. The returns for the four years are 20%, -10%, 15%, and -5%. Calculate
the arithmetic average return and the geometric average return.

5. You are considering purchasing shares in a company that has a beta of 0.9. The average return for the S&P
500 is 11%, and the average return for US Treasury bills has been 2%. Based on the CAPM, what is your
expected return for the stock?

6. Your portfolio has had a 15% rate of return with a standard deviation of 18% and a beta of 1.1. The average
return for the S&P 500 has been 11%, and the average return for US Treasury bills has been 2%. Calculate
the Sharpe ratio, Treynor ratio, and Jensen’s alpha for your portfolio.

7. The monthly returns for Visa (V) and Pfizer (PFE) for 2018–2020 are provided in the chart below. In
addition, the monthly return for the SPDR S&P 500 ETF Trust (SPY) is provided; SPY is often used as a proxy
for the returns of the S&P 500, or a broad market index. Using Excel, calculate the arithmetic average
monthly returns for V, PFE, and SPY. Also, calculate the standard deviation of returns for each of V, PFE,
and SPY.
Monthly Returns for SPY, V, and PFE for 2018–2020

Date SPY V PFE

Jan-18 0.0618 0.0895 0.0226
Feb-18 -0.0364 -0.0104 -0.0197
Mar-18 -0.0313 -0.0253 -0.0135
Apr-18 0.0092 0.0607 0.0316
May-18 0.0243 0.0303 -0.0186
Jun-18 0.0013 0.0149 0.0196
Jul-18 0.0417 0.0324 0.1006

Table 15.8
476 15 • Video Activity

Date SPY V PFE

Aug-18 0.0319 0.0742 0.0398
Sep-18 0.0014 0.0233 0.0705
Oct-18 -0.0649 -0.0816 -0.0229
Nov-18 0.0185 0.0280 0.0736
Dec-18 -0.0933 -0.0673 -0.0485
Jan-19 0.0864 0.0233 -0.0275
Feb-19 0.0324 0.0971 0.0301
Mar-19 0.0136 0.0563 -0.0203
Apr-19 0.0454 0.0528 -0.0438
May-19 -0.0638 -0.0189 0.0224
Jun-19 0.0644 0.0774 0.0526
Jul-19 0.0201 0.0256 -0.1034
Aug-19 -0.0167 0.0158 -0.0847
Sep-19 0.0148 -0.0473 0.0201
Oct-19 0.0268 0.0398 0.0679
Nov-19 0.0362 0.0316 0.0039
Dec-19 0.0240 0.0201 0.0270
Jan-20 0.0045 0.0589 -0.0495
Feb-20 -0.0792 -0.0865 -0.0934
Mar-20 -0.1300 -0.1123 -0.0233
Apr-20 0.1336 0.1092 0.1752
May-20 0.0476 0.0924 -0.0044
Jun-20 0.0133 -0.0089 -0.1352
Jul-20 0.0636 -0.0143 0.1768
Aug-20 0.0698 0.1134 -0.0083
Sep-20 -0.0413 -0.0553 -0.0288
Oct-20 -0.0210 -0.0913 -0.0332
Nov-20 0.1088 0.1576 0.1381
Dec-20 0.0326 0.0414 -0.0293

Table 15.8

8. Using the monthly returns provided in the table in problem 7, use Excel to calculate the beta for V and the
beta for PFE. Which of these stocks has more systematic risk? What would you expect for the comparative
returns of V and PFE?

Video Activity
How to Double Your Money in Seven Years

Click to view content (https://openstax.org/r/double_your_money)

Access for free at openstax.org

 15 • Video Activity 477

In this video, Jim Cramer explains how compounding can help investors build and preserve wealth. He
provides suggestions for how young people can use the stock market to build financial independence.

1. According to Jim Cramer, if you invest $1,000 in the S&P 500, how much can you expect your investment to
be worth in 35 years?

2. Gather data over the past 10 years for the level of the S&P 500. How many of those years did the S&P 500
have a return of at least 10%? If you had invested in $1,000 in an S&P 500 index fund 10 years ago, would
you have doubled your money yet? Is your answer consistent with Jim Cramer’s message?

John Bogle and the Buy-and-Hold Strategy

Click to view content (https://openstax.org/r/grow_with_America)

In this video, the legendary investor Jack Bogle, founder and former CEO of Vanguard, discusses strategies for
investors.

3. When discussing following a buy-and-hold strategy, in which an investor makes a purchase and holds the
same investment for the long term, Bogle says that the success of such a strategy depends on what is
bought. What distinction does Bogle make between buying and holding an individual stock and buying
and holding a broad-based index fund?

4. How would you describe Bogle’s attitude toward risk in the stock market? Do you agree with this attitude?
Why or why not?
478 15 • Video Activity

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 16 • Why It Matters 479

16
How Companies Think about Investing

Figure 16.1 Companies make decisions about investments every day. (credit: modification of “Tesla Factory, Fremont (CA, USA)” by
Maurizio Pesce/flickr, CC BY 2.0)

Chapter Outline
16.1 Payback Period Method
16.2 Net Present Value (NPV) Method
16.3 Internal Rate of Return (IRR) Method
16.4 Alternative Methods
16.5 Choosing between Projects
16.6 Using Excel to Make Company Investment Decisions

Why It Matters
One of the most important decisions a company faces is choosing which investments it should make. Should
an automobile manufacturer purchase a new robot for its assembly line? Should an airline purchase a new
plane to add to its fleet? Should a hotel chain build a new hotel in Atlanta? Should a bakery purchase tables
and chairs to provide places for customers to eat? Should a pharmaceutical company spend money on
research for a new vaccine? All of these questions involve spending money today to make money in the future.

The process of making these decisions is often referred to as capital budgeting. In order to grow and remain
competitive, a firm relies on developing new products, improving existing products, and entering new
markets. These new ventures require investments in fixed assets. The company must decide whether the
project will generate enough cash to cover the costs of these initial expenditures once the project is up and
running.

For example, Sam’s Sporting Goods sells sporting equipment and uniforms to players on local recreational and
school teams. Customers have been inquiring about customizing items such as baseball caps and equipment
bags with logos and other designs. Sam’s is considering purchasing an embroidery machine so that it can
provide these customized items in-house. The machine will cost $16,000. Purchasing the embroidery machine
would be an investment in a fixed asset. If it purchases the machine, Sam’s will be able to charge customers
for customization.
480 16 • How Companies Think about Investing

The managers think that selling customized items will allow the company to increase its cash flow by $2,000
next year. They predict that as customers become more aware of this service, the ability to customize products
in-house will increase the company’s cash flow by $4,000 the following year. The managers expect the
machine will be used for five years, with the embroidery products increasing cash flows by $5,000 during each
of the last three years the machine is used. Should Sam’s Sporting Goods invest in the embroidery machine?
In this chapter, we consider the main capital budgeting techniques Sam’s and other companies can use to
evaluate these types of decisions.

16.1 Payback Period Method

Learning Outcomes
By the end of this section, you will be able to:
• Define payback period.
• Calculate payback period.
• List the advantages and disadvantages of using the payback period method.

The payback period method provides a simple calculation that the managers at Sam’s Sporting Goods can use
to evaluate whether to invest in the embroidery machine. The payback period calculation focuses on how
long it will take for a company to make enough free cash flow from the investment to recover the initial cost of
the investment.

Payback Period Calculation

In order to purchase the embroidery machine, Sam’s Sporting Goods must spend $16,000. During the first
year, Sam’s expects to see a $2,000 benefit from purchasing the machine, but this means that after one year,
the company will have spent $14,000 more than it has made from the project. During the second year that it
uses the machine, Sam’s expects that its cash inflow will be $4,000 greater than it would have been if it had not
had the machine. Thus, after two years, the company will have spent $10,000 more than it has benefited from
the machine. This process is continued year after year until the accumulated increase in cash flow is $16,000,
or equal to the original investment. The process is summarized in Table 16.1.

Year 0 1 2 3 4 5
Initial Investment ($) (16,000)
Cash Inflow ($) - 2,000 4,000 5,000 5,000 5,000
Accumulated Inflow ($) - 2,000 6,000 11,000 16,000 21,000
Balance ($) (16,000) (14,000) (10,000) (5,000) - 5,000

Table 16.1

Sam’s Sporting Goods is expecting its cash inflow to increase by $16,000 over the first four years of using the
embroidery machine. Thus, the payback period for the embroidery machine is four years. In other words, it
takes four years to accumulate $16,000 in cash inflow from the embroidery machine and recover the cost of
the machine.

LINK TO LEARNING

Calculating the Payback Period

It is possible that a project will not fully recover the initial cost in one year but will have more than
recovered its initial cost by the following year. In these cases, the payback period will not be an integer but

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 16.1 • Payback Period Method 481

will contain a fraction of a year. This video demonstrates how to calculate the payback period
(https://openstax.org/r/how-to-calculate) in such a situation.

Advantages
The principal advantage of the payback period method is its simplicity. It can be calculated quickly and easily.
It is easy for managers who have little finance training to understand. The payback measure provides
information about how long funds will be tied up in a project. The shorter the payback period of a project, the
greater the project’s liquidity.

Disadvantages
Although it is simple to calculate, the payback period method has several shortcomings. First, the payback
period calculation ignores the time value of money. Suppose that in addition to the embroidery machine,
Sam’s is considering several other projects. The cash flows from these projects are shown in Table 16.2. Both
Project B and Project C have a payback period of five years. For both of these projects, Sam’s estimates that it
will take five years for cash inflows to add up to $16,000. The payback period method does not differentiate
between these two projects.

Year 0 1 2 3 4 5 6
Project A ($) (16,000) 2,000 4,000 5,000 5,000 5,000 5,000
Project B ($) (16,000) 1,000 2,000 3,000 4,000 6,000 -
Project C ($) (16,000) 6,000 4,000 3,000 2,000 1,000 -
Project D ($) (16,000) 1,000 2,000 3,000 4,000 6,000 8,000

Table 16.2

However, we know that money has a time value, and receiving $6,000 in year 1 (as occurs in Project C) is
preferable to receiving $6,000 in year 5 (as in Projects B and D). From what we learned about the time value of
money, Projects B and C are not identical projects. The payback period method breaks the important finance
rule of not adding or comparing cash flows that occur in different time periods.

A second disadvantage of using the payback period method is that there is not a clearly defined acceptance or
rejection criterion. When the payback period method is used, a company will set a length of time in which a
project must recover the initial investment for the project to be accepted. Projects with longer payback periods
than the length of time the company has chosen will be rejected. If Sam’s were to set a payback period of four
years, Project A would be accepted, but Projects B, C, and D have payback periods of five years and so would
be rejected. Sam’s choice of a payback period of four years would be arbitrary; it is not grounded in any
financial reasoning or theory. No argument exists for a company to use a payback period of three, four, five, or
any other number of years as its criterion for accepting projects.

A third drawback of this method is that cash flows after the payback period are ignored. Projects B, C, and D all
have payback periods of five years. However, Projects B and C end after year 5, while Project D has a large cash
flow that occurs in year 6, which is excluded from the analysis. The payback method is shortsighted in that it
favors projects that generate cash flows quickly while possibly rejecting projects that create much larger cash
flows after the arbitrary payback time criterion.

Fourth, no risk adjustment is made for uncertain cash flows. No matter how careful the planning and analysis,
a business is seldom sure what future cash flows will be. Some projects are riskier than others, with less
certain cash flows, but the payback period method treats high-risk cash flows the same way as low-risk cash
flows.
482 16 • How Companies Think about Investing

16.2 Net Present Value (NPV) Method

Learning Outcomes
By the end of this section, you will be able to:
• Define net present value.
• Calculate net present value.
• List the advantages and disadvantages of using the net present value method.
• Graph an NPV profile.

Net Present Value (NPV) Calculation

Sam’s purchasing of the embroidery machine involves spending money today in the hopes of making more
money in the future. Because the cash inflows and outflows occur in different time periods, they cannot be
directly compared to each other. Instead, they must be translated into a common time period using time value
of money techniques. By converting all of the cash flows that will occur from a project into present value, or
current dollars, the cash inflows from the project can be compared to the cash outflows. If the cash inflows
exceed the cash outflows in present value terms, the project will add value and should be accepted. The
difference between the present value of the cash inflows and the present value of cash outflows is known as
net present value (NPV).

The equation for NPV can be written as

Consider Sam’s Sporting Goods’ decision of whether to purchase the embroidery machine. If we assume that
after six years the embroidery machine will be obsolete and the project will end, when placed on a timeline,
the project’s expected cash flow is shown in Table 16.3:

Year 0 1 2 3 4 5 6
Cash Flow ($) (16,000) 2,000 4,000 5,000 5,000 5,000 5,000

Table 16.3

Calculating NPV is simply a time value of money problem in which each cash flow is discounted back to the
present value. If we assume that the cost of funds for Sam’s is 9%, then the NPV can be calculated as

Because the NPV is positive, Sam’s Sporting Goods should purchase the embroidery machine. The value of the
firm will increase by $2,835.63 as a result of accepting the project.

Calculating NPV involves computing the present value of each cash flow and then summing the present values
of all cash flows from the project. This project has six future cash flows, so six present values must be
computed. Although this is not difficult, it is tedious.

A financial calculator is able to calculate a series of present values in the background for you, automating
much of the process. You simply have to provide the calculator with each cash flow, the time period in which
each cash flow occurs, and the discount rate that you want to use to discount the future cash flows to the
present.

Follow the steps in Table 16.4 for calculating NPV:

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 16.2 • Net Present Value (NPV) Method 483

Step Description Enter Display

1 Select cash flow worksheet CF CF0 XXXX

2 Clear the cash flow worksheet 2ND [CLR WORK] CF0 0

3 Enter initial cash flow 16000 +/- ENTER CF0 = -16,000.00

4 Enter cash flow for the first year ↓ 2000 ENTER C01 = 2,000.00
↓ F01 = 1.0
5 Enter cash flow for the second year ↓ 4000 ENTER C02 = 4,000.00
↓ F02 = 1.0
6 Enter cash flow for the third year ↓ 5000 ENTER C03 = 5,000.00
↓ F03 = 1.0
7 Enter cash flow for the fourth year ↓ 5000 ENTER C04 = 5,000.00
↓ F04 = 1.0
8 Enter cash flow for the fifth year ↓ 5000 ENTER C05 = 5,000.00
↓ F05 = 1.0
9 Enter cash flow for the sixth year ↓ 5000 ENTER C06 = 5,000.00
↓ F06 = 1.0
10 Select NPV NPV I 0.00

11 Enter discount rate 9 ENTER I= 9.00

12 Compute NPV ↓ CPT NPV = 2,835.63

1
Table 16.4 Calculator Steps for NPV

LINK TO LEARNING

Net Present Value

This video provides another example of how to use NPV (https://openstax.org/r/how-to-use-NPV) to
evaluate whether a project should be accepted or rejected.

Advantages
The NPV method solves several of the listed problems with the payback period approach. First, the NPV
method uses the time value of money concept. All of the cash flows are discounted back to their present value
to be compared. Second, the NPV method provides a clear decision criterion. Projects with a positive NPV
should be accepted, and projects with a negative NPV should be rejected. Third, the discount rate used to
discount future cash flows to the present can be increased or decreased to adjust for the riskiness of the
project’s cash flows.

Disadvantages
The NPV method can be difficult for someone without a finance background to understand. Also, the NPV
method can be problematic when available capital resources are limited. The NPV method provides a criterion

1 The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other
financial calculators for these types of calculations.
484 16 • How Companies Think about Investing

for whether or not a project is a good project. It does not always provide a good solution when a company
must make a choice between several acceptable projects because funds are not available to pursue them all.

THINK IT THROUGH

Calculating NVP
Suppose your company is considering a project that will cost $30,000 this year. The cash inflow from this
project is expected to be $6,000 next year and $8,000 the following year. The cash inflow is expected to
increase by $2,000 yearly, resulting in a cash inflow of $18,000 in year 7, the final year of the project. You
know that your company’s cost of funds is 9%. Use a financial calculator to calculate NPV to determine
whether this is a good project for your company to undertake (see Table 16.5).

Solution:

Step Description Enter Display

1 Select cash flow worksheet CF CF0 XXXX

2 Clear the cash flow worksheet 2ND [CLR WORK] CF0 0

3 Enter initial cash flow 30000 +/- ENTER CF0 = -30,000.00

4 Enter cash flow for the first year ↓ 6000 ENTER C01 = 6,000.00
↓ F01 = 1.0
5 Enter cash flow for the second year ↓ 8000 ENTER C02 = 8,000.00
↓ F02 = 1.0
6 Enter cash flow for the third year ↓ 10000 ENTER C03 = 10,000.00

↓ F03 = 1.0
7 Enter cash flow for the fourth year ↓ 12000 ENTER C04 = 12,000.00

↓ F04 = 1.0
8 Enter cash flow for the fifth year ↓ 14000 ENTER C05 = 14,000.00

↓ F05 = 1.0
9 Enter cash flow for the sixth year ↓ 16000 ENTER C06 = 16,000.00

↓ F06 = 1.0
10 Enter cash flow for the seventh year ↓ 18000 ENTER C07 = 18,000.00

↓ F07 = 1.0
11 Select NPV NPV I 0.00

12 Enter discount rate 9 ENTER I= 9.00

13 Compute NPV ↓ CPT NPV = 26,946.90

Table 16.5 Calculator Steps for NPV

The NPV for this project is $26,946.90. Undertaking this project will add a net present value of $26,946.90;
therefore, this is a good project that should be undertaken.

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 16.2 • Net Present Value (NPV) Method 485

LINK TO LEARNING

Calculating the NPV of an MBA Program

The NPV calculation can be used as a decision tool when you are deciding whether you should spend
money today to make money in the future. This website on calculating the NPV on an MBA degree
(https://openstax.org/r/calculating-the-NPV) lets you apply this concept in an educational setting. The
initial cost of the MBA includes both the dollars spent on tuition and the wages that a full-time student
could have earned if they were not in school. Why is it appropriate to include these forgone wages in the
calculation? What adjustments would students need to make to this analysis if they wanted to consider
attending a part-time MBA program that allowed them to continue working while completing the program?

NPV Profile
The NPV of a project depends on the expected cash flows from the project and the discount rate used to
translate those expected cash flows to the present value. When we used a 9% discount rate, the NPV of the
embroidery machine project was $2,836. If a higher discount rate is used, the present value of future cash
flows falls, and the NPV of the project falls.

Theoretically, we should use the firm’s cost to attract capital as the discount rate when calculating NPV. In
reality, it is difficult to estimate this cost of capital accurately and confidently. Because the discount rate is an
approximate value, we want to determine whether a small error in our estimate is important to our overall
conclusion. We can do this by creating an NPV profile, which graphs the NPV at a variety of discount rates and
allows us to determine how sensitive the NPV is to changes in the discount rate.

To construct an NPV profile for Sam’s, select several discount rates and compute the NPV for the embroidery
machine project using each of those discount rates. Table 16.6 below shows the NPV for several discount rates.
Notice that if the discount rate is zero, the NPV is simply the sum of the cash flows. As the discount rate
becomes larger, the NPV falls and eventually becomes negative.

The information in Table 16.6 is presented in a graph in Figure 16.2. We can see that the graph crosses the
horizontal axis at about 14%. To the left, or at lower discount rates, the NPV is positive. If you are confident
that the firm’s cost of attracting funds is less than 14%, the company should accept the project. If the cost of
capital is more than 14%, however, the NPV is negative, and the company should reject the project.

Discount Rate NPV ($)

0% 10,000
3% 7,231
9% 2,836
12% 1,081
14% 42
15% (442)
18% (1,773)
21% (2,939)

Table 16.6 NPV for Various

Discount Rates
486 16 • How Companies Think about Investing

Figure 16.2 NPV Profile Graph

16.3 Internal Rate of Return (IRR) Method

Learning Outcomes
By the end of this section, you will be able to:
• Define internal rate of return (IRR).
• Calculate internal rate of return.
• List advantages and disadvantages of using the internal rate of return method.

Internal Rate of Return (IRR) Calculation

The internal rate of return (IRR) is the discount rate that sets the present value of the cash inflows equal to
the present value of the cash outflows. In considering whether Sam’s Sporting Goods should purchase the
embroidery machine, the IRR method approaches the time value of money problem from a slightly different
angle. Instead of using the company’s cost of attracting funds for the discount rate and solving for NPV, as we
did in the first NPV equation, we set NPV equal to zero and solve for the discount rate to find the IRR:

The IRR is the discount rate at which the NPV profile graph crosses the horizontal axis. If the IRR is greater
than the cost of capital, a project should be accepted. If the IRR is less than the cost of capital, a project should
be rejected. The NPV profile graph for the embroidery machine crossed the horizontal axis at 14%. Therefore,
if Sam’s Sporting Goods can attract capital for less than 14%, the IRR exceeds the cost of capital and the
embroidery machine should be purchased. However, if it costs Sam’s more than 14% to attract capital, the
embroidery machine should not be purchased.

In other words, a company wants to accept projects that have an IRR that exceed the company’s cost of
attracting funds. The cash flow from these projects will be great enough to cover the cost of attracting money
from investors in addition to the other costs of the project. A company should reject any project that has an
IRR less than the company’s cost of attracting funds; the cash flows from such a project are not enough to
compensate the investors for the use of their funds.

Calculating IRR without a financial calculator is an arduous, time-consuming process that requires trial and
error to find the discount rate that makes NPV exactly equal zero. Your calculator uses the same type of trial-
and-error iterative process, but because it uses an automated process, it can do so much more quickly than
you can. A problem that might require 30 minutes of detailed mathematical calculations by hand can be

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 16.3 • Internal Rate of Return (IRR) Method 487

completed in a matter of seconds with the assistance of a financial calculator.

All the information your calculator needs to calculate IRR is the value of each cash flow and the time period in
which it occurs. To calculate IRR, begin by entering the cash flows for the project, just as you do for the NPV
calculation (see Table 16.7). After these cash flows are entered, simply compute IRR in the final step.

Step Description Enter Display

1 Select cash flow worksheet CF CF0 XXXX

2 Clear the cash flow worksheet 2ND [CLR WORK] CF0 0

3 Enter initial cash flow 16000 +/- ENTER CF0 = -16,000.00

4 Enter cash flow for the first year ↓ 2000 ENTER C01 = 2,000.00
↓ F01 = 1.0
5 Enter cash flow for the second year ↓ 4000 ENTER C02 = 4,000.00
↓ F02 = 1.0
6 Enter cash flow for the third year ↓ 5000 ENTER C03 = 5,000.00
↓ F03 = 1.0
7 Enter cash flow for the fourth year ↓ 5000 ENTER C04 = 5,000.00
↓ F04 = 1.0
8 Enter cash flow for the fifth year ↓ 5000 ENTER C05 = 5,000.00
↓ F05 = 1.0
9 Enter cash flow for the sixth year ↓ 5000 ENTER C06 = 5,000.00
↓ F06 = 1.0
10 Compute IRR IRR CPT IRR = 14.09

Table 16.7 Calculator Steps for IRR

Advantages
The primary advantage of using the IRR method is that it is easy to interpret and explain. Investors like to
speak in terms of annual percentage returns when evaluating investment possibilities.

Disadvantages
One disadvantage of using IRR is that it can be tedious to calculate. We knew the IRR was about 14% for the
embroidery machine project because we had previously calculated the NPV for several discount rates. The IRR
is about, but not exactly, 14%, because NPV is not exactly equal to zero (just very close to zero) when we use
14% as the discount rate. Before the prevalence of financial calculators and spreadsheets, calculating the exact
IRR was difficult and time-consuming. With today’s technology, this is no longer a major consideration. Later
in this chapter, we will look at how to use a spreadsheet to do these calculations.

No Single Mathematical Solution. Another disadvantage of using the IRR method is that there may not be a
single mathematical solution to an IRR problem. This can happen when negative cash flows occur in more than
one period in the project. Suppose your company is considering building a facility for an upcoming Olympic
competition. The construction cost would be $350 million. The facility would be used for one year and generate
cash inflows of $950 million. Then, the following year, your company would be required to convert the facility
into a public park area for the city, which is expected to cost $620 million. Placing these cash flows in a timeline
results in the following (Table 16.8):
488 16 • How Companies Think about Investing

Year 0 1 2
Cash Flow ($Millions) (350) 950 (620)

Table 16.8

The NPV profile for this project looks like Figure 16.3. The NPV is negative at low interest rates, becomes
positive at higher interest rates, and then turns negative again as the interest rate continues to rise. Because
the NPV profile line crosses the horizontal axis twice, there are two IRRs. In other words, there are two interest
rates at which NPV equals zero.

Figure 16.3 NPV Profile Graph for a Project with Two IRRs

Reinvestment Rate Assumption. The IRR assumes that the cash flows are reinvested at the internal rate of
return when they are received. This is a disadvantage of the IRR method. The firm may not be able to find any
other projects with returns equal to a high-IRR project, so the company may not be able to reinvest at the IRR.

The reinvestment rate assumption becomes problematic when a company has several acceptable projects and
is attempting to rank the projects. We will look more closely at the issues that can arise when considering
mutually exclusive projects later in this chapter. If a company is simply deciding whether to accept a single
project, the reinvestment assumption limitation is not relevant.

Overlooking Differences in Scale. Another disadvantage of using the IRR method to choose among various
acceptable projects is that it ignores differences in scale. The IRR converts the cash flows to percentages and
ignores differences in the size or scale of projects. Issues that occur when comparing projects of different
scales are covered later in this chapter.

16.4 Alternative Methods

Learning Outcomes
By the end of this section, you will be able to:
• Calculate profitability index.
• Calculate discounted payback period.
• Calculate modified internal rate of return.

Profitability Index (PI)

The profitability index (PI) uses the same inputs as the NPV calculation, but it converts the results to a ratio.
The numerator is the present value of the benefits of doing a project. The denominator is the present value of

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 16.4 • Alternative Methods 489

the cost of doing the project. The formula for calculating PI is

For the embroidery machine project that Sam’s Sporting Goods is considering, the PI would be calculated as

The numerator of the PI formula is the benefit of the project, and the denominator is the cost of the project.
Thus, the PI is the benefit relative to the cost. When NPV is greater than zero, PI will be greater than 1. When
NPV is less than zero, PI will be less than 1. Therefore, the decision criterion using the PI method is to accept a
project if the PI is greater than 1 and reject a project if the PI is less than 1.

Note that the NPV method and the PI method of project evaluation will always provide the same answer to the
accept-or-reject question. The advantage of using the PI method is that it is helpful in ranking projects from
best to worst. Issues that arise when ranking projects are discussed later in this chapter.

Discounted Payback Period

The payback period method provides a fast, simple approach to evaluating a project, but it suffers from the
fact that it ignores the time value of money. The discounted payback period method addresses this flaw by
discounting cash flows using the company’s cost of funds and then using these discounted values to
determine the payback period.

Consider Sam’s Sporting Goods’ decision regarding whether to purchase an embroidery machine. The
expected cash flows and their values when discounted using the company’s 9% cost of funds are shown in
Table 16.9. Earlier, we calculated the project’s payback period as four years; that is how long it would take the
company to recover all of the cash that it would spend on the project. Remember, however, that the payback
period does not consider the company’s cost of funds, so it underestimates the true breakeven time period.

Year 0 1 2 3 4 5 6
Cash Flow ($) (16,000.00) 2,000.00 4,000.00 5,000.00 5,000.00 5,000.00 5,000.00
Discounted Cash Flow ($) (16,000) 1,834.86 3,366.72 3,860.92 3,542.13 3,249.66 2,981.34
Cumulative Discounted
(16,000.00) (14,165.14) (10,798.42) (6,937.50) (3,395.37) (145.72) 2,835.62
Cash Flow ($)

Table 16.9

When the cash flows are appropriately discounted, the project still has not broken even by the end of year 5.
The discounted payback period would be years. This adjusted calculation addresses the
payback period method’s flaw of not considering the time value of money, but managers are still confronted
with the other disadvantages. No objective criterion for acceptance or rejection exists because of the lack of a
theoretical underpinning for what is an acceptable payback period length. The discounted payback period
ignores any cash flows after breakeven occurs; this is a serious drawback, especially when comparing mutually
exclusive projects.

Modified Internal Rate of Return (MIRR)

Financial analysts have developed an alternative evaluation technique that is similar to the IRR but modified in
an attempt to address some of the weakness of the IRR method. This modified internal rate of return
(MIRR) is calculated using the following steps:

1. Find the present value of all of the cash outflows using the firm’s cost of attracting capital as the discount
490 16 • How Companies Think about Investing

rate.
2. Find the future value of all cash inflows using the firm’s cost of attracting capital as the discount rate. All
cash inflows are compounded to the point in time at which the last cash inflow will be received. The sum of
the future value of cash inflows is known as the project terminal value.
3. Compute the yield that sets the future value of the inflows equal to the present value of the outflows. This
yield is the modified internal rate of return.

For our embroidery machine project, the MIRR would be calculated as shown in Table 16.10:

Year 0 1 2 3 4 5 6
Cash Flow ($) (16,000.00) 2,000.00 4,000.00 5,000.00 5,000.00 5,000.00 5,000.00
3,077.25
5,646.33
6,475.15
5,940.50
5,450.00
Terminal Value $31,595.22

Table 16.10

1. The only cash outflow is the $16,000 at time period 0.

2. The future value of each of the six expected cash inflows is calculated using the company’s 9% cost of
attracting capital. Each of the cash flows is translated to its value in time period 6, the time period of the
final cash inflow. The sum of the future value of these six cash flows is $31,595.22. Thus, the terminal value
is $31,595.22
3. The interest rate that equates the present value of the outflows, $16,000, to the terminal value of
$31,595.22 six years later is found using the formula

The MIRR solves the reinvestment rate assumption problem of the IRR method because all cash flows are
compounded at the cost of capital. In addition, solving for MIRR will result in only one solution, unlike the IRR,
which may have multiple mathematical solutions. However, the MIRR method, like the IRR method, suffers
from the limitation that it does not distinguish between large-scale and small-scale projects. Because of this
limitation, the MIRR cannot be used to rank projects; it can only be used to make accept-or-reject decisions.

16.5 Choosing between Projects

Learning Outcomes
By the end of this section, you will be able to:
• Choose between mutually exclusive projects.
• Compare projects with different lives.
• Compare projects of different scales.
• Rank projects when resources are limited.

So far, we have considered methods for deciding to accept or to reject a single stand-alone project.
Sometimes, managers must make decisions regarding which of two projects to accept, or a company might be
faced with a number of good, acceptable projects and have to decide which of those projects to take on during

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 16.5 • Choosing between Projects 491

the current year.

Choosing between Mutually Exclusive Projects

Earlier in this chapter, we saw that the embroidery machine that Sam’s Sporting Goods was considering had a
positive NPV, making it a project that Sam’s should accept. However, another, more expensive embroidery
machine may be available that is able to make more stitches per minute. Although the initial cost of this heavy-
duty machine is higher, it would allow Sam’s to embroider and sell more items each year, generating more
revenue. The two embroidery machines are mutually exclusive projects. Mutually exclusive projects compete
with one another; purchasing one embroidery machine excludes Sam’s from purchasing the other embroidery
machine.

Table 16.11 shows the cash outflow and inflows expected from the original embroidery machine considered as
well as the heavy-duty machine. The heavy-duty machine costs $25,000, but it will generate more cash inflows
in years 3 through 6. Both machines have a positive NPV, leading to decisions to accept the projects. Also, both
machines have an IRR exceeding the company’s 9% cost of raising capital, also leading to decisions to accept
the projects.

When considered by themselves, each of the machines is a good project for Sam’s to pursue. The question the
managers face is which is the better of the two projects. When faced with this type of decision, the rule is to
take the project with the highest NPV. Remember that the goal is to choose projects that add value to the
company. Because the NPV of a project is the estimate of how much value it will create, choosing the project
with the higher NPV is choosing the project that will create the greater value.

Year 0 1 2 3 4 5 6 NPV IRR

Regular Machine ($) (16,000) 2,000 4,000 5,000 5,000 5,000 5,000 2,835.62 14.10%
Heavy-Duty Machine ($) (25,000) 2,000 4,000 8,000 9,000 9,000 9,000 3,970.67 13.20%

Table 16.11

LINK TO LEARNING

Olympic Project Economics

The investment analysis procedures used by companies are also used by government entities when
evaluating projects. Olympic host cities receive direct revenues from broadcast rights, ticket sales, and
licensing agreements. The cities also expect indirect benefits from increased tourism, including increased
employment and higher tax revenues. These benefits come after the city makes a major investment in
infrastructure, spending money on stadiums, housing, and transportation. The investment in infrastructure
2
for the 2014 Winter Olympics in Sochi, Russia, was over $50 billion. Why do you think the infrastructure
investment for these games was so much higher than the amount spent by cities hosting previous games?
If your city were discussing the possibility of bidding to be an Olympic host city, what would you suggest it
consider when evaluating the opportunity? Check out this article (https://openstax.org/r/this-article) for
more information.

Choosing between Projects with Different Lives

Suppose you are considering starting an ice-cream truck business. You find that you can purchase a used truck
for $50,000. You estimate that the truck will last for three years, and you will be able to sell enough ice cream

2 David Filipov. “Russia Spent $50 Billion on the Sochi Olympics. It Might Actually Have Been Worth It.” Washington Post, November
15, 2017. https://www.washingtonpost.com/world/europe/that-sochi-olympic-boondoggle-russians-say-all-the-investment-is-
paying-off/2017/11/13/65014bd0-b82c-11e7-9b93-b97043e57a22_story.html
492 16 • How Companies Think about Investing

treats to generate a cash inflow of $40,000 during each of those years. Your cost of capital is 10%. The positive
NPV of $49,474 for the project makes this an acceptable project.

Another ice-cream truck is also for sale for $50,000. This truck is smaller and will not be able to hold as many
frozen treats. However, the truck is newer, with lower mileage, and you estimate that you can use it for six
years. This newer truck will allow you to generate a cash inflow of $30,000 each year for the next six years. The
NPV of the newer truck is $80,658.

Because both trucks are acceptable projects but you can only drive one truck at a time, you must choose which
truck to purchase. At first, it may be tempting to purchase the newer, lower-mileage truck because of its
higher NPV. Unfortunately, when comparing two projects that have different lives, a decision cannot be made
simply by comparing the NPVs. Although the ice-cream truck with the six-year life span has a much higher NPV
than the larger truck, it consumes your resources for a long time.

There are two methods for comparing projects with different lives. Both assume that when the short-life
project concludes, another, similar project will be available.

Replacement Chain Approach

With the replacement chain approach, as many short-life projects as necessary are strung together to equal
the life of the long-life project. You can purchase the newer, lower-mileage ice-cream truck and run your
business for six years. To make a comparison, you assume that if you purchase the larger truck that will last
for three years, you will be able to repeat the same project, purchasing another larger truck that will last for
the next three years. In essence, you are comparing a six-year project with two consecutive three-year projects
so that both options will generate cash inflows for six years. Your timeline for the projects (comparing an
older, larger truck with a newer, lower-mileage truck) will look like Table 16.12:

Year 0 1 2 3 4 5 6
Older Truck ($) ($50,000) 40,000 40,000 40,000 40,000 40,000 40,000
Older Truck ($) (50,000)

Newer Truck ($) (50,000) 30,000 30,000 30,000 30,000 30,000 30,000

Table 16.12

The present values of all of the cash inflows and outflows from purchasing two of the older, larger trucks
consecutively are added together to find the NPV of that alternative. The NPV of this alternative is $86,645,
which is higher than the NPV of $80,658 of the newer truck, as shown in Table 16.13:

Year 0 1 2 3 4 5 6
Older Truck ($) 40,000 40,000 40,000 40,000 40,000 40,000
Older Truck ($) (50,000)
Net Present Value (50,000) 36,363.64 33,057.85 (7,513.15) 27,320.54 24,836.85 22,578.96

Table 16.13

When using the replacement chain approach, the short-term project is repeated any number of times to equal
the length of the longer-term project. If one project is 5 years and another is 20 years, the short one is

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 16.5 • Choosing between Projects 493

repeated four times. This method can become tedious when the length of the longer project is not a multiple
of the shorter project. For example, when choosing between a five-year project and a seven-year project, the
short one would have to be duplicated seven times and the long project would have to be repeated five times
to get to a common length of 35 years for the two projects.

Equal Annuity Approach

The equal annuity approach assumes that both the short-term and the long-term projects can be repeated
forever. This approach involves the following steps:

Step 1: Find the NPV of each of the projects.

• The NPV of the larger, older ice-cream truck is $49,474.

• The NPV of the smaller, newer ice-cream truck is $80,658.

Step 2: Find the annuity that has the same present value as the NPV and the same number of periods as the
project.

• For the larger, older ice-cream truck, we want to find the three-year annuity that would have a present
value of $49,474 when using a 10% discount rate. This is $19,894.
• For the smaller, newer ice-cream truck, we want to find the six-year annuity that would have a present
value of $80,658 when using a 10% discount rate. This is $18,520.

Step 3: Assume that these projects, or similar projects, can be repeated over and over and that these annuities
will continue forever. Calculate the present value of these annuities continuing forever using the perpetuity
formula.

We again find that the older, larger truck is preferred to the newer, smaller truck.

These methods correct for unequal lives, but managers need to be aware that some unavoidable issues come
up when these adjustments are made. Both the replacement chain and equal annuity approaches assume that
projects can be replicated with identical projects in the future. It is important to note that this is not always a
reasonable assumption; these replacement projects may not exist. Estimating cash flows from potential
projects is prone to errors, as we will discuss in Financial Forecasting these errors are compounded and
become more significant as projects are expected to be repeated. Inflation and changing market conditions
are likely to result in cash flows varying in the future from our predictions, and as we go further into the
future, these changes are potentially greater.

Choosing Projects When Resources Are Limited

Choosing positive NPV projects adds value to a company. Although we often assume that the company will
choose to pursue all positive NPV projects, in reality, managers often face a budget that restricts the amount
of capital that they may invest in a given time period. Thus, managers are forced to choose among several
positive NPV projects. The goal is to maximize the total NPV of the firm’s projects while remaining within
budget constraints.

LINK TO LEARNING

Profitability Index
Managers should reject any project with a negative NPV. When managers find themselves with an array of
projects with a positive NPV, the profitability index can be used to choose among those projects. To learn
494 16 • How Companies Think about Investing

more, watch this video about how a company might use the profitability index (https://openstax.org/r/
might-use).

For example, suppose Southwest Manufacturing is considering the seven projects displayed in Table 16.14.
Each of the projects has a positive NPV and would add value to the company. The firm has a budget of $200
million to put toward new projects in the upcoming year. Doing all seven of the projects would require initial
investments totaling $430 million. Thus, although all of the projects are good projects, Southwest
Manufacturing cannot fund them all in the upcoming year and must choose among these projects. Southwest
Manufacturing could choose the combination of Projects A and D; the combination of Projects B, C, and E; or
several other combinations of projects and exhaust its $200 million investment budget.

NPV Initial Investment Profitability Cumulative Investment Required

Project
($Millions) ($Millions) Index ($Millions)
A 60 150 1.40 150
B 25 100 1.25 250
C 10 70 1.14 320
D 15 50 1.30 370
E 11 30 1.37 400
F 7 20 1.35 420
G 2 10 1.20 430

Table 16.14 Projects Being Considered by Southwest Manufacturing

To decide which combination results in the largest added NPV for the company, rank the projects based on
their profitability index, as is done in Table 16.15. Projects A, E, and F should be chosen, as they have the
highest profitability indexes. Because those three projects require a cumulative investment of $200 million,
none of the remaining projects can be undertaken at the present time. Doing those three projects will add $78
million in NPV to the firm. Out of this set of choices, there is no combination of projects that is affordable given
Southwest Manufacturing’s budget that would add more than $78 million in NPV.

