КФ / Лекции / Brealey Myers - Principles Of Corporate Finance 7th Ed (eBook)

since preferred dividends are fixed, the prices of preferred shares change when long-term interest rates change. A $1 million investment in preferred shares could be worth only $900,000 on April 15, when taxes are due. Wouldn’t it be nice if someone invented a preferred share that was insulated from fluctuating interest rates?

Well, there are such securities, and you can probably guess how they work: Specify a dividend payment which goes up and down with the general level of interest rates.28 The prices of these securities are less volatile than those of fixed-dividend preferreds.

Varying the dividend payment on preferred stock doesn’t quite do the trick. For example, if investors become more concerned about the risk of preferred stock, they might demand a higher relative return and the price of the stock could fall. So companies sometimes add another wrinkle to floating-rate preferred. Instead of being tied rigidly to interest rates, the dividend can be reset periodically by means of an auction which is open to all investors. Existing shareholders can enter the auction by stating the minimum dividend they are prepared to accept; if this turns out to be higher than the rate that is needed to sell the issue, the shareholders sell the stock to the new investors at its face value. Alternatively, shareholders can simply enter a noncompetitive bid, keeping their shares and receiving whatever dividend is set by the other bidders. The result is similar to the variable-rate demand note: Because auction-rate preferred stock can be resold at regular intervals for its face value, its price cannot wander far in the interim.29

Why would any firm want to issue floating-rate preferreds? Dividends must be paid out of after-tax income, whereas interest comes out of before-tax income. Thus, if a taxpaying firm wants to issue a floating-rate security, it would normally choose to issue floating-rate debt to generate interest tax shields.

However, there are plenty of firms that are not paying taxes. These firms cannot make use of the interest tax shield. Moreover, they have been able to issue floatingrate preferreds at yields lower than what they would have to pay on a floating-rate debt issue. (The corporations buying the preferreds are happy with these lower yields because 70 percent of the dividends they receive escape tax.)

Floating-rate preferreds were invented in Canada in the mid-1970s, when several billion dollars’ worth were issued before the Canadian tax authorities cooled off the market by limiting the dividend tax exclusion on some types of floating-rate issues. They were reinvented in the United States in May 1982, when Chemical New York Corporation, the holding company for Chemical Bank, raised $200 million. The securities proved so popular that over $4 billion of floating-rate preferreds were issued by the following spring. Then the novelty wore off, and the frequency of new issues slowed down. It was back to business as usual, with one important exception: There was one more item on the menu of investment opportunities open to corporate money managers.

28Usually there are limits on the maximum and minimum dividends that can be paid. Thus if interest rates leap to 100 percent, the preferred dividend would hit a ceiling of, say, 15 percent. If interest rates fall to 1 percent, the preferred dividend would hit a floor at say, 5 percent.

29See M. J. Alderson, K. C. Brown, and S. L. Lummer, “Dutch Auction Rate Preferred Stock,” Financial Management 16 (Summer 1987), pp. 68–73.

In the United States a high proportion of small purchases are paid for by check. To SUMMARY make the best use of their cash, companies need to understand how a company’s

cash changes when it writes or deposits a check. The cash shown in the company’s ledger is not the same as the available balance in your bank account. The difference is the net float. When you have written a large number of checks awaiting clearance, the available balance will be larger than the ledger balance. When you have just deposited a large number of checks that have not yet been cleared by the bank, the available balance will be smaller. If you can predict how long it will take checks to clear, you may be able to play the float and get by on a smaller cash balance.

You can also manage the float by speeding up collections and slowing down payments. One way to speed collections is to use concentration banking. Customers make payments to a regional office which then pays the checks into a local bank account. Surplus funds are transferred from the local account to a concentration bank. An alternative technique is lock-box banking. In this case customers send their payments to a local post office box. A local bank empties the box at regular intervals and clears the checks. Concentration banking and lock-box banking reduce mailing time and the time required to clear checks.

Large-value payments are almost always made electronically. In the United States there are two large-value systems—Fedwire (for dollar payments within the country) and CHIPS (for cross-border payments). Bulk payments, such as wages and dividends, are usually made by means of the Automated Clearinghouse (ACH) system.

