Corporate Financial Policy and R&D Management Second Edition JOHN B. GUERARD JR. John Wiley & Sons, Inc. Corporate Financial Policy and R&D Management Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com. Corporate Financial Policy and R&D Management Second Edition JOHN B. GUERARD JR. 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Library of Congress Cataloging-in-Publication Data: ISBN-13 978-0-471-45823-4 ISBN-10 0-471-45823-6 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 Contents Preface ix About the Author xi CHAPTER 1 Corporate Financial Policy and R&D Management 1 CHAPTER 2 An Introduction to Financial Statements 3 The Balance Sheet 3 Assets 4 Liabilities and Capital 10 Current Liabilities 10 Long-Term Debt 11 Capital Section of the Balance Sheet 12 Book Value of Common Stock 14 Consolidated Balance Sheets 14 The Operating Statements: The Income Statement and Sources and Uses of Funds 18 Sources and Uses of Funds 24 CHAPTER 3 Ratio Analysis 31 Ratio Analysis and the Firm’s Perceived Financial Health 31 Current Analysis Ratios 32 Leverage Ratio 33 Sales Efficiency Ratio 34 Profitability Ratios 34 Financial Ratios and the Perceived Financial Health of Firms 35 Time Series of Ratios in the United States, 1970–2003 37 Limitations of Ratio Analysis 38 v vi CONTENTS CHAPTER 4 Debt, Equity, Financial Structure, and the Investment Decision 41 Definition of Leverage—Profits and Financial Risk 42 The Pure Theory of the Optimal Financial Structure 44 Modigliani and Miller—Constant Capital Costs 46 The Optimal Capital Structure and the M&M Hypothesis 48 Empirical Factors Influencing Financial Structures 49 Cost of Capital 50 Real Options and the Investment Decision 53 Abandonment Value 54 Option to Delay a Project 66 Implications of Viewing the Right to Delay a Project as an Option 67 CHAPTER 5 An Introduction to Statistical Analysis and Simultaneous Equations 69 The Linear Regression Model 71 Multiple Regression 79 Least Squares Estimates of the Regression Coefficients 80 Multiple Coefficient of Determination 81 Estimation of Simultaneous Equations Systems 82 Estimation of Parameters in Multiple Equation (Regression) Models 84 Two-Stage Least Squares (2SLS) 86 Three-Stage Least Squares (3SLS) 89 The Three-Stage Least Squares Estimator 89 CHAPTER 6 Interdependencies among Corporate Financial Policies 93 The Model 94 The Data 178 Estimated Simultaneous Equations Results 178 CHAPTER 7 Comparing Census/National Science Foundation R&D Data with Compustat R&D Data 181 Innovation, R&D, and Stockholder Wealth 182 Financial Decision Estimation Results 183 Comparison of R&D Expenditure Data 186 Comparison of Regression Results 188 Relation of Current Results to Prior Research 193 Extensions of the Simultaneous Equations Approach 195 Contents vii Summary and Conclusions 197 Suggestions for Future Research 198 CHAPTER 8 The Use of Financial Information in the Risk and Return of Equity 201 Introduction to Modern Portfolio Theory 209 Determinants of Stock Selection Models 212 Further Estimations of a Composite Equity Valuation Model 213 Appendix 8.A: Multifactor Risk Models 218 BARRA Model Mathematics 219 Risk Prediction with Multiple-Factor Models 220 Appendix 8.B: US-E3 Descriptor Definitions 227 Volatility 227 Momentum 229 Size 229 Size Nonlinearity 229 Trading Activity 229 Growth 230 Earnings Yield 232 Value 232 Earnings Variability 233 Leverage 233 Currency Sensitivity 234 Dividend Yield 235 Non-Estimation Universe Indicator 235 CHAPTER 9 The Optimization of Efficient Portfolios: How the R&D Quadratic Term Enhances Stockholder Wealth 237 Efficient Portfolio Optimization Results 238 CHAPTER 10 The (Not So Special) Case of Social Investing 249 Stock Selection in Unscreened and Screened Universes 253 Stock Selection and the Domini Social Index Securities 258 Recent Socially Responsible Research 258 Summary and Conclusions 259 CHAPTER 11 R&D Management and Corporate Financial Policy: Conclusions 261 Exercises 263