NPV Initial Investment Profitability Cumulative Investment Required

Project
($Millions) ($Millions) Index ($Millions)
A 60 150 1.40 150
E 11 30 1.37 180
F 7 20 1.35 200
D 15 50 1.30 250
B 25 100 1.25 350
G 2 10 1.20 360
C 10 70 1.14 430

Table 16.15 Projects Ranked by Profitability Index

Notice that when choices must be made among projects, the decision cannot be made by simply ranking the
projects from highest to lowest NPV. Project D has an NPV of $15 million, which is higher than both the $11
million of Project E and the $7 million of Project F. However, Project D requires $50 million for an initial

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 16.5 • Choosing between Projects 495

investment. For the same $50 million of investment funds, Southwest Manufacturer can accept both Projects E
and F for a total NPV of $18 million. Investment capital is a scare resource for this company. By ranking
projects based on their profitability index, the company is able to determine the best way to allocate its scarce
capital for the largest potential increase in NPV.

CONCEPTS IN PRACTICE

Capital Budgeting Challenges

Although the basic techniques of project evaluation are straightforward, real-world capital budgeting
decisions are complex and multifaceted. The goal of capital budgeting is to choose the projects that will
bring the most value to the shareholders of the company. The NPV rule provides a clear, concise criterion
for which projects will bring value to the shareholders. It is important to remember, however, that all of the
project valuation calculations are based on projected cash flows. These projected cash flows are estimates,
based on the best educated guesses that a company makes about its business opportunities over the next
few years. Because no company has a crystal ball that can predict the future, its calculation of NPV is an
estimate of what it expects.

Think, for example, of an oil company deciding whether to drill for oil. The project will require expenditures
on equipment, land, and other items. The cash inflows will depend on the likelihood of oil being found, the
quantity of oil produced by the well, and the price at which the oil can be sold. If a company estimates that
oil will sell for $100 per barrel during the next few years, the project will have a much higher NPV than if the
company estimates that oil will sell for only $50 per barrel.

A project that has a positive NPV and is accepted when a company is planning how to allocate its capital
toward investments may end up being a bad project that the company wishes it had avoided if the future is
much different from what it projected. Managers must stay attuned to economic developments and
reevaluate capital budgeting decisions when significant changes occur. In spring 2020, managers around
the globe were faced with a dramatically changing economic environment amid a pandemic. Oil companies,
for example, saw oil prices drop from over $50 per barrel at the beginning of March to under $15 per barrel
by the end of April.

LINK TO LEARNING

Reducing Capital Spending

In June 2020, McKinsey & Company looked at major companies around the world that were reducing their
capital expenditures in the face of the COVID-19 pandemic. These companies were cutting their capital
budgets by 10% to 80% from their originally planned levels for 2020. Reductions were especially large in the
oil and gas industry, as companies found their revenue projections, and thus the NPV of their planned
projects, falling dramatically. In addition, companies found themselves needing to free up cash; with more
3
limited cash resources, fewer positive NPV projects could be accepted and funded. Due to the COVID-19
pandemic, many CFOs were challenged to stabilize their corporate cash flows. This article explains how
quickly reducing capital spending (https://openstax.org/r/quickly-reducing), which is usually a quick
enough fix, was able to help.

3 Tom Brinded, Zak Cutler, Erikhans Kok, and Prakash Parbhoo. “Resetting Capital Spending in the Wake of COVID-19.” McKinsey &
Company. June 25, 2020. https://www.mckinsey.com/business-functions/operations/our-insights/resetting-capital-spending-in-the-
wake-of-covid-19
496 16 • How Companies Think about Investing

16.6 Using Excel to Make Company Investment Decisions

Learning Outcomes
By the end of this section, you will be able to:
• Calculate NPV using Excel.
• Calculate IRR using Excel.
• Create an NPV profile using Excel.

A Microsoft Excel spreadsheet provides an alternative to using a financial calculator to automate the arithmetic
necessary to calculate NPV and IRR. An advantage of using Excel is that you can quickly change any
assumptions or numbers in your problem and recalculate NPV or IRR based on that updated information.
Excel is a versatile tool with more than one way to set up most problems. We will consider a couple of
straightforward examples of using Excel to calculate NPV and IRR.

Suppose your company is considering a project that will cost $30,000 this year. The cash inflow from this
project is expected to be $6,000 next year and $8,000 the following year. The cash inflow is expected to
increase by $2,000 yearly, resulting in a cash inflow of $18,000 in year 7, the final year of the project. You know
that your company’s cost of funds is 9%. Your company would like to evaluate this project.

Calculating NPV Using Excel

To calculate NPV using Excel, you would begin by placing each year’s expected cash flows in a sheet, as in row
5 in Figure 16.4. One approach to calculating NPV is to use the formula for discounting future cash flows, as is
shown in row 6.

Figure 16.4 Inserting Present Cash Flows Using Excel ($ except Cost of Funds)

Figure 16.5 shows the present value of each year’s cash flow resulting from the formula. The NPV is then
calculated by summing the present values of the cash flows.

Download the spreadsheet file (https://openstax.org/r/spreadsheet-file) containing key Chapter 16

Excel exhibits.

Figure 16.5 NPV Calculated by Summing Present Values of Cash Flows ($ except Cost of Funds)

Alternatively, Excel is programmed with financial functions, including a calculation for NPV. The NPV formula is
shown in cell J7 in Figure 16.6 below. However, it is important to pay attention to how Excel defines NPV. The
Excel NPV function calculates the sum of the present values of the cash flows occurring from period 1 through
the end of the project using the designated discount rate, but it fails to include the initial investment at time

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 16.6 • Using Excel to Make Company Investment Decisions 497

period zero at the beginning of the project. The NPV function in cell J6 will return $56,947 for this project. You
must subtract the initial cash outflow of $30,000 that occurs at time 0 to get the NPV of $26,947 for the project.

When entering the Excel-programmed NPV function, you must remember to include references only to the
cells that contain cash flows from year 1 to the end of the project. Then, subtract the initial investment of year
0 to calculate NPV according to the standard definition of NPV—the present values of the cash inflows minus
the present value of the cash outflow. Note: Because of the nonstandard use of the term NPV by Excel, many
users prefer to use the method described above rather than this predefined function.

Figure 16.6 NPV Formula ($ except IRR/Cost of Funds)

Calculating IRR Using Excel

Excel also provide a function for calculating IRR. This function is shown in Figure 16.7, cell J8. The IRR function
properly uses all the project’s cash flows, including the initial cash outflow at time 0, in its calculation, unlike
the NPV function. This function will correctly return the IRR of 27.7% for the project. Figure 16.8 shows the
completed spreadsheet.

Figure 16.7 Function for Calculating IRR ($ except IRR/Cost of Funds)

Figure 16.8 Final Spreadsheet ($ except IRR/Cost of Funds)

Using Excel to Create an NPV Profile

Firms often do not know exactly what their cost of attracting capital is, so they must use estimates in their
decision-making. Also, the cost of attracting capital can change with economic and market conditions.
Especially if markets are volatile, a company may use an NPV profile to see how sensitive their decisions are to
changes in financing costs. Excel simplifies the creation of an NPV profile.

Middleton Manufacturing is considering installing solar panels to heat water and provide lighting throughout
its plant. To do so will cost the company $800,000 this year. However, this upgrade will save the company an
estimated $150,000 in electrical costs each year for the next 10 years. Constructing an NPV profile of this
project will allow Middleton to see how the NPV of the project changes with the cost of attracting funds.
498 16 • How Companies Think about Investing

First, the project cash flows must be placed in an Excel spreadsheet, as is shown in cells D2 through N2 in
Figure 16.9. The company’s cost of funds is placed in cell B1; begin by putting in 10% for this rate. Next, the
formula for NPV is placed in cell B6; cell B6 shows the NPV of the cash flows in cells D2 through N2, using the
rate that is in cell B1.

For reference, compute IRR in cell B4. Calculating IRR is not necessary for creating the NPV profile. However, it
gives a good reference point. Remember that if the IRR of a project is greater than the firm’s cost of attracting
capital, then the NPV will be positive; if the IRR of a project is less than the firm’s cost of attracting capital, then
the NPV will be negative.

An NPV profile is created by calculating the NPV of the project for a variety of possible costs of attracting
capital. In other words, you want to calculate NPV using the project cash flows in cells D2 through N2, using a
variety of discount rates in cell B1. This is accomplished by using the Excel data table function. The data table
function shows how the outcome of an Excel formula changes when one of the cells in the spreadsheet
changes. In this instance, you want to determine how the value of the NPV formula (cell B6) changes when the
discount rate (cell B1) changes.

Figure 16.9 Project Cash Flows Inserted into Excel

To do this, enter the range of interest rates that you want to consider down a column, beginning in cell A7.
This example shows rates from 1% to 20% entered in cells A7 through A26. Your Excel file should now look like
the screenshot in Figure 16.9.

Next, highlight the cells containing the NPV calculation and the range of discount rates. Thus, you will highlight
cells A6 through A26 and B6 through B26 (see Figure 16.10). Click Data at the top of the Excel menu so that you
see the What-If Analysis feature. Choose Data Table. Because the various discount rates you want to use are in
a column, use the “Column input cell” option. Enter “B1” in this box. You are telling Excel to calculate NPV
using each of the numbers in this column as the cost of attracting funds in cell B1. Click OK.

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 16.6 • Using Excel to Make Company Investment Decisions 499

Figure 16.10 Creating a Data Table in Excel

After clicking OK, the cells in column B next to the list of various discount rates will fill with the NPVs
corresponding to each of the rates. This is shown in Figure 16.11.

Figure 16.11 NPV Calculated for Various Discount Rates

Now that the various NPVs are calculated, you can create the NPV profile graph. To create the graph, begin by
highlighting the discount rates and NPVs that are in cells A7 through A26 and B7 through B26. Next, go to the
Insert tab in the menu at the top of Excel. Several different chart options will be available; choose Scatter. You
will end up with a chart that looks like the one in Figure 16.12. You can customize the chart by renaming it,
labeling the axes, and making other cosmetic changes if you like.

You will notice that the NPV profile crosses the x-axis between 13% and 14%; remember that the NPV will be
zero when the discount rate that is used to calculate the NPV is equal to the project’s IRR, which we previously
calculated to be 13.43%. If the firm’s cost of raising funds is lower than 13.43%, the NPV profile shows that the
project has a positive NPV, and the project should be accepted. Conversely, if the firm’s cost of raising funds is
greater than 13.43%, the NPV of this project will be negative, and the project should not be accepted.
500 16 • How Companies Think about Investing

Figure 16.12 NPV Profile Created Using Excel

Middleton Manufacturing can use this NPV profile to evaluate its solar panel installation project. If the
managers think that the cost of attracting funds for the company is 10%, then the project has a positive NPV of
$121,685 and the company should install the panels. The NPV profile shows that if the managers are
underestimating the cost of funds even by 30% and it will really cost Middleton 13% to attract funds, the
project is still a good project. The cost of attracting funds would have to be higher than 13.43% for the solar
panel project to be rejected.

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 16 • Summary 501

Summary
16.1 Payback Period Method
The payback period is the simplest project evaluation method. It is the time it takes the company to recoup its
initial investment. Its usefulness is limited, however, because it ignores the time value of money.

16.2 Net Present Value (NPV) Method

Net present value (NPV) is calculated by subtracting the present value of a project’s cash outflows from the
present value of the project’s cash inflows. A project should be accepted if its NPV is positive and rejected if its
NPV is negative.

16.3 Internal Rate of Return (IRR) Method

The internal rate of return (IRR) of a project is the discount rate that sets the present value of a project’s cash
inflows exactly equal to the present value of the project’s cash outflows. A project should be accepted if its IRR
is greater than the firm’s cost of attracting capital.

16.4 Alternative Methods

The discounted payback period uses the time value of money to discount future cash flows to see how long it
will be before the initial investment of a project is recovered. MIRR provides a variation on IRR in which all cash
flows are compounded using the cost of capital, resolving the reinvestment rate assumption problem of the
IRR method; unlike IRR, which may have multiple mathematical solutions, MIRR will result in one solution. The
profitability index is calculated as the NPV of the project divided by the initial cost of the project.

16.5 Choosing between Projects

Firms may need to choose among a variety of good projects. The projects may have different lives or be
differently sized projects that require different amounts of resources. By choosing projects with the highest
profitability index, companies can take on the projects that will lead to the greatest increase in value for the
company.

16.6 Using Excel to Make Company Investment Decisions

Excel spreadsheets provide a way to easily calculate the NPV and IRR of a project. Using Excel to create an NPV
profile allows a company to see how much its estimates of the cost of raising funds can err from the true cost
and have the project still be an acceptable project.

Key Terms
capital budgeting the process a business follows to evaluate potential major projects or investments
discounted payback period the length of time it will take for the present value of the future cash inflows of
a project to equal the initial cost of the investment
equal annuity approach a method of comparing projects of different lives by assuming that the projects can
be repeated forever
internal rate of return (IRR) the discount rate that sets the NPV of a project equal to zero
modified internal rate of return (MIRR) the yield that sets the future value of the cash inflows of a project
equal to the present value of the cash outflows of the project
mutually exclusive projects projects that compete against each other so that when one project is chosen,
the other project cannot be done
net present value (NPV) the present value of the cash inflows of a project minus the present value of the
cash outflows of the project
payback period the length of time it will take for a company to make enough money from an investment to
recover the initial cost of the investment
502 16 • CFA Institute

profitability index (PI) the present value of cash inflows divided by the present value of cash outflows
replacement chain approach a method of comparing projects of differing lives by repeating shorter
projects multiple times until they reach the lifetime of the longest project

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-level-i-study-session). Reference with permission of CFA Institute.

Multiple Choice
1. Which of the following is a disadvantage of using the payback method?
a. It only considers cash flows that occur after the project breaks even.
b. It ignores the time value of money.
c. It is difficult to calculate.
d. You must know the company’s cost of raising funds to be able to use it.

2. A company should accept a project if ________.

a. the NPV of the project is positive
b. the NPV of the project is negative
c. the IRR of the project is positive
d. the IRR of the project is negative

3. The net present value of a project equals ________.

a. the future value of the cash inflows minus the future value of the cash outflows
b. the present value of the cash inflows minus the future value of the cash outflows
c. the present value of the cash inflows minus the present value of the cash outflows
d. the future value of the cash inflows minus the present value of the cash outflows

4. The IRR of a project is the discount rate that ________.

a. makes the NPV equal to zero
b. equates the present value of the cash inflows to the future value of the cash outflows
c. makes the NPV positive
d. equates the present value of cash outflows to the future value of the cash inflows

5. The IRR method assumes that ________.

a. cash flows are reinvested at the firm’s cost of attracting funds when they are received
b. cash flows of a project are never reinvested
c. cash flows are reinvested at the internal rate of return when they are received
d. the NPV of a project is negative

6. When cash outflows occur during more than one time period, ________.
a. the project’s NPV will definitely be negative
b. the project can have multiple IRRs
c. the project should not be done
d. the time value of money is not important

7. The discounted payback period method ________.

a. is used to compare two projects that have different lives
b. fails to consider the time value of money

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 16 • Review Questions 503

c. provides an objective criterion for an accept-or-reject decision grounded in financial theory

d. discounts cash flows using the company’s cost of funds to overcome a flaw of the payback period
method

8. Which of the following is a method of adjustment for comparing projects of different lives?
a. IRR
b. Modified IRR
c. Payback period
d. Equal annuity

9. When a company can only fund some of its good projects, it should rank the projects by ________.
a. PI
b. IRR
c. NPV
d. payback period

10. If a company is considering two mutually exclusive projects, which of the following statements is true?
a. The company must do both projects if it chooses to do one of the projects.
b. The IRR method should be used to compare the projects.
c. Doing one of the projects means the other project cannot be done.
d. The company does not need to compare the projects because it can choose to do both.

Review Questions
1. Describe the disadvantages of using the payback period to evaluate a project.

2. Explain why a company would want to accept a project with a positive NPV and reject a project with a
negative NPV.

3. Westland Manufacturing could spend $5,000 to update its existing fluorescent lighting fixtures to newer
fluorescent fixtures that would be more energy efficient. Explain why updating the light fixtures with
newer fluorescent fixtures and replacing the existing fixtures with LED fixtures would be considered
mutually exclusive projects.

4. When faced with a decision between two good but mutually exclusive projects, should a manager base the
decision on NPV or IRR? Why?

Problems
1. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. What is the payback period of this
project?

2. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the NPV of this project?

3. If Westland Manufacturing finds that its cost of funds is 11%, what will happen to the NPV of the project in
problem 2?

4. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. What is the IRR of this project?
504 16 • Video Activity

5. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the PI of this project?

6. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the modified IRR of this project?

7. Westland Manufacturing spends $20,000 to update the lighting in its factory to more energy-efficient LED
fixtures. This will save the company $4,000 per year in electricity costs. The company estimates that these
fixtures will last for 10 years. If the company’s cost of funds is 8%, what is the discounted payback period
of this project?

8. Holiday Hotels is considering two different floorings to use in its buildings. The less expensive tile will need
to be replaced every five years. The more durable, more expensive tile will need to be replaced every eight
years. To use the replacement chain approach to compare these two projects, how many times would you
have to assume each type of tile would be replaced?

9. You will be living in your college town for two more years. You are considering purchasing a townhouse
that will cost you $250,000 today. You estimate that if you do, your expenses for each of the next two years
will be $6,000 less than if you rented an apartment. You think that you would be able to lease the
townhouse to another college student afterward for $12,000 per year and that your taxes, maintenance,
and other expenses for the townhouse would be $5,000 per year. You expect to lease the townhouse for
five years before you sell it, and you expect to be able to sell the townhouse for $275,000. Use Excel to
create an NPV profile for this undertaking. If it will cost you 3% to borrow money, should you buy the
townhouse? What if it will cost you 8% to borrow money?

Video Activity
Calculating NPV and IRR

Click to view content (https://openstax.org/r/CFA-Level-I)

Businesses use NPV and IRR to determine whether or not a project will add value for shareholders. Watch this
CFA® Level I Corporate Finance video to learn more. Working along with the video, you will gain practice in
using your financial calculator to calculate IRR.

1. According to the video, how should a company use NPV and IRR to decide whether a project should be
undertaken?

2. In the video, Trim Corp. is considering a project that is expected to have cash inflows of $350, $250, and
$150 in years 1, 2, and 3, respectively. What do you think would happen to the NPV of the project if the
company expected the same cash flows, but in reverse order? In other words, what do you think would
happen to the NPV if the $150 were the cash inflow of year 1, $250 were the cash inflow for year 2, and
$350 were the cash inflow for year 3? Using the same discount rate as in the video, 25%, calculate the NPV
for the project with this string of cash outflows. Was the outcome what you thought it would be?

The Tokyo Olympics

Click to view content (https://openstax.org/r/tokyo-olympics)

The capital investment a city must undertake to host the Olympic Games is massive. Learn more about the
capital investments and expenses Tokyo faced as host of the 2020 Summer Olympics and how it was impacted
by a global pandemic by watching this video, How the Tokyo Olympics Became the Most Expensive Summer
Games Ever.

3. Given the costs discussed in the video, create an Excel spreadsheet to estimate the NPV and IRR of hosting

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 16 • Video Activity 505

the Olympic Games for a city.

4. How would the numbers in your Excel spreadsheet change because of the COVID-19 pandemic? Create an
NPV profile for Tokyo’s Olympic Games given the changes that were caused by the pandemic.
506 16 • Video Activity

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 17 • Why It Matters 507

17
How Firms Raise Capital

Figure 17.1 A company can only attract capital if it offers an expected return that is competitive with other options. (credit:
modification of “1166357_33949449” by Jenifer Corrêa/flickr, CC BY 2.0)

Chapter Outline
17.1 The Concept of Capital Structure
17.2 The Costs of Debt and Equity Capital
17.3 Calculating the Weighted Average Cost of Capital
17.4 Capital Structure Choices
17.5 Optimal Capital Structure
17.6 Alternative Sources of Funds

Why It Matters
The most important job that company managers have is to maximize the value of the company. Some obvious
things come to mind when you think of how managers would do this. For example, to maximize the value of
American Airlines, the managers need to attract customers and sell seats on flights. They also need to keep
costs as low as possible, which means keeping the costs of purchasing fuel and making plane repairs as low as
possible. While the concept of keeping costs low is simple, the specific decisions a firm makes can be complex.
If American Airlines wants to purchase a new airplane, it needs to consider not just the dollar cost of the initial
purchase but also the passenger and cargo capacity of the plane as well as ongoing maintenance costs.

In addition to paying salaries to its pilots and flight attendants, American Airlines must pay to use investors’
money. If the company wants to purchase a new airplane, it may borrow money to pay for the plane. Even if
American Airlines does not need to incur debt to buy the plane, the money it uses to buy the plane ultimately
belongs to the owners or shareholders of the company. The company must consider the opportunity cost of
this money and the return that shareholders are expecting on their investments.

Just as different planes have distinctive characteristics and costs, the different types of financing that American
Airlines can use will have different characteristics and costs. One of the tasks of the financial manager is to
consider the trade-offs of these sources of funding. In this chapter, we look at the basic principles that
managers use to minimize the cost of funding and maximize the value of the firm.
508 17 • How Firms Raise Capital

17.1 The Concept of Capital Structure

By the end of this section, you will be able to:
• Distinguish between the two major sources of capital appearing on a balance sheet.
• Explain why there is a cost of capital.
• Calculate the weights in a company’s capital structure.

The Basic Balance Sheet

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for
example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to
store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. These
items the company needs to conduct its operations are assets. They appear on the left-hand side of the
balance sheet.

The company has to pay for these assets. The sources of the money the company uses to pay for these assets
appear on the right-hand side of the balance sheet. The company’s sources of financing represent its capital.
There are two broad types of capital: debt (or borrowing) and equity (or ownership).

Figure 17.2 is a representation of a basic balance sheet. Remember that the two sides of the balance sheet
must be . Companies typically finance their assets through equity (selling
ownership shares to stockholders) and debt (borrowing money from lenders). The debt that a firm uses is
often referred to as financial leverage. The relative proportions of debt and equity that a firm uses in
financing its assets is referred to as its capital structure.

Figure 17.2 Basic Balance Sheet for Company with Debt, Preferred Stock, and Common Equity in Capital Structure

Attracting Capital
When a company raises money from investors, those investors forgo the opportunity to invest that money
elsewhere. In economics terms, there is an opportunity cost to those who buy a company’s bonds or stock.

Suppose, for example, that you have $5,000, and you purchase Tesla stock. You could have purchased Apple
stock or Disney stock instead. There were many other options, but once you chose Tesla stock, you no longer
had the money available for the other options. You would only purchase Tesla stock if you thought that you
would receive a return as large as you would have for the same level of risk on the other investments.

From Tesla’s perspective, this means that the company can only attract your capital if it offers an expected
return high enough for you to choose it as the company that will use your money. Providing a return equal to
what potential investors could expect to earn elsewhere for a similar risk is the cost a company bears in
exchange for obtaining funds from investors. Just as a firm must consider the costs of electricity, raw
materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting
capital so that it can purchase its assets.

Weights in the Capital Structure

Most companies have multiple sources of capital. The firm’s overall cost of capital is a weighted average of its

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 17.2 • The Costs of Debt and Equity Capital 509

debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the
fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of
capital (WACC).

The weights in the WACC are the proportions of debt and equity used in the firm’s capital structure. If, for
example, a company is financed 25% by debt and 75% by equity, the weights in the WACC would be 25% on the
debt cost of capital and 75% on the equity cost of capital. The balance sheet of the company would look like
Figure 17.3.

These weights can be derived from the right-hand side of a market-value-based balance sheet. Recall that
accounting-based book values listed on traditional financial statements reflect historical costs. The market-
value balance sheet is similar to the accounting balance sheet, but all values are current market values.

Figure 17.3 Balance Sheet of Company with Capital Structure of 25% Debt and 75% Equity

Just as the accounting balance sheet must balance, the market-value balance sheet must balance:

This equation reminds us that the values of a company’s debt and equity flow from the market value of the
company’s assets.

Let’s look at an example of how a company would calculate the weights in its capital structure. Bluebonnet
Industries has debt with a book (face) value of $5 million and equity with a book value of $3 million.
Bluebonnet’s debt is trading at 97% of its face value. It has one million shares of stock, which are trading for
$15 per share.

First, the market values of the company’s debt and equity must be determined. Bluebonnet’s debt is trading at
a discount; its market value is . The market value of Bluebonnet’s equity
equals . Thus, the total market
value of the company’s capital is . The weight of debt in
Bluebonnet’s capital structure is . The weight of equity in its capital structure is

17.2 The Costs of Debt and Equity Capital

By the end of this section, you will be able to:
• Calculate the after-tax cost of debt capital.
• Explain why the return to debt holders is not the same as the cost to the firm.
• Calculate the cost of equity capital.

The costs of debt and equity capital are what company lenders (those who allow the firm to use their capital)
expect in return for providing that capital. Just as current market values of debt and equity should be used in
determining their weights in the capital structure, current market values of debt and equity should be used in
determining the costs of those types of financing.
510 17 • How Firms Raise Capital

Cost of Debt Capital

A company’s cost of debt is the interest rate it would have to pay to refinance its existing debt. Because a
firm’s existing debt trades in the marketplace, its price changes according to market conditions. The overall
credit environment can change due to changing macroeconomic conditions, causing a change in the price of
debt securities. In addition, as there are changes in the overall riskiness of the firm and its ability to repay its
creditors, the price of the debt securities issued by the firm will change.

The market price of a company’s existing bonds implies a yield to maturity. Recall that the yield to maturity is
the return that current purchasers of the debt will earn if they hold the bond to maturity and receive all of the
payments promised by the borrowing firm.

Yield to Maturity and the Cost of Debt

Bluebonnet’s debt is selling for 97% of its face value. This means that for every $100 of face value, investors
are currently paying $97 for an outstanding bond issued by Bluebonnet Industries. This debt has a coupon
rate of 6%, paid semiannually, and the bonds mature in 15 years.

Because the bonds are selling at a discount, the yield that investors who purchase these bonds will receive if
they hold the bond to maturity exceeds 6%. The purchasers of these bonds will receive a coupon payment of
every six months for the next 15 years. They will also receive the $100 face value when the
bonds mature in 15 years. To calculate the yield to maturity of these bonds using your financial calculator,
input the information shown in Table 17.1.

Step Description Enter Display

1 Enter number of coupon payments 30 N N = 30.00

2 Enter the price paid for the bond 97 +/- PV PV = -97.00

3 Enter the coupon payment 3 PMT PMT = 3.00

4 Enter the face value of the bond 100 FV FV = 100.00

5 Compute the semiannual rate CPT I/Y I/Y = 3.156

6 Multiply 3.156 by 2 to get YTM 6.312

1
Table 17.1 Calculator Steps for Finding the Yield to Maturity

The yield to maturity (YTM) of Bluebonnet Industries bonds is 6.312%. This YTM should be used in estimating
the firm’s overall cost of capital, not the coupon rate of 6% that is stated on the outstanding bonds. The
coupon rate on the existing bonds is a historical rate, set under economic conditions that may have been
different from the current market conditions. The YTM of 6.312% represents what investors are currently
requiring to purchase the debt issued by the company.

After-Tax Cost of Debt

Although current debt holders demand to earn 6.312% to encourage them to lend to Bluebonnet Industries,
the cost to the firm is less than 6.312%. This is because interest paid on debt is a tax-deductible expense. When
a firm borrows money, the interest it pays is offset to some extent by the tax savings that occur because of this
deductible expense.

The after-tax cost of debt is the net cost of interest on a company’s debt after taxes. This after-tax cost of
debt is the firm’s effective cost of debt. The after-tax cost of debt is calculated as , where is the
before-tax cost of debt, or the return that the lenders receive, and T is the company’s tax rate. If Bluebonnet

1 The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other
financial calculators for these types of calculations.

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 17.2 • The Costs of Debt and Equity Capital 511

Industries has a tax rate of 21%, then the firm’s after-tax cost of debt is

This means that for every $1,000 Bluebonnet borrows, the company will have to pay its lenders
in interest every year. The company can deduct $63.12 from its income, so this
interest payment reduces the taxes the company must pay to the government by .
Thus, Bluebonnet’s effective cost of debt is , or .

THINK IT THROUGH

Calculating the After-Tax Cost of Debt

Royer Roasters has issued bonds that will mature in 18 years. The bonds have a coupon rate of 8%, and
coupon payments are made semiannually. These bonds are currently selling at a price of $102.20 per $100
face value. Royer’s tax rate is 28%. What is Royer’s after-tax cost of debt?

Solution:

The purchasers of these bonds will receive a coupon payment of every six months for
the next 18 years. The owners of the bonds will also receive the $100 face value when the bonds mature in
18 years. To calculate the yield to maturity of these bonds, input the information in Table 17.2 in your
financial calculator.

Step Description Enter Display

1 Enter number of coupon payments 36 N N = 36.00

2 Enter the price paid for the bond 102.20 +/- PV PV = -102.20

3 Enter the coupon payment 4 PMT PMT = 4.00

4 Enter the face value of the bond 100 FV FV = 100.00

5 Compute the semiannual rate CPT I/Y I/Y = 3.885

6 Multiply 3.885 by 2 to get YTM 7.771

Table 17.2 Calculator Steps to Find Bond Yield to Maturity

The bondholders require 7.771% to entice them to purchase the debt issued by the company. Royer
Roasters is able to deduct interest expenses before taxes. Thus, its after-tax cost of debt is

Cost of Equity Capital

Companies can raise money by selling stock, or ownership shares, of the company. Stock is known as equity
capital. The cost of common stock capital cannot be directly observed in the market; it must be estimated. Two
primary methods for estimating the cost of common stock capital are the capital asset pricing model (CAPM)
and the constant dividend growth model.

CAPM

The CAPM is based on using the firm’s systematic risk to estimate the expected returns that shareholders
require to invest in the stock. According to the CAPM, the cost of equity (re) can be estimated using the
formula

For example, suppose that Bluebonnet Industries has an equity beta of 1.3. Because the beta is greater than
512 17 • How Firms Raise Capital

one, the stock has more systematic risk than the average stock in the market. Assume that the rate on 10-year
US Treasury notes is 3% and serves as a proxy for the risk-free rate. If the long-run average return for the
stock market is 11%, the market risk premium is this means that people who invest in the
stock market are rewarded for the risk they are taking by being paid 8% more than they would have been paid
if they had purchased US Treasury notes. Bluebonnet Industries cost of equity capital can be estimated as

Constant Dividend Growth Model

The constant dividend growth model provides an alternative method of calculating a company’s cost of equity.
The basic formula for the constant dividend growth model is

Thus, three things are needed to complete this calculation: the current stock price, what the dividend will be in
one year, and the growth rate of the dividend. The current price of the stock is easy to obtain by looking at the
financial news. The other two items, the dividend next year and the growth rate of the dividend, will occur in
the future and at the current time are not known with certainty; these two items must be estimated.

Suppose Bluebonnet paid a dividend of $1.50 per share to its shareholders last year. Also suppose that this
dividend has been growing at a rate of 2% each year for the past several years and that growth rate is
expected to continue into the future. Then, the dividend in one year can be expected to be
. If the current stock price is $12.50 per share, then that cost of equity is estimated
as

THINK IT THROUGH

Using the Constant Dividend Growth Model

What does an increase in the price of a company’s stock imply about the equity cost of capital for the
company? To find out what the constant dividend growth model suggests, assume that the stock price for
Bluebonnet Industries increases to $16.50 per share. If there is no expectation that the growth rate of the
dividends will increase, what would the new estimated equity cost of capital be?

Solution:

Using the price of $16.50 per share in the constant dividend growth model equation results in an estimated
equity cost of capital of

Thus, an increase in the price of the stock, holding all of the other variables in the equation constant,
implies that the equity cost of capital drops to 11.27%.

17.3 Calculating the Weighted Average Cost of Capital

By the end of this section, you will be able to:
• Calculate the weighted average cost of capital (WACC).
• Describe issues that arise from estimating the cost of equity capital.
• Describe the use of net debt in calculating WACC.

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 17.3 • Calculating the Weighted Average Cost of Capital 513

Once you know the weights in a company’s capital structure and have estimated the costs of the different
sources of its capital, you can calculate the company’s weighted average cost of capital (WACC).

WACC Equation
WACC is calculated using the equation

D%, P%, and E% represent the weight of debt, preferred stock, and common equity, respectively, in the capital
structure. Note that must equal 100% because the company must account for 100% of its
financing. The after-tax cost of debt is . The cost of preferred stock capital is represented by rpfd, and
the cost of common stock capital is represented by re.

For a company that does not issue preferred stock, P% is equal to zero, and the WACC equation is simply

Earlier in this chapter, we calculated the weights in Bluebonnet Industries’ capital structure to be
and . We also calculated the after-tax cost of debt for Bluebonnet to be 4.99%. If we use the CAPM
to estimate the cost of equity capital for the firm, Bluebonnet’s WACC is computed as

If we use the constant dividend discount model to estimate the cost of equity for Bluebonnet Industries, the
WACC is computed as

Calculating WACC in Practice

The equation for calculating WACC is straightforward. However, issues come up when financial managers
calculate WACC in practice. Both the weights of the equity components and the cost of the equity components
are needed to calculate the WACC. The WACC that financial managers derive will depend on the assumptions
and models they use to determine what weights and capital costs to use.

Issues in Estimating the Cost of Equity Capital

We have explored two ways of estimating the cost of equity capital: the CAPM and the constant dividend
growth model. Often, these methods will produce similar estimates of the cost of capital; seldom will the two
methods provide the same value.

In our example for Bluebonnet Industries, the CAPM estimated the cost of equity capital as 13.4%. The
constant dividend growth model estimated the cost of capital as 14.24%. The exact value of the WACC
calculation depends on which of these estimates is used. It is important to remember that the WACC is an
estimate that is based on a number of assumptions that financial managers made.

For example, using the CAPM requires assumptions be made regarding the values of the risk-free interest rate,
the market risk premium, and a firm’s beta. The risk-free interest rate is generally determined using US
Treasury security yields. In theory, the yield on US Treasury securities that have a maturity equivalent to the
length of the company’s investors’ investment horizon should be used. It is common for financial analysts to
use yields on long-term US Treasury bonds to determine the risk-free rate.

To estimate the market risk premium, analysts turn to historical data. Because this historical data is used to
estimate the future market risk premium, the question arises of how many years of historical data should be
used. Using more years of historical data can lead to more accurate estimates of what the average past return
has been, but very old data may have little relevance if today’s financial market environment is different from
what it was in the past. Old data may have little relevance for investors’ expectations today. Typical market risk
premiums used by financial managers range from 5% to 8%.
514 17 • How Firms Raise Capital

The same issue with how much historical data should be considered arises when calculating a company’s beta.
Different financial managers can calculate significantly different betas even for well-established, stable
companies. In April 2021, for example, the beta for IBM was reported as 0.97 by MarketWatch and as 1.25 by
Yahoo! Finance.

The CAPM estimate of the cost of equity capital for IBM is significantly different depending on what source is
used for the company’s beta and what value is used for the market risk premium. Using a market risk
premium of 5%, the beta of 0.97 provided by MarketWatch, and a risk-free rate of 3% results in a cost of capital
of

If, instead, a market risk premium of 8% and the beta of 1.25 provided by Yahoo! Finance are used, the cost of
capital is estimated to be

CONCEPTS IN PRACTICE

Estimating the Equity Cost of Capital

Although the calculation of the cost of capital using the CAPM equation is simple and straightforward, there
is not one definitive equity cost of capital for a company that all financial managers will agree on. Consider
the eight companies spotlighted in Table 17.3.

Four estimates of the equity cost of capital are calculated for each firm. The first two estimates are based
on the beta provided by MarketWatch for each of the companies. A risk-free rate of 3% is assumed. Market
risk premiums of both 5% and of 8% are considered. A market risk premium of 5% would suggest that long-
run investors who hold a well-diversified portfolio, such as one with all of the stocks in the S&P 500, will
average a return 5 percentage points higher than the risk-free rate, or 8%. If you assume instead that the
average long-run return on the S&P 500 is 11%, then people who purchase a portfolio of those stocks are
rewarded by earning 8 percentage points more than the 3% they would earn investing in the risk-free
security.

The last two estimates of the cost of equity capital for each company also use the same risk-free rate of 3%
and the possible market risk premiums of 5% and 8%. The only difference is that the beta provided by
Yahoo! Finance is used in the calculation.

MarketWatch Yahoo! Finance

Company Industry
Beta MRP = 5% MRP = 8% Beta MRP = 5% MRP = 8%
Kroger Food retail 0.31 4.55% 5.48% 0.66 6.30% 8.28%
Coca-Cola Nonalcoholic beverages 0.69 6.45% 8.52% 0.62 6.10% 7.96%
AT&T Telecommunications 0.74 6.70% 8.92% 0.74 6.70% 8.92%
Kraft Heinz Food products 0.82 7.10% 9.56% 1.14 8.70% 12.12%
Microsoft Software 1.19 8.95% 12.52% 0.79 6.95% 9.32%
Goodyear Tire and Rubber Tires 1.24 9.20% 12.92% 2.26 14.30% 21.08%
American Airlines Passenger airlines 1.34 9.70% 13.72% 1.93 12.65% 18.44%
KB Homes Residential construction 1.42 10.10% 14.36% 1.83 12.15% 17.64%

Table 17.3 Estimates of Equity Cost of Capital for Eight Companies (source: Yahoo! Finance; MarketWatch)

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 17.3 • Calculating the Weighted Average Cost of Capital 515

The range of the equity cost of capital estimates for each of the firms is significant. Consider, for example,
Goodyear Tire and Rubber. According to MarketWatch, the beta for the company is 1.24, resulting in an
estimated cost of equity capital between 9.20% and 12.92%. The beta provided by Yahoo! Finance is much
higher, at 2.26. Using this higher beta results in an estimated equity cost of capital for Goodyear Tire and
Rubber between 14.30% and 21.08%. This leaves the financial managers of Goodyear Tire and Rubber with
an estimate of the equity cost of capital between 9.20% and 21.08%, using a range of reasonable
assumptions.

What is a financial manager to do when one estimate is more than twice as large as another estimate? A
financial manager who believes the equity cost of capital is close to 9% is likely to make very different
choices from one who believes the cost is closer to 21%. This is why it is important for a financial manager
to have a broad understanding of the operations of a particular company. First, the manager must know
the historical background from which these numbers were derived. It is not enough for the manager to
know that beta is estimated as 1.24 or 2.26; the manager must be able to determine why the estimates are
so different. Second, the manager must be familiar enough with the company and the economic
environment to draw a conclusion about what set of assumptions will most likely be reasonable going
forward. While these numbers are based on historical data, the financial manager’s main concern is what
the numbers will be going forward.

It is evident that estimating the equity cost of capital is not a simple task for companies. Although we do
see a wide range of estimates in the table, some general principles emerge. First, the average company has
a beta of 1. With a risk-free rate of 3% and a market risk premium in the range of 5% to 8%, the cost of
equity capital will fall within a range of 8% to 11% for the average company. Companies that have a beta
less than 1 will have an equity cost of capital that falls below this range, and companies that have a beta
greater than 1 will have an equity cost of capital that rises above this range.

