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Journal of Law and Financial Management - Volume 13 (1) June 2014

Editorial »

Measuring the Effects of Non-Cash Investing & Financing Activities

By Charles W Mulford & Husbert Nicholson

In this study, for a sample of 120 companies, we identify and recast the statement of cash flows for the implied cash effects of six general categories of non-cash activity, transactions affecting 1) capital expenditures and operating activities, 2) capital expenditures and other investing activities, 3) capital expenditures and financing activities, 4) other investing activities and operating activities, 5) other investing activities and financing activities, and 6) financing activities and operating activities. We focus on the implied cash effects of two key non-cash activities from category three, debt issued for capital assets and capital lease financing of capital assets. These are transactions that directly affect capital expenditures and free cash flow. When revising the statement of cash flows to include the implied cash effects of these two non-cash transactions, we find a reduction in free cash flow in 62 instances for a median amount that comprised 2.8% of reported free cash flow. Among the 62 firms, 24 saw free cash flow decline by more than 5%, 16 by more than 10% and 9 by more than 25%. In a paired t-test, adjusted free cash flow was significantly less than reported free cash flow at the .00 level.

Given the importance of non-cash capital expenditures to calculations of free cash flow, the FASB may wish to revise its stance regarding the exclusion of all non-cash activities from the statement of cash flows. As to analysts and investors, in the absence of changes to the reporting of non-cash activities, such users of financial statements will want to ensure that such non-cash activities are given explicit consideration when analysing financial results.

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Can Naughty Be Nice for Investors: A Multi-Factor Examination of Vice Stocks

By Greg M Richey

This article examines the return characteristics of a portfolio of US 'vice stocks', firms that manufacture and sell socially irresponsible products such as alcohol, tobacco, gaming services and national defense. First of all, I construct a portfolio using the daily returns of 41 vice stocks over the period October 2007 to October 2013 and find the Jensen's alpha (CAPM), Fama-French Three Factor and Carhart Four-Factor results for the entire portfolio, the entire portfolio during bear and bull markets, and each vice industry individually. Full-period results show a positive, yet insignificant alpha for the entire portfolio and each vice industry. Bear market results show a positive and significant alpha for the entire portfolio as well as for all industry portfolios except the tobacco industry. Bull market results for the portfolio are less conclusive with a significant alpha only in the three and four-factor models.

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Impact of the Maturity and Source of the Risk-Free Rate in Equity Estimation Under the CAPM

By Colin Cannonier, Gregory Faulk & Joseph Smolira

There is divergence of opinion among academics and practitioners on the appropriate maturity and source of the risk-free rate when applying the Capital Asset Pricing Model (CAPM). For projects with betas near one, this divergence should be immaterial. What is not clear is how far project betas can diverge from one before these differences become significant. This cannot be readily ascertained perusing risk-free rate and market risk premium values published in textbooks and research since different data sets are used. Using standardised, readily available data sets and employing the methodologies proposed by three popular corporate finance textbooks, the results of this paper indicate that, except for a very narrow set of circumstances for betas near one, different risk-free rate maturity and source choices can significantly impact project selection via expected equity returns. However, even though statistically significant, for a given data source (current/historical) the maturity choice is well within cost of capital estimation variation expected by practitioners. For a given term, more variation occurs across source selection. Since the practitioner may have to justify the input parameters used for estimating equity costs for capital budgeting projects, this study focuses on the empirical consequences of choosing a particular set of CAPM input parameters over alternatives.

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