Banks provide many services. They handle checks, manage lock boxes, provide advice, obtain references, and so on. Firms either pay cash for these services or pay by maintaining sufficient cash balances with the bank.

In many cases you will want to keep somewhat larger balances than are needed to pay for the tangible services. One reason is that the bank may be a valuable source of ideas and business connections. Another reason is that you may use the bank as a source of short-term funds. Leaving idle cash at your bank may be implicit compensation for the willingness of the bank to stand ready to advance credit when needed. A large cash balance may, therefore, be good insurance against a rainy day.

Cash provides liquidity, but it doesn’t pay interest. Securities pay interest, but you can’t use them to buy things. As financial manager you want to hold cash up to the point where the marginal value of liquidity is equal to the interest that you could earn on securities.

Cash is just one of the raw materials that you need to do business. It is expensive keeping your capital tied up in large inventories of raw materials when it could be earning interest. So why do you hold inventories at all? Why not order materials as and when you need them? The answer is that it is also expensive to keep placing many small orders. You need to strike a balance between holding too large an inventory of cash (and losing interest on the money) and making too many small adjustments to your stock of cash (and incurring additional administrative and transaction costs). If interest rates are high, you want to hold relatively small inventories of cash. If your cash needs are variable and your costs are high, you want to hold relatively large inventories.

If you have more cash than is currently needed, you can invest it in the money market. There is a wide choice of money-market investments, with different

906PART IX Financial Planning and Short-Term Management

d.Suppose that the use of remote banks had involved Merrill Lynch in extra expenses. What was the maximum extra cost per check that Merrill Lynch would have been prepared to pay?

8.The processing cost of making a payment through the ACH system is roughly half the cost of making the same payment by check. Why, therefore, do firms often rationally choose to make payments by check?

9.How would you expect a firm’s cash balance to respond to the following changes?

a.Interest rates increase.

b.The volatility of daily cash flow decreases.

c.The transaction cost of buying or selling marketable securities goes up.

10.A firm maintains a separate account for cash disbursements. Total disbursements are $100,000 per month, spread evenly over the month. Administrative and transaction costs of transferring cash to the disbursement account are $10 per transfer. Marketable securities yield 1 percent per month. Determine the size and number of transfers that will minimize the cost of maintaining the special account.

11.Suppose that the rate of inflation accelerates from 5 to 10 percent per year. Would firms’ cash balances go up or down relative to sales? Explain.

12.Suppose that interest rates double.

a.What, according to the Baumol model, would happen to the firm’s average cash balances?

b.Recalculate the gain from operating the lock-box system described in Section 31.1 given the new level of interest rates.

13.A three-month Treasury bill and a six-month bill both sell at a discount of 10 percent. Which offers the higher annual yield?

14.In Section 31.3 we described a six-month bill that was issued on an annually compounded yield of 5.19 percent. Suppose that one month has passed and the investment still offers the same annually compounded return. What is the percentage discount? What was your return over the month?

15.Look again at question 14. Suppose another month has passed, so the bill has only one month left to run. It is now selling at a discount of 5 percent. What is the yield calculated on a simple interest basis? What was your realized return over the two months?

16.Look up current interest rates offered by short-term investment alternatives. Suppose that your firm has $1 million excess cash to invest for the next two months. How would you invest this cash? How would your answer change if the excess cash were $5,000, $20,000, $100,000, or $100 million?

17.In February 2002 high-grade corporate bonds sold at a yield of 5.89 percent, while taxexempts of comparable maturity offered 3.99 percent annually. If an investor receives the same after-tax return from corporates and tax-exempts, what is that investor’s marginal rate of tax? What other factors might affect an investor’s choice between the two types of securities?

18.The IRS prohibits companies from borrowing money to buy tax-exempts and also deducting the interest payments on the borrowing from taxable income. Should the IRS prohibit such activity? If it didn’t, would you advise the company to borrow to buy taxexempts?

19.Suppose you are a wealthy individual paying 39.1 percent tax on income. What is the expected after-tax yield on each of the following investments?

a.A municipal note yielding 6.5 percent pretax.

b.A Treasury bill yielding 10 percent pretax.

c.A floating-rate preferred stock yielding 7.5 percent pretax.