Recall that a company’s beta is heavily influenced by the type of industry. Grocery stores and providers of
food products, for example, tend to have betas less than 1. During recessionary times, people still eat, but
during expansionary times, people do not significantly increase their spending on these products. Thus,
companies such as Kroger, Coca-Cola, and Kraft Heinz will tend to have low betas and a range of equity cost
of capital below 8% to 11%.

The sales of companies in other industries tend to be much more volatile. During expansionary periods,
people fly to vacation destinations and purchase new homes. During recessionary periods, families cut back
on these discretionary expenditures. Thus, companies such as American Airlines and KB Homes will have
higher betas and ranges of equity cost of capital that exceed the 8% to 11% average. The higher equity cost
of capital is needed to incentivize investors to invest in these companies with riskier cash flows rather than
in lower-risk companies.

The CAPM estimate depends on assumptions made, but issues also exist with the constant dividend growth
model. First, the constant dividend growth model can be used only for companies that pay dividends. Second,
the model assumes that the dividends will grow at a constant rate in the future, an assumption that is not
always reasonable. It also assumes that the financial manager accurately forecasts the growth rate of
dividends; any error in this forecast results in an error in estimating the cost of equity capital.

Given the differences in assumptions made when using the constant dividend growth model and the CAPM to
estimate the equity cost of capital, it is not surprising that the numbers from the two models differ. When
estimating the cost of equity capital for a particular firm, financial managers must examine the assumptions
made for both approaches and decide which set of assumptions is more realistic for that particular company.
516 17 • How Firms Raise Capital

Net Debt

Many practitioners use net debt rather than total debt when calculating the weights for WACC. Net debt is the
amount of debt that would remain if a company used all of its liquid assets to pay off as much debt as
possible. Net debt is calculated as the firm’s total debt, both short-term and long-term, minus the firm’s cash
and cash equivalents. Cash equivalents are current assets that can quickly and easily be converted into cash,
such as Treasury bills, commercial paper, and marketable securities.

Consider, for example, Apple, which had $112.436 billion in total debt in 2020. The company also had $38.016
billion in cash and cash equivalents. This meant that the net debt for Apple was only $74.420 billion. If Apple
2
used all of its cash and cash equivalents to pay debt, it would be left with $74.420 billion in debt.

Cash and cash equivalents can be viewed as negative debt. For firms with relatively low levels of cash, this
adjustment will not have a large impact on the overall WACC estimate. However, the adjustment can be
important for firms that hold substantial cash reserves.

17.4 Capital Structure Choices

By the end of this section, you will be able to:
• Distinguish between a levered and an unlevered firm.
• Explain why the choice of capital structure does not impact the value of a firm in perfect financial markets.
• Calculate the interest tax shield.
• Explain how the interest tax shield encourages the use of leverage.

So far, we have taken the company’s capital structure as given. Each firm’s capital structure, however, is a
result of intentional decisions made by the financial managers of the company. We now turn our attention to
the issues that financial managers consider when making these decisions.

The Unlevered Firm

Let’s begin our discussion of capital structure choices by exploring the financing decisions you would face if
you were to start a T-shirt business. Suppose that your hometown will host an international cycling
competition. The competition itself will last for a month; cyclists will arrive early to train in the local climate.
News coverage will be significant, meaning a lot of media personnel will be visiting your area. In addition to
fans attending the event, it is expected that tourism will increase over the next year as recreational cyclists will
want to ride the route of the professional race. You decide to operate a business for one year that will sell T-
shirts highlighting this event.

You will need to make an up-front investment of $40,000 to start the business. You estimate that you will
generate a cash flow of $52,000, after you cover all of your operating costs, at the end of next year. You know
that these profits are risky; you think a 10% risk premium is appropriate for the level of riskiness of the
business. If the risk-free rate is 4%, this means that the appropriate discount rate for you to use is 14%. The
value of this business opportunity is

This looks as if it will be a profitable business that should be undertaken. However, you do not have the
$40,000 for the up-front investment and will need to raise it.

First, consider raising money solely by selling ownership shares to your family and friends. How much would
those shares be worth? The value of the stock would be equal to the present value of the expected future cash
flows. The potential stockholders would expect to receive $45,614 in one year. If they agree with you that the
riskiness of this T-shirt business warrants a discount rate of 14%, then they will value the stock at

2 “Historical Data.” Apple Inc. (AAPL). Yahoo! Finance, accessed October 29, 2021. https://finance.yahoo.com/quote/AAPL/history/

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 17.4 • Capital Structure Choices 517

If you sell all of the equity in the company for $45,614 and purchase the equipment necessary for the project
for $40,000, you have $5,614 to keep as the entrepreneur who created the business.

This business would be financed 100% by equity. The lack of any debt in the capital structure means the firm
would have no financial leverage. The equity in a firm that has no financial leverage is called unlevered
equity.

The Levered Firm

Next, consider borrowing some of the money that you will need to start this T-shirt business. Although the
cash flows from the business are uncertain, suppose you are certain that the business will generate at least
$18,000. (Perhaps you have a guaranteed order from the cycling competition sponsors.) If you borrowed
$17,000 at the risk-free interest rate of 4%, you would owe to the lenders at the
end of the year. Because you are certain that you will generate at least $18,000 in cash, which is greater than
$17,680, you can borrow the $17,000 without any risk of defaulting.

The $17,000 will not be enough to pay for all the start-up costs. You will also need to raise some capital by
selling equity. Because your firm will have some debt, or financial leverage, the equity that you raise will be
known as levered equity. The equity holders expect the firm to generate $52,000 in cash flows. Debt holders
must be paid before equity holders, so this will leave for the shareholders.

The expected future cash flows generated by the business are determined by the productivity of its assets, not
the manner in which those assets are financed. It is the present value of these expected future cash flows that
determines the firm’s value. Thus, the firm’s value in perfect capital markets will not change as a result of the
company taking on leverage.

LINK TO LEARNING

MM Proposition I
Nobel laureates Franco Modigliani and Merton Miller wrote influential papers exploring capital structure
and the cost of a firm’s capital. They began by considering what would occur in a perfectly competitive
market. One of the assumptions of this perfect capital market is that there are no taxes. The idea that the
market value of the unlevered and levered firm is the same in perfect capital markets is known in the field
of finance as MM Proposition I.

Visit Milken Institute’s 5-Minute Finance site to explore more about Modigliani and Miller’s contributions
(https://openstax.org/r/Modigliani) to the understanding of capital structure.

The value of your T-shirt business remains at $45,614. You can calculate the value of the levered equity as

Now, shareholders are willing to pay $28,614 for ownership in this company. They expect to get $34,320 in one
year in return for purchasing this equity. What discount rate does this imply?
518 17 • How Firms Raise Capital

Notice that the expected return to shareholders has risen from 14% for the unlevered firm to 19.94% for the
levered firm. Recall that the expected return to shareholders equals the risk-free rate plus a risk premium. The
risk-free rate has remained 4%. With leverage, the risk premium rises from 10% to 15.94%.

Why does this risk premium increase? Recall that debt holders are paid before equity holders. Equity holders
are residual claimants; they will only receive payment if there is money left over after the debt holders are fully
paid. The business is risky. You are certain that the company will have cash flow of at least $18,000 at the end
of the year and that $17,680 will be paid to the debt holders. Therefore, if the company performs poorly
(perhaps bad weather results in the cancellation of much of the cycling competition) and the cash flows fall
way below what you are expecting, there may be only several hundred dollars left for the shareholders.

When the firm was unlevered, if the cash flow at the end of the year was only $18,000, the shareholders would
receive $18,000. When leverage is used, the same cash flow would result in shareholders receiving only $320.
The risk to the shareholders increases as leverage is used; thus, the risk premium that shareholders require
also increases as leverage is used.

Leverage and the WACC

What happens to the WACC as leverage is used? To figure this out, we must calculate the weights of debt and
equity in the capital structure:

In perfect capital markets, an assumption we are making for now, there are no taxes. Because we are using
only debt and common stock, the weight of preferred stock is zero, and our WACC can be calculated as

Notice that the use of leverage does not change the WACC. When only equity was used to finance the
business, stockholders required a 14% expected return to encourage them to let the firm use their capital.
When leverage was used, the debt holders only required a 4% return. However, the existence of debt holders,
who stand in front of shareholders in the order of claimants, puts shareholders in a riskier position. There is a
greater chance that the shareholders will not receive payment from this uncertain business. Thus, the
shareholders require a higher rate of return to let the leveraged firm use their capital.

The cost-savings benefits of using lower-cost debt in your company’s capital structure are exactly offset by the
higher return that shareholders require when leverage is used. Mathematically, the increase in the cost of
equity when leverage is used will be proportional to the debt–equity ratio. Financial managers refer to this
outcome as MM Proposition II. The relationship is expressed by the formula

where ru is the required return to equity holders of the unlevered firm.

Table 17.4 shows how the cost of equity increases as the weight of debt in the capital structure increases. As
the company uses more debt, the risk to equity holders increases. Because equity holders risk that there will
be no residual money after bondholders are paid, the equity holders require a higher rate of return to invest in
the company as its use of leverage increases. Although debt holders face less risk than equity holders, the risk
that they face increases as the amount of debt the company takes on increases. Once the company’s debt
exceeds its guaranteed cash flow, which is $18,000 in our example, debt holders face some risk that the
company will not be able to pay them. At that point, the cost of debt rises above the risk-free rate. As the

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 17.4 • Capital Structure Choices 519

weight of debt approaches 100%, the cost of debt capital approaches the cost of equity of the unlevered firm.
In other words, if you financed the T-shirt business solely through the use of debt, the debt holders would
require a 14% return because they would be bearing the entire risk of the business and would demand to be
rewarded for doing so.

As the leverage of the firm increases, both the cost of debt capital and the cost of equity capital increase.
However, as the firm’s leverage increases, it is using proportionately more of the relatively cheaper source of
capital—debt— and proportionately less of the relatively more expensive source of capital—equity. Thus, the
WACC remains constant as leverage increases, despite the rising cost of each component.

Amount of Debt Amount of Equity Weight of Debt Weight of Equity Cost of Debt Cost of Equity WACC
$- $45,614 0% 100% 0.0400 0.1400 14%
$5,000 $40,614 11% 89% 0.0400 0.1523 14%
$10,000 $35,614 22% 78% 0.0400 0.1681 14%
$15,000 $30,614 33% 67% 0.0400 0.1890 14%
$17,000 $28,614 37% 63% 0.0400 0.1994 14%
$20,000 $25,614 44% 56% 0.0600 0.2025 14%
$30,000 $15,614 66% 34% 0.0800 0.2553 14%
$40,000 $5,614 88% 12% 0.1000 0.4250 14%

Table 17.4 Alternative Capital Structures for Your T-Shirt Business

The Impact of Taxes

In perfect capital markets, the choice of capital structure will not impact the value of the firm or the cost of the
firm’s financing. In the real world, however, capital markets are not perfect. One of the important market
imperfections is the presence of corporate taxes. Because the choice of capital structure can impact the taxes
that a company pays, in the real world, capital structure can impact the cost of capital and the firm’s value.

Assume that your T-shirt business venture will result in earnings before interest and taxes (EBIT) of $52,000
next year and that the corporate tax rate is 28%. If your company is unlevered, it has no interest expense, and
its net income will be $37,440, as shown in Table 17.5.

Without Leverage With Leverage

EBIT $52,000.00 $52,000.00
Interest Expense 0.00 280.00
Income before Taxes 52,000.00 51,720.00
Taxes (28%) 14,560.00 14,481.60
Net Income $37,440.00 $37,238.40

Table 17.5 Net Income and Leverage

If your company uses leverage, raising $7,000 of financing by issuing debt with a 4% interest rate, it will have
an interest expense of $280. This lowers its taxable income to $51,720 and its taxes to $14,481.60. Because
interest is a tax-deductible expense, using leverage lowers the company’s taxes.

Table 17.6 shows that the company’s net income is lower with leverage than it would be without leverage. In
other words, debt obligations will reduce the value of the equity. However, less equity is needed because some
of the firm is financed through debt. The important consideration is how the use of leverage changes the total
520 17 • How Firms Raise Capital

amount of dollars available to all investors. Table 17.6 shows this impact.

Without Leverage With Leverage

Interest Paid to Debt Holders $0.00 $280.00
Amount Available to Stockholders 37,440.00 37,238.40
Total Available for All Investors $37,440.00 $37,518.40

Table 17.6 Total Dollars Available to Investors

Using leverage allows the firm to generate $37,518.40 to pay its investors, compared to only $37,440 that is
available if the firm is unlevered. Where does the extra $78.40 to pay investors come from? It comes from the
reduction in taxes that the firm pays due to leverage. If the company uses no debt, it pays $14,560 in taxes. The
levered firm pays only $14,481.60 in taxes, a savings of $78.40.

The $280 that the levered company pays in interest is shielded from the corporate tax, resulting in tax savings
of . The additional amount available to investors because of the tax deductibility of
interest payments is known as the interest tax shield. The interest tax shield is calculated as

When interest is a tax-deductible expense, the total value of the levered firm will exceed the value of the
unlevered firm by the amount of this interest tax shield. The tax-advantage status of debt financing impacts
the WACC. The WACC with taxes is calculated as

This formula can be written as

Thus, the WACC with taxes is lower than the pretax WACC because of the interest tax shield. The more debt the
firm has, the greater the dollar amount of this interest tax shield. The presence of the interest tax shield
encourages firms to use debt financing in their capital structures.

17.5 Optimal Capital Structure

By the end of this section, you will be able to:
• Explain how increased use of leverage increases the possibility of financial distress.
• Explain how the possibility of financial distress impacts the cost of capital.
• Discuss the trade-offs a firm faces as it increases its leverage.
• Explain the concept of an optimal capital structure.

Debt and Financial Distress

The more debt a company uses in its capital structure, the larger the dollar value of the interest tax shield.
Why, then, do we not see firms using a capital structure composed 100% of debt to maximize this interest tax
shield?

The answer to this question lies in the fact that as a company increases its debt, there is a greater chance that
the firm will be unable to make its required interest payments on the debt. If the firm has difficulty meeting its

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 17.5 • Optimal Capital Structure 521

debt obligations, it is said to be in financial distress.

A firm in financial distress incurs both direct and indirect costs. The direct costs of financial distress include
fees paid to lawyers, consultants, appraisers, and auctioneers. The indirect costs include loss of customers and
suppliers.

Trade-Off Theory
Trade-off theory weighs the advantages and disadvantages of using debt in the capital structure. The
advantage of using debt is the interest tax shield. The disadvantage of using debt is that it increases the risk of
financial distress and the costs associated with financial distress.

A company has an incentive to increase leverage to exploit the interest tax shield. However, too much debt will
make it more likely that the company will default and incur financial distress costs. Calculating the precise
balance between these two is difficult if not impossible.

For companies with a low level of debt, the risk of default is low, and the main impact of an increase in
leverage will be an increase in the interest tax shield. At some point, however, the tax savings that result from
increasing the amount of debt in the capital structure will be just offset by the increased probability of
incurring the costs of financial distress. For firms that have higher costs of financing distress, this point will be
reached sooner. Thus, firms that face higher costs of financial distress have a lower optimal level of leverage
than firms that face lower costs of financial distress.

LINK TO LEARNING

Netflix
Netflix has experienced phenomenal growth in the past 25 years. Starting as a DVD rental company, Netflix
quickly shifted its model to content streaming. In recent years, the company has become a major producer
of content, and it is currently the largest media/entertainment company by market capitalization. It is
expensive for Netflix to fund the production of this content. Netflix has funded much of its content through
selling debt.

You can view the company’s explanation of this capital structure choice by looking at the answers the
company provides to common investor questions (https://openstax.org/r/the-company-provides). You can
also find the company’s financial statements on its website and see how the level of debt on Netflix’s
balance sheet has increased over the past few years.

Figure 17.4 demonstrates how the value of a levered firm varies with the level of debt financing used. Vu is the
value of the unlevered firm, or the firm with no debt. As the firm begins to add debt to its capital structure, the
value of the firm increases due to the interest tax shield. The more debt the company takes on, the greater the
tax benefit it receives, up until the point at which the company’s interest expense exceeds its earnings before
interest and taxes (EBIT). Once the interest expense equals EBIT, the firm will have no taxable income. There is
no tax benefit from paying more interest after that point.
522 17 • How Firms Raise Capital

Figure 17.4 Maximum Value of a Levered Firm

As the firm increases debt and increases the value of the tax benefit of debt, it also increases the probability of
facing financial distress. The magnitude of the costs of financial distress increases as the debt level of the
company rises. To some degree, these costs offset the benefit of the interest tax shield.

The optimal debt level occurs at the point at which the value of the firm is maximized. A company will use this
optimal debt level to determine what the weight of debt should be in its target capital structure. The optimal
capital structure is the target. Recall that the market values of a company’s debt and equity are used to
determine the costs of capital and the weights in the capital structure. Because market values change daily
due to economic conditions, slight variations will occur in the calculations from one day to the next. It is
neither practical nor desirable for a firm to recalculate its optimal capital structure each day.

Also, a company will not want to make adjustments for minor differences between its actual capital structure
and its optimal capital structure. For example, if a company has determined that its optimal capital structure is
22.5% debt and 77.5% equity but finds that its current capital structure is 23.1% debt and 76.9% equity, it is
close to its target. Reducing debt and increasing equity would require transaction costs that might be quite
significant.

Table 17.7 shows the average WACC for some common industries. The calculations are based on corporate
information at the end of December 2020. A risk-free rate of 3% and a market-risk premium of 5% are assumed
in the calculations. You can see that the capital structure used by firms varies widely by industry. Companies in
the online retail industry are financed almost entirely through equity capital; on average, less than 7% of the
capital comes from debt for those companies. On the other hand, companies in the rubber and tires industry
tend to use a heavy amount of debt in their capital structure. With a debt weight of 63.62%, almost two-thirds
of the capital for these companies comes from debt.

After-Tax
Industry Name Equity Weight Debt Weight Beta Cost of Equity Tax Rate WACC
Cost of Debt
Retail (online) 93.33% 6.67% 1.16 8.82% 2.93% 2.19% 8.38%
Computers/peripherals 91.45% 8.55% 1.18 8.92% 3.71% 1.88% 8.32%
Household products 87.07% 12.93% 0.73 6.65% 5.06% 2.19% 6.07%
Drugs (pharmaceutical) 84.62% 15.38% 0.91 7.54% 1.88% 2.19% 6.72%

Table 17.7 Capital Structure, Cost of Debt, Cost of Equity, and WACC for Selected Industries (data source: Aswath
Damodaran Online)

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 17.6 • Alternative Sources of Funds 523

After-Tax
Industry Name Equity Weight Debt Weight Beta Cost of Equity Tax Rate WACC
Cost of Debt
Retail (general) 82.41% 17.59% 0.90 7.49% 12.48% 1.88% 6.51%
Beverages (soft) 82.24% 17.76% 0.79 6.96% 3.32% 2.19% 6.11%
Tobacco 76.74% 23.26% 0.72 6.61% 8.69% 1.88% 5.51%
Homebuilding 75.34% 24.66% 1.46 10.29% 15.91% 2.19% 8.30%
Food processing 75.18% 24.82% 0.64 6.18% 8.56% 2.19% 5.19%
Restaurants/dining 74.79% 25.21% 1.34 9.72% 3.19% 2.19% 7.82%
Apparel 71.74% 28.26% 1.10 8.49% 4.75% 2.19% 6.71%
Farming/agriculture 68.94% 31.06% 0.87 7.37% 6.45% 1.88% 5.67%
Packaging & containers 64.47% 35.53% 0.92 7.61% 15.67% 1.88% 5.57%
Food wholesalers 64.10% 35.90% 1.03 8.17% 0.52% 2.19% 6.02%
Hotels/gaming 63.60% 36.40% 1.56 10.82% 2.02% 2.19% 7.68%
Telecom. services 54.60% 45.40% 0.66 6.30% 3.93% 1.40% 4.07%
Retail (grocery and food) 51.46% 48.54% 0.24 4.21% 13.52% 2.19% 3.23%
Air transport 38.26% 61.74% 1.61 11.04% 6.00% 2.19% 5.58%
Rubber & tires 36.38% 63.62% 1.09 8.47% 5.30% 1.88% 4.28%

Table 17.7 Capital Structure, Cost of Debt, Cost of Equity, and WACC for Selected Industries (data source: Aswath
Damodaran Online)

Industries that have high betas, such as hotels/gaming and air transport, have high equity costs of capital.
More recession-proof industries, such as food processing and household products, have low betas and low
equity costs of capital. The WACC for each industry ends up being influenced by the weights of equity and debt
the company chooses, the riskiness of the industry, and the tax rates faced by companies in the industry.

17.6 Alternative Sources of Funds

By the end of this section, you will be able to:
• Calculate the required return to preferred shareholders.
• Calculate the WACC of a firm that issues preferred shares.
• Discuss how issuing new equity impacts the cost of equity capital.
• Explain the functionality of convertible debt.

A company can finance its assets in two ways: through debt financing and through equity financing. Thus far,
we have treated these sources as two broad categories, each with a single cost of capital. In reality, a company
may have different types of debt or equity, each with its own cost of capital. The same principle would apply:
the WACC of the firm would be calculated using the weights of each of these types multiplied by the cost of
that particular type of debt or equity capital.

Preferred Shares
Although our calculations of WACC thus far have assumed that companies finance their assets only through
debt and common equity, we saw at the beginning of the chapter that the basic WACC formula is

In addition to common stock, a company can raise equity capital by issuing preferred stock. Owners of
524 17 • How Firms Raise Capital

preferred stock are promised a fixed dividend, which must be paid before any dividends can be paid to
common stockholders.

In the order of claimants, preferred shareholders stand in line between bondholders and common
shareholders. Bondholders are paid interest before preferred shareholders are paid annual dividends.
Preferred shareholders are paid annual dividends before common shareholders are paid dividends. Should
the company face bankruptcy, the same priority of claimants is followed in settling claims—first bondholders,
then preferred stockholders, with common stockholders standing at the end of the line.

Preferred stock shares some characteristics with debt financing. It has a promised cash flow to its holders.
Unlike common equity, the dividend on preferred stock is fixed and known. Also, there are consequences if
those preferred dividends are not paid. Common shareholders cannot receive any dividends until preferred
dividends are paid, and in some cases, preferred shareholders receive voting rights until they are paid the
dividends that are due. However, preferred shareholders cannot force the company into bankruptcy as debt
holders can. For tax and legal purposes, preferred stock is treated as equity.

The cost of the preferred equity capital is calculated using the formula

Suppose that Greene Building Company has issued preferred stock that pays a dividend of $2.00 each year. If
this preferred stock is selling for $21.80 per share, then the company’s cost of preferred stock is

THINK IT THROUGH

Calculating Common Equity Financing

Greene Building Company uses 40% debt, 15% preferred stock, and 45% common stock in its capital
structure. The yield to maturity on the company’s bonds is 7.2%. The cost of preferred equity is 9.17%. In
the most recent year, Greene paid a dividend of $3.15 to its common shareholders. This dividend has been
growing at a rate of 3.0% per year, which is expected to continue in the future. The company’s common
stock is trading for $32.25 per share. Greene pays a corporate tax rate of 21%. Estimate the WACC for
Greene.

Solution:

The cost of Greene’s common equity financing must be calculated. This can be done using the constant
dividend growth model:

The weights and the costs for each component of capital are placed in the WACC formula:

The WACC for Greene Building Company is estimated to be 9.47%. Note that debt financing is the cheapest
cost of capital for Greene. The reason for this is twofold. First, because debt holders face the least amount
of risk because they are paid first in the order of claimants, they require a lower return. Second, because
interest payments are tax-deductible, the interest tax shield lowers the effective cost of debt to the

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 17.6 • Alternative Sources of Funds 525

company. Preferred shareholders will require a higher rate of return than debt holders, 9.17%, because
they are later in the order of claimants. Common shareholders are the residual claimants, standing at the
end of the line to receive payment. After all other claimants are paid, any remaining money belongs to the
shareholders. If this residual amount is small, the common shareholders receive a small payment. If there is
nothing left after all other claimants have been paid, common shareholders receive nothing. Thus, common
shareholders have the greatest amount of risk and require the highest rate of return.

Also, note that the weights for debt, preferred stock, and common stock in the capital structure sum to
100%. The company must finance 100% of its assets.

Issuing New Common Stock

An existing firm can acquire equity capital to expand its assets in two ways: the retention of earnings or the
sale of new shares of stock. Thus far in the chapter, the cost of equity capital calculations have assumed that
the earnings were being retained for equity capital financing.

The net income that is left after all expenses are paid is the residual income that belongs to the shareholders.
Instead of receiving a fixed payment for letting the firm use their capital (like bondholders who receive fixed
interest payments), the reward to shareholders for letting the company use their capital varies from year to
year. In a good year, net income and the reward to shareholders is high. In a poor year, net income is low or
perhaps even negative.

The net income can either be paid immediately and directly to shareholders in the form of dividends or be
retained within the company to fund growth. Shareholders are willing to allow the company to retain these
earnings because they expect that the money will be used to fund profitable projects, leading to an even larger
reward for shareholders in future years.

Although managers do not need to actively solicit the funds that are retained to fund the business, managers
cannot view these funds as costless. The shareholders will require a return on those funds to entice them to
allow the company to delay paying the dollars to them immediately in terms of a dividend.

Suppose a company has $1 million in net income one year. If it pays $250,000 in dividends and retains
$750,000, then it can finance $750,000 more in assets. If the company has a capital structure of 25% debt and
75% equity and wants to maintain that capital structure, it must increase its debt by $250,000 to balance the
increase in equity. Thus, the company would be increasing its total financing by $1 million. Of that financing,
25% would be debt financing, and 75% would be equity financing.

To increase its assets by more than $1 million, the company would need to decide to either change its capital
structure or issue new stock. Consider the firm represented by the market-value balance sheet in Figure 17.5.
The firm has $900 million in assets. These assets are financed by $225 million in debt capital and $675 million
in equity capital, resulting in a capital structure of 25% debt and 75% equity.

Figure 17.5 Market-Value Balance Sheet for a Company with $900 Million in Assets and a Capital Structure of 25% Debt and
75% Equity

The retained earnings of $750,000 cause the equity on the balance sheet to increase to $675.75 million. The
526 17 • How Firms Raise Capital

company could sell $250,000 in bonds, increasing its debt to $225.25 million. Figure 17.6 shows the impact on
the balance sheet. The company has increased its financing by $1,000,000 and can expand assets by
$1,000,000. The capital structure remains 25% debt and 75% equity.

Figure 17.6 Balance Sheet with $1 Million Growth Financed through Retained Earnings and New Debt

What if the economy is in an expansionary period and this company thinks it has the opportunity to grow at a
rate of 5%? The company knows that it will need more assets to be able to grow. If it needs 5% more assets, its
assets will need to increase to $945 million. To increase the left-hand side of its balance sheet, the company
will also need to increase the right-hand side of the balance sheet.

Where does the company get the $45 million in capital? With $750,000 in retained earnings, the company can
increase its equity to $675.75 million, but if the remainder of $44.25 million was financed through debt, the
company’s capital structure would change. Its weight of debt would increase to

If the company has determined that its optimal capital structure is 25% debt and 75% equity, financing the
majority of the growth through debt would cause it to stray from these levels. Funding the growth while
keeping the capital structure the same would require the firm to issue new shares. Figure 17.7 shows how the
firm would need to finance $45 million in growth while maintaining its desirable capital structure. The firm
would need to increase equity capital to $708.75 million; retained earnings could provide $750,000, but $33
million of new equity would need to be sold.

Figure 17.7 Balance Sheet with $45,000,000 in Financing Coming from Debt, Retained Earnings, and New Stock

Investors who are providing common equity financing require a return to entice them to let the company use
their money. If this company has paid $0.50 per share in dividends to shareholders and this dividend is
expected to increase by 3% each year, we can use the constant dividend growth model to estimate how much
common shareholders require. If the stock is trading for $8.00 per share, the cost of common equity financing
is estimated as

If, however, the firm must issue more equity, its cost of equity for those additional shares will be higher than
9.44%. Even if shareholders are willing to pay $8.00 per share for the stock, the firm will incur flotation costs;
this means the firm will not receive the entire $8.00 to use to finance new assets and generate a profit for
shareholders. Flotation costs include the costs of filing with the Securities and Exchange Commission (SEC) as

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 17.6 • Alternative Sources of Funds 527

well as the fees paid to investment bankers to place the new shares.

When new equity must be issued to finance the company, the flotation costs must be subtracted from the
price of the stock to determine the net proceeds the firm will receive. The cost of this new equity capital is
calculated as

where F represents the flotation costs of the new stock issue. If, in this example, the flotation cost is $0.25 per
share, then the cost of raising new equity capital is

Issuing new common equity is the most expensive form of raising capital. Equity capital is already expensive
because the common shareholders are the residual claimants who will only be paid if all other claimants are
paid. Because of this risk, they require a higher rate of return than providers of capital who have precedence in
the order of claimants. Flotation costs must be added to this equity cost when new shares are issued to grow
the company.

THINK IT THROUGH

Cost of Issuing New Equity

You are a financial manager for American Motor Works (AMW). The target capital structure for the company
is 30% debt and 70% equity. You know that your company’s after-tax cost of debt is 4.6%. Your company
paid a dividend of $3 per share last year, and it has a policy of increasing its dividend at a rate of 1.5% each
year. AMW stock is currently trading for $27.50 per share. You estimate that the company’s retained
earnings will be $10 million this year. If the company needs to issue new shares of stock, flotation costs are
expected to be $0.75 per share.

Given this information, you are tasked with calculating the company’s WACC. You need to provide an
estimate of WACC if retained earnings are used and an estimate if new equity must be issued.

Solution:

First, calculate the cost of equity capital for AMW using the constant dividend growth model:

Using 12.57% as the equity cost of capital and 4.6% as the after-tax cost of debt, the WACC is calculated as

The WACC for AMW when it is using retained earnings for equity financing is 10.18%. If the company has
$10 million in retained earnings this year, its equity will increase by $10 million. Given its target capital
structure of 30% debt and 70% equity, AMW will be able to increase its overall financing by
by using its retained earnings and issuing new debt of $4,285,714.

If AMW wants to expand its assets by more than $14,285,714 during the next year, it will need to issue new
stock or increase the weight of debt in its capital structure. The company will incur flotation costs of $0.65
per share to issue new stock. The cost of new equity capital will be
528 17 • How Firms Raise Capital

With this more expensive newly issued equity capital, AMW’s WACC will become

If AMW wants to take on a large project that requires investment in more than $14,285,714 worth of assets,
such as building a new production facility, the company will need to issue more equity and will face a higher
WACC than when using retained earnings as its equity financing.

Convertible Debt
Some companies issue convertible bonds. These corporate bonds have a provision that gives the bondholder
the option of converting each bond held into a fixed number of shares of common stock. The number of
common shares the bondholder would receive for each bond is known as the conversion ratio.

Suppose that you own a convertible bond issued by Sheridan Sodas with a face value of $1,000 and a
conversion ratio of 20 shares that matures today. If you convert the bond today, you will receive 20 shares of
Sheridan common stock. If you do not convert, you will receive $1,000. If you convert, you are basically paying
$1,000 for 20 shares of Sheridan stock. The conversion price is If Sheridan is trading for more
than $50 per share, you would want to convert. If Sheridan is trading for less than $50 per share, you would
not want to convert; you would prefer the $1,000. In other words, you will choose to convert whenever the
stock price exceeds the conversion price at maturity.

A convertible bond gives the holder an option; the bondholder is able to choose between the face value cash
or receiving shares of stock. Options always have a positive value to holders. It is always preferable to be able
to choose $1,000 or shares of stock than to simply be given $1,000. There is a possibility that the shares of
stock will be more valuable, and there is no way the choice can put you in a worse position.

Because holders of convertible bonds have the valuable option of conversion that holders of nonconvertible
bonds do not have, convertible debt can be offered with a lower interest rate. It might seem as if the firm
could lower its weighted average cost of capital by issuing convertible debt rather than nonconvertible debt.
However, this is not the case. Remember that holders of convertible bonds choose whether they would prefer
to convert the bond and become a stockholder or receive the face value of the bond at maturity.

If a bond has a face value of $1,000, the convertible bond holders will consider whether the stock they can
convert to is worth more than $1,000. Only when the price of the stock has increased enough that the value of
the stock received is more than $1,000 will the bondholders convert. However, this means that instead of
paying $1,000, the firm is paying the bondholder in stock worth more than $1,000. In essence, the firm (and
the current shareholders) would be selling an equity position in the company for less than the market price of
that equity position. The lower interest rate compensates for the possibility that conversion will occur.

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 17 • Summary 529

Summary
17.1 The Concept of Capital Structure
Capital structure refers to how a company finances its assets. The two main sources of capital are debt
financing and equity financing. A cost of capital exists because investors want a return equivalent to what they
would receive on an investment with an equivalent risk to persuade them to let the company use their funds.
The market values of debt and equity are used to calculate the weights of the components of the capital
structure.

17.2 The Costs of Debt and Equity Capital

The yield to maturity (YTM) on a company’s outstanding bonds represents the return that debt holders are
requiring to lend money to the company. Because interest expenses are tax-deductible, the cost of debt to the
company is less than the YTM. The cost of equity capital is not directly observed, so financial managers must
estimate this cost. Two common methods for estimating the cost of equity capital are the constant dividend
growth model and the capital asset pricing model (CAPM).

17.3 Calculating the Weighted Average Cost of Capital

Calculate the weighted average cost of capital (WACC) using the formula

Remember that the WACC is an estimate; different methods of estimating the cost of equity capital can lead to
different estimations of WACC.

17.4 Capital Structure Choices

An unlevered firm uses no debt in its capital structure. A levered firm uses both debt and equity in its capital
structure. In perfect financial markets, the value of the firm will be the same regardless of the firm’s decision
to use leverage. With the tax deductibility of interest expenses, however, the value of the firm can increase
through the use of debt. As the level of debt increases, the value of the interest tax shield increases.

17.5 Optimal Capital Structure

A company wants to choose a capital structure that maximizes its value. Although increasing the level of
financial leverage, or debt, in the capital structure increases the value of the interest tax shield, it also
increases the probability of financial distress. As the weight of debt in the capital structure increases, the
return that providers of both debt and equity capital require to entice them to provide money to the firm
increases because their risk increases. Trade-off theory suggests that the value of a company that uses debt
equals the value of the unlevered firm plus the value of the interest tax shield minus financial distress costs.

17.6 Alternative Sources of Funds

Preferred stock is a type of equity capital; the owners of preferred stock receive preferential treatment over
common stockholders in the order of claimants. A fixed dividend is paid to preferred shareholders and must
be paid before common shareholders receive dividends. Equity capital can be raised through either retaining
earnings or selling new shares of stock. Significant flotation costs are associated with issuing new shares of
stock, making it the most expensive source of financing. Convertible debt allows the debt holders to convert
their debt into a fixed number of common shares instead of receiving the face value of the stock at maturity.

Key Terms
after-tax cost of debt the net cost of interest on a company’s debt after taxes; the firm’s effective cost of
debt
capital a company’s sources of financing
530 17 • CFA Institute

capital structure the percentages of a company’s assets that are financed by debt capital, preferred stock
capital, and common stock capital
conversion price the face value of a convertible bond divided by its conversion ratio
conversion ratio the number of shares of common stock receivable for each convertible bond that is
converted
convertible bonds bonds that can be converted into a fixed number of shares of common stock upon
maturity
financial distress when a firm has trouble meeting debt obligations
financial leverage the debt used in a company’s capital structure
flotation costs costs involved in the issuing and placing of new securities
interest tax shield the reduction in taxes paid because interest payments on debt are a tax-deductible
expense; calculated as the corporate tax rate multiplied by interest payments
levered equity equity in a firm that has debt outstanding
net debt a company’s total debt minus any cash or risk-free assets the company holds
preferred stock equity capital that has a fixed dividend; preferred shareholders fall in between debt holders
and common stockholders in the order of claimants
trade-off theory a theory stating that the total value of a levered company is the value of the firm without
leverage plus the value of the interest tax shield less financial distress costs
unlevered equity equity in a firm that has no debt outstanding
weighted average cost of capital (WACC) the average of a firm’s debt and equity costs of capital, weighted
by the fractions of the firm’s value that correspond to debt and equity

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/CFA-Level-I-Study). Reference with permission of CFA Institute.

Multiple Choice
1. Sandage Auto Parts has debt outstanding with a market value of $2 million. The company’s common stock
has a book value of $3 million and a market value of $8 million. What weight is equity in Sandage’s capital
structure?
a. 11%
b. 20%
c. 60%
d. 80%

2. The capital structure of a company refers to ________.

a. whether the company purchases assets or liabilities with its equity
b. the proportion of debt and equity the company uses in financing is assets
c. the ability of the company to use its assets to generate equity for the owners
d. whether the company uses short-term assets or long-term assets to create its product

3. Which of the following should be used when calculating the weights for a company’s capital structure?
a. Book values
b. Current market values
c. Historic accounting values
d. Par and face values

4. Two methods for estimating a company’s cost of common stock capital are ________.

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 17 • Multiple Choice 531

a. the historic method and the current method

b. the weighted valuation model and the beta model
c. the constant dividend growth model and the CAPM
d. the balance sheet method and the face value method

5. Which of the following would be the most reasonable approach to calculating the cost of debt for a
company?
a. Using the coupon rate on the company’s existing bonds
b. Using the interest amount reported on the income statement
c. Using the yield to maturity on the company’s existing bonds
d. Multiplying the amount of debt on the company’s balance sheet by the risk-free rate

6. Net debt equals ________.

a. Debt/Equity
b. Debt × (1 – Tax Rate)
c. total debt minus the cash and risk-free assets the company owns
d. the yield to maturity of a company’s bonds divided by the tax rate

7. Unlevered equity refers to ________.

a. the equity in a firm with no debt
b. a firm’s equity minus the firm’s debt
c. the equity in a firm in the absence of taxation and transaction costs
d. the portion of a firm’s capital structure that is financed by its owners

8. In perfect capital markets, ________.

a. a company’s WACC does not change as it changes its capital structure
b. a company can lower its WACC by using more debt in its capital structure
c. a company can lower its WACC by using more equity in its capital structure
d. a company’s cost of debt capital is exactly equal to its cost of equity capital when the company uses
50% debt and 50% equity in its capital structure

9. The interest tax shield occurs because ________.

a. interest payments are a tax-deductible expense
b. interest payments are made from after-tax income
c. investors require a lower rate of return the higher the company’s tax rate
d. investors require a lower rate of return the more debt the company incurs

10. As a company increases the weight of debt in its capital structure, ________.
a. its cost of debt capital falls
b. the weight of equity capital also increases
c. the value of the interest tax shield decreases
d. its possibility of financial distress increases

11. A company is said to be in financial distress if ________.

a. it is not fully exploiting the interest tax shield
b. it needs to raise capital to finance a new project
c. it has difficulty meeting its debt obligations
d. its cost of equity capital exceeds its cost of debt capital

12. Issuing new stock ________.

532 17 • Review Questions

a. costs the same as retaining earnings

b. will not impact a company’s WACC
c. is the most expensive source of capital because of flotation costs
d. is the cheapest source of capital because dividends do not have to be paid each year

13. If a bond with a face value of $1,000 has a conversion ratio of 10 shares, the conversion price is ________.
a. $0.01
b. $10
c. $100
d. $1,000

Review Questions
1. Why does a company’s capital have a cost?

2. Why is the rate that debt holders require to entice them to lend money to a company different from the
company’s effective cost of debt capital?

3. Assume that the corporate tax rate is 21%. Congress is discussing increasing the corporate tax rate to 32%.
How might this change the capital structures that companies choose?

4. Describe the order of claimants and how it impacts the returns that various providers of capital require to
entice them to provide funding to a company.

5. Explain what is meant by trade-off theory.

Problems
1. SodaFizz has debt outstanding that has a market value of $3 million. The company’s stock has a book
value of $2 million and a market value of $6 million. What are the weights in SodaFizz’s capital structure?

2. The yield to maturity on SodaFizz’s debt is 7.2%. If the company’s marginal tax rate is 21%, what is
SodaFizz’s effective cost of debt?

3. SodaFizz paid a dividend of $2 per share last year; its dividend has been growing at a rate of 2% per year,
and that growth rate is expected to continue into the future. The stock of SodaFizz is currently trading at
$19.50 per share. According to the constant dividend growth model, what is the cost of equity capital for
SodaFizz?

4. SodaFizz has a beta of 1.1. If the risk-free rate is 3% and the market risk premium is 11%, what is the cost
of equity capital for SodaFizz according to the capital asset pricing model?

5. Given the answers to Problems 1, 2, and 3, what is SodaFizz’s WACC when the constant dividend growth
model is used to calculate its equity cost of capital?

6. Given the answers to Problems 1, 2, and 4, what is SodaFizz’s WACC when the CAPM is used to calculate
SodaFizz’s equity cost of capital?

7. Shirley Manufacturing paid $1 million in interest payments last year. The company is in the 21% tax
bracket and has $15 million in debt outstanding. How much was the company’s interest tax shield last
year?

8. King Medical Supplies has issued preferred stock that pays a yearly dividend of $4 per share. This
preferred stock is trading at a price of $47 per share. What is King’s cost of preferred stock capital?

9. McPherson Pharmaceutical has common stock that is trading for $75 per share. The company paid a

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 17 • Video Activity 533

dividend of $5.25 last year. This dividend is expected to increase at a rate of 3% per year. What is the cost
of equity capital for McPherson? If McPherson issues new shares with a flotation cost of $2 per share,
what is the company’s cost of new equity?

Video Activity
Calculating the Weighted Average Cost of Capital

Click to view content (https://openstax.org/r/WACC)

1. What is the formula for calculating WACC? What do each of the components of this formula represent?

2. In the video, the tax rate for Brick and Mortar Co. was 30%. What would your calculation of the company’s
WACC be if there was a change in the tax code and the tax rate for Brick and Mortar Co. fell to 15%? Why
does the tax rate impact a firm’s WACC? Do you think the managers of Brick and Mortar Co. should
consider making any changes to its capital structure if the tax rate falls to 15%? Why or why not?

Capital Structure for Real Estate Companies

Click to view video content (https://openstax.org/r/optimal-capital)

3. Why doesn’t one optimal capital structure exist for commercial real estate businesses?

4. How do you think a family that runs a multigenerational commercial real estate business will think about
risk compared to a young entrepreneur who is beginning to build a commercial real estate business? How
do you think the capital structures of these two entities are likely to compare? How would those capital
structures likely be linked to the risk profiles of the two companies?
534 17 • Video Activity

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 18 • Why It Matters 535

18
Financial Forecasting

Figure 18.1 Forecasts are an important financial tool. (credit: modification of “Red Post-It Label, Calculator and Ballpen” by
photosteve101/flickr, CC BY 2.0)

Chapter Outline
18.1 The Importance of Forecasting
18.2 Forecasting Sales
18.3 Pro Forma Financials
18.4 Generating the Complete Forecast
18.5 Forecasting Cash Flow and Assessing the Value of Growth
18.6 Using Excel to Create the Long-Term Forecast

Why It Matters
Though no one in business has a crystal ball, managers must often do all they can to predict the future as
accurately as possible. This is called forecasting. Accounting and finance professionals use past performance
along with what they know about the business, its competitors, the economy, and the company’s plans for the
future to assemble detailed financial forecasts. Forecasts are useful to many individuals for different reasons.
A budget, a type of static forecast, helps accountants and managers see how their plans for the coming year
can be achieved. It outlines sales targets and how much can be spent on cost of goods sold and expenses to
achieve the company’s bottom-line (net income) targets. Investors use financial forecasts to help guide their
decisions to buy, sell or hold stocks or to estimate future potential income through dividends. Perhaps most
importantly, for our purposes in finance, forecasts are used to help predict and manage cash flows.

A business can have all the profit in the world at the end of the year, but if it doesn’t raise enough cash
(liquidity) to pay the bills and pay its employees halfway through the year, it could still go bankrupt despite
being profitable. Forecasting sales and expenses helps assemble a cash forecast—when sales will be collected
and when expenses will be paid—so that financial managers can look forward far enough to have enough time
to react accordingly and secure short- or long-term financing to meet gaps in cash flow.
536 18 • Financial Forecasting

18.1 The Importance of Forecasting

Learning Outcomes
By the end of this section, you will be able to:
• Discuss how to use financial statements in forecasting firm financials.
• Explain why balance sheet items are important in forecasting a firm’s financial result.
• Explain why income statement items are important in forecasting a firm’s financial result.

In this section, we will briefly review some of the basic elements of financial statements and how we can
analyze historical statements to help assemble financial forecasts. Financial forecasting is important to short-
and long-term firm success. It helps a firm plan for the resources it will need, ensuring it will have enough cash
on hand at the right time to cover daily operations and capital expenditures. It helps the firm communicate its
future potential and manage its shareholders’ expectations. It also helps management assess future risk and
set plans in place to mitigate that risk.

Financial forecasting involves using historical data, analysis tools, and other information we can gather to
make an educated guess about the future financial performance of the firm. Historical figures provide a
reasonable starting point. We use tools such as ratios, common size, and trend analysis to fine-tune our
forecast. And finally, we assess what we know about the firm, its competitors, the economy, and anything else
that might impact performance and further fine-tune our forecast from there.

It’s important to take a moment to consider the role of ethics in forecasting. Ethics is a huge issue in the world
of accounting and finance in general, and forecasting is no different. There can be tremendous pressure on
management to perform, to deliver certain levels of profit, and to meet shareholder expectations.

Forecasting, as you will learn throughout this chapter, is not an exact science. There is a great deal of
subjectivity that can come into play when forecasting sales and expenses. Ethical behavior is crucial in this
area. Those who create forecasts must have a firm understanding of where their data comes from, how
reliable it is, and whether or not their assumptions and projections are reasonably justified.

Financial Statement Foundations

In Financial Statements, you were introduced to a firm called Clear Lake Sporting Goods. You learned about
the four key financial statements: the income statement, balance sheet, statement of stockholders’
equity, and statement of cash flows. Each one provides a different view of the firm’s financial health and
performance.

Clear Lake Sporting Goods is a small merchandising company (a company that buys finished goods and sells
them to consumers) that sells hunting and fishing gear. It uses financial statements to understand its
profitability and current financial position, to manage cash flow, and to communicate its finances to outside
parties such as investors, governing bodies, and lenders. We will use Clear Lake’s company information and
historical financial statements in this chapter as we explore its forecasting process. It’s important to note that
in this chapter, we are focusing on just one firm and the one method its managers have chosen to forecast
financial performance. There are a variety of types of firms in actual application, and they may choose to
forecast their financial performance differently. We are demonstrating just one approach here.

The balance sheet shows all the firm’s assets, liabilities, and equity at one point in time. It also supports the
accounting equation in a very clear and transparent way. We find one section of the balance sheet contains all
current and noncurrent assets that must total the other section of the balance sheet: total liabilities and
equity. In Figure 18.2, we see that Clear Lake Sporting Goods has total assets of $250,000 in the current year,
which balances with its total liabilities and equity of $250,000.

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 18.1 • The Importance of Forecasting 537

Figure 18.2 Balance Sheet

The income statement reflects the performance of the firm over a period of time. It includes net sales, cost of
goods sold, operating expenses, and net income. In Figure 18.3, we see that Clear Lake had $120,000 in net
sales, $60,000 in cost of goods sold, and $35,000 in net income in the current year.

Figure 18.3 Full Income Statement

Finally, the statement of cash flows is used to reconcile net income to cash balances. The statement begins
with net income, then reflects adjustments to balance sheet accounts and noncash expenses. The statement of
538 18 • Financial Forecasting

cash flows is broken down into three key categories: operating, investing, and financing. This allows users to
clearly see what elements of the business are generating or using cash. In Figure 18.4, we see that Clear Lake
had cash flow from operating activities of $53,600, cash used for investing activities of ($18,600), and cash
used for financing activities of ($15,000).

Figure 18.4 Statement of Cash Flows

Another key concept to remember about the financial statements is that the statement of cash flows is
necessary to truly understand how the firm is using and generating cash. A common misconception is that if a
firm reports net income on its income statement, then it must have plenty of cash, and if it reports a loss, it
must be short on cash. Although this can be true, it’s not necessarily the case. Historically speaking, we need
the statement of cash flows to get the full picture of how cash was used or generated in the past. Looking to
the future, we need a cash flow forecast to plan for possible gaps in cash flow and, potentially, how to make
the best use of any cash surplus. Throughout this chapter, we will see how to use historical financial
statements to help develop the future cash forecast.

It’s also important to remember that the four financial statements are tied together. Net income from the
income statement feeds into retained earnings, which live on the balance sheet. Equity balances on the
balance sheet feed information to the statement of stockholders’ equity. And information from both the
income statement (net income and noncash expenses) and the balance sheet (changes in working capital
accounts) all feed into the statement of cash flows. These relationships will be helpful to understand when
using historical statements and preparing forecasts.

Balance Sheet Analysis

Fully understanding the items that are on the balance sheet and how they relate to one another and to other
financial statements will help you create a financial forecast. In Financial Statements, you learned that on the
classified balance sheet, both assets and liabilities are broken down into current and noncurrent categories.
You also know that the balance sheet must live up to its name—it must balance. This means that total assets
(what the company owns) must equal total liabilities and equity (what the company owes).

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 18.1 • The Importance of Forecasting 539

You continued your financial statement development in Measures of Financial Health, where you saw how to
use elements of the balance sheet to assess financial health. Ratios based on balance sheet accounts can be
useful for understanding relationships between balance sheet items—how they related in the past and then, in
forecasting, how those relationships might change or remain the same in the future. Examples of balance
sheet ratios include the current ratio, quick ratio, cash ratio, debt-to-assets ratio, and debt-to-equity ratio.

In Financial Statements, you also explored common-size analysis. To prepare a common-size analysis of the
balance sheet, every item on the statement must be expressed as a percentage of total assets. Seeing each
item as a percentage—that is, seeing its relationship to total assets—is also helpful for assessing historical
statements and how those percentages or relationships can be used to predict future balances in the forecast.
For example, in Figure 18.5, you can see that Clear Lake’s current assets represented 80% of its total assets in
both the current and prior years.

Figure 18.5 Common-Size Balance Sheet

Income Statement Analysis

Like balance sheet analysis, income statement analysis is also quite helpful in preparing for the forecasting
process. In Financial Statements, you learned that the income statement is commonly broken down into a few
sections. Cost of goods sold is deducted from net sales to arrive at gross margin. Gross margin refers to the
profits earned solely on the sale of the product itself, without consideration for the expenses incurred to run
the business. Next, operating expenses are deducted to reflect operating income. Operating income reflects
the profits of the core business function. Finally, other items, such as interest expense, tax expense, and other
gains and losses, are deducted to arrive at net income, a.k.a. the bottom line. Each segment of the income
statement is helpful for assessing past performance and estimating future expenses for a forecast.

You continued your financial statement development in Measures of Financial Health, where you saw how to
540 18 • Financial Forecasting

use elements of the income statement to assess historical financial performance. Ratios based on the income
statement can be useful for understanding relationships between net sales and expenses—how they related in
the past and then, in forecasting, how those relationships might change or remain the same. Examples of
income statement ratios include gross margin, operating margin, and profit margin. Common ratios that
incorporate items from both the balance sheet and the income statement include return on assets (ROA),
return on equity (ROE), inventory turnover, accounts receivable turnover, and accounts payable turnover.

LINK TO LEARNING

Performance Trends
Review the most recent annual report for Big 5 Sporting Goods (https://openstax.org/r/
annual_report_for_Big_5_Sporting-Goods). Review the company’s sales and gross margins for the current
and past two years. How is their performance? Are their sales trending up or down? Why might the
contribution margin have increased or decreased?

In Financial Statements, you also explored common-size analysis. To prepare a common-size analysis of the
income statement, every item on the statement must be expressed as a percentage of net assets. Seeing each
item as a percentage, in terms of its relationship to total sales, is also helpful for assessing historical
statements and how those percentages or relationships can be used to predict future balances in the forecast.
For example, in Figure 18.6, you can see that Clear Lake’s cost of goods sold represented 50% of its net sales in
both the current and prior years.

Figure 18.6 Common-Size Income Statement

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 18.2 • Forecasting Sales 541

18.2 Forecasting Sales

Learning Outcomes
By the end of this section, you will be able to:
• Explain how sales are the main driver for a financial forecast.
• Determine a past time period to formulate the basis for a financial forecast.
• Explain the advantages and disadvantages of using past data to forecast future financial performance.
• Calculate past sales growth averages.
• Justify adjusting relationships when forecasting future financial performance.

In this section of the chapter, you will begin to explore the first step of creating a forecast: forecasting sales.
We will discuss common time frames for sales forecasts and why we use historical data in our forecasts (but
only with caution), and we will work through the process of forecasting future sales. We will be using the
percent-of-sales method to forecast some expenses for Clear Lake Sporting Goods, the example used
throughout the chapter. This method relies on sales data, further highlighting why accuracy in forecasting
sales is crucial.

Sales as the Driver

A significant portion of a business’s costs are driven by how much it sells. Thus, the sales forecast is the
necessary first step in preparing a financial forecast. Common costs driven by sales include direct product
costs, direct labor costs, and other key variable costs (i.e., costs that vary proportionately to sales), such as
sales commissions.

Looking to the Past

Forecasting sales is not always an easy task, as no one knows the future. We can, however, use the information
we do have to forecast future sales with the greatest accuracy possible. Most firms start by looking at the past.
A firm may look at past sales from a variety of prior periods. It’s common to look at the past 12 months to
estimate the coming 12 months. Looking at 12 consecutive months helps identify seasonality of sales trends,
what time of year sales tend to drop off and when they increase, possible sales spikes that might reoccur, and
any other trends that tend to appear over a 12-month period. In Figure 18.7, we see Clear Lake’s sales by
month for the past 12 months.

Past data is often used in conjunction with probabilities and weighted average calculations derived from
probabilities. Though used in several areas of forecasting, this approach is particularly common in drafting the
sales forecast. Using multiple scenarios and the probability of each scenario occurring is a common approach
to estimating future sales.

Figure 18.7 Historical Sales Data

We can see at first glance that sales remain fairly steady from January to April. Sales then goes up significantly
in April and May, seem to peak in June, taper off a bit in July, then decline steeply from August to the end of the
year, with the lowest sales being in November and December. Though not exact, it’s easy to quickly see that
sales follow a seasonal pattern. We will focus on just one year of data here to keep things simple. However, it’s
important to note that when a firm has a seasonal sales pattern, it normally uses more than one year of data
to detect and evaluate the pattern. It’s not uncommon for firms to have a seasonal sales pattern that
fluctuates based on an external factor such as weather patterns, patterns in business or demand, or other
542 18 • Financial Forecasting

factors such as holidays. Common examples might include farm-based businesses that function on a weather
pattern for harvesting and selling crops or a toy company that fluctuates around gift-giving holidays.

This knowledge is helpful when assembling a first pass at the next year’s sales forecast. Using common-size
and horizontal (trend) analyses on sales is also helpful, as shown in Figure 18.8. We can see the exact
percentages that sales went up or down each month:

• In January, the company had sales of $9,000, which was of the total annual sales.
• In June, the company had $19,000 sales, which was of the total annual sales and
of January sales.

Figure 18.8 Historical Sales Data as Percentages

Once a baseline in the 12-month period is assessed, it can also be helpful to look for trends in other ways. For
example, the past several years might be assessed to see if there is a trend in total growth or decline for those
years on a summary basis or by period. Clear Lake Sporting Goods had sales in the current year of $126,000, in
the prior year of $105,000, and two years ago of $89,000. This reflects a 20% increase and an 18% increase,
respectively. It might be reasonable to expect a roughly 18 to 20% increase in total sales in the future with only
this information in mind. Keep in mind that we will learn about many other factors to consider in the forecast,
so the 18 to 20% increase is a good general guideline to consider along with other factors.

THINK IT THROUGH

Sales Forecast for Big 5 Sporting Goods

Review the 2020 annual report for Big 5 Sporting Goods (https://openstax.org/r/
2020_annual_report_for_Big_5_Sporting_Goods). Locate the consolidated statements of operations on page
F-7. Using the company’s net sales figures for the current and prior years, what percentage might you
recommend for their sales forecast for the next year?

Solution:

Big 5’s sales for 2020 and 2019 were $1,041,212,000 and $996,495,000, respectively. This represents a 4.5%
growth from the prior year. Forecasted sales, based solely on this information, might be appropriate at
4.5% growth for the next year, keeping in mind that many other factors should also be considered along
with this information. Historical sales are only one set of data to use as a starting point.

Looking at Figure 18.9, assume that Clear Lake Sporting Goods decides to take its first pass at a forecast using
the more conservative estimate of 18% total sales growth. The company could consider last year’s sales of
$126,000 and increase them by 18% to arrive at total forecasted sales for next year of
. Next, to get the monthly sales, the company could use the same percent of the
total for each month that it did for the previous year. For example, sales in January of last year were 7.1% of
the full year’s sales. To find the forecast for the next year, the company would take the forecasted sales of
$148,680 for the year and multiply that by 7.1% to get $10,620 for January. The process is repeated for each

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 18.2 • Forecasting Sales 543

month to get the full year.

Figure 18.9 Forecasted Sales Data

Keep in mind that this is only a starting point. These estimates will be reviewed, assessed, and updated as
more information and other factors are taken into consideration.

It can also be helpful to look at a shorter period, perhaps just the last few months, on a more detailed basis (by
department, by customer, etc.) to see if there are any possible new trends beginning to develop that might be
an indicator of performance in the coming year. For example, Clear Lake Sporting Goods might look at
detailed sales records for October, November, and December and see that it had an old product line that was
discontinued in early October, which contributed to a 2% reduction in monthly sales. This reduction in monthly
sales will likely continue into the new year until the new line the company has signed on begins arriving in
stores. Thus, the management team feels they should reduce their first quarter monthly estimates by 2%, as
reflected in Figure 18.10. January is now , for example.

Figure 18.10 Adjusted Forecasted Sales Data

Changes for the Future

It’s important to note that the past is not always a reliable predictor of the future. Circumstances can often
change to make the future quite different from the past. The business itself may change, the economy can
change, the customer base may undergo a shift in demographics or a change in buying habits, new
competition may emerge, and so on. So while past performance is helpful, it is only one step in the process of
forecasting sales.

LINK TO LEARNING

Big 5 Sporting Goods MD&A Report

Review the most recent annual report for Big 5 Sporting Goods (https://openstax.org/r/
annual_report_for_Big_5_Sporting_Goods). Review the management’s discussion and analysis (MD&A)
report (Item 7). What information does the report share about the firm, the economy, and other factors
that might be useful for forecasting sales growth for next year?

Most firms first look to the past to target some form of baseline estimate for the coming year; then, managers
begin making adjustments based on what they know about the future. Assume that Clear Lake Sporting Goods
will be adding a new brand to its collection of fishing supplies in March. The manufacturer plans to begin
running its commercials in late February, which managers anticipate will increase Clear Lake’s monthly sales
544 18 • Financial Forecasting

by about $500 in March, $1,000 in April, $1,400 in May, and $2,000 per month in June, July, and August. We see
the monthly adjustments to Clear Lake’s latest sales forecast in Figure 18.11. March, for example, is now
$10,908 ($10,408 prior estimate plus $500 increase from new brand).

Figure 18.11 Forecasted Sales Data with New Brand

What we have discussed here are only some brief examples of the myriad factors that might impact a sales
budget for the coming year. It’s critical that all members of the team take the time and effort to research their
customers and the factors that impact their business in order to effectively assess the impact of these factors
on future sales. Though only two adjustments were made here, it’s likely that a large firm would have to
consider many, many factors that would ultimately impact monthly sales figures before arriving at a
conclusion.

18.3 Pro Forma Financials

Learning Outcomes
By the end of this section, you will be able to:
• Define pro forma in the context of a financial forecast.
• Describe the factors that impact the length of a financial forecast.
• Explain the risks associated with a financial forecast.

In this section of the chapter, we will move beyond the sales forecast and look at the general nature, length,
and timeline of forecasts and the risks associated with using them. We’ll look at why we use them, how long
they generally are, what the key variables in a forecast are, and how we pair those variables with common-size
analysis to develop the forecast.

Purpose of a Forecast
As mentioned earlier in the chapter, forecasts serve different purposes depending on who is using them. Our
focus here, however, is the world of finance. In this realm, the key purpose of pro forma (future-looking)
financial statements is to manage a firm’s cash flow and assess the overall value that the firm is generating
through future sales growth. Growing just for the sake of growing doesn’t always yield favorable income for
the firm. A larger top-line sales figure that results in lower net income doesn’t make sense in the grand
scheme of things. The same is true of profitable sales that don’t generate enough cash flows at the right time.
The firm may make a profit, but if it doesn’t manage the timing of its cash flows, it could be forced to shut
down if it can’t cover the costs of payroll or keep the lights on. Forecasting helps assess both cash flow and the
profitability of future growth. Managers can forecast cash flow using data from forecasted financial
statements; this allows them to identify potential gaps in cash and plan ahead in order to either alter collection
and payment policies or obtain funding to cover the gap in the timing of cash flows.

LINK TO LEARNING

Pro Forma Financial Statements

Review the video Business Plan and Pro-Forma Financial Statements (https://openstax.org/r/
Business_Plan_and_Pro-Forma_Financial_Statements) to learn about the basics of pro forma financial
statements and why they are helpful.

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 18.3 • Pro Forma Financials 545

Length of a Forecast
Forecasts can generally be for any length of time. The length generally depends on the user’s needs. A one-
year forecast, broken down by month, is quite typical. A firm will often go through a formal budgeting process
near the end of its calendar or fiscal year to project financial plans and goals for the coming year. Once that is
done, a rolling financial forecast is then done monthly to adjust as time moves on, more information becomes
available, and circumstances change.

To be useful, the future forecast for financial planning purposes is almost always calculated as monthly
increments rather than one total figure for the next 12 months. Breaking the data down by month allows
finance managers to more clearly see fluctuations in cash flows in and out, identify potential gaps in cash flow,
and plan ahead for their cash needs.

Forecasts can also be done for several years into the future. In fact, they commonly are. However, once the
firm is looking out beyond 12 months, it gets difficult to forecast items with a great degree of accuracy. Often,
forecasts beyond a year will be completed only to quarterly or even annual figures rather than monthly.
Forecasts that far into the future are often strategic in nature, made more to communicate future plans for the
firm than for more detailed decision-making and cash flow planning.

Common-Size Financials
As we saw earlier in the chapter, common-size analysis involves using historical financial statements as a basis
for future forecasts. Financial statements provide a great starting point for analysis, as we can see the
relationships between sales and costs on the income statement and the relationships between total assets and
line items on the balance sheet.

For example, in Figure 18.6, we saw that for the past two years, cost of goods sold has been 50% of sales. Thus,
in the first draft of a forecast for Clear Lake, it’s likely that managers would estimate cost of goods sold at 50%
of their forecasted sales. We can begin to see why forecasting sales first is crucial and why doing so as
accurately as possible is also important.

Select Variables to Use

A simple way to begin a full financial statement forecast might be to simply use the common-size statements
and forecast every item using historical percentages. It’s a logical way to begin a very rough draft of the
forecast. However, several variables should be taken into consideration. First, managers must address the cost
of an account and determine if it’s a variable or fixed item. Variable costs tend to vary directly and
proportionally with production or sales volume. Common examples include direct labor and direct materials.
Fixed costs, on the other hand, do not change when production or sales volume increases or decreases within
the relevant range. Granted, if production were to increase or decrease by a large amount, fixed costs would
indeed change. However, in normal month-to-month changes, fixed costs often remain the same. Common
examples of fixed costs include rent and managerial salaries.

So, if we were to approach our common-size income statement, for example, we would likely use the
percentage of sales as a starting point to forecast variable items such as cost of goods sold. However, fixed
costs may not be accurately forecast as a percentage of sales because they won’t actually change with sales.
Thus, we would likely look at the history of the dollar values of fixed costs in order to forecast them.

CONCEPTS IN PRACTICE

COVID-19 Makes Forecasting Difficult for Big 5 Sporting Goods

Big 5 Sporting Goods announced record earnings in the third quarter of 2020, attributing its huge success
that quarter to the impact of people’s reactions to the COVID-19 pandemic. With so many people in
546 18 • Financial Forecasting

quarantine still wanting to make healthy lifestyle choices, sporting goods stores were making record sales.
Record-breaking sales, however, are not certain in the future. The impacts of the pandemic are extremely
difficult to predict, making it a challenge for Big 5 Sporting Goods and other companies to assemble pro
forma financial statements.

(sources: https://www.globenewswire.com/news-release/2020/10/27/2115470/0/en/Big-5-Sporting-Goods-
Corporation-Announces-Record-Fiscal-2020-Third-Quarter-Results.html; https://finance.yahoo.com/news/
investors-want-big-5-sporting-054658521.html; https://www.cpapracticeadvisor.com/accounting-audit/
news/21206691/four-ways-covid19-will-impact-2021-financial-forecasting-and-planning)

Determine Potential Changes in Variables

So far, we have focused on using historical common-size statements to create a draft (not a final version) of
the forecast. This is because the past isn’t always a perfect indicator of the future, and our finances don’t
always follow a linear pattern. We use the past as a good starting point; then, we must assess what else we
know to fine-tune and make adjustments to the forecast.

Many items impact the forecast, and they will vary from one organization to another. The key is to do research,
gather data, and look around at the market, the economy, the competition, and any other factors that have the
potential to impact the future sales, costs, and financial health of the company. Though certainly not an
exhaustive list, here are a few examples of items that may impact Clear Lake Sporting Goods.

• It has an old product line that was discontinued in early October, contributing to a 2% reduction in
monthly sales that will likely continue into the new year until a new line begins arriving in stores.
• It will be adding a new brand to its collection of fishing supplies in March. The manufacturer plans to
begin running commercials in late February. Managers anticipate that this will increase Clear Lake’s
monthly sales by about $500 in March, $1,000 in April, $1,400 in May, and $2,000 per month in June, July,
and August.
• The company has just finished updating its employee compensation package. It goes into effect in January
of the new year and will result in an overall 4% increase in the cost of labor.
• The landlord indicated that rent will increase by $50 per month starting July 1.
• Some fixed assets will be fully depreciated by the end of March. Thus, depreciation expense will go down
by $25 per month beginning in April.
• There are rumors of new regulations that will impact the costs of importing some of the more difficult-to-
obtain hunting supplies. Managers aren’t entirely sure of the full impact of the new legislation at this time,
but they anticipate that it could increase cost of goods sold for the affected product line when the new
legislation goes into effect in the last quarter. Their best estimate is that it could increase the overall cost
of goods sold by up to 2%.

We will use all of this data later in the chapter when we are ready to compile a complete forecast for Clear
Lake.

18.4 Generating the Complete Forecast

Learning Outcomes
By the end of this section, you will be able to:
• Generate a forecasted income statement that incorporates pertinent sales, functional, and policy
variables.
• Generate a forecasted balance sheet.
• Connect the balance sheet and income statement forecasts with appropriate feedback linkages.

In this section of the chapter, we will tie together what we have learned so far about forecasting sales,

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 18.4 • Generating the Complete Forecast 547

common-size analysis, and using what we know about the company and its environment to create a full set of
pro forma (forward-looking or forecasted) financial statements.

Forecast the Income Statement

To arrive at a fully forecasted income statement, we use historical income statements, common-size income
statements, and any additional information we have about future sales and costs, such as the effects of the
economy and competition. As we saw earlier in the chapter, we begin with forecasted sales because they are
the basis for many of the forecasted costs.

Let’s begin with the sales forecast for Clear Lake Sporting Goods that we saw earlier in the chapter, in Figure
18.9, and use it along with the prior year income statement by month shown in Figure 18.12. We will consider
other data we have about the business to begin creating a full income statement (see Figure 18.13).

Figure 18.12 Prior Year Monthly Income Statement by Month

The first two key points regarding product lines have already been built into the sales forecast. Notice that the
cost of goods sold was 50% in the prior year. However, based on possible future legislation, to be conservative,
we should increase the cost of goods sold by 2% in the last quarter of the year. Thus, we will forecast cost of
goods sold at 50% of sales in the first nine months and increase it to 52% in the last three months of the year.

Rent is a fixed cost that historically amounts to $458 per month. However, we know that the landlord is
increasing rent by $50 starting on July 1. Thus, we will forecast rent at the same fixed cost of $458 per month
for the first six months and increase it to $508 per month for the second half of the year.

Depreciation, also a fixed cost, was historically $300 per month. However, we know that depreciation expense
will go down by $25 beginning in April. Thus, we forecast depreciation at $300 for the first three months and at
$275 for the last 9 months.

Salaries expense has historically been $450 per month. However, we know that the company is implementing a
new compensation program on January 1 that will increase salaries expense by 4% ($18). Thus, we will forecast
salaries for the whole year at $468.

Utilities expense seems to vary somewhat by sales from month to month, as shops are open longer hours
during their busy season. However, the total utilities expense is not expected to change for the coming year.
Thus, the forecast for utilities expense remains at $2,500, broken down by month as a percentage of sales.

Interest expense is a fixed cost and isn’t anticipated to change. Thus, the same $167 interest expense per
month is forecast for the coming year.
548 18 • Financial Forecasting

Finally, income tax expense is forecasted as a percentage of operating income because tax liability is incurred
as a direct result of operating income. Figure 18.13 shows the next 12 months’ forecast for Clear Lake Sporting
Goods using all of this data.

Figure 18.13 Forecasted Income Statement

Forecast the Balance Sheet

Now that we have a reasonable income statement forecast, we can move on to the balance sheet. The balance
sheet, however, is entirely different from the income statement. It requires a bit more research and additional
assumptions. Just like the income statement, it’s often a work in progress. A first draft is a good starting point,
but adjustments must be made once it is created, and all the interrelationships between the statements, cash
flow in particular, are taken into consideration.

The balance sheet is a bit more difficult to forecast because the statement reflects balances at just a given
point in time. Account balances change daily, so forecasting just one snapshot in time for each month can be a
challenge. A good starting point is to assess general company financial policies or rules of thumb. For
example, assume that Clear Lake pays most of its vendors on net 30-day terms. A good way to forecast
accounts payable on the balance sheet might be to add up the cost of goods sold from the forecasted income
statement for the prior month. For example, in Figure 18.14, we see that Clear Lake has forecasted its accounts
payable for March as the cost of goods sold in March from its forecasted income statement.

For accounts receivable, Clear Lake generally receives payment from customers within net 90-day terms. Thus,
it uses the sum of the current and prior two months’ forecasted sales to estimate its accounts receivable
balance.

Inventory will vary throughout the year. For the first six months, the company tries to build inventory for four
months of sales. Once the busy season hits, inventory goes down to three months’ worth of future sales, then
finally drops to only two months of sales in December. Thus, managers use their sales forecast by month to
estimate their inventory ending balance each month.

The equipment balance is forecasted by reducing the prior month’s balance by the forecasted depreciation
expense on the forecasted income statement.

Unearned revenue is historically around 50% of the current month’s sales. Thus, Clear Lake estimates its
unearned revenue balance each month by taking the current month’s net sales from the forecasted income
statement and multiplying it by 50%.

Short-term investments, notes payable, and common stock are not anticipated to change, so the current
balance is forecasted to remain the same for the next 12 months.

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 18.4 • Generating the Complete Forecast 549

To forecast the ending balance for retained earnings for each month, managers add the monthly net income
from the forecasted balance sheet to the prior balance and subtract a quarterly $10,000 dividend.

Once all of these accounts are completed, the balance sheet is out of balance. Given that all of these events
are somewhat related but are not tied together dollar for dollar, it’s not surprising when the forecasted
balance sheet is finished and does not balance. To complete the first draft (see Figure 18.14), the cash account
is used as a variable and plugged in to make the balance sheet balance. Notice that by the end of the year, the
company has $59,905 in cash. However, look at what happens midyear—the cash account falls to only $8,782.
In the next section, we will generate a cash flow forecast, which will allow Clear Lake to update its balance
sheet forecast once it estimates what it will do to cover the cash flow gaps.

Figure 18.14 Forecasted Balance Sheet Draft

Linkages between the Forecasted Balance Sheet and the Income Statement
Notice that in the discussion in the prior section on the balance sheet forecast, a lot of the information in the
forecasted income statement was used to generate the forecasted balance sheet. The balance sheet accounts
generally depend on activity reported in the income statement. For example, for many firms, the balance in
their accounts receivable account is tied to their sales. Looking at historical balances in the accounts receivable
account and how those relate to historical sales will help determine how to use the forecasted future sales to
estimate the future balance of accounts receivable.

The same is true of accounts payable. Looking at past balances, past expenses (normally cost of goods sold),
and the firm’s payment terms for its vendors allows managers to use forecasted cost of goods sold or other
expenses to estimate the balance in the accounts payable account.

We learned in Financial Statements that net income flows into retained earnings. Thus, the net income from
the forecasted income statement can be used to help estimate the ending balance in retained earnings. If the
firm intends to issue any dividends in the coming year, managers should also estimate that reduction in their
forecast.

It’s also common to find other general policies or procedures that help drive performance and aid in
forecasting balances. For example, if the company has a goal of maintaining a certain level of inventory or a
minimum balance in its cash account, that information can be used to guide the estimate for those accounts.
550 18 • Financial Forecasting

18.5 Forecasting Cash Flow and Assessing the Value of Growth

Learning Outcomes
By the end of this section, you will be able to:
• Generate a cash flow forecast.
• Assess a cash flow forecast to determine future cash funding needs.
• Use pro forma financial statements and cash flow forecasts to assess the value of growth to the firm.

In this section of the chapter, we will use the forecasted income statement, forecasted balance sheet, and
other information we know about the firm’s policies and goals for the coming year to generate and assess a
cash flow forecast.

Create a Cash Flow Forecast

A cash flow forecast isn’t overly complex, yet it is not easy to assemble because it requires making many
assumptions about the future. A cash forecast begins with the beginning cash balance, adds anticipated cash
inflows, and deducts anticipated cash outflows. This identifies cash surpluses and shortages.

For Clear Lake Sporting Goods, for example, we see in Figure 18.15 that the company begins with cash of
$42,581,000 in January of the new year. Next, it lists the cash inflows, or cash received from customers. Given
the assumption that customers pay in 90-day terms, the cash flow is filled in by plugging in the sales forecast
for the three prior months. For example, the cash flow from customers of $10,508 for June is the same as the
net sales forecast for March (see Figure 18.13).

Figure 18.15 Forecasted Cash Inflows

Next, Clear Lake identifies cash outflows, which include accounts payable, salaries, rent, utilities, dividends,
and interest payments. Accounts payable are normally paid within 30 days, so the forecast for cost of goods
sold for the prior month is used as an estimate of amount paid for payables. For example, in Figure 18.16, we
see that the accounts payable settled in June of $8,610 is the cost of goods sold for May from the forecasted
income statement.

Salaries are paid monthly and thus represent the same recurring monthly cash outflow, as does rent. Utilities,
like accounts payable, are assumed to be paid within 30 days. Thus, the cash outflow for utilities is the utilities
expense for the prior month from the forecasted income statement.

Management intends to pay a quarterly dividend of $10,000. Thus, in Figure 18.16, we see $10,000 cash
outflows forecasted for March, June, September, and December. Interest on the long-term liability is paid
quarterly. Thus, the $500 cash outflows in March, June, September, and December are simply the monthly
interest expense of $167 from the income statement, summed for each quarter.

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 18.5 • Forecasting Cash Flow and Assessing the Value of Growth 551

Figure 18.16 Forecasted Cash Inflows and Outflows

Using a Cash Forecast to Determine Additional Funds Needed

Finally, at the end of the cash flow forecast, cash outflows are subtracted from the cash inflows. This identifies
whether a cash surplus (extra) or cash deficit (not enough) exists for each month. For example, in Figure
18.17, we see that in March, Clear Lake is forecasting $4,800 of cash inflows and $17,800 of total cash outflows,
which results in a cash deficit of $13,000.

Clear Lake has a general policy to not let its cash balance fall below $35,000. Thus, managers need to assess
their monthly balances and potential deficits and identify months when financing is necessary. For example,
the deficit of $13,000 in March is enough to push the cash balance lower than $35,000. Thus, it’s estimated that
the company will need $5,000 in short-term financing in March. It has an estimated surplus in April, so $3,000
of the borrowing is returned.

Figure 18.17 Forecasted Cash Surplus or Deficit

Assessing the Value of Growth

It’s a fairly common assumption that most, if not all, businesses want to grow. While it certainly can be good
as a firm to grow in size, growth just for the sake of growth isn’t necessarily a good goal. A firm can grow in
size based on customers, employees, locations, or simply sales. However, that doesn’t mean that the growth
will increase profits. Growth may increase profits, but this is not a safe assumption. Scaling up operations
takes careful planning, which includes monitoring the profitability of the sales and, of course, the cash flow it
552 18 • Financial Forecasting

would require. Growing a business can require more inventory, more locations, more equipment, and more
manpower, all of which cost money. Even if the forecasted growth is profitable, it may pose problems from a
cash flow perspective. It’s important that the firm review not only its forecasted income statement and
balance sheet but also its cash forecast, as this can reveal some serious gaps in funding depending on the
extent, timing, and nature of the planned growth.

For example, assume that Clear Lake Sporting Goods intends to run a large-scale ad campaign to boost sales
in its busy season. Historically, the store relied primarily on its prime location for high volumes of retail foot
traffic. Managers felt, however, that given the increase in competition, they could boost sales significantly by
running the ad campaign in the first quarter. The campaign would cost $30,000. Forecasts already reflect a
cash deficit at the end of the first quarter of $13,000, so the additional $30,000 ad campaign, which would
require payment up front, would create a much larger need for funding. It’s also important that managers
look at the increased cost of doing business along with the increased cost in advertising to ensure that the
move would be profitable. Fortunately, Excel or other forecasting software can be used to create a forecast
with formulas that tie together, making scenario analysis such as this a much easier process.

Scenarios in Forecasting
Forecasting is almost never a linear process. In other words, we don’t do one forecast and call it good. The first
draft is completed using historical data, and then changes are made a bit at a time as all potential variables are
assessed for their impact on the forecast. It’s quite common to then use the work-in-progress forecast to
complete scenario analysis. This is particularly true when the forecast is completed in Excel or other budgeting
or forecasting software. Elements of the forecast can be changed to see what the overall impact would be to
the firm. Assuming the forecast is set up using formulas in Excel or other software, a change to one figure or
one variable would then “ripple” through the forecast to reflect the overall impact.

Often, a firm may complete an initial forecast (scenario) under the assumption that the economy is in a
“normal state.” The firm can then alter the initial forecast for different scenarios, such as the economy in a
recession or the economy in a state of expansion. This helps the firm understand different possible future
states and highlights how changes in the economy such as inflation may cause revenue and expenses to
increase.

Assume that Clear Lake’s initial forecast is created under the assumption that the economy will remain
average. Management also wants to know the worst-case scenario. What will their financial results look like if
the economy were in a recession, for example? If management assumes their sales would drop to only 60% of
the prior year sales in a recessionary economy, they could alter the formula in Excel driving their sales and
variable costs, resulting in a new pro forma income statement. In Figure 18.18, we can see that net income
would drop to $16,391 under this assumption, compared to the net income of $47,653 forecasted under
average economy assumptions in Figure 18.13.

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 18.5 • Forecasting Cash Flow and Assessing the Value of Growth 553

Figure 18.18 Forecasted Cash Surplus or Deficit

Though creating a full forecast in Excel can be a bit complex, it is a powerful tool that is useful for analysis.
Elements can be used to vary just about anything, from something small such as a 1% increase in the cost of a
product to a company-wide increase in salaries, the introduction of an entire new product line, or the purchase
of a new production machine, among other possibilities.

For example, assume that Clear Lake has completed a first pass at its forecast and is reviewing the forecasted
profit for the next 12 months. Managers feel the profit is currently low, as they always want to target a certain
percentage. They might tinker with variables in the forecast file to see the impact on profits of potential
changes they are considering. They may reduce the new salaries package by a percentage point to see if it
gets them closer to their goal. They may adjust cost of goods sold by a certain percentage if they feel they can
negotiate with vendors to work down their costs. They may adjust rent and see if they can find a better retail
location to either reduce costs or increase sales due to increased foot traffic in a new location. They may save
an entirely new version of the forecast and change it drastically to see what investing in opening a second
retail location would do.

As you can see, the list of possibilities is endless. Though the main goal of financial managers may be cash
planning, the power of a well-developed forecast is tremendous. It can help assess potential growth, new
opportunities, and even small changes in the business as well.

Sensitivity Analysis in Forecasting

Sensitivity analysis will often look at the change in just one variable rather than the entire scenario. It
examines how sensitive a particular output (commonly net income) will be to a change in a particular
underlying input (sales or costs, for example). What if sales are 10% more or less than forecasted? What if the
prices the firm can charge its customers are 10% more or less? What if the cost of goods sold increases by
10%? The purpose is to see which variables are crucial to “get right.” It isn’t worth spending a lot of research
dollars to make sure you are accurately predicting a variable if that variable won’t notably change the
outcome. However, a slight change in other variables may have significant impact.

Using pro forma financial statements created in Excel allows management to quickly generate new pro forma
financials and see the impact that each possible variable might have on the overall financial results.
554 18 • Financial Forecasting

18.6 Using Excel to Create the Long-Term Forecast

Learning Outcomes
By the end of this section, you will be able to:
• Generate a financial statement forecast using spreadsheet tools.
• Connect the balance sheet and income statement using appropriate formula referencing.
• Use spreadsheet functions to generate appropriate iterations that balance financial forecasts.

Throughout this chapter, we have seen forecasted financial statements for Clear Lake Sporting Goods along
with its forecasted cash flow. These statements could all have been generated by hand, of course, but that
wouldn’t be an effective use of time. As mentioned in prior sections, several different types of software can be
quite effective in making the forecasting process faster and more flexible. In this section, we will review just
one common option, Microsoft Excel.

Download the spreadsheet file (https://openstax.org/r/spreadsheet_file) containing key Chapter 18

Excel exhibits.

Using the “Sheet”

Creating a budget in Excel can be very simple or extremely complex, depending on the size and complexity of
the business and the number of formulas and dependencies that are written into the Excel workbook.

Creating the forecast in Excel follows the same steps and flow we just explored in this chapter but with the
power of a software program to do the math for you. We begin with the sales forecast, which uses several key
formulas in Excel.

1. First, sales are projected to be 18% higher than the prior year. Thus, a total projection for the year is
calculated using a simple link and multiplication function tied to last year’s total sales. In Figure 18.19, you
can see the formula in cell O4 is “='Figure 18.12'!N4*1.18”. This formula simply does the math to increase
the prior year’s sales by 18%.
2. Next, the sales are distributed by month. In Figure 18.19, we see in cell B5 that the forecasted income
statement sheet is linked to the percent of annual sales from the Prior Year Income Statement (Figure
18.12) sheet. Then, in cell B4, January sales are estimated with a formula that multiplies the total
forecasted sales in O4 by the percent of annual sales for January of the prior year. Notice that the formula
then multiplies that product by 0.98. This is because Clear Lake discontinued a product line in the last
quarter of the prior year, and management feels that this will reduce sales in the first quarter of the new
year by roughly 2%.

Figure 18.19 Forecasted Sales Formulas in Excel

3. As Clear Lake continues to fill out its forecasted income statement, the next formula we see is a simple
sum formula to calculate net sales in B8 (see Figure 18.20). It’s a simple formula that subtracts sales
returns and allowances in B7 from gross sales in B4. Similar formulas are also found in B10 for gross
margin and B18 for net income.
4. In cell B9, we see a multiplication formula that multiplies sales from B4 by 0.5, or 50%. This is because

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 18.6 • Using Excel to Create the Long-Term Forecast 555

management feels that cost of goods sold will remain the same as last year, in most quarters at least, and
last year’s percentage was 50%.
5. Rent, depreciation, and salaries are all simply typed in, as they are fixed expenses that remain the same as
last year.
6. The utilities calculation, found in cell B14, is somewhat similar to the sales calculation. The total utilities
expense from O14 is multiplied by the current month’s sales in B4 divided by the total annual sales in O4.
This spreads out the utility cost by month based on the percentage of annual sales.

Figure 18.20 Forecasted Income Statement Formulas

Clear Lake’s forecasted balance sheet ties very closely to both the forecasted income statement and the prior
year’s income statement. In Figure 18.21, we see in C7 an addition formula using the sum of the current
month and three months of prior sales as an estimate of the ending accounts receivable balance. The formula
for inventory is similar but forward looking. In C8, inventory is estimated by adding the cost of goods sold for
the current month and next three months from the forecasted income statement.

Total current assets in C10 is calculated with a SUM formula that adds together the values in all the selected
cells. Amounts such as short-term investments and common stock that are not anticipated to change are
simply typed as a number in the cell. Much like in the income statement, subtotals are found in C13 for total
assets, C17 for current liabilities, C24 for total equity, and C25 for total liabilities and equity. Retained earnings
in C23 pulls the ending retained earnings balance from the end of last year (hidden in column B) and adds the
556 18 • Financial Forecasting

net income for January in the forecasted income statement to get the current month’s ending balance.

Figure 18.21 Forecasted Balance Sheet Formulas

Much like the balance sheet, the cash forecast also relies heavily on data from the forecasted income
statement as well as the forecasted balance sheet. To begin the year, in Figure 18.22, we see that the formula
in B4 pulls the cash balance from the forecasted balance sheet. In B6, the formula pulls the sales for the three
months prior from the previous year’s income statement. This is because it’s assumed that cash is collected
from customers 90 days after the sale. The same approach is used for accounts payable, rent, salaries, and
utilities. The formulas pull the expenses from a prior month depending on the assumed timing for payment.
Utilities, for example, are assumed to be paid within 30 days, so the cash outflow in February is assumed to be
the utilities expense for January from the forecasted income statement. Note that interest payments are
assumed to be zero in January and February, but in March, the formula in D14 sums the interest expenses on
the forecasted income statement for January, February, and March. This is because interest is paid quarterly.

Finally, note the formula in C4. The beginning cash balance for a given month is the same as the ending cash
balance from the prior month; thus, the figure in B18 is linked to C4 to start the new month.

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 18.6 • Using Excel to Create the Long-Term Forecast 557

Figure 18.22 Cash Forecast Formulas

Using Excel Functions to Balance

Once we get a draft of the forecasts outlined, then the tinkering starts. Additional information can be used to
adjust the formulas, as we saw with the 2% reduction in January sales for the forecasted income statement.
Because we have linked most (though not all) of our expenses, subtotals, and statements together using
formulas, management can also use the forecast workbook to perform scenario and sensitivity analyses,
essentially asking “what if?” and looking at the results. When completed, however, before finalizing the
forecast, it’s important that the financial statements are in balance (particularly the balance sheet, just as the
name implies).

Notice that throughout, we used formulas to calculate subtotals to ensure they are correct and change as
needed. We also linked figures, such as the ending and beginning cash balances, to ensure they are in balance.
Perhaps the easiest but most important thing to do is to ensure that the balance sheet balances. We can do
this with a simple formula that compares total assets to total liabilities and equity. We can see in Figure 18.23
that subtracting one from the other in cell C27 should result in $0. If there is a difference, the formula will
highlight it, forcing us to investigate and correct the sheet so that it balances.
558 18 • Financial Forecasting

Figure 18.23 Forecasted Balancing Formula

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 18 • Summary 559

Summary
18.1 The Importance of Forecasting
Forecasting financial statements is important to different users for different reasons. In finance, it’s most
important for assessing the value of future growth plans and planning for future cash flow needs.

18.2 Forecasting Sales

The sales forecast is the foundation on which much of the rest of the forecast is built. Thus, the sales forecast
is completed first. Historical sales data and any other information on the firm, its products, the economy, its
customers, and its competitors are all used to create the most accurate sales forecast possible.

18.3 Pro Forma Financials

Pro forma financial statements are forward looking in nature. They use the sales forecast, historical data,
financial statement analyses, relationships between accounts and statements, and any other information
known about the firm, the environment, and the future to create the most accurate financial statement
forecast possible.

18.4 Generating the Complete Forecast

Interrelationships among historical data, the forecasted income statement, and the forecasted balance sheet
are all used to estimate each line item in the financial statements.

18.5 Forecasting Cash Flow and Assessing the Value of Growth

Once the income statement and balance sheet forecasts are complete, data from those statements,
information on company policies, and account relationships are used to generate a cash forecast. The cash
forecast is important for identifying any gaps in cash flow so that financial managers can plan for cash needs.
It’s also important to review not only the cash forecast but all forecasted financial statements to assess the
overall impact and value of proposed firm growth.

18.6 Using Excel to Create the Long-Term Forecast

Excel can be a powerful tool for creating financial forecasts. Formulas that complete mathematical functions
and tie accounts and financial statements together are used to create the statements, ensure that they
balance, and facilitate scenario and sensitivity analyses.

Key Terms
balance sheet a financial statement that reflects a firm’s asset, liability, and equity account balances at a
given point in time
cash deficit an excess of cash outflows over cash inflows for a given period
cash forecast a financial statement that estimates a firm’s future cash inflows and outflows
cash surplus an excess of cash inflows over cash outflows for a given period
common-size describes a financial statement in which each element is expressed as a percentage of a base
amount
financing activities cash business transactions reported on the statement of cash flows that reflect the use
of financed funds
forecast an estimate of future performance based on historical performance and other contextual
information
income statement a financial statement that measures a firm’s financial performance over a given period of
time
investing activities cash business transactions reported on the statement of cash flows that reflect the
acquisition or disposal of long-term assets
560 18 • Multiple Choice

operating activities cash business transactions reported on the statement of cash flows that relate to
ongoing day-to-day operations
pro forma in the context of financial statements, forward-looking
scenario analysis analysis of how various situations and circumstances would impact the financial forecast
sensitivity analysis analysis of the sensitivity of an output variable to a change in an input variable
statement of cash flows a financial statement that lists a firm’s cash inflows and outflows over a given
period of time
statement of stockholders’ equity a financial statement that reports the difference between the beginning
and ending balances of each of the stockholders’ equity accounts during a given period

Multiple Choice
1. Which type of financial statement analysis is most commonly used to create a baseline estimate for a
financial forecast?
a. Trend analysis
b. Common-size analysis
c. Ratio analysis
d. Liquidity analysis

2. What key element of the income statement is used to estimate several other key income statement lines?
a. Cost of goods sold
b. Gross margin
c. Sales
d. Fixed costs

3. Jamal wants to forecast sales for the first quarter of next year. His first assumption is that sales will likely
grow by 3% in the coming year. If Jamal’s monthly sales were $10,000, $9,000, and $11,000 in the first
quarter of this year, what should his sales forecast be for the first quarter of next year?
a. $30,000
b. $30,900
c. $33,000
d. $33,500

4. In the context of a firm’s financial statements, what does pro forma mean?
a. Forward looking
b. Historical
c. Board approved
d. Audited

5. What is the most common length of a forecast if the goal is to forecast cash and assess possible short-
term growth?
a. 3 months
b. 12 months
c. 3 years
d. 5 years

6. When completing a first pass at a forecasted income statement, which type of costs are assumed to be
tied directly to sales?
a. Fixed costs
b. Period costs

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 18 • Review Questions 561

c. Variable costs
d. Sunk costs

7. In the cash forecast, if cash inflows exceed cash outflows, what does this create?
a. A cash surplus
b. A cash deficit
c. A long-term liability
d. An undeclared dividend

8. Amelia wants to use a formula in Excel to estimate her utilities expense for each month. She normally pays
her utilities within 30 days. What formula or link might she use in Excel to estimate her cash outflow for
utilities?
a. Sum the past three months’ cost of goods sold from the forecasted income statement
b. Link to the prior month’s accounts payable from the forecasted balance sheet
c. Link to the prior month’s utilities expense from the forecasted balance sheet
d. Link to the prior month’s ending cash balance from the cash flow forecast

9. Amelia wants to use a formula in Excel to estimate her sales for each month. She believes her sales for the
next year will be about 7% higher than this year’s. She also has a big new ad campaign running late this
year that she thinks will add another $5,000 to January sales. Which of the following is an appropriate Excel
formula for Amelia’s January sales?
a. =(lastyearsalesA2*1.07)+5000
b. =(lastyearsales+5000*1.07)
c. =lastyearsalesA2+5000*.07
d. =lastyearsalesA2*5000*1.07

Review Questions
1. Javier’s firm has created a forecasted income statement that shows the firm with a net profit of $25,000 for
the coming year. What can we assume about Javier’s cash flows?

2. Lulu’s firm’s sales grew by 9%, 11%, and 10% over the past three years, respectively. Lulu wants to take her
first pass at forecasting sales for next year. What percent sales growth would you recommend she use,
and why?

3. Aria wants to create a set of pro forma financial statements. Her goal is to plan for future cash flows and
operations as well as help envision her long-term strategy. What time frames should Aria consider for her
operations and cash flows versus her long-term strategy?

4. What information might you use to calculate the ending balance for retained earnings on a forecasted
balance sheet?

5. Damon estimates his beginning cash balance for June to be $10,000, with cash inflows of $4,000 and cash
outflows of $6,000 for the month. What is Damon’s forecasted ending balance for June?

6. Tanneh wants to use an Excel formula to help her estimate sales for January in her forecasted income
statement. She already has her sales estimate for the full year. Assuming she wants to use the past year’s
income statement percentages to forecast next year’s sales, how would she calculate estimated sales for
January?
562 18 • Problems

Problems
1. ABC Company has the following data for its monthly sales. Complete the % of Annual Sales row.

2. Using the same data as in Problem 1, assume that ABC Company expects a 10% increase in sales in the
coming year (10% more than the $575,000 it had in the past year). Prepare its sales forecast, assuming the
company breaks its sales down by month using the same percentages as the actual sales from the past
year, which you calculated in the first problem.

3. ABC Company anticipates its sales being a bit lower than normal in January and February of the coming
year due to major road construction on the street where it is located, which will draw away foot traffic
from the store. The company anticipates that this will reduce its sales in these two months by 5%. Use the
information from Problems 1–2 to update the sales forecast.

4. ABC Company’s cost of goods sold last year was 60%. It anticipates that this will be the same in the
coming year. Its sales returns and allowances are small, normally 1% of sales. Use the information from
Problems 1–3 to estimate the company’s sales returns and allowances, net sales, and cost of goods sold
and calculate its gross margin.

5. Use the partial income statement generated in Problem 4 along with the following additional information
to complete ABC Company’s forecasted income statement in Excel.
a. Rent expense is $1,000 per month. However, the landlord has indicated that rent will go up to $1,250
in the fourth quarter.
b. Depreciation expense is $2,250 per month and does not change throughout the year.
c. Salaries expense is $1,500 per month and is expected to go up by 10% in the second half of the year,
when a new compensation plan will be implemented.
d. Utilities expense is $5,000 for the entire year and should be allocated to each month based on that
month’s percentage of annual sales.
e. Interest expense is $500 per month.
f. Income tax is 25% of operating income less interest expense.

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 18 • Video Activity 563

Video Activity
What Is a Pro Forma?

Click to view content (https://openstax.org/r/what-is-a-pro-forma)

1. What is a pro forma financial statement? What are some scenarios in which you might find a pro forma
financial statement helpful?

2. Why might someone compile a pro forma financial statement that is intentionally inaccurate? What factors
contribute to the accuracy of a pro forma?

Cash Flow Forecasting Explained: How to Complete a Cash Flow Forecast Example

Click to view content (https://openstax.org/r/Cash_Flow_Forecasting)

3. Assume you are the financial manager for a large electronics retailer. What benefits could you gain from
preparing a cash forecast?

4. Assume you are the financial manager for a large electronics retailer. You are going to prepare a cash
forecast. What key cash inflows and outflows do you anticipate will be in your forecast?
564 18 • Video Activity

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 19 • Why It Matters 565

19
The Importance of Trade Credit and Working Capital in Planning

Figure 19.1 Working capital describes the resources that are needed to meet the daily, weekly, and monthly operating cash flow
needs. (credit: modification of "Sealey Power Products Warehouse" by Mark Hunter/flickr, CC BY 2.0)

Chapter Outline
19.1 What Is Working Capital?
19.2 What Is Trade Credit?
19.3 Cash Management
19.4 Receivables Management
19.5 Inventory Management
19.6 Using Excel to Create the Short-Term Plan

Why It Matters
During the COVID-19 pandemic, many families and small businesses realized the importance of financial
resiliency. In personal finance, financial resiliency is the ability to overcome financial difficulties such as sudden
job loss or significant unexpected expenses—to spring back quickly.

To help promote resiliency, personal financial planners advise clients to maintain liquid assets equal to three
to six months of living expenses, keep debt levels low, manage the household budget, keep insurance in force
(health, property, and life), establish a solid credit history, and make wise use of credit cards and home equity
lines of credit.

In business finance, financial resiliency is not important only during pandemics but is important through the
ups and downs of seasonal cycles and economic downturns. Managing cash, accounts receivable, and
inventory while making optimal use of trade credit (accounts payable) makes for a business that meets its
operating needs and pays its debts when due.

Working capital management is also critical during good times. Even though profits might be rising, a business
with growing demand for its products and services still needs to have working capital management tools to
pay its bills. Growth in sales and profits do not immediately mean sufficient cash flow, so planning ahead with
tools such as a cash budget is key.
566 19 • The Importance of Trade Credit and Working Capital in Planning

19.1 What Is Working Capital?

By the end of this section, you will be able to:
• Define working capital.
• Calculate a firm’s operating cycle and cash cycle.
• Compute inventory days, accounts receivable days, and accounts payable days.

The concept of business capital is often associated with the cash and assets (such as land and equipment) that
the owners contributed to the business. Early political economists like Adam Smith and Karl Marx identified
this concept of capital, along with labor and entrepreneurship, to be the factors of production.

That general idea of capital is important and critical to a company’s productive capacity. This chapter is about
a specific type of capital— working capital—that is just as important as long-term capital. Working capital
describes the resources that are needed to meet the daily, weekly, and monthly operating cash flow needs.
Employees are paid out of working capital as well as cash from operations, the fulfillment of merchandise
orders is possible because of working capital, and the liquidity of a company hinges upon how well
management plans and controls working capital.

Understanding working capital begins with the concept of current assets—those resources of a business that
are cash, near cash, or expected to be turned into cash within a year through the normal operations of the
business. Current assets are necessary for the everyday operation of the firm, and they are synonymous with
term gross working capital.

Cash is needed to pay the bills and meet the payroll. Excess cash is invested in cash alternatives such as
marketable securities, creating liquidity that can be tapped when operating cash flow needs exceed the
amount of cash on hand (checking account balances). Investment in inventory is necessary to meet the
demand for products (sales), and if the firm extends credit to its customers so that a sale can be made, the
balance sheet will also show accounts receivable—a very common current asset that derives its value from the
probability that customers will pay their bills.

Working capital is often spoken about in two versions: gross working capital and net working capital. As was
previously stated, gross working capital is equivalent to current assets, particularly those that are cash, cash-
like, or will be converted to cash within a short period of time (i.e., in less than one year).

Net working capital (NWC) is a more refined concept of working capital. It is best understood by examining its
formula:

Goal of Working Capital Management

The goal of working capital management is to maintain adequate working capital to

• meet the operational needs of the company;

• satisfy obligations (current liabilities) as they come due; and
• maintain an optimal level of current assets such as cash (provides no return), accounts receivable, and
inventory.

Working capital management encompasses all decisions involving a company’s current assets and current
liabilities. One very important aspect of working capital management is to provide enough cash to satisfy both
maturing short-term obligations and operational expenditures—keeping the company sufficiently liquid.

In summary, working capital management helps a company run smoothly and mitigates the risk of illiquidity.
Well-run companies make effective use of current liabilities to finance an optimal level of current assets and
maintain sufficient cash balances to meet short-term operating goals and to satisfy short-term obligations.
Working capital management is accomplished through

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 19.1 • What Is Working Capital? 567

• cash management;
• credit and receivables management;
• inventory management; and
• accounts payable management.

Components of Working Capital Management

In contrast to net working capital, gross working capital is synonymous with current assets, particularly those
current assets that are either cash or cash equivalents or that will be converted to cash within a short period of
time (i.e., in less than one year).

Below is a list of the components of gross working capital.

• Cash and cash equivalents

• Marketable securities
• Accounts receivable
• Inventory

Here is an example. On December 31, a company has the following balances and gross working capital:

Think of the $1,105,000 of gross working capital as a source of funds for the most pressing obligations (i.e.,
current liabilities) of the company. Gross working capital is available to pay the bills. However, some of the
current assets would need to be converted to cash first. Accounts receivable need to be collected, and
inventory would need to be sold before it too can become cash. What if the company had $600,000 of current
liabilities? That amount of current obligations could not be paid out of cash until the marketable securities
were sold and a significant portion of accounts receivable were collected.

The second, more refined and useful concept of working capital is net working capital:

For example, if a company has $1,000,000 of current assets and $750,000 of current liabilities, its net working
capital would be $250,000 ($1,000,000 less $750,000).

NWC provides a better picture because it takes into account the liability “coverage” provided by the current
assets. As the above example shows, the current assets would “cover” the current liabilities with an excess of
$250,000. Think of it this way: if the current assets could be converted to cash, they could be used to meet the
current obligations with another $250,000 of cash leftover.

Current liabilities include

• accounts payable;
• dividends payable;
• notes payable (due within a year);
• current portion of deferred revenue;
• current maturities of long-term debt;
• interest payable;
• income taxes payable; and
• accrued expenses such as compensation owed to employees.

Net working capital possibilities can be thought of as a spectrum from negative working capital to positive, as
568 19 • The Importance of Trade Credit and Working Capital in Planning

explained in Table 19.1.

Negative Net Working Capital Zero Net Working Capital Positive Net Working Capital
Current liabilities are greater than Current assets equal current Current assets are greater than
current assets. liabilities. current liabilities.
Indicates that the company can
Indicates that current assets could meet its current obligations.
Could indicate a liquidity problem. cover current obligations. However, However, excessively high net
There is difficulty satisfying current there is no positive margin (safety working capital could mean too
obligations. cushion) or “liquid reserve” to little cash and therefore an
satisfy unexpected cash needs. opportunity cost (forgoing rates of
return on alternative investment).

Table 19.1 Spectrum of Net Working Capital

Measures of Financial Health provides information on a variety of financial ratios to help users of financial
statements understand the strengths and weakness of companies’ financial statements. Three of the financial
ratios covered in that chapter are brought back into this chapter’s discussion to demonstrate how financial
managers examine working capital and liquidity. Liquidity is the ease with which an asset can be converted
into cash. Those ratios are the current ratio, the quick ratio, and the cash ratio. A higher ratio indicates a
greater level of liquidity.

The formulas for the three liquidity ratios are:

Notice how the current ratio includes the two elements of net working capital—current assets and current
liabilities. It makes for a quick comparison of relative size or proportion.

THINK IT THROUGH

Current Ratio
A company has $2,000,000 of current assets, while its current liabilities are $1,000,000. What is the current
ratio, and what does it mean?

Solution:

The current ratio would be which is a 2:1 proportion of current asset value to
the amount of the current liabilities. This means that if all the current assets could be converted to cash,
then the current liabilities could be satisfied two times.

There are two drawbacks to the current ratio: (1) it is a working capital analytic as of a point in time but is not
indicative of future liquidity or future cash flows and (2) as an indicator of liquidity, it can be deceptive if a
significant proportion of the current assets are inventory, supplies, or prepaid expenses. Inventory is not very
liquid as it can take an extended time period to convert to cash, and assets such as supplies and prepaid
expenses never become cash and therefore are not a source of funds to pay bills.

The quick ratio is considered a more conservative indication of liquidity since it does not include a firm’s

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 19.1 • What Is Working Capital? 569

inventory: .

THINK IT THROUGH

Quick Ratio
A company’s current assets total $2,000,000, but $500,000 of that is inventory and the current liabilities total
$1,000,000. What is the quick ratio, and what does it mean?

Solution:

The quick ratio would be and would indicate a smaller cushion of net
working capital.

THINK IT THROUGH

Cash Ratio
The cash ratio is even more conservative in that it presents a picture of liquidity by excluding all current
assets except cash and marketable securities.

A company’s total current assets are $2,000,000, but only $1,100,000 of the current assets consist of cash
and marketable securities. Assuming $1,000,000 of current liabilities, what would be the cash ratio and what
does it mean?

Solution:

The cash ratio would be and the amount of cash is enough to pay the
current bills by $100,000.

Working capital ratios, like any financial ratio, are most valuable when examined in light of trends and in
comparison to industry/peer averages. For example, a deteriorating current ratio over several quarters (a
decline in the company’s current ratio) could indicate a reduced ability to pay bills.

Working capital ratios are also compared to industry averages, which are available in databases produced by
such financial publishers as Dun & Bradstreet, Dow Jones Company, and the Risk Management Association
(RMA). These information services are available via subscriptions and through many libraries. For example, if a
company’s current ratio is 0.9 while the industry average is 2.0, then the company is less liquid than the
average company in its industry and strategies, and techniques need to be considered to change things and to
better compete with peer groups. Industry averages can be aspirational, motivating management to set
liquidity goals and best practices for working capital management.

It is common to think about working capital with a simple assumption: current assets are being “financed” by
current liabilities. However, such an assumption may be an oversimplification. Some level of current assets is
often necessary to meet longer-term obligations, and in that way, you could think of some amount of current
assets as a permanent based of working capital that may need to be financed with longer-term sources of
capital.

Think of a company with seasonal business. During busy times, more working capital will be needed than
during certain other portions of the year, such as less busy times. But there will always be some level—a
permanent base—of working capital needed. Think of it this way: the total working capital of many companies
will ebb and flow depending on many variables such as the operating cycle, production needs, and the growth
of revenue. Therefore, working capital can be thought of as having a permanent base that is always needed
570 19 • The Importance of Trade Credit and Working Capital in Planning

and a total working capital amount that increases when activity levels (i.e., production and sales volume) are
higher (see Figure 19.2).

The Cash Cycle

The cash cycle, also called the cash conversion cycle, is the time period between when a business begins
production and acquires resources from its suppliers (for example, acquisition of materials and other forms of
inventory) and when it receives cash from its customers. This is offset by the time it takes to pay suppliers
(called the payables deferral period).

Figure 19.2 Working Capital Needs Can Vary: Temporary and Permanent Working Capital

The cash cycle is measured in days, and it is best understood by examining its formula:

The inventory conversion period is also called the days of inventory. It is the time (days) it takes to convert
inventory to sales and is calculated by following these steps:

1. First, calculate the Inventory Turnover Ratio using this formula:

The Average Inventory is arrived at as follows:

2. Then, use the Inventory Turnover Ratio to calculate the Inventory Conversion Period:

The receivables collection period, also called the days sales outstanding (DSO) or the average collection
period, is the number of days it typically takes to collect cash from a credit sale. It is calculated by following
these steps:

1. First, calculate the Accounts Receivable Turnover using this formula:

The Average Accounts Receivable is arrived at as follows:

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 19.1 • What Is Working Capital? 571

2. Then, use the Accounts Receivable Turnover to calculate the Receivables Collection Period:

The payables deferral period, also known as days in payables, is the average number of days its takes for a
company to pay its suppliers. It is calculated by following these steps:

1. First, calculate the Accounts Payable Turnover using this formula:

The Average Accounts Payable is arrived at as follows:

2. Then, use the Accounts Payable Turnover to calculate the Payables Deferral Period:

THINK IT THROUGH

Periods of the Cash Cycle

Scenario 1: King Sized Products (KSP) Inc. has annual credit sales of $40,000,000. The average inventory is
$3,000,000, and the company has average accounts receivable of $6,000,000 and average accounts payable
of $2,800,000. The cost of goods sold for KSP Inc. is $30,000,000. The cash cycle for the company is 57.2
days. Calculate the inventory conversion, receivables collection, and payable deferral periods.

Solution:

Inventory conversion period:

•
•

Receivables collection period:

•
•

Payables deferral period:

•
•

The solution (the entire cash conversion cycle) is also illustrated in a chart, Figure 19.3.
572 19 • The Importance of Trade Credit and Working Capital in Planning

Figure 19.3 Cash Conversion Cycle

Shortening the inventory conversion period and the receivables collection period or lengthening the payables
deferral period shortens the cash conversion cycle. Financial managers monitor and analyze each component
of the cash conversion cycle. Ideally, a company’s management should minimize the number of days it takes
to convert inventory to cash while maximizing the amount of time it takes to pay suppliers.

Quickly converting inventory to sales speeds up cash inflows and shortens the cash cycle, but it also could help
reduce inventory losses as a result of obsolescence. Inventory becomes obsolete because of a variety of
factors including time—inventory that has not been sold for a long period of time and is not expected to be
sold in the future has to be written down or written off according to accounting rules. Write-offs of inventory
can result in significant losses for a company. In the food business, inventory conversion periods take on great
importance because of spoilage of perishable goods; in retailing, seasonal items lose value the longer they
stay on the shelves.

Various inventory management techniques are used to shorten production time in manufacturing, and in
retailing, strategies are used to reduce the amount of time a product sits on the shelf or is stored in the
warehouse. Production techniques such as just-in-time inventory systems and marketing and pricing
strategies can have an impact on the number of days in the inventory conversion cycle.

For the receivables collection period, a relatively long receivables collection period means that the company is
having trouble collecting cash from its customers and so whatever can be done to speed up collections while
still offering competitive credit terms should be pursued by financial managers. For example, companies that
converted paper invoicing to e-invoicing most likely reduce the average collection period by some number of
days, as it makes sense that if a bill is transmitted electronically, lag time is cut (no delays because of “snail
mail”) and collections (payments back to the company from customers) may happen sooner. Other credit
management techniques, some of which are explained in subsequent sections, can help minimize and control
the receivables collection period.

The payables deferral period is the one element that probably cannot be optimized without violating credit
terms. Certainly, cash balances can be conserved by delaying payments to vendors for as long as possible;
however, payments on trade credit need to be made on time or the company’s relationship with the supplier
can suffer. In a worst-case scenario, the company’s credit rating could also deteriorate.

A credit rating, also called a credit score, is a measure produced by an independent agency indicating the

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 19.1 • What Is Working Capital? 573

likelihood that a company will meet its financial obligations as they come due; it is an indication of the
company’s ability to pay its creditors. Three business credit rating services are Equifax Small Business,
Experian Business, and Dun & Bradstreet.

THINK IT THROUGH

The Cash Conversion Cycle

Considering the previous Think It Through (Scenario 1), what if you could reduce inventory levels, hold
lower accounts receivable balances, and rely more heavily on accounts payable while maintaining the same
sales level?

Here’s Scenario 2. Because of better inventory management, credit and collections management, and
negotiation of longer payment periods with vendors, King Sized Products (KSP) Inc. needs less investment
in inventory and accounts receivable and is able to utilize a greater amount of trade credit financing.

Annual credit sales are $40,000,000, average inventory is $2,800,000, average accounts receivable are
$5,500,000, average accounts payable are $3,300,000, and cost of goods sold is $30,000,000. What is the
cash conversion cycle?

Solution:

Inventory conversion period:

•
•
•

Receivables collection period:

•
•

Payables deferral period:

•
•

Notice that the investment in inventory and accounts receivable is less and the average accounts payable is
more with no change in credit sales and cost of goods sold—you would certainly anticipate a reduction in
the cash conversion cycle. The improvement would be about 13 days (from 57.2 in Scenario 1 to 44.1 days in
Scenario 2). Figure 19.4 shows a bar chart comparison of the two scenarios.

Scenario 1 Scenario 2
Inventory Conversion Period 36.50 34.07
Receivables Collection Period 54.75 50.21
Payables Deferral Period 34.07 40.15
Cash Conversion Cycle 57.18 44.10

Table 19.2
574 19 • The Importance of Trade Credit and Working Capital in Planning

Figure 19.4 Scenario 1 and 2 Comparison: Shortening the Cash Conversion Cycle

LINK TO LEARNING

A Harvard Business School blog post, How Amazon Survived the Dot-Com Bubble (https://openstax.org/r/
how-amazon-survived), discusses how Amazon managed its cash conversion cycle to the point where it was
receiving payment for the things it sold before Amazon had to pay for them. In that way, Amazon had a
negative cash conversion cycle (which is really a huge positive for a company trying to manage positive
cash flow!).

Working Capital Needs by Industry

When comparing working capital needs by industry, you can see some variation. For example, some
companies in the grocery business can have very low cash conversion cycles, while construction companies
can have very high cash conversion cycles. And some companies, like those in the restaurant business, can
have very low numbers and even have negative cash conversion cycles.

Working capital can also differ from one industry to another. An often cited general rule is that a current ratio
of 2 is considered optimal. However, general rules of thumb must be treated with caution. A better
benchmarking approach is to compare a firm’s ratios—current ratio and quick ratios—to the average of the
industry in which the subject company operates.

Take, for example, a home construction company. Such as firm has a long operating cycle because of the
production process (building homes), and the “storage of finished goods” can result in very high current
ratios—such as 11 or 12 times current liabilities—whereas a retailer like Walmart or Target would have much
lower current ratios.

In recent years, Walmart Stores Inc. (NYSE: WMT) has had a current ratio of around 0.9 and has been able to
manage its working capital needs by efficient management of its supply chain, quick turnover of inventory,
1
and a very small investment in accounts receivables. Big retailers like Walmart are effective at negotiating
favorable payment terms with their vendors. The ability to generate consistent positive cash flow from
operations allows a retailer like Walmart to operate with relatively low amounts of working capital.

The credit policies of a company also affect working capital. A company with a liberal credit policy will require a
greater amount of working capital, as collection periods of accounts receivable are longer and therefore tie up

1 Walmart Inc. “2020 Annual Report.” 2020. https://corporate.walmart.com/media-library/document/2020-walmart-annual-

report/_proxyDocument?id=00000171-a3ea-dfc0-af71-b3fea8490000

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 19.2 • What Is Trade Credit? 575

more dollars in receivables.

Almost all businesses will have times when additional working capital is needed to pay bills, meet the payroll
(salaries and wages), and plan for accrued expenses. The wait for the cash to flow into the company’s treasury
from the collection of receivables and cash sales can be longer during tough times.

During the COVID-19 pandemic, the US government made paycheck protection program (PPP) loans available
to help alleviate working capital problems for small and large business when the economy slowed because of
shutdowns and social distancing. And although 60 percent of the PPP loan proceeds were to go to cover
payroll-related costs, 40 percent could be used to bolster working capital to meet rent, utilities costs, and some
interest expense while companies were “treading water”—waiting for positive cash flow to pick up under a
2
recovery.

It isn’t just during downturns that working capital is strained. Growing companies, even if they are extremely
profitable, need additional working capital as they ramp up operations by acquiring raw materials, component
parts, supplies, or other forms of inventory; hiring temporary or additional employees; and taking on new
projects. Whenever additional resources are needed, working capital is also needed.

Some of the current assets and expenditures needed in a growing company may need to be financed from
sources that are not spontaneous financing—trade credit (accounts payable). Such forms of external
financing such as lines of credit, short-term bank loans, inventory-based loans (also called floor planning),
and the factoring of accounts receivables might have to be relied upon.

19.2 What Is Trade Credit?

By the end of this section, you will be able to:
• Compute the cost of trade credit.
• Define cash discount.
• Define discount period.
• Define credit period.

Trade credit, also known as accounts payable, is a critical part of a business’s working capital management
strategy. Trade credit is granted by vendors to creditworthy companies when those companies purchase
materials, inventory, and services.

A company’s purchasing system is usually integrated with other functions such production planning and sales
forecasting. Purchasing managers search for and evaluate vendors, negotiate order quantities, and prepare
purchase orders. In carrying out the purchasing process, credit terms are granted by the company’s vendors
and purchases of inventory and services can be made on trade credit accounts—allowing the purchaser time
to pay. The purchaser carries an accounts payable balance until the account is paid.

Trade credit is referred to as spontaneous financing, as it occurs spontaneously with the gearing up of
operations and the additional investment in current assets. Think of it this way: If sales are increasing, so too is
production. Increased sales mean more current assets (accounts receivable and inventory), and increased
sales mean increases in accounts payable (financing happening spontaneously with increased sales and
inventory purchases). Compared to other financing arrangements, such as lines of credit and bank loans,
trade credit is convenient, simple, and easy to use.

Once a company is approved for trade credit, there is no paperwork or contracts to sign, as is the case with
various forms of bank financing. Invoices specify the credit terms, and there is usually no interest expense
associated with trade credit. Accounts payable is a type of obligation that is interest-free and is distinguished
from debt obligations, such as notes payable, that require the creditor to pay back principal and interest.

2 US Small Business Administration. “PPP Loan Forgiveness.” n.d. https://www.sba.gov/funding-programs/loans/covid-19-relief-

options/paycheck-protection-program/ppp-loan-forgiveness
576 19 • The Importance of Trade Credit and Working Capital in Planning

How Trade Credit Works

Trade credit is common in B2B (business to business) transactions and is analogous to consumer spending
using a credit card. With a credit card, a consumer opens an account with a credit limit. Most trade credit is
offered to a company with an open account that has a credit limit up to which the company can purchase
goods or services without having to pay the cash up front. As long as the payments are made in accordance
with the terms of the agreement (also called credit terms), no interest or additional fees are charged on the
credit balance except possibly for a fee for late payment.

Initially, the vendor’s credit department approves both a trade credit limit and credit payment terms (i.e.,
number of days after the invoice date that payment is due). Timely payments on accounts payable (trade
credit) helps create a credit history for the purchasing firm.

Trade Credit Terms

Trade credit arrangements often carry credit terms that offer an incentive, called a discount, for a company
(the buyer) to pay its bill within a relatively short period of time. Net terms, also referred to as the full credit
period, are the number of days that a business (purchaser) has before they must pay their invoice. A common
net term is Net 30, with payment due in full within 30 days of the invoice.

Many vendors also offer cash discounts to customers that pay their bill early. A company’s invoice that
specifies payment terms of “2/10 n/30” (stated as: “two ten net 30”) would allow a 2 percent discount if the
buyer’s account balance is paid within 10 days of the invoice date; otherwise, the net amount owed would be
due in 30 days. The “10 days” in the example is the discount period—the number of days the buyer has to
take advantage of the cash discount for an early payment, also known as quick payment.

For example, Jackson’s Premium Jams Inc. received a $10,500 invoice for the purchase of jelly jars. The invoice
has payment terms of 2/10 n/30. Jackson’s pays the bill within 10 days of the invoice date. Jackson’s payment
would be . The effect of taking a discount because of a quick payment
is a lowering of the cost of inventory in the case of purchases of materials (for a manufacturer), merchandise
(for a retailer or wholesaler), and operating expenses (for any company that “buys” services using trade
credit). In Cost of Trade Credit, there is an example that shows the high annualize opportunity cost (36.73
percent) of not taking advantage of cash discounts.

CONCEPTS IN PRACTICE

Trade Credit of International Trade

When international trade occurs, two important documents are commonly required: a letter of credit and
a bill of lading. A letter of credit is issued by a financial institution on behalf of the foreign buyer
(importer). The bill of lading is a legal document that gives proof of a contract between a transportation
company and the buyer and is one important piece of documentation that allows the buyer to draw on the
letter of credit. A bill of lading serves as a document of title and proof of receipt of goods by the shipper.

The letter of credit secures a promise of payment to the seller (exporter) provided that the terms of the sale
are met. For an international trade transaction, the letter of credit is the main mechanism that establishes a
liability for the buyer. Instead of a trade payable, the buyer uses a line of credit from a bank.

Cost of Trade Credit

Trade credit is often referred to as a no-cost type of financing. Unlike with other credit arrangements (e.g.,
bank loans, lines of credit, and commercial paper), there is usually no interest expense associated with trade
credit, and as long as your account does not become delinquent, there are no special fees. Some accounts
payable arrangements specify an interest penalty or a late fee when the account goes delinquent, but as long

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 19.3 • Cash Management 577

as payments are made on time, trade credit is thought of as a low-cost source of working capital.

However, there is one possible cost associated with trade credit for companies that don’t take advantage of
cash discounts when offered by sellers. Using accounts payable to purchase goods and services can involve an
opportunity cost—a cost of the forgone opportunity of making a quick payment and benefiting from a cash
discount. A business that does not take advantage of a cash discount for early payment of trade credit will pay
more for goods and services than a business that routinely takes advantage of discounts.

The annual percentage rate of forgoing quick payment discounts can be estimated with the following formula:

Example: Novelty Accessories Inc. (NAI) purchases products from a vendor that offers credit payment terms of
2/10, net 30. The annual cost to NAI of not taking advantage of the discount for quick payment is 36.73
percent.

19.3 Cash Management

By the end of this section, you will be able to:
• Explain why firms hold cash.
• List instruments available to a financial manager for investing cash balances.

Cash management means efficiently collecting cash from customers and managing cash outflows. To manage
cash, the cash budget—a forward-looking document—is an important planning tool. To understand cash
management, you must first understand what is meant by cash holdings and the motivations (reasons) for
holding cash. A cash budget example is covered in Using Excel to Create the Short-Term Plan.

Cash Holdings
The cash holdings of a company are more than the currency and coins in the cash registers or the treasury
vault. Cash includes currency and coins, but usually those amounts are insignificant compared to the cash
holdings of checks to be deposited in the company’s bank account and the balances in the company’s
checking accounts.

Motivations for Holding Cash

The initial answer to the question of why companies hold cash is pretty obvious: because cash is how we pay
the bills—it is the medium of exchange. The transactional motive of holding cash means that checks and
electronic funds transfers are necessary to meet the payroll (pay the employees), pay the vendors, satisfy
creditors (principal and interest payments on loans), and reward stockholders with dividend payments. Cash
for transaction is one reason to hold cash, but there is another reason—one that stems from uncertainty and
the precautions you might take to be ready for the unexpected.

Just as you keep cash balances in your checking and savings accounts and even a few dollars in your wallet or
purse for unexpected expenditures, cash balances are also necessary for a business to provide for unexpected
events. Emergencies might require a company to write a check for repairs, for an unexpected breakdown of
equipment, or for hiring temporary workers. This motive of holding cash is called the precautionary motive.

Some companies maintain a certain amount of cash instead of investing it in marketable securities or in
upgrades or expansion of operations. This is called the speculative motive. Companies that want to quickly
take advantage of unexpected opportunities want to be quick to purchase assets or to acquire a business, and
a certain amount of cash or quick access to cash is necessary to jump on an opportunity.
578 19 • The Importance of Trade Credit and Working Capital in Planning

Sometimes cash balances may be required by a bank with which a company conducts significant business.
These balances are called compensating balances and are typically a minimum amount to be maintained in
the company’s checking account.

For example, Jack’s Outback Restaurant Group borrowed $500,000 from First National Bank and Trust. As part
of the loan agreement, First National Bank required Jack’s to keep at least $50,000 in its company checking
account as a way of compensating the bank for other corporate services it provides to Jack’s Outback
Restaurant Group.

Cash Alternatives

Cash that a company has that is in excess of projected financial needs is often invested in short-term
investments, also known as cash equivalents (cash alternatives). The reason for this is that cash does not earn
a rate of return; therefore, too much idle cash can affect the profitability of a business.

Table 19.3 shows a list of typical investment vehicles used by corporations to earn interest on excess cash.
Financial managers search for opportunities that are safe and highly liquid and that will provide a positive rate
of return. Cash alternatives, because of their short-term maturities, have low interest rate risk (the risk that an
investment’s value will decrease because of changes in market interest rates). In that way, prudent investment
of excess cash follows the risk/return trade-off; in order to achieve safe returns, the returns will be lower than
the possible returns achieved with risky investments. Cash alternative investments are not committed to the
stock market.

Security Description
US Treasury bills Obligations of the US government with maturities of 3 and 6 months
Federal agency Obligations of federal government agencies such as the Federal Home Loan Bank and the
securities Federal National Mortgage Association
Certificates of
Issued by banks, a type of savings deposit that pays interest
deposit
Commercial Short-term promissory notes issued by large corporations with maturities ranging from a
paper few days to a maximum of 270 days

Table 19.3 Typical Cash Equivalents

Figure 19.5 shows a note within the 2021 Annual Report (Form 10-K) of Target Corporation. The note discloses
the amount of Target’s cash and cash equivalent balances of $8,511,000,000 for January 30, 2021, and
$2,577,000,000 for February 1, 2020.

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 19.4 • Receivables Management 579

Figure 19.5 Note from Target Corporation 2021 10-K Filing (source: US Securities and Exchange Commission/EDGAR)

In that note, which is a supplement to the company’s balance sheet, receivables from third-party financial
institutions is also considered a cash equivalent. That is because purchases by Target’s customers who use
their credit cards (e.g., VISA or MasterCard) create very short-term receivables—amounts that Target is waiting
to collect but are very close to a cash sale. So instead of being reported as accounts receivable—a line item on
the Target balance sheet that is separate from cash and cash equivalents—these amounts receivable from
third-party financial institutions are considered part of the cash and cash equivalents and are a very liquid asst.
For example, the amount of $560,000,000 for January 30, 2021, is considered a cash equivalent since the
settlement of these accounts will happen in a day or two with cash deposited in Target’s bank accounts. When
a retailer sells product and accepts a credit card such as VISA, MasterCard, or American Express, the cash
3
collection happens very soon after the credit card sale—typically within 24 to 72 hours.

Companies also invest excess funds in marketable securities. These are debt and equity investments such as
corporate and government bonds, preferred stock, and common stock of other entities that can be readily sold
on a stock or bond exchange. Ford Motor Company has this definition of marketable securities in its 2019
Annual Report (Form 10-K):

“Investments in securities with a maturity date greater than three months at the date of purchase and other
securities for which there is more than an insignificant risk of change in value due to interest rate, quoted
4
price, or penalty on withdrawal are classified as Marketable securities.”

19.4 Receivables Management

By the end of this section, you will be able to:
• Discuss how decisions on extending credit are made.
• Explain how to monitor accounts receivables.

For any business that sells goods or services on credit, effective accounts receivable management is critical for
cash flow and profitability planning and for the long-term viability of the company. Receivables management
begins before the sale is made when a number of factors must be considered.

• Can the customer be approved for a credit sale?

3 Creditcardprocessing.com. “How Long Does it Take for a Merchant to Receive Funds?” n.d.
https://www.creditcardprocessing.com/resource/article/long-take-merchant-receive-
funds/#:~:text=The%20time%20that%20it%20takes,days%20to%20process%20the%20payment
4 Ford Motor Company. “2019 Annual Report.” n.d. https://s23.q4cdn.com/725981074/files/doc_downloads/Ford-2019-Printed-
Annual-Report.pdf
580 19 • The Importance of Trade Credit and Working Capital in Planning

• If the credit is approved, what will be the credit terms (i.e., how long do we give customers to pay their
bills)?
• Will there be a cash discount for quick payment?
• How much credit should be extended to each customer (credit limit)?

Accounts receivable is not about accepting credit cards. Credit card sales are not technically accounts
receivable. When a credit card is accepted, it means that the credit card company (e.g., VISA, MasterCard, or
American Express) will guarantee the payment. The cash will be deposited in the merchant’s bank account in a
very short period of time.

When a business makes a sale on account, management (e.g., a credit manager or analyst) does its best to
distinguish between customers who have a high likelihood of paying and customers who have a low likelihood.
Customers with low credit risk are approved; the decision is based on an effective analysis of creditworthiness.

Creditworthiness is judged by looking at a number of factors including an evaluation of the customer’s

financial statements, financial ratios, and credit reports (credit scores) based on a customer’s payment history
on credits owed to other firms. If a company has a prior relationship with a customer seeking trade credit, the
customer’s payment history with the firm is also carefully evaluated before additional credit is granted.

LINK TO LEARNING

Corporate Finance Institute

Credit managers use various tools and techniques to evaluate creditworthiness of customers. The
Corporate Finance Institute’s website states that “the ‘5 Cs of Credit’ is a common phrase used to describe
the five major factors [character, capacity, collateral, capital, and conditions] used to determine a potential
borrower’s creditworthiness.” It goes on to say that “a credit report provides a comprehensive account of
5
the borrower’s total debt, current balances, credit limits, and history of defaults and bankruptcies, if any.”
More on the 5 Cs of credit can be found on the Corporate Finance Institute’s website (https://openstax.org/
r/corporate-finance).

Determining the Credit Policy

A company’s credit policy encompasses rules of credit granting and procedures for the collections of accounts.
It’s how a company will process credit applications, utilize credit scoring and credit bureaus, analyze financial
statements, make credit limit decisions, and conduct collection efforts when accounts become delinquent (still
outstanding after their due date).

Establishing Credit Terms

Trade credit terms were discussed earlier. Recall that part of the terms and conditions of a sale are the credit
terms—elements of a sales agreement (contract) that indicate when payment is due, possible discounts (for
quick payments), and any late fee charges.

If open credit is for a sales transaction, an agreement is made as to the length of time for which credit is to be
granted (payment period) and a discount for early payment. Although companies are free to establish credit
terms as they see fit, most companies look to the practice of the particular industry in which they operate. The
credit terms offered by the competition are a factor. Net terms usually range between 30 days and 90 days,
depending on the industry. Discounts for early payments also differ and are typically from 1 to 3 percent.

Establishing credit terms offered can be thought of as a decision process similar to setting a price for products
and services. Just as a price is the result of a market forces, so too are credit terms. If credit terms are not

5 Corporate Finance Institute. “What Are the 5 Cs of Credit?” n.d. https://corporatefinanceinstitute.com/resources/knowledge/

credit/5-cs-of-credit/

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 19.4 • Receivables Management 581

competitive within the industry, sales can suffer. Typically, companies follow standard industry credit terms. If
most companies in an industry offer a discount for early payments, then most companies will follow suit and
also offer an equal discount.

Once credit terms are established, they can be changed based on both marketing strategies and financial
management goals. For example, discounts for early payments can be more generous, or the full credit
period can be extended to stimulate additional sales. Both discount periods and full credit periods can be
tightened to try to speed up collections. The establishment of and changes to credit terms are usually made in
consultation with the sales and financial management departments.

Monitoring Accounts Receivables

Financial managers monitor accounts receivables using some basic tools. One of those tools is the accounts
receivable aging schedule (report). To prepare the aging schedule, a classifying of customer account
balances is performed with age as the sorting attribute.

An account receivable begins its life as a credit sale. The age of a receivable is the number of days that have
transpired since the credit sale was made (the date of the invoice). For example, if a credit sale was made on
June 1 and is still unpaid on July 15, that receivable is 45 days old. Aging of accounts is thought to be a useful
tool because of the idea that the longer the time owed, the greater the possibility that individual accounts
receivable will prove to be uncollectible.

An aging schedule is a report that organizes the outstanding (unpaid) receivable balances into age categories.
The receivables are grouped by the length of time they have been outstanding, and an uncollectible
percentage is assigned to each category. The length of uncollectible time increases the percentage assigned.
For example, a category might consist of accounts receivable that are 0–30 days past due and is assigned an
uncollectible percentage of 6 percent. Another category might be 31–60 days past due and is assigned an
uncollectible percentage of 15 percent. All categories of estimated uncollectible amounts are summed to get a
total estimated uncollectible balance.

The aging of accounts is useful to the credit and collection managers, both from a global view—estimating
how much of the accounts receivable asset might be bad debts—and on a micro basis—being able to drill
down to see which specific customers are slow paying or delinquent so as to implement collection tactics.

Accountants and auditors also find the aging of accounts to determine a reasonable amount to be reported as
bad debt expense and to establish a sufficient balance in the allowance for doubtful accounts. Bad debt
expense is the cost of doing business because some customers will not pay the amounts they owe (accounts
receivable), while the allowance for doubtful accounts is a contra-asset (it will be deducted from accounts
receivable on the balance sheet) that contains management’s best guess (management’s estimate) as to how
much of its accounts receivable will never be collected.

In Figure 19.6, Foodinia Inc.’s accounts receivable aging report shows that the total receivables balance is
$189,000. The company splits its accounts into four age categories: not due, 30 to 60 days past due, 61 to 90
days past due, and more than 90 days past due. Of the $189,000 owed to Foodinia by its customers, $75,500
($189,000 less $113,500) of invoices have been outstanding (not paid yet) beyond their due dates.
582 19 • The Importance of Trade Credit and Working Capital in Planning

Figure 19.6 Foodinia Inc. Aging of Accounts Receivable Schedule

In addition to preparing aging schedules, financial managers also use financial ratios to monitor receivables.
The accounts receivable turnover ratio determines how many times (i.e., how often) accounts receivable are
collected during an operating period and converted to cash. A higher number of times indicates that
receivables are collected quickly. In contrast, a lower accounts receivable turnover indicates that receivables
are collected at a slower rate, taking more days to collect from a customer.

Another receivables ratio is the number of days’ sales in receivables ratio, also called the receivables collection
period—the expected days it will take to convert accounts receivable into cash. A comparison of a company’s
receivables collection period to the credit terms granted to customers can alert management to collection
problems. Both the accounts receivable turnover ratio and receivables collection period are covered, including
the formulas for calculating the ratios, in the previous section of this chapter.

Accounts Receivables and Notes Receivable

An accounts receivable is an informal arrangement between a seller (a company) and customer. Accounts
receivable are usually paid within a month or two. Accounts receivable don’t require any complex paperwork,
are evidenced by an invoice, and do not involve interest payments. In contrast, a note receivable is a more
formal arrangement that is evidence by a legal contract called a promissory note specifying the payment
amount and date and interest.

The length of a note receivable can be for any time period including a term longer than the typical account
receivable. Some notes receivable have a term greater than a year. The assets of a bank include many notes
receivable (a loan made by a bank is an asset for the bank).

A note receivable can be used in exchange for products and services or in exchange for cash (usually in the
case of a financial lender). Sometimes a company might request that a slow-paying customer sign a note
promissory note to further secure the receivable, charge interest, or add some type of collateral to the
arrangement, in which case the receivable would be called a secured promissory note. Several characteristics
of notes receivable further define the contract elements and scope of use (see Table 19.4).

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 19.5 • Inventory Management 583

Accounts Receivable Notes Receivable

• An informal agreement between customer and • A legal contract with established payment terms
company • Receivable beyond one year and outside of a
• Receivable in less than one year or within a company’s operating cycle
company’s operating cycle • Includes interest
• Does not include interest • Could stipulate collateral

Table 19.4 Key Feature Comparison of Accounts Receivable and Notes Receivable

19.5 Inventory Management

By the end of this section, you will be able to:
• Outline the costs of holding inventory.
• Outline the benefits of holding inventory.

Financial managers must consider the impact of inventory management on working capital. Earlier in the
chapter, the concept of the inventory conversion cycle was covered. The number of days that goods are held
by a business is one of the focal points of inventory management.

Managers look to minimize inventory balances and raise inventory turnover ratios while trying to balance the
needs of operations and sales. Purchasing personnel need to order enough inventory to “feed” production or
to stock the shelves. The sales force wants to meet or surpass their sales budgets, and the operations people
need inventory for the factories, warehouses, and e-commerce sites.

The days in inventory ratio measures the average number of days between acquiring inventory (i.e.,
purchasing merchandise) and its sale. This ratio is a metric to be watched and monitored by inventory
managers and, if possible, minimized. A high days in inventory ratio could mean “aging” inventory. Old
inventory could mean obsolesce or, in the case of perishable goods, spoilage. In either case, old inventory
means losses.

Imagine a company selling high-tech products such as consumer electronics. A high days in inventory ratio
could mean that technologically obsolete products will be sold at a discount. There are similar issues with
older inventory in the fashion industry. Last year’s styles are not as appealing to the fashion-conscious
consumer and are usually sold at significant discounts. In the accounting world, lower of cost or market value
is a test of inventory value to determine if inventory needs to be “written down,” meaning that the company
takes an expense for inventory that has lost significant value. Lower of cost or market is required by Generally
Accepted Accounting Principles (GAAP) to state inventory valuations at realistic and conservative values.

Inventory is a very significant working capital component for many companies, such as manufacturers,
wholesalers, and retailers. For those companies, inventory management involves management of the entire
supply chain: sourcing, storing, and selling inventory. At its very basic level, inventory management means
having the right amount of stock at the right place and at the right time while also minimizing the cost of
inventory. This concept is explained in the next section.

Inventory Cost
Controlling inventory costs minimizes working capital needs and, ultimately, the cost of goods sold. Inventory
management impacts profitability; minimizing cost of goods sold means maximizing gross profit (Gross Profit
= Net Sales Less Cost of Goods Sold).

There are four components to inventory cost:

• Purchasing costs: the invoice amount (after discounts) for inventory; the initial investment in inventory
584 19 • The Importance of Trade Credit and Working Capital in Planning

• Carrying costs: all costs of having inventory in stock, which includes storage costs (i.e., the cost of the
space to store the inventory, such as a warehouse), insurance, inventory obsolescence and spoilage, and
even the opportunity cost of the investment in inventory
• Ordering costs: the costs of placing an order with a vendor; the cost of a purchase and managing the
payment process
• Stockout costs: an opportunity cost incurred when a customer order cannot be filled and the customer
goes elsewhere for the product; lost revenue

Minimizing total inventory costs is a combination of many strategies, the scope and complexity of which are
beyond the scope of this text. Concepts such as just-in-time (JIT) inventory practices and economic order
quantity (EOQ) are tools used by inventory managers, both of which help keep a company lean (minimizing
inventory) while making sure the inventory resources are in place in time to complete the sale.

Benefit of Holding Inventory

Brick-and-mortar stores need goods in stock so that the customer can see and touch the product and be able
to acquire it when they need it. Customers are disappointed if they cannot see and touch the item or if they
find out upon arrival at the store that it is out of stock.

Customers of all kinds don’t want to wait for the delivery of a purchase. We have become accustomed to
Amazon orders being delivered to the door the next day. Product fulfillment and availability is important.
Inventory must be in stock, or sales will be lost.

In manufacturing, the inventory of materials and component parts must be in place at the start of the value
chain (the conversion process), and finished goods need to be ready to meet scheduled shipments. Holding
sufficient inventory meets customer demand, whether it is products on the shelves or in the warehouse that
are ready to move through the supply chain and into the hands of the customer.

19.6 Using Excel to Create the Short-Term Plan

By the end of this section, you will be able to:
• Create a one-year budget.
• Create a cash budget.

A cash budget is a tool of cash management and therefore assists financial managers in the planning and
control of a critical asset. The cash budget, like any other budget, looks to the future. It projects the cash flows
into and out of the company. The budgeting process of a company is a really an integrated process—it links a
series of budgets together so that company objectives can be achieved. For example, in a manufacturing
company, a series of budgets such as those for sales, production, purchases, materials, overhead, selling and
administrative costs, and planned capital expenditures would need to be prepared before cash needs (cash
budget) can be predicted.

Just as you might budget your earnings (salary, business income, investment income, etc.) to see if you will be
able to cover your expected living expenses and planned savings amounts, to be successful and to increase
the odds that sufficient cash will be available in the months ahead, financial managers prepare cash budgets
to

• meet payrolls;
• allocate dollars for contingencies and emergencies;
• analyze if planned collections and disbursements policies and procedures result in adequate cash
balances; and
• plan for borrowings on lines of credit and short-term loans that might be needed to balance the cash
budget.

A cash budget is a model that often goes through several iterations before managers can approve it as the

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 19.6 • Using Excel to Create the Short-Term Plan 585

plan going forward. Changes in any of the “upstream” budgets—budgets that are prepared before the cash
budget, such as the sales, purchases, and production budgets—may need to be revised because of changing
assumptions. New economic forecasts and even cost-cutting measures will require a revision of the cash
budget.

Although a budget might be prepared for each month of a future 12-month period, such as the upcoming
fiscal year, a rolling budget is often used. A rolling budget changes often as the planning period (e.g., a fiscal
year) plays out. When one month ends, another month is added to the end (the next column) of the budget.
For example, if in your budget January is the first month of the planning period, once January is over, next
January’s cash budget column would be added—right after December’s column (at the far right of the
budget).

Sample One-Year (Annual) Operating Budget

Preparing an annual operating budget can be a complex task. In essence, a company budget is a series of
budgets, many of which are interrelated.

The sales budget is prepared first and has an impact on many other budgets. Take the example of a
production budget of a manufacturer. The sales budget impacts what needs to be produced (production
budget), and the production budget influences planned purchases of material (purchases budget), overhead
resources (overhead budget), and the amount of labor costs for the year ahead (direct labor budget.)

For a merchant (such as a wholesaler or retailer), the annual budget would be less complex than that of a
manufacturing firm but would still require an inventory purchases budget and an operating expense budget
(such as selling and administrative expenses). For a service firm, a purchase budget for inventory would not be
necessary, but an operating budget would be. All businesses need a cash budget, which is the topic of the next
section of this chapter.

The example operating budget presented here is of a merchandising company. Budgets are prepared
following a process that begins with a sales (or revenue) forecast. The sales forecast is normally based on
information obtained from both internal and external sources and predicts the amount of units to be sold in
the planning period—usually one year into the future.

A company’s management, in consultation with its marketing and sales executives, would prepare a sales
budget by making assumptions about the number of units that are expected to be sold and the prices that will
be charged. From the sales budget, projections are made as to cash receipts each month, and therefore
assumptions have to be made as to how much of each month’s sales will be cash sales and how much cash will
flow into the company from the collection credit sales (including cash flow in from the prior month’s sales).
Figure 19.7 provides an example of a sales budget and projected accounts receivable collections and cash
sales for the months of January through December. Keep in mind that projected monthly sales amounts are
not equal to cash collected from sales. Because of sales on credit, some cash from sales lags credit sales as
collections can extend beyond the month of sale. Credit terms such terms such as net 30 (net amount owed to
be paid in 30 days) have to be considered when developing a forecasted cash collection pattern.
586 19 • The Importance of Trade Credit and Working Capital in Planning

Figure 19.7 Example of a Sales and Collections Budget

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Excel exhibits.

Sales budgets “drive” the preparation of other budgets. If sales are expected to increase, purchases of
inventory and some operating expenses would also increase. To meet the demand for goods and services (as
defined in the sales budget), a purchases (inventory) budget would be prepared. In this example (Figure 19.8),
the purchases budget shows projected purchases of inventory (merchandise) and the projected payments
(also called disbursements) for each month.

Cash outflows as a result of purchases often do not equal the projected purchase amount. That is because
payments for purchases are usually on credit (accounts payable), and so purchases for one month typically get
spread out over a period of time that encompasses the current month and the month (or months) thereafter.
To keep this example simple, the assumption is that the purchases are paid for in the following month (an
average days payable outstanding of 30 days). However, in other cases, payment patterns may be based on
other payment periods such as 45, 60, or even 90 days, depending on the trade credit terms.

Figure 19.8 Purchases Budget

An operating expense budget is prepared next and is basically a prediction of the selling and administrative
expenditures of the company. Notice in Figure 19.9 that in the operating expense budget, cost of goods sold
(an expense) is not included, nor are noncash expenses such as depreciation. The cash outlays related to
goods sold, at least in a merchandising operation, are accounted for in the purchases budget (payments for
purchases of inventory.)

With the sales, purchases, and operating expense budgets prepared, the cash budget can be prepared. Some
of the “inputs” to the cash budget are from the sales (collections of cash), purchases (payments), and the
operating expense budget (cash expenditures for selling and administrative expenses). A sample cash budget
and a discussion of its preparation follows in the next section of this chapter.

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 19.6 • Using Excel to Create the Short-Term Plan 587

Sample Cash Budget

A cash budget is the last budget to be prepared and is often part of the financial budget (cash budget,
budgeted income statement, and budgeted balance sheet). The purpose of the cash budget is to estimate
cash flows, to help ensure sufficient cash balances are maintained during the planning period, and to plan for
external financing during periods of cash deficits.

When a budget is prepared in Excel, cash budget analysts can play “what if” with different scenarios to see
when cash surpluses and deficits are expected. Cash surpluses means that funds can be invested in
marketable securities to earn a rate of return, while cash deficits mean that financing, such as a line of credit,
will be necessary (assuming forecasts are accurate).

Although the example shown in Figure 19.10 is a monthly cash budget, a cash budget could be prepared using
any useful time elements: weekly, monthly, or quarterly.

One common practice is to use a rolling cash budget. A rolling cash budget is continually updated to add a
new budget period, such as a month’s amount of cash flow activity, as the most recent budgeted month
expires. For example, assume that a 12-month cash budget is prepared for a period covering January 20X1 to
December 20X1. Once the month of January 20X1 has concluded, a 12-month planning period continues by
add January 20X2 to the last column of the budget. The rolling cash monthly budget is an extension of the
initial cash budget model, adding one month and thereby always extending cash flow projections one year
into the future.

Figure 19.9 Operating Expenses Budget

588 19 • The Importance of Trade Credit and Working Capital in Planning

Figure 19.10 Sample Cash Budget

Using Figure 19.9 as an example, Table 19.5 shows the formulas that form the skeleton of a monthly cash
budget.

This is the amount of cash the company expects to have on the first day of the month. For
example, in Figure 19.10, cell B2 is the amount of cash on Jan. 1 to start the year (the planning
Beginning
period). The remaining beginning cash balances for the months February through December
Cash Balance
are the ending cash balances of the previous month. For example, February’s beginning cash
balance (C2) is referenced from cell B9 (ending cash balance for January).
These are the projected cash inflows from collections from customers (accounts receivable),
cash sales, and any other significant cash inflows, such as dividends and interest on
Cash investments or sale of fixed assets. For example, the Cash Collections shown in the Sample
Collections Cash Budget (Figure 19.10) are referenced from the Sales and Collections Budget (Figure
19.7). January’s Cash Collections (cell B3) in the Sample Cash Budget are from cell B12 of the
Sales and Collection Budget.
Cash disbursements are the projected cash outflows, such as those for operating expenses
and payment of payables. For example, Cash Disbursements in the Sample Cash Budget for
Cash
January (Figure 19.10) are the sum of January’s payments for purchases in the Purchases
Disbursements
Budget (Figure 19.8, cell B3) and the January operating expenses (Operating Expenses
Budget, Figure 19.9, cell B12).
The formula for net cash flow is For example, in Figure 19.10, the January Net Cash Flow is
Net Cash Flow
calculated in cell B5.
Beginning Cash Balance + or - Net Cash Flow. This is the projected cash balance before taking
Preliminary
into account the target cash balance to be maintained (minimum cash balance). In the
Ending Cash
Sample Cash Budget (Figure 19.10), the preliminary ending cash balance formula for January
Balance
is =B2+B5 (B2 is the Beginning Cash Balance and B5 is the Net Cash Flow for the month).
Less:
This is a target cash balance that management sets; it is the minimum amount of cash that
Minimum Cash
should be maintained by the company (in Figure 19.10, cells B2:G7 and B17:G17).
Balance

Table 19.5 Excel Formulas for Monthly Cash Budget

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 19.6 • Using Excel to Create the Short-Term Plan 589

A cash surplus means that cash can be invested in marketable securities. A cash deficiency
means that some type of financing, such as a line of credit or bank loan, will be needed to
provide enough cash for operations and to maintain a minimum cash balance. This number is
Cash Surplus found by subtracting the minimum cash balance from the preliminary ending cash balance.
(Deficiency) For example, the cash surplus for January in Figure 19.10 is calculated with this formula:
=B6-B7. Notice that all months in the Sample Cash Budget show a surplus except for August’s
forecast of a deficit, which may require drawing on a line of credit to provide enough cash to
meet obligations in August.

Table 19.5 Excel Formulas for Monthly Cash Budget

590 19 • Summary

Summary
19.1 What Is Working Capital?
Working capital is not only necessary to run a business; it is a resource that will expand and contract with
business cycles and must be carefully managed and monitored. The daily, weekly, and monthly needs of
business operations are met by cash. Financial managers understand the significance of net working capital
(current assets – current liabilities) and various liquidity ratios as they attempt to ensure that bills can be paid.
The cash conversion cycle and the cash budget provide additional working capital management tools.

19.2 What Is Trade Credit?

Trade credit is very prevalent in the business world, especially in B2B (business-to-business) transactions.
Many business exchanges (sales) could not take place without trade credit and the credit terms that are
offered. Like any component of working capital, trade credit must be planned and managed. The creditor (the
company granting the credit) does so based on an analysis of creditworthiness and must monitor payments
and manage slow-paying accounts. The debtor (accounts payable) needs to make payments on time to keep a
clean credit history and to take advantage of discounts.

19.3 Cash Management

Cash management is simply making sure you have enough cash to meet expected obligations and for
contingencies (unexpected or emergency cash needs). Excess cash should be invested low-risk and highly
liquid marketable securities. The cash budget is a critical tool of cash management.

19.4 Receivables Management

Accounts receivables are monitored by management with tools such as the ratios accounts receivable turnover
and average collection period and the aging of receivables. The credit managers’ mantra rings true: “The
older the receivable, the greater the likelihood that the account will not be collected.”

19.5 Inventory Management

Inventory, usually the least liquid of the current assets, presents its own set of management challenges.
Finding the optimal level of inventory is probably more of an art than a science. JIT helps to reduce the
investment in inventory and lower the costs of storage, but stockout costs can be very damaging to
profitability.

19.6 Using Excel to Create the Short-Term Plan

Short-term plans of a business are funded with cash, with cash budgets being a critical tool of planning. The
cash budget takes into account a target amount of cash, factoring in all the motives for holding cash. A cash
budget looks ahead—predicting cash inflows and outflows, allocating for minimum cash balances to be
maintained, and helping management determine short-term financing needed. Although it is the last budget
prepared, the preparation of the cash budget is an important financial planning exercise of companies small
and large.

Key Terms
accounts receivable aging schedule a report that shows amounts owed by customers by the age of the
account, as measured by the number of days since the sale
allowance for doubtful accounts an account that contains the estimated amount of accounts receivable
that will not be collected
bad debt expense an expense that a business incurs as a result of uncollectible accounts receivables
bankruptcies federal court procedures that protect distressed businesses from creditor collection efforts
while allowing the debtor firm to liquidate its assets or devise a reorganization plan

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 19 • Key Terms 591

benchmarking the process of performance analysis that involves comparing financial condition and
operating results against a standard, called a benchmark
bill of lading a document that is a detailed list of a goods that have been shipped; a receipt given by the
carrier (shipping company) to the seller as evidence that the goods have been shipped to the buyer
carrying costs all costs associated with having inventory in stock including storage costs, insurance,
inventory obsolescence, and spoilage
cash budget a report that shows an estimation of cash inflows, outflows, and cash balances over a specific
period of time, such as monthly, quarterly, or annually
cash cycle or cash conversion cycle the time period (measured in days) between when a business begins
production and acquires resources from its suppliers (for example, acquisition of materials and other forms
of inventory) and when it receives cash from its customers; offset by the time it takes to pay suppliers
(called the payables deferral period)
cash discount discount granted to a customer who has purchased goods or services on account (credit) and
pays the invoice within a certain number of days as specified by credit terms
compensating balance minimum balance of cash that a business must deposit and maintain in a bank
account to obtain a loan
contra-asset an account with a balance that is used to offset (reduce) its related asset on the balance sheet
(for example, allowance for doubtful accounts reduces the value of accounts receivable reported on the
balance sheet)
credit period the number of days that a business purchaser has before they must pay their invoice
credit rating a type of score that indicates a business’s creditworthiness
credit terms the terms that are part of a sales credit agreement that indicate when payment is due, possible
discounts, and any fees that will be charged for a late payment
current assets assets that are cash or cash equivalents or are expected to be converted to cash in a short
period of time and will be consumed, used, or expire through business operations within one year or the
business’s operating cycle, whichever is shorter
discount period the number of days the buyer has to take advantage of the cash discount for an early
payment
factoring the process of selling accounts receivables to a financial institution or, in some cases, using the
accounts receivables as security for a loan from a financial institution
floor planning a type of inventory financing whereby a financial institution provides a loan so that the
company can acquire inventory with proceeds from the sale of inventory used to pay down the loan; a
common method of financing inventory for automobile dealers and sellers of other big-ticket (high-priced)
items
gross working capital synonymous with the current assets of a company, those assets that include cash and
other assets that can be converted into cash within a period of 12 months
just-in-time inventory inventory management method in which a company maintains as little inventory on
hand as possible while still being able to satisfy the demands of its customers
letter of credit a letter issued by a bank that is evidence of a guarantee for payments made to a specified
entity (such as a supplier) under specified conditions; common in international trade transactions
liquidity ability to convert assets into cash in order to meet primarily short-term cash needs or emergencies
marketable securities investments that can be converted to cash quickly; short-term liquid securities that
can be bought or sold on a public exchange (market) and tend to mature in a year or less
net terms also referred to as the full credit period; the number of days that a business purchaser has before
they must pay their invoice
net working capital the difference between current assets and current liabilities (Current Assets – Current
Liabilities = Net Working Capital)
operating cycle the time it takes a company to acquire inventory, sell inventory, and collect the cash from
the sale of said goods; synonymous with cash cycle
opportunity cost the cost of a forgone opportunity
592 19 • Multiple Choice

ordering costs costs associated with placing an order with a vendor or supplier
precautionary motive a reason to hold cash balances for unexpected expenditures such as repairs, costs
associated with unexpected breakdown of equipment, and hiring temporary workers to meet unexpected
production demands
quick payment a payment made on an account payable during a period of time that falls within the discount
period
ratios numerical values taken from financial statements that are used in formulas to examine financial
relationships and create metrics of performance, strengths, weaknesses; help analysts gain insight and
meaning
speculative motive a reason for holding an amount of cash—to be able to take advantage of investment
opportunities
stockout costs an opportunity cost (lost revenue) incurred when a customer order cannot be filled because
the item is out of stock and the customer goes elsewhere for the product
supply chain the network of participants and activities between a company and its suppliers and the
company and its customers; exists to distribute a product or to provide a service to the final buyer
trade credit credit granted to a business, also called accounts payable; allows a business to buy goods and
services on account and pay the cash at some point in the future
transactional motive holding an amount of cash to meet operational expenditures such as payroll,
payments to vendors, and loan payments
working capital the resources that are needed to meet the daily, weekly, and monthly operating cash flow
needs

Multiple Choice
1. The term working capital is synonymous with ________.
a. accounts payable
b. current assets
c. equity
d. current liabilities

2. The formula for net working capital is ________.

a. Current Assets – Current Liabilities
b. Fixed Assets – Current Assets
c. Assets – Liabilities
d. Current Assets – Liabilities

3. When sales are made on credit, which current assets typically increase at the time of the sale?
a. cash
b. notes receivable
c. accounts receivable
d. marketable securities

4. Which of the following is NOT a goal of working capital management?

a. meet the operational needs of the company
b. satisfy obligations (current liabilities) as they come due
c. maintain an optimal level of current assets
d. maximize the investment in current assets

5. Accelerated Growth Inc. has the following account balances at year-end.

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 19 • Multiple Choice 593

What is the cash ratio?

a. 1.29
b. 1.43
c. 1.71
d. .088

6. Which of the following is true of these credit terms: 3/15, n/30?

a. 15 percent discount if the payable is paid within 3 days of the invoice date
b. 3 percent discount if the payable is paid in the period between 15 days and 30 days after the invoice
date
c. 3 percent discount if the payable is paid within 15 days of the invoice date
d. 30 percent discount if cash is paid on the sale date and 15% discount if paid 3 days after the invoice
date

7. When reviewing its budgets, including the cash budget, management of Transcend Inc. have considered
best-case and worst-case scenarios. As they completed their analysis, it was decided because of the
possibility of unexpected repairs and unanticipated higher labor costs to add another $30,000 to the
amount of the target cash balance to maintain throughout the year. The reason for this action would be
which of these motives for holding cash?
a. transaction motive
b. opportunity cost mitigation motive
c. precautionary motive
d. speculative motive

8. A large retailer has more than $100 million of cash and cash equivalents on its balance sheet. Which of the
following would not be part of the cash equivalents?
a. cash in banks (checking account balances)
b. US Treasury bond maturing in two years
c. receivables from a bank that processes credit card payments
d. commercial paper

9. An account receivable is created when ________.

a. a customer pays its bill
b. a company accepts a credit card, such as VISA or MasterCard
c. a company sells to a customer on an open account
d. a company sells to a customer only on a cash basis
594 19 • Review Questions

10. Jackson’s Moonshine LLC has a receivables collection period of 47 days. Which the following would be
reasonable conclusions?
a. Jackson’s Moonshine LLC is most likely experiencing serious liquidity issues.
b. Jackson’s Moonshine LLC is most overinvested in marketable securities.
c. If the industry average is 31 days, Jackson’s management should attempt strategies that will lower
their receivables collection period.
d. If the industry average is 53 days, Jackson’s management should attempt strategies that will raise
their receivables collection period.

11. Two Way Power Ltd. (2WP) stocks an inventory item, BB3, that is projected to be in great demand over the
next 12 months. In discussing its sales forecasts with its suppliers, a reasonable estimate shows that 2WP
could lose about $30,000 of sales in month 3 due to inventory financing difficulties. Which, if any, of the
following inventory costs would be affected by this development?
a. purchase cost
b. carrying costs
c. ordering costs
d. stockout costs
e. none of these costs because loss of sales is not an inventory cost

12. If a company has significant inventory in each element of the value chain, it most likely is descriptive of
________.
a. the cost of goods sold of a retailer
b. the inventory balances held by wholesalers and service firms
c. the materials, work in process, and finished goods of a manufacturer
d. the inventory on the shelves of an e-commerce retailer

Review Questions
1. Intelligent Cookies Inc. (ICI) sold $30,000,000 of product in a year that had a cost of goods sold of
$10,000,000. The average inventory carried by ICI was $500,000. On average, it takes 35 days for ICI’s
customers, such as grocery stores and restaurants, to pay on their accounts. ICI buys ingredients,
including flour, spices, and eggs, from its vendors on credit, and ICI takes about 40 days to pay its
suppliers. How many days is ICI’s cash conversion cycle?

2. Shown below are account balances for Electra Engines Inc., a manufacturer. The accounts are shown in a
random order. What is the amount of net working capital?

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 19 • Review Questions 595

3. Shown below are account balances for Electra Engines Inc., a manufacturer. The accounts are shown in a
random order. What is the current ratio and the quick ratio?

4. Imagine that these are the cash collection cycles for some well-run companies:

What types of conclusions can you reach when you see this kind of variability?

Imagine that those cash conversion cycles are based on this information:
596 19 • Review Questions

What would be your analysis of the cash conversion cycles based on the above information (inventory
turnover, accounts receivable turnover, and accounts payable turnover)? Use the worksheet below to
summarize your conclusions.

Worksheet

5. What is the estimated annual percentage rate (APR) of not taking advantage of the early payment
discount based on these terms: 4/15, n/45?

6. If you were a credit manager reviewing a potential customer’s request for a $20,000 line of credit, what
would you analyze? Generally, how would the 5Cs of Credit guide your analysis and help lead you to a
prudent decision to accept or reject the request?

7. Aspire Excellent Inc. is a book publisher. On March 1, Aspire sells $25,000 of books to Get Your Books Inc.
(YBI), a large bookstore chain. The sale is made on account with terms net 60. Aspire’s customers usually
take the full 60 days to pay their invoices. The books cost Aspire $10,000 to manufacture. Below,
summarize the effect on the accounts on March 1 from the standpoint of the seller, Aspire Excellent Inc.,
and the buyer, YBI.

8. The financial manager of New England Blissful Dairies, a distributor of milk, cream, and ice cream
products, has finished the 12-month operating budget. For the month of June, the following projections
were made:

June 1 Cash Balance $90,000

Cash Receipts $300,000
Cash Disbursement $350,000

Taking into account an amount of cash that the firm likes to maintain as a target (minimum cash balance)
of $75,000, prepare the cash budget for June using the format below. Assume that, if necessary, the
company will draw upon a preestablished line of credit with their bank to be able to maintain the target
cash balance.

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 19 • Video Activity 597

Will the company need short-term financing?

9. The sales for Re-Works Inc., a company that fabricates iron fencing from recycled metals, are all on
account. For the first three months of the year, Re-Works management expects the following sales:

Based on past collection patterns, management expects the following:

Also, based on past experience, management forecasts that 5 percent of accounts receivable will be
uncollectible and will eventually be written off.

What are the expected cash receipts for March?

10. With the same sales forecasts as in question 9, Re-Works Inc. management would like to implement some
changes to credit policy and credit terms that they believe would change the collection pattern going
forward and would lower the uncollectible accounts prediction to 3 percent.

What would be the expected cash receipts for March?

Video Activity
How Companies Report Cash Flow

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1. Why isn’t the net income reported on a corporate balance sheet a good estimate of the increase in cash
that occurred during the year?

2. What is the difference between a corporate cash budget and a projected statement of cash flows?
598 19 • Video Activity

Trade Credit and Interest Rates on Short-Term Borrowing

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3. Explain this statement: Accounts payable and accounts receivables are essentially financial opposites.

4. Accounts payable is often called “interest-free financing.” As such, explain why a company would choose
to pay the amount owed on its purchases of inventory 50 days early. Base your answer on these facts:
• The annualized cost of forgoing an early payment discount is approximately 16 percent.
• The company’s cost of borrowing short-term on a bank line of credit is 9 percent.

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 20 • Why It Matters 599

20
Risk Management and the Financial Manager

Figure 20.1 Financial managers must consider prudent ways to manage economic volatility and the risk it poses to a company.
(credit: modification of “Risk text on Dollar banknotes” by Marco Verch/flickr CC BY 2.0)

Chapter Outline
20.1 The Importance of Risk Management
20.2 Commodity Price Risk
20.3 Exchange Rates and Risk
20.4 Interest Rate Risk

Why It Matters
1
Each year, American Airlines consumes approximately four billion gallons of jet fuel. In the spring of 2018, jet
2
fuel prices rose from an average of $2.07 per gallon to a price of $2.19 per gallon. A $0.12-per-gallon increase
in the price of jet fuel may not seem significant, but on an annualized basis, a price increase of this magnitude
would increase the company’s jet fuel bill by approximately $500 million.

That added cost cuts into the profits of the company, leaving less money available to provide a return to the
company’s investors. Rising costs could even cause the business to become unprofitable and close, causing
many employees to lose their jobs. The financial managers of American Airlines are not able to control the
price of jet fuel. However, they must be aware of the risk that price volatility poses to the company and
consider prudent ways to manage this risk.

1 American Airlines. American Airlines 2019 Environmental Data. Accessed July 8, 2021. https://www.americanairlines.in/content/
images/customer-service/about-us/corporate-governance/aag-2019-environmental-data.pdf
2 S&P Global. “Platts Jet Fuel.” S&P Global Platts. Accessed July 8, 2021. https://www.spglobal.com/platts/en/oil/refined-products/
jetfuel#
600 20 • Risk Management and the Financial Manager

20.1 The Importance of Risk Management

Learning Outcomes
By the end of this section, you will be able to:
• Describe risk in the context of financial management.
• Explain how risk can impact firm value.
• Distinguish between hedging and speculating.

What Is Risk?
The job of the financial manager is to maximize the value of the firm for the owners, or shareholders, of the
company. The three major areas of focus for the financial manager are the size, the timing, and the riskiness
of the cash flows of the company. Broadly, the financial manager should work to

• increase cash coming into the company and decrease cash going out of the company;
• speed up cash coming into the company and slow down cash going out of the company; and
• decrease the riskiness of both money coming in and money going out of the company.

The first item in this list is obvious. The more revenue a company has, the more profitable it will be.
Businesspeople talk about “top line” growth when discussing this objective because revenue appears at the
top of the company’s income statement. Also, the lower the company’s expenses, the more profitable the
company will be. When businesspeople talk about the “bottom line,” they are focused on what will happen to
a company’s net income. The net income appears at the bottom of the income statement and reflects the
amount of revenue left over after all of the company’s expenses have been paid.

The second item in the list—the speed at which money enters and exits the company—has been addressed
throughout this book. One of the basic principles of finance is the time value of money—the idea that a dollar
received today is more valuable than a dollar received tomorrow. Many of the topics explored in this book
revolve around the issue of the time value of money.

The focus of this chapter is on the third item in the list: risk. In finance, risk is defined as uncertainty. Risk
occurs because you cannot predict the future. Compared to other business decisions, financial decisions are
generally associated with contracts in which the parties of the contract fulfill their obligations at different
points in time. If you choose to purchase a loaf of bread, you pay the baker for the bread as you receive the
bread; no future obligation arises for either you or the baker because of this purchase. If you choose to buy a
bond, you pay the issuer of the bond money today, and in return, the issuer promises to pay you money in the
future. The value of this bond depends on the likelihood that the promise will be fulfilled.

Because financial agreements often represent promises of future payment, they entail risk. Even if the party
that is promising to make a payment in the future is ethical and has every intention of honoring the promise,
things can happen that can make it impossible for them to do so. Thus, much of financial management hinges
on managing this risk.

Risk and Firm Value

You would expect the managers of Starbucks Corporation to know a lot about coffee. They must also know a
lot about risk. It is not surprising that the term coffee appears in the text of the company’s 2020 annual report
179 times, given that the company’s core business is coffee. It might be surprising, however, that the term risk
3
appears in the report 99 times. Given that the text of the annual report is less than 100 pages long, the word
risk appears, on average, more than once per page.

Starbucks faces a number of different types of risk. In 2020, corporations experienced an unprecedented risk
because of COVID-19. Coffee shops were forced to remain closed as communities experienced government-

3 Starbucks. Starbucks Fiscal 2020 Annual Report. Seattle: Starbucks Corporation, 2020. https://s22.q4cdn.com/869488222/files/
doc_financials/2020/ar/2020-Starbucks-Annual-Report.pdf

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 20.1 • The Importance of Risk Management 601

mandated lockdowns. Locations that were able to service customers through drive-up windows were not
immune to declining revenue due to the pandemic. As fewer people gathered in the workplace, Starbucks
experienced a declining number of to-go orders from meeting attendees. In addition, Starbucks locations
faced the risk of illness spreading as baristas gathered in their buildings to fill to-go orders.

While COVID-19 brought discussions of risk to the forefront of everyday conversations, risk was an important
focus of companies such as Starbucks before the pandemic began. (The term risk appeared in the company’s
4
2019 annual report 82 times. ) Starbucks’s business model revolves around turning coffee beans into a
pleasurable drink. Anything that impacts the company’s ability to procure coffee beans, produce a drink, and
sell that drink to the customer will impact the company’s profitability.

The investors in the company have allowed Starbucks to use its capital to lease storefronts, purchase espresso
machines, and obtain all of the assets necessary for the company to operate. Debt holders expect interest to
be paid and their principal to be returned. Stockholders expect a return on their investment. Because investors
are risk averse, the riskier they perceive the cash flows they will receive from the business to be, the higher the
expected return they will require to let the company use their money. This required return is a cost of doing
business. Thus, the riskier the cash flows of a company, the higher the cost of obtaining capital. As any cost of
operating a business increases, the value of the firm declines.

LINK TO LEARNING

Starbucks
The most recent annual report for Starbucks Corp., along with the reports from recent years, is available on
the company’s investor relations website under the Financial Data section (https://openstax.org/r/
Financial_Data_section). Go to the most recent annual report for the company. Search for the word risk in
the annual report, and read the discussions surrounding this topic. Note the major types of risk the
company discusses. Pay attention to the types of risk that Starbucks categorizes as uncontrollable and
which types of risk the company attempts to mitigate.

In the following sections, you will learn about some of the types of risk that firms commonly face. You will also
learn about ways in which firms can reduce their exposure to these risks. When firms take actions to reduce
their exposures to risk, they are said to be hedging. Firms hedge to try to protect themselves from losses.
Thus, in finance, hedging is a risk management tool.

Certain strategies are commonly used by firms to hedge risk, which is part of corporate financial management.
Many of these same strategies can be used by economic players who wish to speculate. Speculating occurs
when someone bets on a future outcome. It involves trying to predict the future and profit off of that
prediction, knowing that there is some risk that an incorrect prediction will lead to a loss. Speculators bet on
the future direction of an asset price. Thus, speculation involves directional bets.

If you are concerned that the price of hand sanitizer is going to rise because people are concerned about a
new virus and you purchase a few extra bottles to keep on your shelf “just in case,” you are hedging. If you see
this situation as a business opportunity and purchase bottles of hand sanitizer, hoping that you can sell them
on eBay in a few weeks at twice what you paid for them, you are speculating.

In the popular press, you will often hear of some of the strategies in this chapter discussed in terms of people
using them to speculate. In upper-level finance courses, these strategies are discussed in more depth,
including how they might be used to speculate. In this chapter, however, the focus is on the perspective of a
financial manager using these strategies to manage risk.

4 Starbucks. Starbucks Fiscal 2019 Annual Report. Seattle: Starbucks Corporation, 2019. https://s22.q4cdn.com/869488222/files/
doc_financials/2019/2019-Annual-Report.pdf
602 20 • Risk Management and the Financial Manager

20.2 Commodity Price Risk

Learning Outcomes
By the end of this section, you will be able to:
• Describe commodity price risk.
• Explain the use of long-term contracts as a hedge.
• Explain the use vertical integration as a hedge.
• Explain the use of futures contracts as a hedge.

One of the most significant risks that many companies face arises from normal business operations.
Companies purchase raw materials to produce the products and provide the services they sell. A change in the
market price of these raw materials can significantly impact the profitability of a company.

For example, Starbucks must purchase coffee beans in order to make its coffee drinks. The price of coffee
beans is highly volatile. Sample prices of a pound of Arabica coffee beans over the past couple of decades are
shown in Table 20.1. Over this period, the price of coffee beans ranged from a low of $0.52 per pound in the
summer of 2002 to a high of over $3.00 per pound in the spring of 2011. The costs, and thus the profits, of
Starbucks will vary greatly depending on if the company is paying less than $1.00 per pound for coffee or if it is
paying three times that much.

Date Price per Pound ($)

January 1, 2000 1.09
January 1, 2004 0.74
January 1, 2008 1.39
January 1, 2012 2.41
January 1, 2016 1.46
January 1, 2020 1.50

Table 20.1 Price of Coffee in Select Years,

5
2000-2020

Long-Term Contracts
One method of hedging the risk of volatile input prices is for a firm to enter into long-term contracts with its
suppliers. Starbucks, for example, could enter into an agreement with a coffee farmer to purchase a particular
quantity of coffee beans at a predetermined price over the next several years.

These long-term contracts can benefit both the buyer and the seller. The buyer is concerned that rising
commodity prices will increase its cost of goods sold. The seller, however, is concerned that falling commodity
prices will mean lower revenue. By entering into a long-term contract, the buyer is able to lock in a price for its
raw materials and the seller is able to lock in its sales price. Thus, both parties are able to reduce uncertainty.

While long-term contracts reduce uncertainty about the commodity price, and thus reduce risk, there are
several possible disadvantages to these types of contracts. First, both parties are exposed to the risk that the
other party may default and fail to live up to the terms of the contract. Second, these contracts cannot be
entered into anonymously; the parties to the contract know each other’s identity. This lack of anonymity may
have strategic disadvantages for some firms. Third, the value of this contract cannot be easily determined,
making it difficult to track gains and losses. Fourth, canceling the contract may be difficult or even impossible.

5 Data from International Monetary Fund. “Global Price of Coffee, Other Mild Arabica (PCOFFOTMUSDM).” FRED. Federal Reserve
Bank of St. Louis, accessed August 6, 2021. https://fred.stlouisfed.org/series/PCOFFOTMUSDM

Access for free at openstax.org

 20.2 • Commodity Price Risk 603

Vertical Integration
A common method of handling the risk associated with volatile input prices is vertical integration, which
involves the merger of a company and its supplier. For Starbucks, a vertical integration would involve
Starbucks owning a coffee bean farm. If the price of coffee beans rises, the firm’s costs increase and the
supplier’s revenues rise. The two companies can offset these risks by merging.

Although vertical integration can reduce commodity price risk, it is not a perfect hedge. Starbucks may
decrease its commodity price risk by purchasing a coffee farm, but that action may expose it to other risks,
such as land ownership and employment risk.

Futures Contracts
Another method of hedging commodity price risk is the use of a futures contract. A commodity futures
contract is designed to avoid some of the disadvantages of entering into a long-term contract with a supplier.
A futures contract is an agreement to trade an asset on some future date at a price locked in today. Futures
exist for a range of commodities, including natural resources such as oil, natural gas, coal, silver, and gold and
agricultural products such as soybeans, corn, wheat, rice, sugar, and cocoa.

Futures contracts are traded anonymously on an exchange; the market price is publicly observable, and the
market is highly liquid. The company can get out of the contract at any time by selling it to a third party at the
current market price.

A futures contract does not have the credit risk that a long-term contract has. Futures exchanges require
traders to post margin when buying or selling commodities futures contracts. The margin, or collateral, serves
as a guarantee that traders will honor their obligations. Additionally, through a procedure known as marking
to market, cash flows are exchanged daily rather than only at the end of the contract. Because gains and
losses are computed each day based on the change in the price of the futures contract, there is not the same
risk as with a long-term contract that the counterparty to the contract will not be able to fulfill their obligation.

THINK IT THROUGH

The CME Group

In 2007, the Chicago Mercantile Exchange merged with the Chicago Board of Trade to form CME Group Inc.
CME Group provides trading in futures as well as other types of contracts that companies can use to hedge
risk.

You can watch the video Getting Started with Your Broker (https://openstax.org/r/
Getting_Started_with_Your_Broker) to learn how futures contracts for agricultural products such as coffee
beans, corn, wheat, and soybeans are traded. You will also see other types of futures contracts traded,
including futures for silver, crude oil, natural gas, Japanese yen, and Russian rubles.
604 20 • Risk Management and the Financial Manager

20.3 Exchange Rates and Risk

Learning Outcomes
By the end of this section, you will be able to:
• Describe exchange rate risk.
• Identify transaction, translation, and economic risks.
• Describe a natural hedge.
• Explain the use of forward contracts as a hedge.
• List the characteristics of an option contract.
• Describe the payoff to the holder and writer of a call option.
• Describe the payoff to the holder and writer of a put option.

The managers of companies that operate in the global marketplace face additional complications when
managing the riskiness of their cash flows compared to domestic companies. Managers must be aware of
differing business climates and customs and operate under multiple legal systems. Often, business must be
conducted in multiple languages. Geopolitical events can impact business relationships. In addition, the
company may receive cash flows and make payments in multiple currencies.

Exchange Rates
The costs to companies are impacted when the prices of the raw materials they use change. Very little coffee is
grown in the United States. This means that all of those coffee beans that Starbucks uses in its espresso
machines in Seattle, New York, Miami, and Houston were bought from suppliers outside of the United States.
6
Brazil is the largest coffee-producing country, exporting about one-third of the world’s coffee. When a
company purchases raw materials from a supplier in another country, the company needs not just money but
the money that is used in that country to make the purchase. Thus, the company is concerned about the
exchange rate, or the price of the foreign currency.

7
Figure 20.2 Brazilian Reals to One US Dollar

The currency used in Brazil is called the Brazilian real. Figure 20.2 shows how many Brazilian reals could be
purchased for $1.00 from 2010 through the first quarter of 2021. In March 2021, 5.4377 Brazilian reals could be
purchased for $1.00. This will often be written in the form of

6 Global Agricultural Information Network. Brazil: Coffee Annual 2019. GAIN Report No. BR19006. Washington, DC: USDA Foreign
Agricultural Service, May 2019. https://apps.fas.usda.gov/newgainapi/api/report/
downloadreportbyfilename?filename=Coffee%20Annual_Sao%20Paulo%20ATO_Brazil_5-16-2019.pdf

Access for free at openstax.org

 20.3 • Exchange Rates and Risk 605

BRL is an abbreviation for Brazilian real, and USD is an abbreviation for the US dollar. This price is known as a
currency exchange rate, or the rate at which you can exchange one currency for another currency.

If you know the price of $1.00 is 5.4377 Brazilian reals, you can easily find the price of Brazilian reals in US
dollars. Simply divide both sides of the equation by 5.4377, or the price of the US dollar:

If you have US dollars and want to purchase Brazilian reals, it will cost you $0.1839 for each Brazilian real you
want to buy.

The foreign exchange rate changes in response to demand for and supply of the currency. In early 2020, the
exchange rate was . In other words, $1 purchased fewer reals in early 2020 than in it did a
year later. Because you receive more reals for each dollar in 2021 than you would have a year earlier, the dollar
is said to have appreciated relative to the Brazilian real. Likewise, because it takes more Brazilian reals to
purchase $1.00, the real is said to have depreciated relative to the US dollar.

Exchange Rate Risks

Starbucks, like other firms that are engaged in international business, faces currency exchange rate risk.
Changes in exchange rates can impact a business in several ways. These risks are often classified as
transaction, translation, or economic risk.

Transaction Risk

Transaction risk is the risk that the value of a business’s expected receipts or expenses will change as a result
of a change in currency exchange rates. If Starbucks agrees to pay a Brazilian coffee grower seven million
Brazilian reals for an order of one million pounds of coffee beans, Starbucks will need to purchase Brazilian
reals to pay the bill. How much it will cost Starbucks to purchase these Brazilian reals depends on the
exchange rate at the time Starbucks makes the purchase.

In March 2021, with an exchange rate of , it would have cost Starbucks

to purchase the reals needed to receive the one million pounds of coffee
beans. If, however, Starbucks agreed in March to purchase the coffee beans several months later, in July,
Starbucks would not have known then what the exchange rate would be when it came time to complete the
transaction. Although Starbucks would have locked in a price of BRL 7,000,000 for one million pounds of coffee
beans, it would not have known what the coffee beans would cost the company in terms of US dollars.

If the US dollar appreciated so that it cost less to purchase each Brazilian real in July, Starbucks would find that
it was paying less than $1,287,300 for the coffee beans. For example, suppose the dollar appreciated so that
the exchange rate was in July 2021. Then the coffee beans would only cost Starbucks
.

On the other hand, if the US dollar depreciated and it cost more to purchase each Brazilian real, then
Starbucks would find that its dollar cost for the coffee beans was higher than it expected. If the US dollar
depreciated (and the Brazilian real appreciated) so that the exchange rate was in July
2021, then the coffee beans would cost Starbucks . This uncertainty
regarding the dollar cost of the coffee beans Starbucks would purchase to make its lattes is an example of
transaction risk.

7 Data from Board of Governors of the Federal Reserve System (US). “Brazil / US Foreign Exchange Rate (DEXBZUS).” FRED. Federal
Reserve Bank of St. Louis, accessed August 6, 2021. https://fred.stlouisfed.org/series/DEXBZUS
606 20 • Risk Management and the Financial Manager

A global company such as Starbucks has transaction risk not only because it is purchasing raw materials in
foreign countries but also because it is selling its product—and thus collecting revenue—in foreign countries.
Customers in Japan, for example, spend Japanese yen when they purchase a Starbucks cappuccino, coffee
mug, or bag of coffee beans. Starbucks must then convert these Japanese yen to US dollars to pay the
expenses that it incurs in the United States to produce and distribute these products.

The Japanese yen–US dollar foreign exchange rates from 2011 through the first quarter of 2021 are shown in
Figure 20.3. In 2012, $1.00 could be purchased with fewer than 80 Japanese yen. In 2015, it took over 120 yen to
purchase $1.00.

8
Figure 20.3 Japanese Yen to One US Dollar

If a company is receiving yen from customers and paying expenses in dollars, the company is harmed when
the yen depreciates relative to the dollar, meaning that the yen the company receives from its customers can
be exchanged for fewer dollars. Conversely, when the yen appreciates, it takes fewer yen to purchase each
dollar; this appreciation of the yen benefits companies with revenues in yen and expenses in dollars.

THINK IT THROUGH

Projecting Sales in US Dollars

The managers of a firm think that the exchange rate of Japanese yen to US dollars will be
next year. If the company thinks that it will have sales of 50 million yen next year, how
much will it project these sales will be worth in dollars? What happens if the actual exchange rate over the
next year is ?

Solution:

An exchange rate of implies that . If the company expects to have

sales of JPY 50,000,000, it is expecting sales to be worth USD 500,000. If the exchange rate is really
, this is the same as . With this exchange rate, JPY 50,000,000 in
sales would be equivalent to USD 415,000. The company would receive $85,000 less from these sales in
Japan than it was expecting, even if it met its goals as far as the number of units of items sold.

8 Data from Board of Governors of the Federal Reserve System (US). “Japan / US Foreign Exchange Rate (DEXJPUS).” FRED. Federal
Reserve Bank of St. Louis, accessed August 6, 2021. https://fred.stlouisfed.org/series/DEXJPUS

Access for free at openstax.org

 20.3 • Exchange Rates and Risk 607

Translation Risk

In addition to the transaction risk, if Starbucks holds assets in a foreign country, it faces translation risk.
Translation risk is an accounting risk. Starbucks might purchase a coffee plantation in Costa Rica for 120
million Costa Rican colones. This land is an asset for Starbucks, and as such, the value of it should appear on
the company’s balance sheet.

The balance sheet for Starbucks is created using US dollar values. Thus, the value of the coffee plantation has
to be translated to dollars. Because exchange rates are volatile, the dollar value of the asset will vary
depending on the day on which the translation takes place. If the exchange rate is 500 colones to the dollar,
then this coffee plantation is an asset with a value of $240,000. If the Costa Rican colón depreciates to 600
colones to the dollar, then the asset has a value of only $200,000 when translated using this exchange rate.

Although it is the same piece of land with the same productive capacity, the value of the asset, as reported on
the balance sheet, falls as the Costa Rican colón depreciates. This decrease in the value of the company’s
assets must be offset by a decrease in the stockholders’ equity for the balance sheet to balance. The loss is
due simply to changes in exchange rates and not the underlying profitability of the company.

Economic Risk

Economic risk is the risk that a change in exchange rates will impact a business’s number of customers or its
sales. Even a company that is not involved in international transactions can face this type of risk. Consider a
company located in Mississippi that makes shirts using 100% US-grown cotton. All of the shirts are made in the
United States and sold to retail outlets in the United States. Thus, all of the company’s expenses and revenues
are in US dollars, and the company holds no assets outside of the United States.

Although this firm has no financial transactions involving international currency, it can be impacted by
changes in exchange rates. Suppose the US dollar strengthens relative to the Vietnamese dong. This will allow
US retail outlets to purchase more Vietnamese dong, and thus more shirts from Vietnamese suppliers, for the
same amount of US dollars. Because of this, the retail outlets experience a drop in the cost of procuring the
Vietnamese shirts relative to the shirts produced by the firm in Mississippi. The Mississippi company will lose
some of its customers to these Vietnamese producers simply because of a change in the exchange rate.

Hedging
Just as companies may practice hedging techniques to reduce their commodity risk exposure, they may
choose to hedge to reduce their currency risk exposure. The types of futures contracts that we discussed
earlier in this chapter exist for currencies as well as for commodities. A company that knows that it will need
Korean won later this year to purchase raw materials from a South Korean supplier, for example, can purchase
a futures contract for Korean won.

While futures contracts allow companies to lock in prices today for a future commitment, these contracts are
not flexible enough to meet the risk management needs of all companies. Futures contracts are standardized
contracts. This means that the contracts have set sizes and maturity dates. Futures contracts for Korean won,
for example, have a contract size of 125 million won. A company that needs 200 million won later this year
would need to either purchase one futures contract, hedging only a portion of its needs, or purchase two
futures contracts, hedging more than it needs. Either way, the company has remaining currency risk.

In this next section, we will explore some additional hedging techniques.

Forward Contracts

Suppose a company needs access to 200 million Korean won on March 1. In addition to a specified contract
size, currency futures contracts have specified days on which the contracts are settled. For most currency
futures contracts, this occurs on the third Wednesday of the month. If the company needed 125 million Korean
won (the basic contract size) on the third Wednesday of March (the standard settlement date), the futures
608 20 • Risk Management and the Financial Manager

contract could be useful. Because the company needs a different number of Korean won on a different date
from those specified in the standard contract, the futures contract is not going to meet the specific risk
management needs of the company.

Another type of contract, the forward contract, can be used by this company to meet its specific needs. A
forward contract is simply a contractual agreement between two parties to exchange a specified amount of
currencies at a future date. A company can approach its bank, for example, saying that it will need to purchase
200 million Korean won on March 1. The bank will quote a forward rate, which is a rate specified today for the
sale of currency on a future date, and the company and the bank can enter into a forward contract to
exchange dollars for 200 million Korean won at the quoted rate on March 1.

Because a forward contract is a contract between two parties, those two parties can specify the amount that
will be traded and the date the trade will occur. This contract is similar to your agreeing with a hotel that you
will arrive on March 1 and rent a room for three nights at $200 per night. You are agreeing today to show up at
the hotel on a future (specified) date and pay the quoted price when you arrive. The hotel agrees to provide
you the room on March 1 and cannot change the price of the room when you arrive. With a forward contract,
you are also agreeing that you will indeed make the purchase and you cannot change your mind; so, using the
hotel room analogy, this would mean that the hotel will definitely charge your credit card for the agreed-upon
$200 per night on March 1.

The forward contract is an individualized contract between the buyer and the seller; they are both under a
contractual obligation to honor the contract. Because this contract is not standardized like the futures contract
(so that it can be traded on an exchange), it can be tailored to the needs of the two parties. While the forward
contract has the advantage of being fine-tuned to meet the company’s needs, it has a risk, known as
counterparty risk, that the futures contract does not have. The forward contract is only as good as the promise
of the counterparty. If the company enters into a forward contract to purchase 200 million Korean won on
March 1 from its bank and the bank goes out of business before March 1, the company will not be able to
make the exchange with a nonexistent bank. The exchanges on which futures contracts are traded guard the
purchaser of a futures contract from this type of risk by guaranteeing the contract.

Natural Hedges

A hedge simply refers to a reduction in the risk or exposure that a company has to volatility and uncertainty.
We have been focusing on how a company might use financial market instruments to hedge, but sometimes a
company can use a natural hedge to mitigate risk. A natural hedge occurs when a business can offset its risk
simply through its own operations. With a natural hedge, when a risk occurs that would decrease the value of
a company, an offsetting event occurs within the firm that increases the value of the company.

As an example, consider a British-based travel agency. One of the major tours the company offers is a tour of
Italy. The company arranges for transportation, lodging, meals, and sightseeing for Brits to visit the highlights
of Rome, Florence, and Venice. Because the company charges customers in British pounds but must pay the
bus companies, hotels, and other service providers in Italy in euros, the travel agency faces significant
transaction exposure. If the value of the British pound depreciates after the company sets the price it will
charge for the tour but before it pays the Italian suppliers, the company will be harmed. In fact, if the British
pound depreciates by a great deal, the company could end up in a situation in which the British pounds it
collects are not enough to purchase the euros it needs to pay its suppliers.

The company could create a natural hedge by offering tours of London to individuals living in the European
Union. The travel agency could charge people who live in Germany, Italy, Spain, or any other country that has
the euro as its currency for a travel package to London. Then the agency would pay British restaurants, tour
guides, hotels, and bus companies in British pounds. This segment of the business also has currency risk. If
the British pound depreciates, the company gains because the euros it collects from its EU customers will
purchase more British pounds than before.

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 20.3 • Exchange Rates and Risk 609

Thus, the company has created a situation in which if the British pound depreciates, the decrease in value of
its tours of Italy is exactly offset by the increase in value of its tours of London. If the British pound
appreciates, the opposite occurs: the company experiences a gain in its division that charges British pounds
for tourists traveling to Italy and an offsetting loss in its division that charges euros for tourists traveling to
London.

Options

A financial option gives the owner the right, but not the obligation, to purchase or sell an asset for a specified
price at some future date. Options are considered derivative securities because the value of a derivative is
derived from, or comes from, the value of another asset.

Options Terminology

Specific terminology is used in the finance industry to describe the details of an options contract. If the owner
of an option decides to purchase or sell the asset according to the terms of the options contract, the owner is
said to be exercising the option. The price the option holder pays if purchasing the asset or receives if selling
the asset is known as the strike price or exercise price. The price the owner of the option paid for the option is
known as the premium.

An option contract will have an expiration date. The most common kinds of options are American options,
which allow the holder to exercise the option at any time up to and including the expiration date. Holders of
European options may exercise their options only on the expiration date. The labels American option and
European option can be confusing as they have nothing to do with the location where the options are traded.
Both American and European options are traded worldwide.

Option contracts are written for a variety of assets. The most common option contracts are options on shares
of stock. Options are traded for US Treasury securities, currencies, gold, and oil. There are also options on
agricultural products such as wheat, soybeans, cotton, and orange juice. Thus, options can be used by financial
managers to hedge many types of risk, including currency risk, interest rate risk, and the risk that arises from
fluctuations in the prices of raw materials.

Options are divided into two main categories, call options and put options. A call option gives the owner of
the option the right, but not the obligation, to buy the underlying asset. A put option gives the owner the
right, but not the obligation, to sell the underlying asset.

Call Options

If a Korean company knows that it will need pay a $100,000 bill to a US supplier in six months, it knows how
many US dollars it will need to pay the bill. As a Korean company, however, its bank account is denominated in
Korean won. In six months, it will need to use its Korean won to purchase 100,000 US dollars.

The company can determine how many Korean won it would take to purchase $100,000 today. If the current
exchange rate is , then it will need KWN 110,000,000 to pay the bill. The current
exchange rate is known as the spot rate.

The company, however, does not need the US dollars for another six months. The company can purchase a call
option, which is a contract that will allow it to purchase the needed US dollars in six months at a price stated in
the contract. This allows the company to guarantee a price for dollars in six months, but it does not obligate
the company to purchase the dollars at that price if it can find a better price when it needs the dollars in six
months.

The price that is in the contract is called the strike price (exercise price). Suppose the company purchases a
call contract for US dollars with a strike price of KWN 1,200/USD. While this contract would be for a set size, or
a certain number of US dollars, we will talk about this transaction as if it were per one US dollar to highlight
how options contracts work.
610 20 • Risk Management and the Financial Manager

The company must pay a price, known as the premium, to purchase this call option contract. For our example,
let’s assume the premium for the call option contract is KWN 50. In other words, the company has paid KWN
50 for the right to buy US dollars in six months for a price of KWN 1,200/USD.

In six months, the company makes a choice to either (1) pay the strike price of KWN 1,200/USD or (2) let the
option expire. If the company chooses to pay the strike price and purchase the US dollars, it is exercising the
option. How does the company choose which to do? It simply compares the strike price of KWN 1,200/USD to
the market, or spot, exchange rate at the time the option is expiring.

If, six months from now, the spot exchange rate is , it will be cheaper for the company
to buy the US dollars it needs at the spot price than it would be to buy the dollars with the option. In fact, if the
spot rate is anything below , the company will not choose to exercise the option. If,
however, the spot exchange rate in six months is , the company will exercise the option
and purchase each US dollar for only KWN 1,200.

The profitability, or the payoff, to the owner of a call option is represented by the chart in Figure 20.4 below.
Possible spot prices are measured from left to right, and the financial gain or loss to the company of the
option contract is measured vertically. If the spot price is anything less than KWN 1,200/USD, the option
expires without being exercised. The company paid KWN 50 for something that ended up being worthless.

Figure 20.4 The Payoff to the Holder of a Call Option

If, in six months, the spot exchange rate is , then the company will choose to exercise
the option. The company will be saving KWN 25 for each dollar purchased, but the company originally paid 50
KWN for the contract. So, the company will be 25 KWN worse off than if it had never purchased the call option.

If the spot exchange rate is , the company will be in exactly the same position having
purchased and exercised the call option as it would have been if it had not purchased the option. At any spot
price higher than KWN 1,250/USD, the firm will be in a better financial position, or will have a positive payoff,
because it purchased the call option. The more the Korean won depreciates over the next six months, the
higher the payoff to the firm of owning the call contract. Purchasing the call contract is a way that the
company can protect itself from the currency exposure it faces.

For any transaction, there must be two parties—a buyer and a seller. For the company to have purchased the
call option, another party must have sold the call option. The seller of a call option is called the option writer.
Let’s consider the potential benefits and risks to the writer of the call option.

When the company purchases the call option, it pays the premium to the writer. The writer of the option does
not have a choice regarding whether the option will be exercised. The purchaser of the option has the right to
make the choice; in essence, the writer of the option sold the right to make that decision to the purchasers of
the call option.

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 20.3 • Exchange Rates and Risk 611

Figure 20.5 shows the payoff to the writer of the call option. Recall that the buyer of the call option will let the
option expire if the spot rate is less than when the call option matures in six months. If
this occurs, the writer of the option collected the KWN 50 option premium when the contract was sold and
then never hears from the purchaser again. This is what the writer of the option is hoping for; the writer of the
call option profits when the options contract is not exercised

Figure 20.5 The Payoff to the Writer of a Call Option

If the spot rate is above , then the holder of the option will choose to exercise the right
to purchase the won at the option strike price. Then the writer of the option will be obligated to sell the Korean
won at a price of KWN 1,200/USD. If the spot rate is , the option writer will be obligated
to sell the dollars for KWN 50 less than what they are worth; because the option writer was initially paid a KWN
50 premium for taking on that obligation, the option writer will just break even. For any exchange rate higher
than , the writer of the call option will have a loss.

The option contract is a zero-sum game. Any payoff the owner of the option receives is exactly equal to the
loss the writer of the option has. Any loss the owner of the option has is exactly equal to the payoff the writer
of the option receives.

Put Options

While the call option you just considered gives the owner the right to buy an underlying asset, the put option
gives the owner to right to sell an underlying asset. Take, for example, an Indian company that has a contract
to provide graphic artwork for a US company. The US company will pay the Indian company 200,000 US dollars
in three months.

While the Indian company receives US dollars, it must pay its workers in Indian rupees. Because the company
does not know what the spot exchange rate will be in three months, it faces transaction risk and may be
interested in hedging this exposure using a put option.

The company knows that the current spot rate is , meaning that the company would be able
to use $200,000 to purchase if it possessed the $200,000 today. If
the Indian rupee appreciates relative to the US dollar over the next three months, however, the company will
receive fewer rupees when it makes the exchange; perhaps the company will not be able to purchase enough
rupees to cover the wages of its employees.

Assume the company can purchase a put option that gives it the right to sell US dollars in three months at a
strike price of INR 75/USD; the premium for this put option is INR 5. By purchasing this put option, the
company is spending INR 5 to guarantee that it can sell its US dollars for rupees in three months at a price of
INR 75/USD.
612 20 • Risk Management and the Financial Manager

If, in three months, when the company receives payment in US dollars, the spot exchange rate is higher than
, the company will simply exchange the US dollars for rupees at that exchange rate, allowing
the put option to expire without exercising it. The payoff to the company for the option is INR -5, the premium
that was paid for the option that was never used (see Figure 20.6).

Figure 20.6 The Payoff to the Holder of a Put Option

If, however, in three months, the spot exchange rate is anything less than , then the
company will choose to exercise the option. If the spot rate is between and
, the payoff for the option is negative. For example, if the spot exchange rate is
, the company will exercise the option and receive three more Indian rupees per dollar than
it would in the spot market. However, the company had to spend INR 5 for the option, so the payoff is INR -2.
At a spot exchange rate of , the company has a zero payoff; the benefit of exercising the
option, INR 5, is exactly equal to the price of purchasing the option, the premium of INR 5.

If, in three months, the spot exchange rate is anything below , the payoff of the put option is
positive. At the theoretical extreme, if the USD became worthless and would purchase no rupees in the spot
market when the company received the dollars, the company could exercise its option and receive INR 75/USD,
and its payoff would be INR 70.

Now that we have considered the payoff to a purchaser of a put contract, let’s consider the opposite side of
the contract: the seller, or writer, of the put option. The writer of a put option is selling the right to sell dollars
to the purchaser of the put option. The writer of the put option collects a premium for this. The writer of the
put has no choice as to whether the put option will be exercised; the writer only has an obligation to honor the
contract if the owner of the put option chooses to exercise it.

The owner of the option will choose to let the option expire if the spot exchange rate is anything above
. If that is the case, the writer of the put option collects the INR 5 premium for writing the
put, as shown by the horizontal line in Figure 20.7. This is what the writer of the put is hoping will occur.

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 20.3 • Exchange Rates and Risk 613

Figure 20.7 The Payoff to the Writer of a Put Option

The owner of the option will choose to exercise the option if the exchange rate is less than .
If the spot exchange rate is between and , the writer of the put option has
a positive payoff. Although the writer must now purchase US dollars for a price higher than what the dollars
are worth, the INR 5 premium that the writer received when entering into the position is more than enough to
offset that loss.

If the spot exchange rate drops below , however, the writer of the put option is losing more
than INR 5 when the option is exercised, leaving the writer with a negative payoff. In the extreme, the writer of
the put will have to purchase worthless US dollars for INR 75/USD, resulting in a loss of INR 70.

Notice that the payoff to the writer of the put is the negative of the payoff to the holder of the put at every
spot price. The highest payoff occurs to the writer of the put when the option is never exercised. In that
instance, the payoff to the writer is the premium that the holder of the put paid when purchasing the option
(see Figure 20.7).

Table 20.2 provides a summary of the positions that the parties who enter into options contract are in.
Remember that the buyer of an option is always the one purchasing the right to do something. The seller or
writer of an option is selling the right to make a decision; the seller has the obligation to fulfill the contract
should the buyer of the option choose to exercise the option. The most the seller of an option can ever profit is
by the premium that was paid for the option; this occurs when the option is not exercised.

Benefits Harm
Party to an Right of Obligation of Maximum
When When Maximum Loss
Option Contract the Party the Party Profit
Price of Price of
Buyer of a call To buy underlying Unlimited underlying Premium paid
rises falls
Price of Price of
Premium
Seller of a call To sell underlying underlying Unlimited
received
falls rises
Price of Price of
Strike price
Buyer of a put To sell underlying underlying Premium paid
minus premium
falls rises

Table 20.2 Summary of Option Contracts

614 20 • Risk Management and the Financial Manager

Benefits Harm
Party to an Right of Obligation of Maximum
When When Maximum Loss
Option Contract the Party the Party Profit
Price of Price of
Premium Strike price
Seller of a put To buy underlying underlying
received minus premium
rises falls

Table 20.2 Summary of Option Contracts

20.4 Interest Rate Risk

Learning Outcomes
By the end of this section, you will be able to:
• Describe interest rate risk.
• Explain how a change in interest rates changes the value of cash flows.
• Describe the use of an interest rate swap.

An interest rate is simply the price of borrowing money. Just as other prices are volatile, interest rates are also
volatile. Just as volatility in other prices leads to uncertain cash flows for a company, volatility in interest rates
can also lead to uncertain cash flows.

Measuring Interest Rate Risk

Suppose that a company is supposed to pay a bill of $1,000 in 10 years. The present value of this bill depends
on the level of interest rates. If the interest rate is 5%, the present value of the bill is . If

the interest rate rises to 6%, the present value of the bill is . The increase in the interest

rate by 1% causes the present value of the expected cash flow to fall by .

Interest rate risk can be highlighted by looking at bonds. Consider two $1,000 face value bonds with a 5%
coupon rate, paid semiannually. One of the bonds matures in five years, and the other bond matures in 30
years. If the market interest rate is 5%, each of these bonds will sell for face value, or $1,000. If, instead, the
market interest rate is 6%, the five-year bond will sell for $957.35 and the 30-year bond will sell for $861.62.

Notice that as the interest rate rises, the price of both of these bonds will fall. However, the price of the longer-
term bond will fall by more than the price of the shorter-term bond. The longer-term bond price will fall by
1.38%; the shorter-term bond price will fall by only 0.43%.

Consider two additional $1,000 face value bonds. The difference is that these bonds have a 6% coupon rate,
paid semiannually. If a bond has a 6% coupon rate and matures in five years, it will sell for $1,043.76 when the
market interest rate is 5%. A 30-year bond that matures in 30 years and has a 6% coupon rate will sell for
$1,154.54 when the market interest rate is 5%. However, if the interest rate in the economy is 6%, both of these
bonds will sell for a price of $1,000. The price of the five-year bond will drop by 4.19%; the price of the 30-year
bond will drop by 13.39%.

THINK IT THROUGH

Calculating Bond Prices as the Interest Rates Changes

You are considering purchasing a $10,000 face value bond with a 4% coupon rate, paid semiannually, that
matures in 20 years. If you require a 5% return to purchase this bond, what is the maximum price you

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 20.4 • Interest Rate Risk 615

would be willing to pay for the bond? If, instead, you require an 8% return to purchase this bond, what is
the maximum price you would be willing to pay for the bond?

Solution:

If the bond pays coupon interest semiannually, you will receive one-half of the face value of the bond
multiplied by the coupon rate every six months. So, you will receive 40 coupon payments of
. At maturity, you will receive one lump sum of the face value of the bond. Follow
the steps in Table 20.3 to calculate the price of the bond if you require a 5% return, using a financial
calculator.

Step Description Enter Display

1 Enter the number of coupon payments you will receive 40 N N = 40

2 Enter your semiannual required return 2.5 I/Y I/Y = 2.5

3 Enter the semiannual coupon payment 200 PMT PMT = 200

4 Enter the face value of the bond 10000 FV FV = 10,000

5 Calculate the present value CPT PV PV = -8,744.86

9
Table 20.3 Calculator Step to Price a Bond Requiring a 5% Return

When your required yield is 5%, the most you would be willing to pay for this bond is $8,744.86.

To calculate the price of the bond if your required return is 8%, use the same process, replacing the I/YR in
step 2 with 4 (see Table 20.4). All other variables remain the same because the characteristics of the bond
have not changed.

Step Description Enter Display

1 Enter the number of coupon payments you will receive 40 N N = 40

2 Enter your semiannual required return 4 I/Y I/Y = 4

3 Enter the semiannual coupon payment 200 PMT PMT = 200

4 Enter the face value of the bond 10000 FV FV = 10,000

5 Calculate the present value CPT PV PV = -6,041.45

Table 20.4 Calculator Steps to Price a Bond Requiring an 8% Return

If your required return is 8% to invest in this bond, you will be willing to pay only $6,041.45 to purchase the
bond.

Thus, if interest rates rise because of changing market conditions, the price of bonds will fall.

The sensitivity of bond prices to changes in the interest rate is known as interest rate risk. Duration is an
important measure of interest rate risk that incorporates the maturity and coupon rate of a bond as well as
the level of current market interest rates. Calculating duration is a complex topic that is beyond the scope of
this introductory textbook, but it is useful to note that

• the higher the duration of a bond, the more sensitive the price of the bond will be to interest rate

9 The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other
financial calculators for these types of calculations.
616 20 • Risk Management and the Financial Manager

changes;
• the duration of a bond will be higher when market yields are lower, all else being equal;
• the duration of a bond will be higher the longer the maturity of the bond, all else being equal; and
• the duration of a bond will be higher the lower the coupon rate on the bond, all else being equal.

Swap-Based Hedging
As the name suggests, a swap involves two parties agreeing to swap, or exchange, something. Generally, the
two parties, known as counterparties, are swapping obligations to make specified payment streams.

To illustrate the basics of how an interest rate swap works, let’s consider two hypothetical companies, Alpha
and Beta. Alpha is a strong, well-established company with a AAA (triple-A) bond rating. This means that Alpha
has the highest rating a company can have. With this high rating, Alpha can borrow at relatively low interest
rates. Often, companies in this situation will borrow at a floating rate. This means that their interest rate goes
up and down as interest rates in the overall economy vary. The floating rate will be tied to a benchmark rate
that is widely quoted in the financial press. Historically, companies have often used the London Interbank
Offered Rate (LIBOR) as the benchmark rate. Because published quotes for LIBOR will be phased out by 2023,
firms are beginning to use alternative rates. As of yet, no single alternative has emerged as the most
commonly used rate; therefore, LIBOR will be used in our example. Suppose that Alpha finds that it can
borrow money at rate equal to ; thus, if LIBOR is 2.75%, the company will pay 3.0% to borrow.
If the company wants to borrow at a long-term fixed rate, its cost of borrowing will be 5.0%.

LINK TO LEARNING

LIBOR Transition
Although the basic principles of financial transactions remain the same over time, the particular financial
instruments used change from time to time. Innovation, regulation, and technological advances lead to
these changes in financial instruments. The use of LIBOR as a benchmark rate is winding down in the early
2020s. To find out more about this transition and how it impacts companies, visit the About LIBOR
Transition (https://openstax.org/r/About_LIBOR_Transition) website.

Beta has a BBB bond rating. Although this is considered a good, investment-grade rating, it is lower than the
rating of Alpha. Because Beta is less creditworthy and a bit riskier than Alpha, it will have to pay a higher
interest rate to borrow money. If Beta wants to borrow money at a floating rate, it will need to pay
If LIBOR is 2.75%, Beta must pay 3.5% on its floating rate debt. In order for Beta to borrow at
a long-term fixed rate, its cost of borrowing will be 6.75%.

Let’s consider how these two companies can enter into a swap in which both parties benefit. Table 20.5
summarizes the situation and the rates at which Alpha and Beta can borrow. It also illustrates a way in which
an interest rate swap can benefit both Alpha and Beta.

Alpha Beta
Bond rating AAA BBB
Floating rate
Fixed rate 5 6.75
Rate company chooses Fixed at 5.0 Floating at
Swap N/A N/A
Beta pays Alpha fixed rate 5.5 -5.5

Table 20.5 Example of a Swap Agreement

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 20.4 • Interest Rate Risk 617

Alpha Beta
Alpha pays Beta floating rate -LIBOR +LIBOR
Payments and receipts
Net amount -6.25
Benefit 0.75 0.5

Table 20.5 Example of a Swap Agreement

Alpha borrows in the capital markets at a fixed rate of 5%. Beta chooses to borrow at a floating rate that equals
Beta also agrees to pay Alpha a fixed rate of 5.5%. In essence, Beta is paying 5.5% to
Alpha, 0.75% to its lender, and LIBOR to its lender.

In return, Alpha promises to pay Beta LIBOR. The exact amount that Alpha will pay to Beta fluctuates as LIBOR
fluctuates. However, from Beta’s perspective, the payment of LIBOR it receives from Alpha exactly offsets the
payment of LIBOR it makes to its lender. When LIBOR increases, the rate of that Beta is
paying to its lender increases, but the LIBOR rate it receives from Alpha also increases. When LIBOR decreases,
Beta receives less from Alpha, but it also pays less to its lender. Because the LIBOR it receives from Alpha is
exactly equal to the LIBOR it pays to its lender, Beta’s net amount of interest paid is 6.25%—the 5.5% it pays to
Alpha plus the 0.75% it pays to its lender.

Alpha is in the position of paying 5.0% to its lender and LIBOR to Beta while receiving 5.5% from Beta. This
means that Alpha’s net interest paid is Alpha is said to have swapped its fixed interest rate for
a floating rate. Because it is paying , it will experience fluctuating interest rates; however, as a
company with a AAA bond rating, it is a strong, creditworthy company that can withstand that interest rate
exposure. It would have cost Alpha to borrow the money from its lenders at a variable rate.
By participating in this swap arrangement, Alpha has been able to lower its interest rate by 0.75%.

Through this swap arrangement, Beta has been able to fix its interest rate at 6.25% rather than having a
variable rate. This predictability is a benefit for a company, especially one that is in a bit more precarious
position as far as its creditworthiness and stability. The 6.25% Beta pays as a result of this arrangement is 0.5%
below the 6.75% it would have paid if it simply borrowed from its lenders at a fixed rate.
618 20 • Summary

Summary
20.1 The Importance of Risk Management
Risk arises due to uncertainty. The future is unpredictable. One job of the financial manager is to manage the
risks of both cash inflows and cash outflows. Investors are risk-averse. The riskier a firm’s cash flows are, the
higher the rate of return investors require to provide capital to the company.

20.2 Commodity Price Risk

Companies do not know how much they will have to pay for raw materials in future months. The price of raw
materials will change as economic conditions change, impacting a company’s cost of goods sold and profits.
Some ways that a company can hedge this risk are through vertical integration, long-term contracts, and
futures contracts.

20.3 Exchange Rates and Risk

Exchange rates are unpredictable. This leads to transaction risk, translation risk, and economic risk as currency
values change. A forward contract is an agreement between two parties to make an exchange at a particular
rate on a given date in the future. Companies can use options to mitigate the risks. A call option gives the
holder the right, but not the obligation, to purchase an underlying asset. A put option give the holder the right,
but not the obligation, to sell an underlying asset.

20.4 Interest Rate Risk

When interest rates increase, the present value of future cash flows decreases. Duration is a measure of
interest rate risk. A swap involves two parties agreeing to exchange something, often specified payment
streams.

Key Terms
American option an option that the holder can exercise at any time up to and including the exercise date
appreciate when one unit of a currency will purchase more of a foreign currency than it did previously
call option an option that gives the owner the right, but not the obligation, to buy the underlying asset at a
specified price on some future date
depreciate when one unit of a currency will purchase less of a foreign currency than it did previously
derivative a security that derives its value from another asset
duration a measure of interest rate risk
economic risk the risk that a change in exchange rates will impact the number of customers a business has
or its sales
European option an option that the holder can exercise only on the expiration date
exchange rate the price of one currency in terms of another currency
exercise price (strike price) the price the option holder pays for the underlying asset when exercising an
option
exercising choosing to purchase or sell the asset underlying a held option according to the terms of the
option contract
expiration date the date an option contract expires
forward contract a contractual agreement between two parties to exchange a specified amount of assets on
a specified future date
futures contract a standardized contract to trade an asset on some future date at a price locked in today
hedging taking an action to reduce exposure to a risk
margin the collateral that must be posted to guarantee that a trader will honor a futures contract
marking to market a procedure by which cash flows are exchanged daily for a futures contract, rather than
at the end of the contract

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 20 • CFA Institute 619

natural hedge when a company offsets the risk that something will decrease in value by having a company
activity that would increase in value at the same time
option an agreement that gives the owner the right, but not the obligation, to purchase or sell an asset at a
specified price on some future date
option writer seller of a call or put option
premium the price a buyer of an option pays for the option contract
put option an option that gives the owner the right, but not the obligation, to sell the underlying asset at a
specified price on some future date
speculating attempting to profit by betting on the uncertain future, knowing that a risk of loss is involved
spot rate the current market exchange rate
strike price (exercise price) the price an option holder pays for the underlying asset when exercising the
option
swap an agreement between two parties to exchange something, such as their obligations to make specified
payment streams
transaction risk the risk that a change in exchange rates will impact the value of a business’s expected
receipts or expenses
translation risk the risk that a change in exchange rates will impact the value of items on a company’s
financial statements
vertical integration the merger of a company with its supplier

CFA Institute
This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session
(https://openstax.org/r/cfa-institute-Level-I-Study-Session). Reference with permission of CFA Institute.

Multiple Choice
1. Which of the following does a financial manager want to do to maximize the value of the firm?
a. Decrease the speed of money coming into the firm
b. Speed up cash going out and slow down cash coming in
c. Decrease the riskiness of cash inflows and cash outflows
d. Increase the volatility and speed of cash going out of the firm

2. In finance, risk is ________.

a. the same thing as profit
b. ignored because it is inevitable
c. thought of as uncertainty or unpredictability
d. something that financial managers should strive to increase and maximize

3. American Jeans Corp. purchases a cotton farm. The cotton grown on the farm will be used to make denim
cloth for the company’s jeans. This is an example of ________.
a. striking a price
b. vertical integration
c. a forward contract
d. an American option

4. The price that a holder of an option pays to buy the underlying asset when exercising a call option is
known as ________.
a. the strike price
b. the maturity price
620 20 • Multiple Choice

c. the exchange price

d. the underlying premium

5. Which of the following gives the holder the right, but not the obligation, to purchase an underlying asset?
a. A call option
b. A forward contract
c. A European put option
d. An American put option

6. An American option allows the holder to ________.

a. exercise the option only on the expiration date
b. exercise the option at any time up to and including the expiration date
c. sell stocks, and a European option allows the holder to purchase stocks
d. purchase stocks, and a European option allows the holder to purchase bonds

7. The holder of a(n) ________ has the right to buy and the holder of a(n) ________ has the right to sell an
underlying asset.
a. call option; put option
b. put option; call option
c. American option; European option
d. European option; American option

8. The three main categories of foreign exchange risk a company faces are ________.
a. economic risk, business risk, and exposure risk
b. exposure risk, fluctuation risk, and forward risk
c. transaction risk, translation risk, and economic risk
d. appreciation risk, depreciation risk, and duplication risk

9. In January, the exchange rate between the South Korean won and the US dollar was
. Three months later, the exchange rate was . This means that
________.
a. the Korean won appreciated relative to the US dollar
b. the Korean won depreciated relative to the US dollar
c. the US dollar depreciated relative to the Korean won
d. both the Korean won and the US dollar appreciated

10. In January, the exchange rate between the South Korean won and the US dollar was
. Three months later, the exchange rate was . This means
that ________.
a. it will cost US companies more to purchase raw materials from South Korea
b. it will cost Korean companies more to purchase raw materials from the United States
c. US companies that sell their products in South Korea will find their revenue has increased
d. Korean companies that sell their products in the United States will find that their revenue has
decreased

11. A foreign exchange forward contract ________.

a. is a standardized contract that is inflexible
b. occurs when a company swaps its translation exposure for transaction exposure
c. is a contractual agreement between two parties to exchange a specified amount of currencies on a
future date

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 20 • Review Questions 621

d. states the date on which a trade will take place, but the price for the trade will be determined at the
time the trade occurs

12. Which of the following is a measure of interest rate risk?

a. LIBOR
b. Duration
c. Translation exposure
d. Contract inflexibility

13. A swap occurs when ________.

a. a company exchanges obligations with another company to make specified payment streams
b. a company purchases commodities from a company in another country, exposing it to both
commodity and currency risk
c. a company chooses a local supplier over an international supplier to avoid currency exposure
d. a company chooses a foreign supplier so that its commodity risk will be offset by its currency risk

Review Questions
1. What is the difference between someone using a derivative security to hedge risk and someone using a
derivative security to speculate?

2. Explain how vertical integration may be used as a method of hedging against commodity price risk.

3. What is the difference between a forward contract and a futures contract?

4. You are considering purchasing a call option to purchase Mexican pesos in three months with a strike
price of MXN 20/USD. The premium for this call option is MXN 2. Show the payoff you will receive at
various prices in a diagram.

5. You are considering writing a call option to purchase Mexican pesos in three months with a strike price of
MXN 20/USD. The premium for this call option is MXN 2. Show the payoff you will receive at various prices
in a diagram.

6. Why are options considered to be a “zero-sum game”?

Problems
1. The Olive Orchard is a US retail outlet for high-quality olive oils. One of the major suppliers of olive oil for
the company is a farm in Greece. The Olive Orchard must pay the Greek farm 5.00 euros per liter of olive
oil it purchases. The Olive Orchard would like to purchase 7,000 liters of the Greek farm’s olive oil next
year. Currently, it costs 0.900 euros to purchase 1 US dollar. If the exchange rate remains constant, how
much will it cost the Olive Orchard (in US dollars) to purchase the 7,000 liters? If the exchange rate
changes so that it costs 0.8599 euros to purchase 1 US dollar, how much will it cost to purchase the 7,000
liters of olive oil?

2. International Automobile Parts (IAP) holds a call option to purchase US dollars. The strike price on the call
option is JPY 115/USD. IAP paid JPY 10 for the option. The spot price is JPY 120/USD, and the option expires
today. Should IAP exercise the option? What is IAP’s payoff?

3. Global Producers (GP) holds a put option to sell US dollars. The strike price on the put option is JPY 114/
USD. GP paid JPY 10 for the option. The spot price is JPY 120/USD, and the option expires today. Should GP
exercise the option? What is GP’s payoff?
622 20 • Video Activity

Video Activity
Hedging at Southwest Airlines

Click to view content (https://openstax.org/r/Single_Biggest_Risk)

Jet fuel costs represent a major expense for airlines. Southwest Airlines has been known as the most
aggressive airline when it comes to hedging the risk of jet fuel cost volatility. In this interview, the CEO of
Southwest Airlines, Gary Kelly, discusses crude oil prices in the spring of 2012 and the impact on Southwest
Airlines.

1. How volatile are oil prices, and how large of an impact does that volatility have on the cost structure of an
airline?

2. Gary Kelly states that he sees fuel prices as the largest single business risk Southwest Airlines faces and
that hedging that risk has become more expensive. Why do you think it became more expensive for
Southwest Airlines to hedge this risk in 2012?

BMW in the United States

Click to view content (https://openstax.org/r/BMW_US_Natural_Hedging)

While the name BMW may sound German, a significant amount of BMW’s production occurs outside of
Germany. Watch this video to learn about this international activity of BMW.

3. In the video, the potential car buyer is concerned about the impact of the value of the euro on the price of
the BMW. Why, if he is paying for the car in US dollars, do you think that he is impacted by the currency
exchange rate?

4. How do you think opening plants in the United States, and in other parts of the world, provides a currency
hedge for BMW?

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 Index 623

Index
Symbols Apple, Inc. 112, 131, 132, 134, Brokers 22
“C&G” Credit Ratings 358 135, 136, 137, 139, 141, 142, 147, Budget analyst 19
(ESG) 53 153, 154, 156, 157, 284, 450 Buffett 332, 370, 373
(GAAP) 156 appreciated 605 Bureau of Labor Statistics 77,
2014 Winter Olympics 491 arithmetic average return 453 217
3M 288 arithmetic mean 382 Bureau of Labor Statistics (BLS)
3M (MMM) 450 articles of incorporation 44 18, 79
401k plans 9 articles of organization 44 business cycle 83
assets 134 Business Cycle Dating
A AT&T 514 Committee 300
AAPL (Apple) 468 audit committee (AC) 48 Business finance 8
accounting equation 105, 134
Accounting Standards Update B C
No. 2014-09 110 bad debt expense 581 C corporation 42
accounts receivable aging balance sheet 536 Cabela’s 184
schedule 581 Bank of America Merrill Lynch call option 609
accounts receivable turnover 22 Call risk 302
ratio 168 Banking Act of 1935 10 capital 508
accrual basis 144 bankruptcies 580 capital asset pricing model
accrual-basis accounting 102 bar graph 400 (CAPM) 461
acid-test ratio 172 Bass Pro Shops 184 capital budgeting 479
after-tax cost of debt 510 benchmarking 574 capital employed 325
agency problem 50 Bennett 284 capital gain yield 450
Agency theory 52 Berkshire Hathaway 332 capital gains 304
agent 50 Berkshire Hathaway (BRK) 373 capital investments 269
AIG 47 Bernard L. Madoff Investment capital market 27
Alibaba 177 Securities LLC 52 Capital structure 9, 508
allowance for doubtful best-fit linear regression model capitalize 112
accounts 581 427 CAPM 464
Alphabet (Google) 359 beta 432, 463 Carnival Cruises 304
Amazon 21, 43, 180, 327, 332, Big 5 Sporting Goods 540, 542 Carrying costs 584
341, 359 bill of lading 576 cash basis 144
Amazon (AMZN) 178 Billion Prices Project 78 cash budget 577
American Airlines 67, 507, 514, Billions 9 cash conversion cycle 570
515, 599 Biogen 332, 341 cash cycle 570
American Express 579 Bivariate data 403 cash deficit 551
American Institute of Certified BlackRock 356 cash discounts 576
Public Accountants (AICPA) 110 Blue Ribbon Companies 49 cash flow 264
American options 609 Bluebonnet Industries 509 cash forecast 550
American Superconductor board of directors 44 cash rate 298
Corporation 169 bond call 306 cash ratio 173
amortization 323 bond laddering 305 cash surplus 551
AMZN (Amazon) 467 Bond price 287 cash-basis accounting 102
annual meeting 55 bond ratings 302 Cavallo 78
annual report 54 bond returns 369 CDs 354
annuity 231 Book value per share 181 Census Bureau 79
annuity due 234 Brazil 604 CEO 47
Apple 179, 359, 508 British 608 certificate of deposit (CD) 384
624 Index

ceteris paribus 68 COVID-19 179, 300, 458, 495, discount window 355
CFO 14 545, 565, 600 discounted cash flow (DCF) 341
Chapter 11 bankruptcy 121 CPI Inflation Calculator 77 discounted payback period 489
Chicago Board of Trade 603 CPI, 403 Disney 450
Chicago Mercantile Exchange credit 106 Diversifiable risk 13
603 Credit analyst 19 diversification 458
chief financial officer 14 credit period 576, 581 dividend 323
chief financial officer (CFO) 47, credit rating 572 dividend discount model
423 credit risk 88, 301 (DDM) 325
Chris’s Landscaping 104 Credit Suisse 374 Dividend yield 323, 450
City of Chicago 285 credit terms 580 dividends 138
Clear Lake Sporting Goods 129, Cuban 263 DJIA 431
167, 536 Current assets 135, 566 Domestic corporation 44
Close (closely held) corporation Current liabilities 136 double-entry accounting 104
44 current ratio 172 Dow 30 28, 370
Cloud storage 17 CVS 455, 456 Dow Jones Company 569
CME Group Inc. 603 CVS Health Corp. (CVS) 454, 456 Dow Jones Industrial Average
Coca-Cola 293, 439, 514, 515 CVS Pharmacy (CVS) 178 (DJIA) 28, 370, 399, 431
Commercial paper (CP) 26, 354 Dun & Bradstreet 569, 573
common stock 319 D DuPont method 183
common-size 539 DAL 456 duration 301, 615
comparable company analysis Damodaran 185, 367, 368, 369, Duration risk 301
(comps) 323 371, 372, 522
compensating balances 578 Danko 228 E
compounding interest 218 Data digitization 17 E-Trade 22
compounding period 218 Data visualization 400 e-trail 17
comptroller 14 days’ sales 167 earnings per share (EPS) 321
conference call 55 Days’ sales in inventory 171 Earnings per share (EPS) 176
conflicts of interest 49 dealers 22 EBIT 324
constant perpetuity 229 debenture 358 EBITDA 133
consumer price index (CPI) 77, debit 106 EBITDA (earnings before
217, 357, 363, 403 debt-to-assets ratio 174 interest, taxes, depreciation, and
Consumer Price Index for All debt-to-equity ratio 175 amortization) 177
Urban Consumers: All Items deep discount bonds 288 Economic exposure 90
(CPIAUCSL) 78 default 286 Economic risk 607
contra-asset 581 Default risk 13, 301 Economic value 30
conversion price 528 Delta Airlines 304 Economics 23
conversion ratio 528 Delta Airlines (DAL) 451, 455, EDGAR (Electronic Data
Convertible bonds 286, 528 456 Gathering, Analysis, and
core inflation index 77 Demand 68 Retrieval system) 57
corporate charter 44 demand curve 68 EDGAR system 58
Corporate Finance Institute 580 Democrats 24 effective annual rate (EAR) 451
Corporate governance 47, 48 Department of Commerce 82 effective interest rate 243
corporation 40 depreciated 605 efficiency ratios 167
Correlation 418 Depreciation 114, 131, 323 EMC Corporation 270
Correlation analysis 417 derivative 609 empirical rule 399
correlation coefficient 419 direct method 144 Enron 51, 303
Costa Rica 607 discount bond 296 Enterprise value (EV) 324
Coupon payment 284 discount period 576 enterprise value (EV) multiples
Coupon rate 284 discount rate 214, 235 323

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 Index 625

equal annuity approach 493 financial distress 521 Giving Pledge 370, 374
Equifax 240 Financial examiner 19 Glass-Steagall Act (1933) 10
Equifax Small Business 573 Financial Industry Regulatory global markets 57
equilibrium 72 Authority (FINRA) 10 Goodyear Tire and Rubber 514
equilibrium price 72 financial instrument 196 Google 327, 332, 341
equity multiples 323 financial intermediary 22 Gordon growth model 326
European options 609 financial leverage 508 Governmental Accounting
European Union 608 Financial manager 18 Standards Board (GASB) 102
Excel 203, 264, 273, 399, 496, Financial markets and Graham 373
553, 587 institutions 10 graphic user interface (GUI)
exchange rate 604 financial risk 196 406
exchange-traded funds (ETFs) financing activities 538 Great Depression 10
9, 354, 356 firm-specific risk 460 Great Recession 367
exercising 609 Fisher effect 217 Gross 369
expansion 83 Fitch 358 gross domestic product 219
expected value 397 fixed-income securities 302 Gross domestic product (GDP)
expense 102 floating-rate bonds 287 80
expense recognition 111 floor planning 575 gross working capital 566
expenses 130 Florence 608 growing perpetuity 229
Experian 240 flotation costs 526 growth rate 195, 326
Experian Business 573 Foley 17
expiration date 609 Ford 304 H
exponential distribution 395 Ford Motor Company 579 Harding 24
extreme values 383 forecast 535 hedging 601
ExxonMobil (XOM) 456 Foreign corporation 44 Helu 353
Form 10-K 55, 578 Hewlett-Packard 42
F Fortune 49 histogram 401
Facebook 21, 327, 341, 359 Fortune 500 425, 434 holding period percentage
Facebook (FB) 451 forward contract 608 return 451
factoring 575 FRED 91 Houston 604
FASB (Financial Accounting free cash flow 147 hybrid form of business 42
Standards Board) 144 Free cash flow (FCF) 148
federal funds 26, 355 frequency distribution 392 I
Federal Reserve 217, 355, 355 future value 267 IBM 514
Federal Reserve Bank of New future value (FV) 193 IEI 356
York 354 futures contract 603 in inventory 167
Federal Reserve Economic Data income statement 130, 536
(FRED) 91 G income statement (net income)
Federal Reserve funds rate GAAP 102 104
(federal funds rate) 288 gains 104, 130 Indenture 357
Federal Reserve System (the Gates 370, 374 index 93
Fed) 292 GDP 81 indirect method 144
Fidelity 355 GDP deflator 77 individual retirement accounts
Fidelity Investments Inc. 459 general obligation (GO) bonds (IRAs) 9
Finance professor 19 357 inflation 76, 78, 215, 356
Financial Accounting Standards Generally Accepted Accounting Inflation risk 13
Board (FASB) 102 Principles (GAAP) 57, 166, 583 initial public offering 360
Financial analyst 19, 166 geometric average return 452 initial public offerings (IPOs) 21
financial calculator 388, 421 geometric mean 384 Insurance underwriter 19
financial crisis of 2008 355 Germany 608 intangible assets 322
626 Index

intercept 431 (LLP) 42 mode 384

interest 192 linear correlation 420 modified internal rate of return
interest income 287 linear regression 418 (MIRR) 489
interest rate risk 301 liquid asset 216 Modigliani 517
interest tax shield 520 Liquidity 43, 172, 566 money market 25
internal rate of return (IRR) 486 Liquidity risk 301 money market investments 218
Internal Revenue Service 103 Loan amortization 240 money market mutual funds
International Federation of Loan officer 19 (MMMFs) 354
Accountants (IFAC) 110 London 608 money market securities 25
International Financial Reporting London Interbank Offered Rate money supply 217
Standards (IFRS) 54, 57, 57, 102 (LIBOR) 288, 616 MoneyWeek 284
internet 121 long-term asset 111 Monster Beverage 341
interquartile range (IQR) 391 loss 130 Moody’s 358
intrinsic value 326 losses 104 Morgan Stanley 22
Inventory turnover 170 lower-volatility investments 396 mortgage bond 358
investing activities 538 lump sum 233 mortgage loan 240
investment 192 LUV 456 municipal bonds (“munis”) 27,
investment grade 302 286
Investment relations associate M municipal bonds (munis) 357
18 Macroeconomics 76 mutually exclusive projects 491
Investments 9 Malkiel 360
Investopedia 177 management discussion and N
investor 41 analysis (MD&A) 157 NASDAQ 360
investor relations (IR) 54 margin 603 National Bureau of Economic
iPhone 25 market capitalization 322 Research (NBER) 84
Italy 608 market risk premium 464 natural hedge 608
market value ratios 176 Negotiable certificates of deposit
J Market Watch 177 (NCDs) 26, 354
Japan 92, 94 marketable securities 566 Net book value 322
Jensen’s alpha 466 MarketWatch 464, 514 net debt 516
Johnson & Johnson 358 marking to market 603 net income 102, 132
junk bonds 286 Massachusetts Institute of net present value (NPV) 482
just-in-time inventory 572 Technology 78 Net terms 576
MasterCard 11, 579 net working capital 567
K Maturity date 285 Netflix 521
KB Homes 514, 515 McDonald’s Corporation 119 New York 604
Khan Academy 143 McKinley Investment New York Stock Exchange
Korean 607 Management 465 (NYSE) 360
Kraft Heinz 514, 515 McKinsey & Company 495 NFLX (Netflix) 468
Kroger 514, 515 median 383 Nike 21, 404, 418
method of least squares 426 nominal interest rate 87
L Mexican peso 89 Non-diversifiable risk 13
law of demand 68 Mexico 90 Non-stock corporation 44
letter of credit 576 Miami 604 noncash expenses 144
levered equity 517 microeconomics 68 noncurrent assets 135
liabilities 134 Microsoft 42, 155, 358, 359, 514 Noncurrent liabilities 136
limited liability corporation Microsoft Suite 17 Nonprofit corporation 44
(LLC) 42 Miller 517 NOPAT (net operating profit
limited liability partnership mixed stream 264 after taxes) 177
MM Proposition I 517 normal distribution 394

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 Index 627

O price-to-sales (P/S) ratio 323 revenue recognition 108

Obama 24 price/earnings (P/E) ratio 181 Revolving lines of credit
Occidental Petroleum 304 primary market 21, 360 (revolvers) 239
operating activities 538 prime rate 288 Rigobon 78
operating cycle 168, 574 principal 50 Risk Management Association
opportunity cost 221, 577 pro forma 14, 544 (RMA) 569
option 609 probability distribution 397 risk premium 462
option writer 610 producer price index (PPI) 77 risk-free rate 462
Ordering costs 584 Professional corporation 44 Robinhood 22
ordinary annuity 231 Profit margin 182 Rome 608
outliers 383 profitability index (PI) 488
over-the-counter (OTC) market Public benefit corporation 44 S
359 Public Company Accounting S corporation 42
owner’s equity 142 Oversight Board 47 S&P 500 181, 399, 405, 418
put option 609 S&P Global Ratings 358
P Sam’s Sporting Goods 479
P/E TTM 181 Q sample data 382
Par value 284 quarterly 54 Sarbanes-Oxley Act (SOX) 47
partnership 41 quartiles 391 Savings bonds 286
payback period 480 quick payment 576 scatter diagram 418
payday advance loan (PAL) 245 quick ratio 172 scatter plot 404, 418
PayPal 11 scenario analysis 552
Peloton 17, 458 R seasoned equity offering (SEO)
PepsiCo 49 R 438 360
percentiles 391 R statistical analysis tool 406 seasoned equity offerings
perpetuity 228, 326 rating agencies (bond rating (SEOs) 21
Personal financial advisor 19 services) 302 Seattle 604
Personal lines of credit 240 ratios 568 secondary market 21, 360
Political risk 13 real interest rate 87 secondary markets 320
Ponzi scheme 52 real interest rates 217 secretaries of state 44
population data 382 realized return 305, 450 secured personal loan 240
portfolio 396, 458 recession 84 Securities Act of 1933 10, 47
pound 609 Refund anticipation loans Securities and Exchange
PR Newswire 56 (RALs) 245 Commission (SEC) 10, 22, 47,
precautionary motive 577 Regression analysis 417 102, 157
precedent transaction analysis Reinvestment risk 302 Securities Exchange Act of 1934
(precedents) 323 Renaissance Capital 361 10, 47
prediction 425 replacement chain approach Securities Investor Protection
preferred stock 228, 343, 523 492 Corporation (SIPC) 10
premium 610 report 54 Sensitivity analysis 553
premium bond 296 Republicans 24 shareholders (stockholders) 42
present value 267 required rate of return 228 Shark Tank 263
present value (PV) 195 required return 326 Sharpe 465
press release 55 residual 425 Sharpe ratio 465, 465, 465, 465
price-to-book (P/B) ratio 322 retained earnings 137 shelf registration 360
price-to-cash-flow (P/CF) ratio retirement planning 238 Siegel 362
323 Return on equity 183 Simmons 270
price-to-earnings (P/E) ratio return on total assets 182 single payment or lump sum
320 revenue 102, 130 197
revenue bonds 357 slope 431
628 Index

Sochi, Russia 491 Target Corporation 578 US Securities and Exchange

sole proprietor 40 Tellurian Inc. (TELL) 178 Commission (SEC) 354
Solvency 174 Tennessee Energy 285 US Treasury bills (T-bills) 286
South Korean 607 Term loans 239 US Treasury bonds 513
Southwest Airlines (LUV) 456 Term risk 302 US Treasury note rate 288
Spain 608 Tesla 508 US Treasury securities 513
Special purpose acquisition Texas Instruments BAII Plus™ US Treasury Securities 462
companies (SPACs) 361 Professional 197
Speculating 601 The Great Recession of V
speculative motive 577 2007–2009 10 Vanguard 355
spot exchange rate 89 time series graph 403 Variance 386
spot rate 609 time value of money (TVM) 192 Venice 608
SPY 470 times interest earned (TIE) Venmo 11
stacked area graph 91 ratio 176 vertical integration 603
stakeholder 44 Tokyo Olympics 504 vice president of finance (VP-F)
Standard & Poor’s 500 stock Total asset turnover 170 14
market index 418 total returns 366 video conferencing 17
Standard and Poor’s 358 trade credit 575 Vietnamese producers 607
standard deviation 385 Trade-off theory 521 VISA 579
Stanley 227 transaction exposure 90
Starbucks Corporation 600 Transaction risk 605 W
State Street Global Advisors transactional motive 577 Wall Street 9
470 translation exposure 90 Wall Street Journal (WSJ) 24
statement of cash flows 133, translation risk 607 Walmart 359
536 TransUnion 240 Walmart Stores Inc. 574
statement of stockholders’ treasurer 14 Walt Disney Company 142
equity 536 Treasury bills (T-bills) 26, 354 weighted average cost of capital
stock buyback 179 Treasury bonds 27, 357 (WACC) 509
Stock corporation 44 Treasury Inflation-Protected weighted mean 384
stock market crash of 1929 10 Securities, or TIPS 357 Williams 263
stock returns 370 Treasury investments 196 Wilshire US Small-Cap Index
stock value 321 Treasury notes 27 371
Stockout costs 584 Treasury notes (T-notes) 356 working capital 566
strike price (exercise price) 609 Treynor ratio 465 Working capital management 9
structured settlements 235 Trump 24 World Bank 80, 359
Student loans 240 WorldCom 121
subscriber 45 U
Super Display Book (SDBK) 346 underinvested 217 X
Supply 70 unemployed 79 x-axis 400
supply chain 583 uninvested 217 XOM 456
supply curve 71 United Airlines 398
swap 616 United States 94 Y
Switzerland 94 Universal Trading Platform 346 y-axis 400
systematic risk 460 unlevered equity 517 Yahoo! Finance 178, 464, 514
unsecured personal loan 240 Yellen 365
T US Bureau of Economic yield curve 297
T-account 106 Analysis 82 Yield to maturity (YTM) 285
T-Mobil 304 US Department of Labor 79
tangible asset 112 US Department of the Treasury
Target (TGT) 450 462

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 Index 629

Z z-value 390
z-score 390 zero-coupon bonds 286